With the cost of permanent insurance and even temporary insurance increasing dramatically, there is a message going around the industry that these changes are a buying opportunity for clients. Buy it before it disappears or buy before it becomes too exorbitant. Should clients follow this advice? Is this a good strategy? To be able to answer this question one must understand the true value of insurance.
The definition of value
Most people define the value of insurance in relation to one benefit such as the death benefit or the cash surrender value. I used to train advisors in understanding the true meaning of value. First the cash surrender value is what I called the liquidation value. To access the cash value of a policy you must liquidate not only your cash value position but also your death benefit position with the insurance company. Prior such liquidation isn’t it reasonable to assess the value of these two positions? The value of these positions will be dependent on internal and external factors.
The value of these 2 positions can be calculated using actuarial principles and it is done by an actuary. I call this the actuarial value of a policy. However I believe the real value of these 2 positions which determine the value of a policy is achieved by assessing its Fair Market Value. This value is based on what an unrelated and informed third party would pay to acquire your policy. This value can be calculated by a professional or insurance specialist that has the necessary expertise and knowledge to do such valuations. The actuarial value and the Fair Market Value can be different.
The cash value
You think it may be easy to value this benefit as most people view it as a number showing on a report. However the cash value is only half the story. There are benefits and features associated with this cash value. If it is a guaranteed cash value how will it increase in future years? You have to calculate its rate of growth or discounted rate and compare this rate to current guaranteed rates available in the market. Let’s assume the current guaranteed cash value is $50,000 which will increase to $100,000 in 10 years. Current 10 year rates are 4%. The discounted value of this $100,000 is therefore $67,556. This $50,000 cash value is really worth $67,556.
Another benefit that has to be accounted is the guaranteed rate of return offered by Universal Life policies. Some of these policies offer a 4% guaranteed rate of return which is tax sheltered. Outside a tax shelter this is the equivalent to a 6% to 8% guaranteed rate of return. Most clients pay minimum premium and are not maximizing this investment opportunity. Why? Is this because little commission is generated by this type of investment? This will come back to bite the industry. MTAR rules (250% rule) apply after 10 years. If you have not invested in the Universal Life policy in the first 10 years, you have lost the opportunity to invest in this policy and therefore you have lost the benefit of the 4% guaranteed.
Finally advisors should also account for various forms of bonus structures that are based on duration. The value of these bonuses should be calculated.
The death benefit
The death benefit also has a value. The question is what this death benefit is worth today. This will be based on a variety of factors. If you are uninsurable and for example you are expected to die, the value is close to the death benefit. If you are insurable, the value will be driven by the mortality differential. You bought this death benefit at a certain age and at a certain cost. Now you are older and replacing this policy would cost you more. This mortality differential will have to be discounted. For a long time, the death benefit of term policies such as Term 10 had little Fair Market Value. Term rates were falling every year and the client could buy a new Term 10 5 years later at a cheaper price than the original policy even if he was 5 year older. This has now changed.
Most permanent cost of insurance is level. This means that the actuary in calculating this cost of insurance, in addition to mortality rates, has used an interest assumption and a lapse assumption. What you must realize is if the policy was priced using an 8% interest assumption and a 2% lapse assumption and current long term rates are well below 8%, the death benefit will have a very high Fair Market Value.
Also you have to be very careful in accounting for future death benefit increases. These are worth a lot of money if they are issued without underwriting. There is a significant difference in mortality between reselect mortality and point in scale mortality.
Realizing the value of a policy
Now that you know the Fair Market Value of your policy, how can you access some of that value for your own benefit? For a long time, there were only a few people like me who try to educate advisors, lawyers and accountants on how to realize the value of an insurance policy. A lot of entrepreneurs have bought their insurance policies before they incorporated. This means they own these policies personally. These entrepreneurs have now a great advantage by being able to transfer their policy to their corporation preferably at Fair Market Value without triggering any taxable benefit. I remember how I was often accused of promoting a strategy that would fall under the anti-avoidance rule.
Later I was proven right when Revenue Canada liberalize the transfer of life insurance at Fair Market Value rule by allowing the gifting of such policies to charities at FMV. This is now another option that is now available in realizing the FMV of a life insurance policy.
A third option that is not often considered is a Shared Ownership arrangement. I had the opportunity to work in developing this concept a long time ago. This concept is usually only considered at the point of sale where 2 parties agree under a contractual arrangement to share the benefits of a life insurance policy. One usually would own the death benefit while the other party would own the cash value. Why is a Shared Ownership arrangement not considered after the policy has been issued to allow another party to take advantage of the 4% guaranteed rate of return of a Universal Life policy if the current policy owner is only paying minimum premium?
Finally viatical settlements are another option but there is no well developed and regulated market in Canada. I don’t like this option. It entitles a change of ownership to a third party where there is no insurable interest. Anyone believing in insurance is wary of speculating on life insurance policies. If we were to develop a market in Canada for life insurance policies, I believe the solution is to develop a lending market where policyowners could borrow against their life insurance based not on the cash value but on the Fair Market Value.
Lending against policies
Basically what I am talking about here is a Reverse mortgage arrangement not based on the value of the home but the value of a life policy. I like this arrangement because there would be no change of ownership. The lender would primarily make its profit through the loan rate and not based on when the policyowner dies. This removes most of the danger from speculating on death.
Insurance products are extremely well suited for lending arrangements because they can be collaterally assigned and this assignment is defined and protected by provincial Insurance Acts. There is also the beneficiary designation which can be changed to protect the lender.
Sadly the banks are not interested in this market. When I was at Maritime Life, we were then developing our leveraging concept on cash surrender value and we were on the process of negotiating our leveraging arrangement with one of the major bank. I had asked why the bank did not consider the value of a death benefit. I was given different accounting reasons such as the amount of reserve that would be necessary to put behind these loans. But it was clear in the end; they did not comprehend the value of a life policy. For example if a policy had a $0 cash value but the cash value would suddenly increase to $50,000 in 1 year, the bank would still consider the policy as having no value and not lend against this guaranteed cash value.
The answer I believe is to seed private pool of money that could be used to support this type of lending. I am currently looking at this.
The insurance industry is facing a major problem in the existence of toxic insurance products. These are products whereby unscrupulous actuaries have used irresponsible pricing assumptions. These products could cost insurance companies billions of dollars. Julie Dickson Superintendant of OSFI stated that the insurance company’s losses were directly correlated to the sophistication of the consumer. The more the customer knows about managing his product in order to extract the highest benefit the more insurance companies will lose. Is this why we have such opposition to viatical settlements? Is this why lack of service is such an issue in the insurance industry? Is this why no one has ever dared to create a lending program targeting the FMV of these toxic products?
Segregated funds the new value frontier
With the disappearance of the guarantees of 100% on seg funds and the decrease in the income guarantees of the seg funds, these guarantees are valuable. A client must assess the FMV of these guarantees prior switching to another investment. I am worried that there are no replacement rules pertaining to seg funds; no requirements to disclose the value of these guarantees prior recommending a switch out of a seg funds.
Should you buy permanent insurance before its price increased or because it may disappear as a product? First remember life insurance is a long term solution. Second, historically actuaries have managed lines of products on the short term. In the past they have priced insurance products at a bargain price because they used the short term interest rates that were high at the time expecting these short term rates to stay where they were. These policies were a great investment.
Now they are using short term interest rates that are very low to price these products at an exorbitant price. On the short term this permanent insurance may seem a bargain as their price will increase but on the long term their FMV will be greatly reduced as interest rates will not forever remain low. These policies will not be a great investment
So basically I would recommend that you buy permanent insurance only because you need it without taking into account that prices of these policies may increase in the short term.