The math of life insurance pt. 2

In term and non-participating permanent products, the lapse assumption is embedded in the guaranteed cost. That cost cannot change. Whatever lapse rate the actuary used when pricing the product, the client who stays captures that benefit with certainty for the life of the contract.

The life insurance capital adequacy test now requires the insurer to hold capital against adverse lapse scenarios, which means the guaranteed cost is conservatively set relative to the actual lapse experience the insurer expects. The floor is solid and cannot be revised upward.

In participating whole life, the picture is more nuanced. Par products carry guaranteed cash surrender values — when a policyholder surrenders, the insurer pays out that cash value, substantially reducing the lapse profit compared to a product with zero cash values.

As cash values grow toward the death benefit in later years, the lapse profit approaches zero. Par’s primary performance driver has shifted accordingly: the participating account — a professionally managed pool of long-duration assets including bonds, equities, real estate and mortgages — generates value through investment returns, mortality experience and expense management, with lapse dynamics as a secondary and diminishing factor.

This matters for carrier selection in ways the illustration never reveals. Some insurers price their par products using mortality tables based on experience from approximately 40 years ago, when life expectancies were roughly 10 years shorter than they are today, with no future improvement factors built in. That contributes to a surplus that flows back annually as dividends — a documented, recurring source of dividend support built on conservative assumptions rather than optimistic projections.

The insurer using updated mortality tables with improvement factors will show a larger illustrated number. The insurer using conservative historical tables will show a smaller one — and is more likely to deliver or exceed what it illustrated.

That distinction is invisible in a side-by-side illustration comparison. It requires an advisor who understands what is behind the numbers, not just what the numbers say. The mutual company structure compounds this advantage because no shareholders extract returns. Every dollar of profit flows to participating policyholders, and there is no quarterly earnings pressure influencing dividend scale management.

There is an uncomfortable implication in lapse-supported pricing that our industry has not addressed honestly with consumers. If staying is the variable that determines whether the policyholder wins, then the most important question at the point of sale is not how much coverage the client qualifies for. It is whether they can afford to keep paying the premium.

The research on lapse behaviour is consistent across decades and jurisdictions. Lapse rates spike during recessions, periods of high unemployment and personal financial shocks — divorce, health events, business failures. The policyholder who bought comfortably within their financial capacity will stay through the hard years. The policyholder who stretched — whose premium was manageable in a good year and became a burden in a difficult one — is the policyholder who lapses at year four and generates the profit that funds the returns of everyone else in the pool.

The policy sized correctly for staying power is worth more than the policy sized for maximum coverage at the time of sale. That statement runs against the incentive structure of commission-based distribution. But it is what the math says. And it is the conversation that genuinely serves the client’s long-term interest.

Understanding all of this and explaining it to clients in plain language can reframe the sales process. It reaffirms your role as a trusted advisor who walks the talk when it comes to transparency. It puts the client first.

Allocate across insurance products

By allocating across term, non-participating and participating products, rather than concentrating on a single product type, you give your client optionality. Each component can be evaluated and adjusted independently as circumstances change.

The client is never in an all-or-nothing position. The term component provides cheap optionality with conversion rights. The non-par component provides the guaranteed floor. The par component reaches for long-term growth. Right-sized across all three, the client has staying power in every market condition — and the structural advantage that staying power provides.

This does create a tension that should be stated plainly. The more advisors explain lapse-supported pricing to clients, the more clients stay in their policies. The more clients stay, the more actual lapse rates fall below the assumptions embedded in current pricing.

Actuaries respond to experience data. So, when actual lapse rates persistently underperform assumptions, pricing adjusts — premiums rise, projected performance moderates and the competitive advantage of the staying policyholder diminishes.

Sharing this information is, in the long run, part of what makes it more expensive. The Canadian term to 100 crisis proved this. The product was priced assuming 5–6% annual lapses. Consumers figured out that the rational response to a zero-cash-value permanent policy was to never lapse. Actual rates fell to 1–2%. The pricing broke.

This does not justify withholding the information. The advisor’s obligation is to the client sitting across the table today. That client deserves to understand how the product they are buying actually works — including the mechanism that makes staying so consequential. The aggregate market effect of widespread consumer education is a second-order consequence that the individual advisor cannot and should not factor into their disclosure decision.

The window is narrowing

The window is narrowing. The consumer who understands this and structures their allocation accordingly is capturing an advantage that will cost more to replicate as the information becomes more widely understood.

There is a concrete and current example of how this erosion happens in practice — and it is being actively promoted by advisors and charitable gift planners across Canada. The charitable donation of a term life insurance policy on an impaired life is a legitimate, tax-effective philanthropic strategy.

The donor receives a charitable receipt based on the policy’s fair market value. The charity receives a death benefit that is, in many cases, a near-certainty rather than a contingency. The advisor adds demonstrable value. Every participant in the transaction wins, with one exception — whichever carrier is counting on the lapse assumption.

The strategy is designed to identify the policies where the lapse assumption is carrying the most weight. Charitable gift planners target insureds who are approaching or past age 70 with impaired health — precisely the policyholders whose original term policy was priced on the assumption that the majority would lapse before a claim was filed.

The policy was underwritten years earlier when the insured was healthy and the premium was set at standard rates reflecting normal mortality. Now the insured is impaired, the probability of a near-term claim is high and a charity with professional administrative capacity will continue paying the premium without interruption. The insurer is left holding a policy it priced for a healthy life, on an impaired life, with zero probability of lapse. The adverse selection is not incidental. It is the mechanism.

This is a genuinely costly innovation for insurance companies. The strategy is entirely legal, demonstrably beneficial to donors and charities and well within the advisor’s professional mandate.

Naming it here is not an argument against the strategy. It is an illustration of a broader point: lapse assumptions are not immutable physics. They are pricing inputs that respond to information, advisor behaviour and market practice.

The Canadian term to 100 crisis was not caused by fraud. It was caused by rational consumer behaviour that the pricing model failed to anticipate. The charitable donation of impaired-life term policies is rational advisor behaviour that applies the same pressure to the same mechanism.

The industry has noticed. The Canadian Association of Gift Planners has acknowledged that regulators have expressed concerns. What the industry has not yet done is explain this dynamic clearly to the consumers whose future premiums will ultimately reflect it.

Three standards

The following are not compliance requirements. They are practice standards that follow from what we know about how these products actually work.

1. The advisor who cannot answer the compared-to-what question in writing has not completed the recommendation. The lapse assumption embedded in a participating illustration is not disclosed. The lapse assumption embedded in a non-participating product is guaranteed — it cannot get worse. These are not equivalent. When the recommendation is made, the rationale for that choice should be visible to the consumer in plain language — which product, why this one and what the alternatives are. Compared to what is not just a consumer question. It is an advisor documentation standard.
2. The advisor who has not walked the client through the difference between guaranteed and projected values has not explained the product. Every permanent life insurance illustration contains both. Most consumers do not know the difference. Pointing to the page, explaining what each column means and noting which inputs can be independently verified and which cannot is the practice standard.
3. Put the recommendation, the math and the rationale in a form the consumer can read, question, keep and share. Not the compliance stack. It wasn’t designed for the consumer. Provide a document that explains what they bought, why, what staying means, what their options are if they consider walking away and where the policy is kept. Recommend that copies go to their accountant, lawyer and adult children. That is what putting it in writing means in practice.

In 1993, William Strain presented a report at the Canadian Tax Foundation’s 45th conference in Montreal, entitled Life Insurance: An Innovative Financial Instrument. He said that the results of any life insurance application will reflect not so much the quality of the tool, as the skill of the artisan.

Thirty years later that observation remains the most precise description of what we actually do. The products are good. But the system was not designed to teach them. That is our job — and it has never been more important than it is right now.