Tax-Exempt Rules for Life Insurance And the changes that are coming! Dominik Briault, FSA, FCIA Director, Actuarial Marketing Services

Tax-Exempt Rules for Life Insurance And the changes that are coming! Dominik Briault, FSA, FCIA Director, Actuarial Marketing Services

This material is for information purposes only and shouldn t be construed as legal or tax advice. Every effort has been made to ensure its accuracy, but errors and omissions are possible. All comments related to taxation are general in nature and are based on current Canadian tax legislation for Canadian residents, which is subject to change. For individual circumstances, consult with legal or tax advisors. 2

3 Session Agenda Life Insurance Industry Sales Tax-Exempt Rules: The basics The current rules The new rules Other considerations Participating Insurance Discussion

Life Insurance Industry Sales

Canadian individual life insurance sales Total premiums 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Term Life Universal Life Whole Life Source: LIMRA Individual Life Insurance Sales Confidential Participants' Report Note: LIMRA doesn t report participating life insurance separately. It s included in the whole life category. Whole life figures include both participating and non-participating whole life sales.

Whole life sales in 2014 Total Canadian industry whole life sales premium: $722 million and 13% growth At the end of 2014, whole life represented 48% of industry life insurance sales Canada Life had the number one market share of whole life sales premium London Life/Great-West Life/Canada Life had a 47% market share of whole life sales at the end of 2014 Canada Life London Life 23% 21% Great-West 3% 53% Other companies Source: LIMRA Individual Life Insurance Sales Confidential Participants' Report. Note: LIMRA doesn t report participating life insurance separately. It s included in the whole life category. Whole life figures include both participating and non-participating whole life sales.

Tax-Exempt Rules

8 Tax-Exempt Rules Basics Tax-Exempt Rules dictate how much cash value can be held within a life insurance policy given the total death benefit and remain tax-exempt Test is meant to distinguish between policies that are deemed to be protection-oriented versus investment-oriented

9 Tax-Exempt Rules Basics Benefits of a tax-exempt life insurance policy: The cash value in the policy grows tax-free; The total death benefit is paid tax-free to the beneficiary(ies) upon the death of the insured There could be exceptions with the new rules When a life insurance policy is non-exempt: The total death benefit is still paid tax-free to the beneficiary(ies) upon the death of the insured; However, the increase in cash value above the ACB since the last policy anniversary becomes taxable on a yearly basis

10 Tax-Exempt Rules Basics To be tax-exempt: The Accumulating Fund (AF) of the policy must be lower than the AF of a hypothetical benchmark policy This benchmark mark policy is often called the Exempt-Test Policy (ETP) The legislation will determine the type of life insurance policy to use to determine the ETP Some additional tests, i.e. the 8% Test and the 250% Test will determine the proper ETP to use for the policy

11 Tax-Exempt Rules Current Current ETP is based on a 20-Pay Endowment Paid at age 85. The ETP is based on the assumptions used in the pricing of the life insurance product The exempt test must be performed at every policy anniversary The test must ensure that the AF of the policy is less than the ETP of the policy for the current anniversary and all future anniversaries The AF of the policy is the greater of: The cash surrender value of the policy; and The 1.5 Full Preliminary Term (FPT) reserve for the policy

Tax-Exempt Rules Current 12

Tax-Exempt Rules Current 13

Tax-Exempt Rules Current 14

Tax-Exempt Rules Current 15

16 Tax-Exempt Rules New New ETP is based on an 8-Pay Endowment Paid at age 90 8-pay to reflect the fact that most life insurance policies are paid over a shorter period of time than previously; and At age 90 to reflect mortality improvement since the 1980s The ETP is based on a set of prescribed assumptions in the law The exempt test must be performed at every policy anniversary The test must ensure that the AF of the policy is less than the ETP of the policy for the current anniversary only. and all future anniversary dates The AF of the policy is the greater of: The cash surrender value (ignoring surrender charges and policy loans) of the policy; and The Net Premium Reserve (NPR) for the policy. 1.5FPT reserve for the policy

Tax-Exempt Rules New 17

Tax-Exempt Rules New 18

Tax-Exempt Rules New 19

Tax-Exempt Rules Differences 20

Tax-Exempt Rules Differences 21

Tax-Exempt Rules New 22

Tax-Exempt Rules New 23

24 Tax-Exempt Rules Other Considerations Impact on Universal Life Products: Two major impacts: Reduction in Maximum Premiums; and Potential Cost of Insurance (COI) increase from change in Investment Income Tax (IIT) rules

25 Tax-Exempt Rules Other Considerations Impact on Universal Life Products (con t): Reduction in Maximum Premiums: Currently, maximum premiums are calculated using the cash surrender value of the policy Theoretically, you could increase the tax-exempt room within a UL policy by increasing the surrender charges of your product Under the new rules, the maximum premiums will be calculated using the cash surrender value ignoring surrender charges and policy loans As a result, maximum premiums will be decreased under the new rules This change will be bigger for some companies based on their current product design

26 Tax-Exempt Rules Other Considerations Impact on Universal Life Products (con t): Potential COI Increase: The current IIT calculation is based on the cash surrender value of the policy Because of the surrender charges and the smaller account values for minimum funded policies, the IIT was smaller as well The new rules will now be using the larger of the Accumulating Fund (AF) and the Net Premium Reserve (NPR), ignoring any policy loan or reinsurance ceded in the IIT calculation This change will increase the amount of IIT that will be paid by each carrier This change will likely lead to an increase in UL COI charges

27 Tax-Exempt Rules Other Considerations ACB/NCPI Impact: Adjusted Cost Basis (ACB) is the amount that can be withdrawn from a life insurance policy tax-free upon full surrender Simplistically, the ACB is calculated as follows (the actual formula is more complex): ACB(t) = ACB(t-1) + Premiums(t) NCPI(t) NCPI = Net Cost of Pure Insurance NCPI is currently calculated using the CIA 1969-75 Mortality Table NCPI(t) = [Total Death Benefit(t) Cash Surrender Value(t)] * q(x)

28 Tax-Exempt Rules Other Considerations ACB/NCPI Impact (con t): The ACB formula is not changing. Besides a small change in the definition of a premium However, there are two changes in the calculation of the NCPI: A newer mortality table must be used... i.e. CIA 1986-92 Mortality Table NCPI(t) = [Total Death Benefit(t) Net Premium Reserve(t)] * q(x) The overall impact is that the NCPI will be materially reduced versus our current rules

29 Tax-Exempt Rules Other Considerations ACB/NCPI Impact (con t): This change in NCPI methodology means: The ACB of the policy will take longer to get to zero, or may never get to zero; More cash value can be withdrawn tax-free for individually-owned policies because of the higher ACB; NCPI deductions will be less for corporately owned policies; The Capital Dividend Account (CDA) credit will likely be less than today for corporately-owned policies because of the higher ACB CDA Credit = Total Death Benefit ACB

30 Tax-Exempt Rules Other Considerations Grandfathering of Inforce Policies: The new legislation says that policies issued prior to January 1 st, 2017 will be grandfathered with the old rules The legislation also sets the rules dictating when such a policy will lose its grandfathered status Discussions are ongoing with government to clarify some of the grandfathering rules. What we know for sure: A change resulting in both an increase in coverage and requiring underwriting => loss of grandfathering; A term conversion to another type of coverage => loss of grandfathering Other changes will be communicated as we finalize our discussions with government

31 Tax-Exempt Rules Other Considerations Impact on Policy Changes: Still reviewing...

Mechanics of participating life insurance

Digging deeper into financial facts 33

How participating life insurance works 34

35 How does participating life insurance work? Participating account operations Policyowner premiums + Investment income - Benefits paid and changes in actuarial liabilities - Expenses and taxes = Participating account earnings Participating surplus account Policyowner Opening balance + Participating account earnings - Distribution Shareholder = Closing balance

Summary of participating account Operations and surplus London Life Participating account ($ millions) SUMMARY OF PARTICIPATING ACCOUNT OPERATIONS IN 2014 Participating policyowner premiums $2,033 + Investment income 1,457 - Benefits paid 871 - Changes in actuarial liabilities 1,312 - Expenses and taxes 453 - Distribution to policyowners & shareholders 823 Policyowner dividends 783 Increase in dividend liability 23 Shareholder portion Cash payment 21 Accrual -4 = Participating account net income $31 PARTICIPATING ACCOUNT BALANCE SHEET Assets $23,844 - Liabilities 22,124 =Closing balance for participating account surplus at Dec. 31, 2014 Participating account surplus $1,720 Opening balance Dec. 31, 2013 $1,661 + Participating account net income 31 + Other comprehensive income 24 + Reallocation of assets 4 = Closing balance for participating account surplus $1,720 Source: December 2014 Financial Facts London Life participating life insurance page 10 36

37 Participating Life Insurance Value Client needs Par feature Wants guarantees Guaranteed base premiums Guaranteed base death benefit Guaranteed base cash values Guaranteed level of term enhancement for 10 years or life Vesting Wants professional management of the investment component of their life insurance policy Participating account managed by a team of investment professionals Have a low to moderate investment risk tolerance The par account is managed such that 80% of invested assets are in fixed income with 20% invested in equities Are attracted to historical long-term stability The standard deviation of the par dividend scale interest rate is 1.7% in 2014.

Participating account stability

Participating account stability Sources: London Life Looking Back at Historical Returns. 39

40 10 year Government of Canada bond yields % Source: GLC, Bloomberg, FTSE TMX Global Debt Capital Markets Inc., June 30, 2014 Past performance is no guarantee of future results. There can be no assurance that any trends shown will continue because economic and market conditions change frequently.

41 Long-Term Bond Yields since 1790 - US Source: http://www.ritholtz.com/blog/2012/01/222-years-of-long-term-interest-rates/

42 London Life participating account performance Asset class Return on total participating account assets Jan 1, 2013 to Dec 31, 2013 Jul 1, 2013 to Jun 30, 2014 Jan 1, 2014 to Dec 31, 2014 Public bonds and private 4.6% 4.2% 4.1% placements Mortgages 4.8% 4.6% 4.5% Stock 19.9% 30.9% 10.8% Real Estate 4.4% 7.7% 8.2% Total Portfolio Yield* 7.0% 7.8% 5.5% * Net of investment expenses Asset returns available in January and February 2015 for new par account investments in bonds and mortgages during this period were about 3.3% Approximately 110 bps below the average return for similar par account assets maturing throughout 2015

Participating insurance competition

London Life vs. Great-West Life / Canada Life Information as of December 31 st, 2014 Product options London Life Great-West Life Canada Life 20 Pay Life, JWL, LP 65 Early CV and Delayed CV products, both with 20-pay and life-pay options, ADO available on all products. Total assets $23.8 billion $4.3 billion $979 million (open block only) Surplus position $1.7 billion $579 million $163 million (open block only) Target investment mix 2015 dividend scale interest rate (DSIR) 80% fixed income 5.90% 6.15% 6.50% Rating reduction program No Yes lower premiums for rated cases Policyowner portion of distributed surplus 97.5% 97.5% 97.0% Sources: 2014 London Life Financial Facts; 2014 Great-West Life Financial Facts, 2014 Canada Life Financial Facts 44

London Life vs. Sun Life Participating Accounts Information as of December 31 st, 2014 London Life Sun Life Product options 20 Pay Life, JWL, LP 65 Early CV and Delayed CV products, both with 20-pay and life-pay options, ADO available on all products Total assets $23.8 billion $426.0 million (open block only) Surplus position $1.7 billion $35 million (open block only) Investment mix 19% equities 34% equities 2015 dividend scale interest rate (DSIR) 5.90% 6.75% Policy loan rate 6.5% 4.5% Policyowner dividends paid $783 million $38 million (open block only) Sources: 2014 London Life Financial Facts; 2014 Sun Life Financial Participating Whole Life Insurance Facts and figures 45

46 Differences in Asset Mix London Life participating account invested assets As at December 31, 2014 Sun Life participating account invested assets As at December 31, 2014 5.2% 0.1% 4.9% London Life participating account invested assets At June 30, 2013 13.8% Cash & Equivalents Public Bonds Private Placements 1.2% Cash & Equivalents 17.4% Public Bonds Private Placements Residential Mortgages 36.8% Residential Mortgages 23.5% 46.1% Commercial Mortgages Common Stock Real Estate 16.4% Commercial Mortgages Common Stock Real Estate 2.5% 3.9% Preferred Stock 11.6% 16.6% Preferred Stock Sun Life: Sun Life 2014 participating whole life facts LondonLife: 2014 London Life participating life insurance financial facts

47 Agency Ratings Ratings* Rating agency London Life Sun Life Assurance Company of Canada Manulife Financial A.M. Best Company A+ A+ A+ Fitch Ratings AA AA-** AA- Moody s Investors Service Aa3 Aa3 A1 Standard & Poor s Ratings Services AA AA- AA- * As of July 29, 2014 ** Source: fitchratings.com

Participating Account Asset Quality (December 31 st, 2014) Public Bonds Asset Quality Sun Life Par account London Life Par account AAA 14.0% 49.8% AA 34.3% 13.0% A 39.9% 22.4% BBB 11.8% 14.3% BB or less 0.0% 0.5% Total 100% 100% Sources: 2014 London Life Financial Facts; 2014 Sun Life Financial Participating Whole Life Insurance Facts and figures 48

Change in Participating Account Surplus Participating Account Surplus End of Year London Life Par account Sun Life Par account 2011 $1,598 million $49 million 2012 $1,811 million $49 million 2013 $1,661 million* $38 million 2014 $1,720 million $35 million Change since 2011 +7.6% -28.6% * 2013 London Life participating account surplus was reduced by $196 million due to a litigation provision release. Sources: 2014, 2013 & 2012 Par Financial facts London Life; Sun Life Participating Whole Life insurance Facts and figures 49

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