Bomb shells

For most clients and advisors the ongoing financial crisis has been measured by its impact on investment portfolios. But it has also generated questions about insurers and insurance products, among them universal life (UL) insurance and whether that product is about to drop a bomb, as the expression goes.

UL has three main components funded by premiums: mortality, expenses and the accumulation account.

The latter holds investments on a tax-exempt basis as well as portions of the death premium not yet spent on the other two components.

Investments inside the account can include equity-linked assets such as indices or mutual funds as well as fixed income assets. This strategy may be appropriate for high-net-worth (HNW) investors who have maxed out their Registered Retirement Savings Plan (RRSP) room; who see the payout as an estate planning tool; or who want joint-last-to-die coverage.

Typically, a broker generates sales illustrations showing projected yields for investment options using software supplied by the insurer. Given recent plummeting equity prices, some illustrations may become the focus of harsh questions – and legal action. Industry sources suggest the possibility of lawsuits against insurers by investors caught by erosion of investment yields or outright losses in their accumulation accounts and anticipate that the fallout may equal or exceed that of the vanishing premiums controversy of the late 1990s.

Vanishing premiums That involved a policy option sold during the high interest rate era of the 1980s.

In theory, the option provided for funding premiums through policy dividends, meaning that they would vanish after what was termed the premium offset date.

In practice, plunging interest rates led insurers to reduce dividend yields and they informed policyholders that they would have to pay premiums beyond the premium offset date. That led to class action lawsuits.

Now brokers who sold equitylinked UL plans may have to ask clients for larger premiums to finance the promised level of coverage. If history repeats itself, the illustrations could trigger some combination of client anger, broker embarrassment and individual or class action lawsuits.

“It could be an industry crisis that would make the vanishing premium situation pale by comparison,” says a brokerage veteran familiar with both issues.

At the same time, falling UL returns may spark increased interest in non-participating or participating whole life insurance. A nonparticipating policy offers complete predictability with a level premium, meaning that the client can accurately budget for premiums, and fixed coverage payout. A participating policy pays dividends that can be used to reduce premium payments or increase the policy coverage.

Whole life surge That predictability has spurred a shift in interest towards whole life, suggested Kevin Cott, 26-year insurance veteran and president of Toronto-based Qualified Financial Services Inc., a managing general agency operating in Ontario and Quebec with 250 brokers. Ironically, QFS made what Cott terms “a conscious turn towards permanent whole life insurance” six years ago, a decision partially driven by the market downturn of 2002.

Falling yields vitiate one of the main reasons for investing in UL insurance, Cott says.

“People are putting money into UL policies for really only one purpose – overfunding,” he says. “That’s to take advantage of taxsheltered growth,” he adds, cautioning that for many individuals, absence of growth negates the reason for owning a UL policy.

Additionally, where investments inside the accumulation account consist of mutual funds, management expenses continue to be charged regardless of the success of the investment.

Interest deductibility The investment climate also calls into question at least one application of the so-called 10/8 strategy, since it combines non-taxable guaranteed interest income with tax-deductible interest expenses. Typically, the insurer guarantees to pay the policyholder 8% interest while the policyholder pays 10% interest on a loan, a move that becomes worthwhile when interest costs qualify as tax-deductible.

Policyholders employing this strategy use interest proceeds for one of three purposes: to invest in a business or portfolio; to carry the cost of the insurance component of the total insurance payment; or to make a separate investment through the insurer’s investment department.

HNW clients considering the strategy as a means of funding their business have not backed off, according to Kim Shaheen, president of Regina-based Kim Shaheen Financial Inc.

According to Shaheen, a typical use of whole life insurance is when an entrepreneur takes the proceeds to finance his or her company’s expansion.

However, the strategy has lost some of its appeal for those who might have used it for other investments.

The market turmoil has led to other concerns. In the broader picture, the debate between guaranteed and non-guaranteed forms of insurance bears some similarities to the contrast between defined benefit and defined contribution pension plans, suggests Robert McCullagh, a financial planner at Calgary-based Benefits Planners Inc., a 20-year financial services veteran and financial planning instructor at Mount Royal College in Calgary and the University of Calgary.

“The comparison between whole life participating policies and UL policies loosely resembles that between DB and DC plans, not in structure but in responsibilities and risks,” he says, explaining that the investment decision in a UL policy is made by the client while the investment decision in a whole life policy is made by the insurer. This leaves the client responsible for decisions on risk and therefore responsible for the outcome.

In another question, the market turmoil has forced clients to re examine risk in their insurance portfolios as well as their investment portfolios, checking whether strategies put in place years earlier and possibly at a higher net worth are still appropriate when factoring in a reduced net worth.

Reduced wealth The issue applies to wealth protection during a client’s lifetime, and estate planning for after a client’s decease.

As wealth protection, it may mean increasing the use of insurance, since the margin for error provided by assets has diminished in recent weeks.

“This is not the time when you might decide that you want to take a significant portion out [of the investment portfolio] to fund critical illness treatment somewhere around the world,” McCullagh explains.

A client may have previously believed that the asset portfolio had sufficient resources to provide for emergencies but now it has diminished.

“If you had to liquidate [investment assets] due to a critical illness, long-term disability or death this would be a very poor time to have to do that.”

The turmoil’s impact on HNW portfolios has also led to a revisit on the use of insurance as an estate planning tool. Some clients had previously believed that the estate executor could simply liquidate assets for distribution, but they now believe that liquidation would become costly in light of the effect of the market downturn on their assets.

Premium options Whether in the WL or UL category, limited-pay plans may provide another answer, suggests Al Kinch, senior consultant, individual insurance, Desjardins Financial Security Investments Inc.

A limited-pay policy carries a lower premium than a WL participating plan or a UL plan in which the policyholder is funding an accumulation account; a limited-pay policy also does not provide dividends but does provide a stated amount of coverage throughout the life of the policy.

Available versions typically require payments for periods ranging between 10 and 20 years.

“As long as you pay the cost of insurance you’ve got basically a guaranteed plan,” Kinch explains.

The fundamental difference between limited-pay universal life plans and whole life plans is that, with some conditions, the policyholder can elect to overfund the UL accumulation account during the life of the policy.

Ironically, the previous resurgence in the market for limitedpay plans occurred at the time of the 2002 market drop, he recalls.

Insurer solvency The impact of the crisis on the insurance sector also triggered questions about the solvency of insurance companies, including the New York-based American International Group, which now has three separate loan arrangements from the U.S. government. That has led to questions from clients, according to advisors and managing general agents.

“These people are putting their faith and trust in these companies for large amounts of coverage,” Shaheen says.

Shaheen, in response to a client’s recent questions, reviewed the work of Assuris, the industryfunded corporation that guarantees (with some limitations) insurance benefits, deposit products, UL accounts and other assets sold by insurers as well as capital requirements.

This crisis underscores the need for an advisor to constantly stay updated on developments, he says.

“We have to be reviewing and knowledgeable about what are some of these differences that sets Canada apart in our insurance industry, [such as] we always have had much more stability.”

Cott has other suggestions for HNW brokers, starting with market awareness. “Unlike ever before they need to stay informed. They need to read, listen, and watch everything related to market conditions today,” he says. “They need to be aware of what’s happening in the market internationally just so that they can communicate on a sound basis.”

Brokers will also have to take more initiative in calling clients.

“Keeping your head in the sand right now is not going to make the problem go away,” he says. “This is a time when your clients are looking ahead for advice.”

Al Emid, a Toronto-based financial journalist, covers insurance, investing and banking.