The beginning of a trend and what you can do about it
“Fun is like life insurance; the older you get, the more it costs.”
– Kim Hubbard (American Humourist)
Recently, two of the largest life insurance companies in Canada announced they were increasing the rates on a certain type of guaranteed insurance they offer by as much as 22%. It will only be a matter of time before other companies make similar announcements.
This memo will provide some background on the reasons for these premium increases and what actions you can take to mitigate any negative impact they may cause.
Let’s start with an Executive Summary first and then get into some detail.
- Rate increases have been expected for many years because of low interest rates. Only stiff competition prevented them from rising before.
- Term-100 and Level Cost of Insurance (LCOI) plans within Universal Life policies are the ones affected by the increase.
- For most of our clients, converting to this type of coverage before rates increase will save considerable premiums and significantly increase the long-term return on their fixed income investments as shown below.
Here are the details:
Rates are being increased on a special type of permanent life insurance called Term-100, or in the case of Universal Life plans, Level Cost of Insurance. Premiums are being increased by as much as 22%. The larger increases are occurring at younger ages and for policies that are joint last-to-die (plans where the death benefit is paid on the last to die of a couple – this type of coverage is commonly used to fund estate tax liabilities because the premiums have traditionally been very low and competitive).
Life companies have been losing money on these types of plans for many years. The primary reasons for this are:
- Interest rates have been falling for 30 years now and lower interest rates will eventually increase the cost of life insurance if other factors remain unchanged.
- Life companies have traditionally counted on a number of individuals cancelling (lapsing) their insurance before they die. These lapse rates help subsidize premiums for those who maintain coverage for their lifetimes. If lapse rates drop, then the cost of permanent insurance (with guaranteed premiums) will also rise.
- Increasing life expectancy will reduce insurance premiums over time. In the case of most Term-100 plans, however, the current premiums already assume increased life expectancy.
Based on the opinions of a few actuaries we have spoken to, most companies would need to increase premiums by as much as 50% in order to make a reasonable profit. Competition from other life companies has prevented this from occurring in the past. Now, however, interest rates are at record lows and all life companies are looking at the rate of return on all of their lines of business.
So what difference does it make if rates for one kind of permanent life insurance are rising?
Especially when one considers the following:
- Rates for renewable term insurance are not rising and unlikely to do so.
- Many people prefer this type of insurance because initial premiums are low and they expect that once they get to a certain age they will no longer have a need for life insurance.
The fact of the matter is there are many reasons for acquiring and keeping life insurance on a permanent basis. The following are true for Term-100 and LCOI plans:
They provide a very good long-term rate of return as an estate asset.
Consider the following example:
Today, a male age 50 could acquire $1-million of permanent life insurance for a guaranteed premium of $10,500/yr. If we assume a life expectancy of age 82, that individual would need to earn an after-tax return of 6% for 32 years to accumulate $1-million after tax. If they are using corporate cash flow to fund the premiums, the return would have to be 7.4%/yr. after tax (13.2%/yr. before tax).
That is a very difficult return to earn in this or any normal interest rate environment.
They can be combined with annuities to provide a very attractive alternative to other fixed income investments at older ages (typically age 60 and older).
Consider the following case study using our 50 year old male above (we’ll call him Fred). Let’s assume the following:
- Fred is planning to retire at age 65 with an expected portfolio of $4–million.
- Instead of buying Term -100 Fred could have acquired Term-10 and kept it until age 65 (at which time he would have no further need for life insurance). Premiums for this kind of coverage would have been $1,665 for the first 10 years and then $12,000 from age 60-65.
- Fred plans on having up to 40% of his capital at retirement in very safe bonds or GICs for safety reasons. We’ll assume current interest rates (about 3.5%).
- As an alternative to GICs or Bonds Fred could combine his Term-100 coverage with a life annuity.
How much difference would there be using his old life insurance and an annuity when compared to his alternative of buying bonds or GICs? The table below outlines the comparison.
Why does this work so well? There are several reasons.
- The life insurance rates were locked-in at age 50 while the annuity rates were acquired at age 65. The older you are the higher the income you will receive on a life-only annuity.
- The life insurance rates at age 50 are less than they should have been. The rates could have been much higher if they were priced to be profitable for the life companies that issued them.
- The life annuity is taxed as a “prescribed annuity,” which means that a large portion of the income is considered return of capital and not taxed.
- Insured annuities work well even when one waits to age 65 to buy the life insurance. However, they work much better if the life insurance rates are locked in at as young an age as possible.
Of course, Fred has paid more for the Term-100 then he would have paid for ten-year term between ages 50 and 65, as shown in the chart below.
Fred has agreed to pay an extra $8,835/yr. for the first ten years (but $1,500 less for the last 5 years ) in order to earn an additional $41,700/yr. after tax for life (the difference between the after-tax bond income of $19,700 and the after-tax insured annuity income of $61,700 for life).
What is his return? That depends on how long Fred lives. Below is a table showing those returns.
Finally, Fred could have kept his ten-year term and converted to a Term-100 at age 65. If rates in 15 years are the same as they are today (not very likely) the premium at his age 65 would be about $30,000 per year vs. $10,500 today – still good enough to make an insured annuity a viable option, but not nearly as effective or safe as locking in his rates today.
The slide below shows what the return is if Fred accepts the risk of converting to Term-100 at age 65 (assuming rates in the future do not increase).
The examples above are, in fact, only the tip of the iceberg when it comes to effective and creative planning with these type of insurance plans. Other planning options include:
Using joint last-to-die guaranteed Term-100 rates with joint annuities to increase safe income from registered assets by 35-50% and eliminate all taxes on those registered assets in the estate (read more about Registered Insured Annuities).
- Combining leverage with both life insurance and annuities to enhance the overall return and increase after-tax cash flows of both business and investment assets.
- Reducing tax on accumulated wealth in holding companies using the capital dividend account created by life insurance at death.
In the end, the key action steps to consider now are the following:
- Sit down with your advisor and review your overall insurance needs
- Get a detailed analysis of the financial impact of locking in your current life insurance rates now. We can provide that analysis for you.
Canadians have been very fortunate for a long time to have been able to buy permanent life insurance at very attractive rates. While the new rates are still competitive they will likely continue to rise unless interest rates increase significantly (and for an extended period of time).
Despite these rising rates, when used strategically as a cash-flowing asset class or as an estate planning tool, insurance can still have a significant impact on your wealth building plans.
I hope the information above will help you understand the current issues better and how you can design your insurance program to provide the best financial outcomes for you and your family.