Heavenly Returns: Life Insurance as Fixed Income
I know what you are thinking. Isn’t insurance about getting tax free money when you die, not about investing? For sure that is the primary purpose. However, some life insurance can also be an attractive long term alternative to some fixed income in your portfolio. I recently went through an analysis of converting my term life insurance policy into a new policy. I am no insurance expert. But working with insurance professionals[1] I recognized the heavenly returns that can be available compared to fixed income alternatives.
Celestial Coverage
Universal life insurance and Participating life insurance (PAR Policy) combine life insurance and tax-sheltered investment growth. I will leave a detailed explanation to your insurance advisor. In this blog I am focusing on the basics of a PAR Policy. You have life insurance coverage until you die, so long as you pay the required premiums. Ironically this is referred to as the “Death Benefit”. The premiums are higher for this type of policy. The reason is that part of the premium pays for the life insurance. The remaining premium gets invested into the insurer’s participating investment account (PAR Account). The value of that within your policy is referred to as the cash value.
You can access the cash value by withdrawing the funds, getting a policy loan, or assigning the cash value as collateral for a loan from a financial institution. Taking out a loan from a financial institution is more common as the rates are low when secured by the cash value. This type of loan also avoids any tax that may be payable from the other two methods. You can also defer loan payments by having the interest and loan amount paid by the Death Benefit. Leaving the policy in place is important for the Death Benefit and for further tax-free cash value growth.
Angelic Asset Mix
While not all insurers invest the PAR Account the same way, from publicly available information we know that Canada Life and Sun LIfe use a long term, conservative approach to investing their PAR Accounts. This means that the cash value is invested in a balanced portfolio with a significant fixed income weight. One advantage of the insurers’ portfolio vs. managing your own is the depth, breadth, and experience of their investment teams. Their scale translates into very low costs for investing. They can also access investment opportunities not available to the individual investor. Examples are commercial real estate, mortgage lending, and private debt. Chart 1 below shows the average mix of the Canada Life and Sun Life PAR Accounts as of December 2020.
Chart 1
Divine Dividends
While the primary purpose of a PAR Policy is the tax-free death benefit, the dividends from the PAR Account have been divine. Insurance companies refer to the smoothed return on the PAR Account as the Dividend Scale Interest Rate. The fluctuation in the Dividend Scale Interest Rate comes from the actual smoothed return on the PAR Account. The Dividend Scale is the actual dividend paid to the policyholder. The Dividend Scale will differ from the Dividend Scale Interest Rate. This is due to the difference (spread) in assumed and actual returns on the PAR Account, combined with the spread between assumed and realized policyholder mortality experience, policyholder lapses, and the insurer’s expenses. The main determinant of the Dividend Scale is the spread between the assumed and actual return on the PAR Account (Dividend Scale Interest Rate). Unfortunately the PAR Policy does not disclose the assumed Dividend Scale.
Chart 2 below compares the average of the published Dividend Scale Interest Rates from Sun Life and Canada Life to rolling 5-year numbers (for smoothing purposes) on other investments. Remember that the Dividend Scale Interest Rate is also a smoothed return. Keep in mind that the actual dividends a policyholder receives (Dividend Scale) may have been lower than the Dividend Scale Interest Rate. The other investments are the rate on 5-year major bank GICs, the return of the Canadian bond market (FTSE/TMX Bond Index), and the return of a conservative balanced portfolio of 80% Canadian bonds and 20% global stocks. As you see, the published Dividend Scale Interest Rate always exceeded 5-year GICs. It has also been higher than rolling 5-year bond returns since 2006 and even the conservative balanced returns since 2008.
Chart 2
Blissful Bond
Given the high credit rating of insurers (AA), I view the actual dividend received by policyholders (Dividend Scale) as akin to the interest on a high-quality corporate bond issued by a utility or major bank. Just as utilities and banks are overseen by regulators, federally regulated life insurers are overseen by the Office of the Superintendent of Financial Institutions (OSFI). OSFI also oversees federally regulated banks and property and casualty insurance companies. Insurance companies must confirm with OSFI that their PAR Policies are being appropriately managed.
Another key consideration is that Assuris backs all Canadian life insurance policies. If your life insurance company fails, Assuris guarantees that your policy will be transferred to a solvent insurer. You will receive at least 85% of the promised benefits. Historically, there have been only four times that Assuris has dealt with an insolvency. Two times policyholders received 100% of their benefits. One time 96% of policyholders received 100%, and 4% received at least 90%. The other time 99% received 100%, and 1% received at least 95%.
The bottom line is that the average of the published Dividend Scale Interest Rates from Sun Life and Canada Life has been incredibly stable. Chart 3 shows how the returns for various asset classes, along with the average Dividend Scale Interest Rate. I compare the returns to their risk or 20 year standard deviation of return. Anything in the top left corner (higher return, lower risk) is superior, and this is where the average Dividend Scale Interest Rate sits.
Chart 3
Paradise Ahead
We know the past, what about the future? In Chart 4 I compare a forecast for the return on my own PAR Policy’s cash value vs. my market forecast. Given the parameters for a PAR Policy, a pre-tax (assuming a 45% tax rate) internal rate of return (IRR) on the cash value can be calculated for each year of the policy. Remember that the actual cash value will depend on the actual dividends received. I went the more conservative route and used the IRRs for the cash value based on the Dividend Scale less 1%. The IRRs are provided in the insurance projections from my life insurance company.
Since most of the premiums in the early years go towards to the life insurance component, and my policy is designed to boost the death benefit as much as possible, it takes a long time to build up my cash value versus the total premiums paid[2]. This results in a negative IRR on the cash value for several years. How long it takes will vary; longer if the dividends paid on the policy are lower than assumed in the policy and shorter if they are higher. While it takes a long time for the cash value to build, in the meantime I have the death benefit in case I leave this earth.
Chart 4
Based on my PAR Policy, it will take just over 15 years before the IRR on the cash value exceeds my long term forecast of 2% for bond returns and 2.8% for an 80% bond/20% stock balanced portfolio. After that the IRR increases significantly. I can access the cash value, if necessary, through a tax efficient loan. For the same premium I am paying, the cash value’s IRR for a younger person will exceed the forecasted returns sooner as their life insurance component is cheaper. That results in more of their premium being invested tax-free in the PAR Account.
Heavenly Return Redux
You want to create the best wealth strategy for yourself, whether you are building a nest egg or are in retirement and estate planning mode. As part of the process, look at whether a PAR Policy’s cash value can substitute for some of the fixed income in your investment portfolio. The historical average Dividend Scale Interest Rate has been compelling. I think it will remain attractive on both an absolute level and risk/return basis for years to come. But PAR Policies are complicated. There are many ways to customize them to your personal needs. For example, the benefits of a PAR Policy can be amplified if the policy is done within a holding company. Make sure you talk to an experienced, reputable, and accredited financial planner or insurance advisor. They can determine if and how to best utilize a PAR Policy in your wealth strategy.
Invest Wisely,
Dave Schaffner, CFA
Principal, Wayfairer Capital Management Ltd.
[1] I would like to thank Robert Bradburn, CFP CIM CLU and Kim Stevens CFP CLU CHS at CWB Wealth Management for their insight and comments as I wrote this blog. I am solely responsible for any factual errors in this blog.
[2] There are other versions of PAR Policies which build up the cash value much faster and are not as concerned with the Death Benefit. With these policies it is possible to see positive IRRs much earlier than year 15. Also note that the cash value doesn’t build up at the same rate as the Death Benefit. The ratio changes over time and can change by the underwriting characteristics of the person being insured.