The Canadian life insurance industry has gone through several changes over the last three years.
Some of the changes affect the efficiency of life insurance products as investment vehicles, their tax advantages, and their use in corporate and estate planning strategies. Many changes are as a result of new legislation, while others are because of prevailing low interest rates.
How tax advantages have changed
Life insurance has preferable tax treatment. The main advantages include:
- For policies owned by Canadian-controlled private corporations, life insurance proceeds can be credited to the capital dividend account (CDA) on death and paid to shareholders as tax-free dividends.
- Any accumulation in the cash or fund value is tax-sheltered.
- Death benefits from life insurance are received tax-free by beneficiaries.
Over the last three years, the following changes have lessened some of these advantages:
- The rules governing corporate-owned life insurance have changed. New legislation results in less that can be credited to the corporate CDA due to changes in how the credit is calculated.
- For any policies issued after December 31, 2016, the amount that can be tax-sheltered in the accumulation account is lower.
- For certain policy transactions that took place after 1999 and before March 22, 2016, the legislation results in less credited to the CDA on death of the insured. That means advisors and clients should review any transfers that took effect during that period. The consideration paid, if any, by the corporation will have to be tracked, along with the policy’s cash surrender value and adjusted cost base at the time of transfer.
Advantages could erode further
The preferential tax treatment of life insurance may not continue in its present form. As such, be wary of strategies that might need to be adjusted or unwound in the future.
Here’s a popular example: the immediate, or deferred, leveraging approach. A lot of the assumptions used when marketing this approach are outdated. For instance, the deduction of Net Cost of Pure Insurance (NCPI) usually figured predominantly in the illustrations. But the lowering of the NCPI in post-2016 insurance products will likely make the strategy less efficient: since the NCPI is now lower, the tax deduction will also be lower.
Another concern: the reduction in the dividend rate as a result of lower interest rates and earnings will also slow the rate of value accumulation in the contract. This will affect the ultimate death benefit.
Illustrations of the benefits of deferred leveraging are commonly based on current tax rates and current tax rules, including interest deductibility. If the rules change, clients may have to unwind their strategies to adapt to the new regime. This could lead them to have to pay off the loans earlier from the accumulated cash surrender value of the contracts or from other corporate assets. If you’re promoting these types of strategies, you must advise clients that the rules could change, dramatically affecting the strategy. Illustrations should be reviewed periodically to show the effects of potential changes.
Across all strategies, low interest rates have also resulted in increases to premiums and reductions to projected and declared dividends. As a result, internal rates of return—which are commonly used to show the efficiency of insurance contracts as long-term investments—are down considerably from several years ago. In today’s environment, it is hard to find an internal rate of return above 3% at life expectancy in a universal life contract. Increased cost of insurance rates and reductions in dividends credited to participating policies are also negatively affecting the growth of these contracts.
Adapting to the new normal
These changes make life insurance less appealing for a client motivated by the tax and investment focus. As such, it might be time for advisors to remember why life insurance was designed in the first place.
Life insurance provides two main benefits, regardless of the tax treatment. First, it provides liquidity upon the death of policyholder. That cash can allow people to pay off their mortgages or debt, for instance, and can help maintain an income for a surviving family.
Second, life insurance transfers the risk of dying prematurely from the individual to the insurance company. The resulting payout can fund buy-sell contracts between partners, equalize an estate and pay taxes on death. Ben Feldman, one of the world’s best life insurance salespeople, wisely noted that everyone dies at some time, but never at the right time.
We in the industry need to go back to basics and consider the real reason insurance was developed: not only as an investment, but as a tool to provide security for our clients and their families.
David Wm. Brown, CFP, CLU, Ch.F.C., RHU, TEP, is a member of the MDRT, and a partner at Al G. Brown and Associates in Toronto.