More on Par Policies a.k.a. “Participating Whole Life Insurance”

Introduction

This article continues the conversation begun in my last article on Par Policies.  For those of you who haven’t read it or have quickly repressed the details from your memory, here’s a brief recap.  Par Policies are a type of permanent life insurance that allows policyholders to reap some of the insurance company’s rewards in exchange for taking on some of its risks.  You take on these risks by paying a higher initial premium.  The insurer doesn’t  expect its costs each year to be as high as it assumed when calculating your premium, so policyholders typically get some of their extra premium dollars back each year through something called a “policy dividend.”  How much do you get back?  This is stated as a percentage and is called the “dividend scale.”  I’ll now talk a bit more about this delightful thing and will see where the conversation goes from there.

More on the Dividend Scale

Insurers generally provide a historical listing of their dividend scale over time and, in today’s investment climate, the numbers look pretty impressive.  Currently, the dividend scales I have seen from Canadian companies range between just under 7% and a bit over 5.5%,  although I don’t pretend that this is an exhaustive list.  Interestingly enough, insurers are quick to point out that the current rates are considerably lower than the historical averages.   On the other hand, as described further in the next section, since the investment returns are interest rate sensitive, further declines in the years to come are likely possible, especially if interest rates stay low.  In fact, many insurers have decreased their dividend scales over the last few years, although these changes are generally done in small increments.

The gaudy numbers mentioned above might make some of you wonder why Par Policies ever fell out of public favour.  Briefly, here are a few reasons (or at least plausible theories):

•   Although today’s dividend scale looks pretty attractive, it didn’t look so attractive in the past in times of higher interest rates and a booming stock market.

• Demutualization of some of the big insurance companies.  When insurance companies were owned by the policyholders (i.e. “mutual insurance companies”), the policyholders’ best interests and the company’s best interests were the same thing.  When the companies changed their ownership structure, traded on the stock market and were owned by shareholders instead of policyholders, it became the companies’ responsibility to satisfy shareholders.  It is arguable that insurance companies then directed their focus to promoting other types of insurance policies that generated greater profits and which they didn’t have to share with policyholders.  In fact, some companies stopped offering Par Policies for several years. I have heard different stories on the pricing of more recent Par Policies compared to old school versions.  In some circles, I’ve heard advisors claim that the older policies had more features and better pricing.  On the other hand, an advisor friend of mine from Sun Life named Gordon Mayede actually did a comparison of old and new policies to show that the costs really haven’t changed.

• The mystery of how the dividend scale is calculated and how Par Policies work. Perhaps some people simply wanted a more transparent type of policy that was easier to understand.

• Universal life insurance policies.  For many years, Canadian insurance companies seemed to focus most of their energy on selling universal life insurance policies and clients became excited at the possibility of reaping substantially higher investment returns on UL Policies.  UL Policies also offered a lot more flexibility than par products, allowed clients the ability to choose how their excess contributions were invested and whose investment returns were easier to understand.  Of course, when the stock markets tumbled and the value of funds within many UL Policies also plummeted, many people look at insurance decided to return to the safe shores of Par Policies, where policy dividends taken as “paid up additions” inside the policy were protected against subsequent losses while still earning additional dividends for policyholders.

How Insurance Premiums are Invested

In many ways, an insurer’s investment portfolio is a lot like an income fund.  It is designed to provide a diversified stream of income that should grow in value steadily overtime while minimizing the risks of significant investment losses.  In fact, our government mandates what type of investments insurers can select and the maximum percentage of each type it can hold.  Generally, the money is invested in different types of bonds, real estate, mortgage, private loans and a relatively small portion of equities, including preferred shares.

Our government has mandated these limits in order to reduce the chances of insurers suffering huge investment losses and being unable to pay out the death claims.  This rationale also takes into account that the portfolios need to continue generating income along the way to pay death claims, while also ensuring that the underlying capital retains its value if more redemptions than expected are required, even during a down market.

Want more information on the underlying investments for each insurance company’s Par Policies?  Although most insurers don’t readily list the exact holdings of their portfolio, they do provide a general breakdown on how the money has been invested on a percentage basis.

One final thought on this subject.  As you might expect when looking at the type of investments it owns, an insurer’s investment returns are generally lower during times of low interest rates (although they may still benefit on the real estate side since low rates can increase property values and decrease mortgage costs on the portfolio’s real estate holdings.)  Generally, decreases to the dividend scale lag decreases in interest rates by a few years.  One reason for this is the money set aside by insurers to “smooth” returns in bad years.  Secondly, because insurers may already own a variety of interest rate sensitive investments that gradually come due over time, it might take several years of low rates to significantly impact the performance as a whole.  Ultimately, it appears that Par Policies are able to maintain their current payouts longer than some other investments during times of low interest rates. On the other hand, for the same reasons, they may be slower to increase the payout during rosier economic times.

Policy Dividends

Now that you are (hopefully) more familiar with the dividend scale and how policy dividends are calculated, let’s investigate your choices on how to direct your policy dividends and the tax consequences that go along with each choice.

To begin, policy dividends are a completely different kettle of fish for tax purposes than dividends that are paid out by public and private companies to their shareholders.  More specifically, policy dividends do not qualify for either the enhanced or the small business dividend tax credits.   The taxable portion of any policy dividend is taxed as income.  How and if you are taxed on policy dividends depends on what you elect to do with them.  Some of your options and choices are as follows:

• Receiving them as cash.  Either you will be taxed on them as income (with no dividend tax credit) or you will get them tax-free.  This depends on something known as the “adjusted cost basis” of the policy.  This is a calculation that takes into account all the premiums you’ve paid and subtracts things like withdrawals (including previous policy dividends) and the “net cost of pure insurance” (which is the running total of what you would have paid in premiums if you’d paid for coverage based on your age each year rather than through a level premium.)  Fortunately, the insurance company calculates this for you and, until your adjusted cost basis reaches zero, you will be able to get your policy dividend payments tax-free.

• Depositing your dividends into a daily interest account with the insurer.  This is called having “dividends on deposit.”  It is a lot like the previous option, except that the insurance company holds onto the money for you, rather than writing you a cheque.  The tax consequences are identical to the previous option and you will also be taxed on any interest paid on the dividends that accumulates after it is transferred into the daily interest account.

• Using them to pay or reduce that year’s premiums.   As the dividends are essentially staying within the policy, they are not taxed.  If your policy dividends are large enough, you even may be able to pay all of that year’s premiums using your policy dividends. This happy event is known  as a “premium offset.”

• Purchasing additional term insurance.  This boosts up your death benefit while this extra coverage remains in force (no new medical evidence is required) and the policy dividends used in this way are not taxable.  On the other hand, since it is term coverage, this does not increase the cash value of your policy or generate additional policy dividends down the road. You may also have the option of converting some of this additional insurance into new permanent coverage.

• Permanently Increasing the Death Benefit.  This is called purchasing “paid up additions.”  Essentially, your policy dividends are used to both bump up the cash value of your policy if you want to cash it in and also permanently increases your tax-free death benefit without increasing your premium payments.  The bump up to your death benefit is a lot less than if you use the dividends to pay for term coverage, since paid up coverage costs a lot more.  Moreover, your paid up additions are also eligible to earn their own policy dividends going forward, which can further grow your death benefit and yearly policy dividend payments.  It is also great to know that once you’ve received these paid up additions, they are yours to keep, even if the company’s future returns are dreadful. 

As you might expect, it takes time for the extra money you contribute each year to participate in the insurer’s profits to reach a meaningful level.  Because of this, tax reasons and the fact that this is a long term strategy, many people initially use their policy dividends towards tax-free paid up additions.  This allows the policy to grow quicker and provides more flexibility down the road.   Although it is a wonderful thing when your policy reaches premium offset, if finances permit you may want to keep purchasing paid up additions, knowing that you can always switch to premium offset later and even withdraw some of the extra cash value created by the paid up additions.

Of course, what option is right for you depends on your current income needs and financial situation.

Conclusion

I am happy to announce that you are now 2/3rds of the way through that mysterious animal that is Par Life Insurance.  My next and final installment:

• focuses on some of the different policy options available to you:
• provides a brief explanation of how some people use Par to fund their retirement; and
• provides some practical suggestions for those of you shopping around for your dream policy.

Until then, I hope that life is treating you right and I welcome your comments, questions and suggestions.

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