Policies as savings, investment, or pension income products: the less gloomy aspects of insurance
Quick overview and cost/benefit characterization of some often misunderstood insurance products
Many people have emotional blocks preventing them from dealing with insurance protection products reasonably, because it involves thinking seriously about bad outcomes. They prefer instead to look at the wealth creation and accumulation side of finance. Even within this realm though, some insurance products offer significant benefits over comparable bank or mutual fund products, especially for the elderly, the risk-averse, or the affluent. There are some very important financial products that are not even available from others than insurers.
When one buys any insurance protection product, the expectation (or at least hope) is that it will be a bad investment, … that is the event triggering the insurance benefit (death, illness, injury) will not happen, or at least not soon. Of course, we still try to improve the investment character side of an insurance purchase by seeking for low costs, but our emotions are rather ambivalent, and once the decision is made, we don’t hope for great financial returns on the policy. We spend out of caution, awareness, or responsibility, not because we look at this spending as an attractive investment in the first place.
The products mentioned on this page are of different nature, in that they assume a more positive-optimistic mindset. It’s not that they’re completely devoid of gloomy potentialities, still their basic nature is that they’ll work for you the best if you live a long and healthy life. The other aspect important to emphasize is that (maybe with the exception of the very last section) what follows has nothing to do with bank-bashing, … they’ve got some well-deserved critique elsewhere. The advantages and strengths of insurance products are, naturally, not equally relevant, available or important for everybody. As always, the ‘advice can be given only on a case by case basis’ applies.
For many people, banks are still the embodiment of financial stability, … or at least the closest approximation to it that they can recognize in our turbulent world. GICs are therefore the No.1, or perhaps the only, choice for them when they feel risk averse. Even though they may wince at the miniscule rates offered these days, they accept them for the safety of their principal. Actually, they have similar options at insurers that can come out as winners from comparison with bank products. The rates and guarantees are comparable and competitive, plus there are some advantages that only products from insurers offer.
Let’s look at five features of GICs and their insurance industry equivalents (called GIOs [Guaranteed Interest Options], GIAs [Guaranteed Interest Accounts], or accumulation annuities) here:
If you want or need to earn higher return on you investment than products in the previous section with guaranteed rates can offer, that means you have to take risks. (Not that you are risk-free with a GIC-type account either: your nominal rate can be guaranteed, even your after-tax return is something you can rather accurately pre-calculate, but your after-inflation real rate is dependent on future inflation for which your predictive power is more limited.) Few people have enough time, expertise, or willingness to do their own portfolio building out of stocks and bonds (not to mention the limited size of assets generally available that would easily exclude the practicality of creating a well-rounded portfolio out of these ‘primary’ asset types), so relying on some professionally managed asset pool is almost inevitable. The most obvious choice is some kind of mutual funds, or ETFs (Exchange Traded Funds) the risk with which is that they may deliver a loss instead of the hoped-for higher return even after several years, or at least not in the time-frame that might be forced on the portfolio by death of the owner. So-called segregated funds provide a solution to these worries. Since ETFs are essentially low-cost index mutual funds (let’s disregard now some other differentiating subtleties) it makes sense to sketch the mutual fund vs. seg fund comparison below.
In many cases, when you look at a mutual fund, you can assume that there is a segregated fund version of it. Similarly, for most segregated funds (also known as individual variable insurance contracts or GIFs … Guaranteed Income Funds), you can get the uninsured (mutual fund) version of it as well. The only disadvantage of the segregated versions is that there is a fee over that of the underlying mutual fund. However, it’s not that all seg fund fees are higher than any of the mutual fund fees; rather, in both cases there is a spread among companies and funds, and the two fee-ranges overlap, … meaning that there are seg fund fees that are lower than some mutual fund fees. Looking at individual fund pairs, typically the seg fund version charges roughly 0.5% extra for the special benefits, … which are:
- Guaranteed principal:
at a preset maturity date, or upon the death of the life insured, the contract guarantees payment of at least 75% or in many cases 100% of the original investment. It’s a life insurance policy, and there is a life insured (usually the owner) but there is no underwriting of medical and other risks at the individual’s level (that would be the case with an ordinary life insurance policy), … only some age restrictions apply, in terms of age limit beyond which one cannot buy (or add deposits to) such policy, or sometimes regarding the guaranteed percentage.
- No probate:
similarly to what you read in the previous section about beneficiary designation with insurance products, fund assets pass directly, discretely, without estate or probate fees, and soon to beneficiaries.
- Creditor protection:
again, like with the guaranteed return products, the asset can be out of reach for creditors.
- Reset options:
with more or less frequency, according to individual seg funds, the owner can ‘reset the clock’, that is the guaranteed maturity or death benefit amounts can be ‘locked-in’ at an increased level after a fortunate period.
For some people, these guarantees and features aren’t worth the extra-cost, but for many others they are. Situations and preferences are widely different, and there are significant differences according to a series of criteria among segregated funds as well, … therefore making the right decisions takes somewhat more expertise and consideration than when one buys a regular mutual fund. Segregated funds are as liquid as mutual funds, can be inside RRSPs, RRIFs, or even RESPs (Registered Education Savings Plans), and interest on money borrowed to purchase them is deductible unlike with other insurance products. There are certain differences from mutual funds in terms of taxation, one interesting aspect being that segregated funds, unlike mutual funds, can allocate incurred capital losses to policy holders annually, which then can be applied against capital gains to improve tax position. Since they are insurance products the only way to get them is from insurance licensed service providers; investment advisors, mutual funds sales people or securities brokers may or may not have such license.
I wrote recently about how annuities and the ‘double-insured mutual funds’ or ‘hybrid of annuities and segregated funds’, known mostly as Guaranteed Minimum Withdrawal Benefit Plans (GMWBs) can be used to create personal pension plans that address unique retirement risks that other investment products wouldn’t: the risk of longevity, and the risk of very detrimental effects of unlucky sequence of returns. For an introduction, please check that recent post. To reiterate briefly the two main points learnt there: (1)Instead of making blanket statements about optimal allocation of retirement assets among various income producing products (traditional cash/fixed income/equity portfolios, annuities, and GMWBs) it is much more useful to do individualized analysis, and (2) In many cases, at least from a retirement income planning perspective, a more important role than the one advocated nowadays would be appropriate for annuities, especially of the inflation indexed variety. In addition, the experiment shown there raised some red flags about the universal applicability and sales methods of GMWBs. I intend to dwell more on GMWBs separately soon; all the more so that there is a great opportunity right now for some people (already owners of such policies) to lock in significant market gains of the last 10 months. Again, these products are available only from insurance companies, via insurance licensed persons.
With the inclusion of proper mix of annuities and segregated funds there is a way of ensuring not only preservation of capital while giving a chance to assets to grow; a modest return can be guaranteed too, albeit at the cost of limiting the upward potential for really good market returns should we have very prosperous years ahead of us. It should be mentioned that while life annuities can be sold exclusively by insurance companies, term annuities are sometimes sold by other financial institutions as well.
The ‘real’ qualifier here refers to life insurance policies where the insurer individually underwrites people and takes on the risk of being obliged to pay very substantial sums of money when they die. As you probably know, with term life and even some permanent life policies, this is basically the whole story. The client either lives and pays premium to a pool or dies and the beneficiary gets paid from that pool. There are some other types of permanent life insurance as well though: whole life and universal life policies where the client pays more money into the policy than would be needed to just keep the protection in force, and in return there is a cash value building up in the policy that can be used in various ways (basically three ways: withdrawal, policy loan, or policy assignment as collateral) while the insured is alive; at death, the remaining cash value passes over to beneficiaries quickly, privately, tax-free, and without paying probate and other estate costs.
I’d bet some respond by saying, ‘Oh, it’s just snake oil again, … it’s too expensive, and I wouldn’t qualify anyway’. Actually, yes, it can be snake oil if offered as a cure-all irrespective of circumstances; but in some cases these policies are very potent tools indeed in the financial toolbox. Costs can be reasonably judged only against benefits, paying ability, and alternatives always, and in many cases these products withstand rigorous tests of these kinds. Yes, insurability is a factor sometimes, but in many of those cases there is some way to achieve more or less the same investment and estate objectives as the original intention was by including ’substitute lives’.
I’ve written several times about the advantageous tax-free accumulation of investments within, and some other nice features of universal life policies; please do a site search for “UL” to find the most relevant pages. One day I’ll consolidate and update these earlier pages into a new one that will become part of the new blog-based site. More urgent would be though, and I want to address this issue first, to write about various whole life policies that are in some cases excellent investment opportunities, both in terms or guarantees and size of long term returns, not to mention again the distinguishing features of insurance, coming with the beneficiary designation detailed above.
It’s a natural concern for people when they hand over their money to any financial institution, what will happen if that institution fails and will not be able to give back their invested capital. My impression is that many people are aware of protection of most bank deposits up to $100,000 by CDIC (Canada Deposit Insurance Corporation), a federal crown corporation; however, I doubt that familiarity with the insurance industry version of this kind of protection is similarly widely spread. Assuris, a not for profit institution funded - according to regulations - by the life insurance industry and endorsed by government provides the same kind of protection for accumulation annuities as bank deposit accounts have from CDIC. In addition, there is at least 85% protection (or up to 100% under some limits) for other insurance benefits, including segregated funds.
Mutual funds are not covered by either CDIC or Assuris. In this regard though, it’s interesting what IFIC, the national association of the Canadian investment funds industry, had to say about CDIC in 2004: “since 1967 it has dealt with the failures of 43 financial institutions and paid out $24 billion to depositors. In contrast there has not been a failure of a mutual fund management company”. As for insurance industry failures, you can find quite reassuring information about the 3 cases of the 1990s, and the financial strength of Assuris on their web site.
Wherever you put your money, I think it’s not paranoid to use more than one institution if your asset size is beyond the limits protected by these institutions. I found it a bit ironic how he responded when two years ago I mentioned to an AIG employee that I was going to recommend a client splitting their large sum investment between two or three insurers because of this concern about excessive concentration. The guy got quite offended by the idea that I wouldn’t completely trust AIG, with all the strength of the world’s largest insurance company behind them. Quite communicative before, he then practically stopped talking to me. Within a year, their company was sold, as a consequence of AIG’s (the parent company’s) catastrophic financial problems. There was nothing wrong with the financial strength of AIG Canada itself, their clients didn’t lose anything, still I think it’s telling how clueless he was about even the short term financial future of their own mother company.
When discussing many living benefit insurance products, you may have heard about so-called Return of Premium riders (ROPs). These are built-in or optional add-on parts of these policies. Their function is to guarantee that if the policy turns out to be not used (or perhaps used only to some limited extent), then at predetermined times (usually the death or the maturity date, but with some policies even at some predetermined earlier date/s) all or some percentage of all premiums paid is given back. It’s certainly a sweetener linked to the bitter pill of paying for something you may never use, but its real financial value is hard to comprehend, especially without some tailor-made calculations combining time-value-of-money and probability aspects. It’s an area of potential snake oil peddling; I’d say, be cautious with people who say they sell a policy only with this ROP rider: they either don’t understand some basics or worse. For an example of how the ROP evaluation can be done, see some example here.
The assessment about the financial value of these riders cannot be reasonably done without those detailed and case-specific calculations; on the other hand, the calculations themselves cannot give a final answer either. Just because a calculation shows that you’re looking at a, let’s say, extremely attractive 8% annual guaranteed tax-free return, it doesn’t automatically mean that you can afford to confidently commit to this illiquid investment, … or that you want to, especially if we’re talking about ROP at death options. Leaving death benefit when one dies is not an unquestionable and universal moral obligation for everybody, even though it’s treated that way sometimes.
‘Will We Ever Again Trust Wall Street?’, asked Jason Zweig in the Wall Street Journal the other day. The animosity against big banks and other financial institutions is not as strong (yet?) in Canada as it is in the US, but they are certainly not the favourites of many people here either. My impression is that, well-deserved or not, the insurance industry has a perhaps even worse reputation than banks, brokerages, or mutual fund companies. I don think that ignorance, greed, questionable marketing practices or similar factors would be more typical in insurance than elsewhere, but these negatives are perhaps more noticeable here because of the heavier reliance on face-to-face contacts. Also, the nature of the field lends itself more to controversies, and invites more ‘bad guys’ and ‘bad behaviour’ from the public, and this must be a contributing factor as well to public-vs-industry conflicts. I’m referring to genuinely ambiguous or hard-to-objectively-assess medical cases, and not too rare false claims and other anomalies committed by individuals. Greed and dishonesty is certainly not the prerogative of corporations, and it’s so much easier to cheat with some insurance than with a big bank, e.g.
Whatever the truth is in these affairs, the point I want to make here is that - just like you are not completely at the mercy of big banks outside insurance, because you can find smaller, more local, more socially responsible by nature institutions, like credit unions, e.g. - you can find similar choices within the insurance field as well. Even after waves of consolidation and demutualization, it’s not just the giants that are out there. There are a few mutual companies, not for profit insurers, and fraternal benefit societies operating still, financially strong and otherwise attractive too, that you can seek out. In fact, they’re quite competitive as well in some comparisons, not the least because they offer various free side-benefits to their policy holders (whom they treat as members as opposed to clients) that may easily tip the scale toward favouring them if features and premiums are close otherwise.
As for investments that fall under the Socially Responsible Investing (SRI) category, the recent good news is that now there are some SRI funds that can be purchased within universal life insurance contracts as well. The choice is not wide yet, but an important first step has been made in this regard.