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Universal Life is a complex financial tool. The unique flexibility of this product has, however, created both opportunities for unique product solutions on the one hand, and no small amount of misunderstanding in the market place. The following information piece was created by the CALU Issue Group on Life Insurance and Living Benefits, thanks to the initiative of CALU members Susan St. Amand and Florence Marino, in order to highlight some facts and clarify some of the assumptions presented to the public via various articles and media commentaries.
Table of Contents
First and foremost, it should be understood that Universal Life provides a tax-free death benefit at the death of the insured. The main purpose of the product was and is to provide liquidity at death. The fact remains the death benefit is intended to provide a high return on the life insurance premium deposited.
Life insurance has a unique ability to allow for any excess funding to accumulate tax-deferred. Restrictions are set out by the Income Tax Act limiting the amount of additional funding and accumulated value in a policy. >A true analysis of Universal Life should include all of the features and benefits. It is the interaction of all aspects of the plan that make it an attractive alternative for long-term insurance planning. Looking at one aspect in isolation from the other factors provides an unfair bias, on either sides of an analysis. Full and complete disclosure of how the various components interact in solving unique problems, is necessary to determine the validity of recommendations to purchase such a complex financial tool.
The pricing for the life insurance benefit is usually based on yearly renewable term prices, term-to-age-65 prices, or Level cost of insurance prices. These rates can have varying guarantees, depending on the company issuing the contract. Like any other life insurance contract, the actuaries price according to the mortality factor applicable, the administrative charges required, the assumed lapse rates, and the interest rate they assume can be earned on the company's internal investments held in reserve. The difference between Universal Life and other forms of permanent life insurance is the ability to see the contract 'unbundled' and promote accountability by providing full disclosure of performance for each component of the plan. Purchasers have an option to fund the cost of life insurance over a shorter period of time, through additional premiums paid into the policy which may be allocated to a wide variety of tax-deferred investment account. Future costs of insurance can be withdrawn internally from the accumulated values within the policy.
Most companies charge a basic monthly administration fee against the accumulation fund. Charges vary depending on the insurer and on the number of lives insured by the policy contract.
Investments within a Universal Life product are similar to investments outside. They all have fees and administration costs associated with them. Fees vary with the investment option chosen. The investment options vary between insurers but generally consist of index-linked accounts and a variety of fixed-term and money market accounts. Clients have the option to vary their investments within the policy and include more than one option within their portfolio. Lower risk investments like fixed term accounts typically have lower fees than a managed account linked to an index fund. Included in the fees are adjustments for investment expenses (management of funds), investment income tax ('IIT'), bonuses, asset-based commissions and product profit margins.
Many insurers provide a financial bonus for long-term clients. This bonus helps to offset the management fees associated with the investment account. Not all contracts are created equal and one must consider the probability of bonus payment, regardless of market conditions or investment choice. The ultimate performance is dependent upon the interaction of the total guaranteed performance on the investment, in conjunction with any unconditional guaranteed bonus. The combination of these guarantees must be considered in determining the probability of performance.
Several companies have responded to clients' concerns over the uncertainty of a bonus payment, by agreeing to reduce the management fees associated with the investment option.
The formulae for determining the guaranteed rates vary from company to company and within the same company by the duration of the particular account. As a general rule, the shorter the investment term, the weaker the minimum guarantee. For example, fixed rate investment accounts with terms of up to one year may have a minimum guaranteed rate of 90% of Government of Canada T-bills less 2%. Typically there is no absolute minimum guaranteed rate for investment terms of less than one year.
The corresponding guaranteed rates for investment terms longer than one year is typically 90% of the bond rate less 1.75%. Absolute minimum guarantees for terms of between one year and five years are generally between 2% and 4%. Some companies offer higher absolute guaranteed rates (perhaps by 100 basis points) for investment accounts longer than five years.The guaranteed interest rates for the indexed accounts are typically expressed in a manner similar to the guarantees for the fixed rate accounts. For example, a guarantee for an indexed account may be 90% of the percentage increase or 110% of the percentage decrease in the market index less 2%. Returns on the indexed investment accounts may be either positive or negative. Because of the investment spread required by the company, the return could be negative where there is a positive percentage change in the related market index.
Over the past few years credited rates on guaranteed term investments have tended to be on average about 1.25% to 1.5% below government bond yields. If we compare that to alternate investments like bank GICs over the past few years they have been on average about 0.75% below government bonds. The banks take a spread as well, albeit a smaller spread than the insurance companies. But there is a reason for this variance in spread:
Interest earned on bank GICs is fully taxable whereas interest earned in a life insurance policy is not subject to taxation unless there is a qualifying policy disposition.
The insurance companies pay a proxy tax on behalf of the policyholders in the form of the IIT. The spread required to pay the IIT can be up to 0.75%, which happens to equal the additional spread that the insurance companies take over the banks.
Recognizing these relationships is important for two reasons: first it can help us in establishing reasonable assumptions about what future credited rates might be based on past experience, assuming that companies don't increase their spreads; and second we often compare the results in a life insurance policy to an outside investment like bank GICs. It is important to recognize a client can earn higher interest in bank GICs than the rates that are usually credited on a comparable option in a Universal Life product.
Otherwise we may be creating overly optimistic expectations and have problems with respect to some of the new disclosure and market conduct requirements. It is interesting to note that even with a lower credited rate, a Universal Life policy can still outperform a taxable savings alternative like bank GICs, in the long run.
The tax-deferred benefits derived from utilizing an exempt life insurance policy increase the higher the consumer's marginal tax rate. It also increases with higher rates of return, just like the compounding effect of rates in an RRSP. But it is important to note, the cost of having the insurance just to gain access to a tax-sheltered investment, is seldom worth the price of admission. Universal life is first and foremost an insurance product, designed to fill a requirement in the consumers' overall planning strategy. It should never be used to replace RRSP contributions or solely as an alternative investment where there is no need to purchase life insurance. Universal life insurance is a flexible insurance product that has the ability to capitalize equity gains and facilitate intergenerational wealth transfer.
The purpose of the illustration is to demonstrate the mechanics of the factors and how each one reacts to the other. Illustrations were not meant for the comparison of different products.
Life insurance companies and advisors have been criticized for not providing full disclosure of the risks and benefits associated with sales illustrations. Illustrations are based on assumptions and assumptions change with each situation. CLHIA has mandated its members provide a hard copy of any sales illustrations, and an information package be delivered, read and signed by each purchaser, prior to acceptance of the policy. The illustration should provide the purchaser with two alternative assumptions for performance based on alternative interest rates (i.e., one higher and one lower than the assumed rate). Clarification of guarantees, Disclosure of guarantees, prices, values and benefits must be clear and fair, and contain appropriate disclosure of amounts that are not guaranteed. Members are to avoid practices that mislead or deceive agents or consumers. Some companies provide advisors with tools allowing them to provide prospective clients with multiple scenarios, including random interest rate scenarios. The agent is now able to provide a more realistic projection of the values and help set client expectations.
Universal Life products require an increased responsibility to monitor these financial products and to communicate variances in the clients' performance expectations. We have earned the right to our clients' business through a continued strong, relationship. Our clients want to know we understand the product, the impact of changes in the environment and the impact of direct changes in their contract. >Full dsclosure and the proper use of sales illustrations are more than just a fulfillment of our obligation to our clients: it also makes good business sense.
The author, Susan St. Amand, CFP, CLU, CH.F.C., TEP, is a member of the CALU Life Insurance & Living Benefits Issue Group. She would like to thank CALU member Florence Marino, LL.B, TEP, and Paul Lorentz, FSA, FCIA, of Manulife, for their assistance in the preparation of this article.