Universal Life Insurance – An Endangered Species?

CPA Magazine, Andrew Guilfoyle, March 2013

Universal life policies have gone the way of the dodo bird in many countries. Is this the case for Canada and should we care? If so, why? A financial product will never evoke the emotions of the nearly extinct cuddly giant panda or cute African penguin, but estate planning advisers are beginning to fear that universal life (UL) policies will eventually go the way of the dodo bird.

Until very recently, UL was the new kid on the block, and it wasn’t supposed to meet its demise so soon.

Life insurance policies can be traced to ancient Rome, while modern life insurance originated in 17th century England. UL is merely decades old and at its inception was hailed as a major step forward in transparency and flexibility from its predecessor, whole life. As its “unbundled” sister, UL has offered permanent coverage at lower premiums — in plain English, if there is no need for the death benefit or cash values to grow over time, the premiums can be much less costly.

However, a confluence of events over the past decade has punished insurance companies offering UL to the point where some have pulled their products. The remaining providers tacitly acknowledge that not only are they getting an insufficient return on capital, in many instances they are losing money on new policies sold.

The main culprit is our low interest-rate environment. UL’s level cost of insurance is predicated on the assumption that a new policyholder (say a 40-year-old male non-smoker) would pay $1,000 a month ($12,000 a year) for $2.5 million of permanent coverage. Rather than taking out a term policy that will expire after 10 or 20 years (which would be cheaper initially), this forward-looking man decides to add an asset to his financial balance sheet rather than an expense on his personal income statement.

So actuaries based the pricing on the insurance company receiving premiums for 40 or 45 years (approximately $500,000) and being on the hook eventually for $2.5 million. (This is a simplified example given the fact that some policies will lapse, etc.)

As life expectancy and mortality continue to improve — and each generation’s 40-year-olds have been living longer than expected — the insurance companies have had double wins in that they have been collecting more years of premiums and have delayed the eventual payouts. In our inflationary world, paying out $1 five or 10 years later than expected in relatively much cheaper dollars has been a net positive to the bottom line of insurance companies.

However, overwhelming this win has been anemically low interest rates. For an insurance company to turn a profit, $500,000 of collected premiums must be invested prudently to ensure that at least $2.5 million is available to be paid out to beneficiaries at the time of the policyholder’s passing.

When long-term government interest rates were 6% or more, this was possible. As fans of the rule of 72 are aware, a 6% rate of return will mean that money doubles in 12 years, and $1 turns into $4 in 24 years. However at 3%, it takes the full 24 years for $1 to turn into $2, and a full 48 years for that $1 to turn into $4. Remembering that the $500,000 is collected over the next 40 or 45 years, insurance companies do not have the ability to invest the collected premiums at a high enough rate of return to earn a profit on the policy.

Of course, low interest rates could suddenly increase and save insurance companies, but each passing year they remain low is another year of compounding at the higher rate that is forgone.

So, if insurance companies have priced these products too low — which they have — why don’t they simply increase prices to a profitable level? Over the past few years they have done so, but competitive pressures have meant they did not raise them when they should have, nor have they raised them to the appropriate level for our lower interest-rate environment. Recall that over 48 years, $1 at 6% turns into $16, while at 3%, $1 turns into $4. So in rough numbers, the 40-year-old perhaps should be paying much more than $1,000 a month — UL purchasers of the past few years have locked in very attractive guaranteed long-term rates of return for their beneficiaries. A second factor is the reserve requirements regulators (such as OFSI) ensure that insurance companies put aside in recognition of these long-term liabilities. As interest rates fall, capital that insurance companies put aside grows. Compared to capital “lite” products such as term insurance, whole life, segregated funds and mutual funds, sales of UL products have made achieving return on investment targets increasingly challenging.

As most insurance companies are now public-stock companies as opposed to mutual companies (through the process of demutualization, much of which took place in the ’90s), another related factor is that stock analysts prefer predictable stable earnings. With the move to IFRS and mark-to-market required pricing (which assumes our current low interest rates continue for the infinite future), small interest-rate movements can cause great paper gains or losses. In a declining interest-rate environment over the past few years, these have been losses, which many insurance company CEOs are growing weary of explaining to shareholders.

Ironically, in some ways the mutual form of company ownership, which companies enthusiastically moved away from, may have been an improved form of corporate ownership for the long-term nature of these products.

In the past, large mutual insurance companies successfully ignored the short-term noises in equity markets. While critics derided their inefficiencies, often viewing them as slow moving and unreceptive to policyholder concerns, the pendulum has perhaps now swung too far the other way, with shareholders asking on a quarterly basis why the companies are not producing a regular and acceptable return on capital. The reality is that while a well-run insurance company should produce an acceptable profit when measured over a multi decade span, even the best-run company will struggle to show a consistent and regular return on investment in the economic times we are currently experiencing. What we are seeing today is that shareholders investing in these businesses are unable to understand or unwilling to match their investing time horizon with the lifespan of the products.

These changes are happening globally. Standard Life was the first to offer individual insurance policies in 1833. However, at the end of 2011, it stopped selling individual policies, preferring to focus on its suite of asset-management and group products.

At the same time, Sun Life decided to leave the US individual insurance market for many of the reasons outlined above, including an unfavourable return on capital for the foreseeable future.

Today in Australia, there are no UL policies sold with level cost of insurance. So, if this indeed is the future for Canada, should we care? And if so, why?

For starters, choice for clients and their advisers is never a bad thing. The need for significant liquidity upon death has certainly not abated — whether for family income needs, US estate-tax needs, beneficiary needs or corporate shareholder requirements.

Many consumers would be hard pressed without checking to know exactly what type of policy they own. Hopefully, they know if it is permanent or temporary (term), but the nuances of whole life versus universal life, or whether it is level cost of insurance or yearly renewable term, are likely not at top of mind. However, if they worked with a good adviser when they implemented the policy, they probably benefited from the choice of available and competitive products in the marketplace.

The trend is that many of these factors may be disappearing, and just like the dodo bird, they may not be truly appreciated and missed until they are suddenly gone.

Andrew Guilfoyle, CA, CFA, is a partner at Guilfoyle Financial, which provides life insurance and investment strategies to assist with the accumulation, preservation and transfer of wealth.

Technical editor: Garnet Anderson, CA, CFA, vice-president and portfolio manager, Tacita Capital Inc. in Toronto.

This article appeared in CA Magazine in March 2013.