If your client is considering a participating whole life policy, explaining policy dividends can help you demonstrate the policy’s benefits and manage your client’s expectations.
Based on a par policy’s profits, annual dividends may be issued to policyholders. These dividends can be used to increase a policy’s cash value and death benefit over time.
The formula for calculating policy dividends is called the “dividend scale,” which is based on a number of factors, including a par policy’s investment returns, policy lapses, claims and expenses, said Steve Krupicz, AVP, advanced sales and actuarial consulting, with Manulife Financial Corp. Specific weightings by each insurer are proprietary, he said.
Insurers can adjust their dividend scales to be competitive, said Sonny Wadera, securities advisor with Kelson Financial Planners Inc. and Manulife Securities Investment Services Inc. in Saint-Laurent, Que.
Portfolio returns are a major component of a par policy’s profits, accounting for 60%–70% of the dividends paid over the policy’s lifetime, Krupicz said. The dividend scale interest rate (DSIR) is used to calculate the proportion of dividends attributable to portfolio returns.
Insurers use “smoothing” — amortizing gains and losses over several years — to help keep the DSIR stable over time. For example, Sun Life Financial Inc.’s average annual DSIR was 7.54% for the 25 years ended in 2019, with a standard deviation of just 0.77%. By comparison, 10-year Government of Canada bond returns averaged 4.26% annually over the same period with a standard deviation of 1.82%, and the S&P/TSX composite index’s average annual total return was 8.32%, but with a standard deviation of more than 16%.
The DSIR projects a par policy’s investment growth, and “it is not the amount of the dividend that’s paid,” said Connie Gale, insurance manager with Wellington-Altus Insurance Inc. in Winnipeg.
When explaining par insurance, financial advisors and clients tend to focus on the DSIR and “the value it brings to a client’s financial security plan,” Wadera said. However, “clients should understand that the DSIR is only one component used to calculate dividends,” he said.
An insurer could experience relatively poor portfolio performance but benefit from mortality gains or cost-cutting, said Peter Wouters, director of tax, retirement and estate planning services with Empire Life Insurance Co.
Still, persistently low interest rates remain an important factor for policy dividends. “Every insurance company is telling advisors there’s downward pressure on their dividend scale interest rates as a result of lower bond rates,” Krupicz said.
The Canadian Life and Health Insurance Association Inc. mandates that insurers provide illustrations of a par policy’s projected values (i.e., cash value and death benefit) using current and lower DSIRs, Krupicz added.
“What if the dividend scale is 1% lower [or] there are no dividends?” Wouters asked. Clients should be shown these projections ahead of choosing a policy, he said. As the years pass, advisors can show clients comparisons of their policy values based on original assumptions and changes.
While the dividend scale may drop, “that doesn’t necessarily mean dividends are dropping, in terms of dollar figures,” because clients benefit from longevity, Wouters noted. (Dividends generally grow in each successive year that a policy is in force.) The impact of a lower dividend scale also varies by the par block of business and the year a policy was purchased.
In addition to showing conservative policy projections to clients, Wadera suggested explaining smoothing to clients and highlighting that whole life policies help limit downside risk.
“Cash value, once credited to the policy, is vested” and can’t be reduced, other than to pay premiums or preserve the policy’s tax-exempt status, Wadera said: “If markets fall, [the cash value] is protected.”
Gale suggested advisors note in reasons-why letters to clients that the DSIR is not guaranteed. Further, “an annual review reminding them why they put the policy in place is really helpful,” she said. “When clients are kept informed, it makes bad news easier to take.”
Dividend scales and the pandemic
Insurers aren’t changing the mortality assumptions in their dividend scales as a result of the Covid-19 pandemic — at least, not yet, said Steve Krupicz, head of advanced sales and actuarial consulting with Manulife Financial Corp.
“We look for longer-term trends,” Krupicz said. Insurers have margins for mortality shocks, he added.
“The increase in claims for the industry [because of Covid-19] is well within the margins that we already hold as provisions for adverse deviations in our reserves,” Krupicz said. “We would need to see a long-term sustained change in mortality before we would reflect it in our dividend formulas.”
Such a trend would have to last at least five years, Krupicz said.