Risks and Failure Modes

A specially designed, high-cash-value, participating whole life insurance policy can let a household down in a handful of recognisable ways: a surrender in the early years, a lapse while a policy loan is outstanding, premiums sized to a good year, a design that does not fit its purpose, the loss of exempt status, a beneficiary designation nobody updated, and a policy nobody services. Which of them threatens you depends on your cash flow, the design and how the policy is looked after, so they are set out below without any ranking. The wider case against the product is on the objections and risks hub.

Some of these failures begin with a choice made before the contract is issued: the premium, the design, the purpose. Others arrive later, with a job loss, a divorce, a cut in the dividend scale or a loan left to grow. Either way, the warning signs can show up on the annual statement or in a letter from the insurer before the damage is final, if someone reads them.

What counts as a failure, and what exactly is failing?

Start with what the policy is. A specially designed, high-cash-value, participating whole life insurance policy is insurance: the insurer pays a death benefit when the person insured dies, in exchange for premiums. It is not a savings account or an investment account, and no deposit insurance covers it. It builds a cash value, and the owner can ask the insurer for an advance against that value. That advance is a policy loan: the insurer lends, the owner owes the insurer, and the interest is paid to the insurer.

The financing approach known as The Infinite Banking Concept® uses that feature. The owner funds a participating policy, lets the cash value grow, then takes policy loans for large purchases and repays them on a schedule the owner sets. Nothing in the method changes what the contract is. Every failure below is the failure of an insurance contract, or of the arrangement a household builds around one.

Three kinds of failure are worth keeping apart, because each has a different remedy:

• The contract ends badly. A surrender, a lapse or the loss of exempt status. The contract did what it says; the timing or the funding went wrong.
• The arrangement around the contract fails. A designation nobody updated, a family loan with no written terms, a policy nobody services, an illustration read as a promise. The contract may be performing exactly as written.
• The insurer fails. Solvency supervision and Assuris protection apply, within limits set out further down.

What does a surrender in the early years cost?

The cost of putting a policy in force is weighted to the first years. A large part of each early premium pays for the insurance itself, the advisor's commission and the contract's charges, so the cash surrender value starts well below the premiums paid and closes the gap slowly. Surrender in that window and the difference does not come back. Nothing malfunctioned: the guaranteed column showed it from the start. The real costs sets out where that money goes.

Tax on a surrender follows section 148 of the Income Tax Act. A surrender is a disposition, and only the part of the proceeds above the policy's adjusted cost basis immediately before the surrender is income (subsection 148(1)). For a surrender, the proceeds are the cash surrender value less any policy loans owing, under the definition of "proceeds of the disposition" in subsection 148(9). When the proceeds are below the basis, the surrender creates no income, but the loss is still real.

Illustrative example. Assume you pay $10,000 a year for four years, $40,000 in total. At the end of year four the guaranteed cash surrender value is $26,000, there is no policy loan, and the insurer reports an adjusted cost basis of $31,000. The figures are chosen to show the arithmetic, not taken from any contract. If you surrender then, you receive $26,000. The proceeds are below the basis, so the surrender creates no income, and $14,000 of what you paid does not come back.

Before anyone discusses returns, ask for one number in writing: the first policy year in which the guaranteed cash surrender value equals or passes the total premiums paid under the proposed funding. Ask for the same year on the illustrated basis as well, remembering that it rests on dividends that are not guaranteed. That crossing year measures your exposure if you leave early. It does not tell you whether the policy is a good decision, which depends on the insurance, the alternatives and your household.

What happens if the premiums stop?

Stopping premiums has no single outcome; the contract decides. An unpaid premium is first covered by a grace period whose length is set by the contract and the province's insurance law. After that, depending on the contract and the values in it, one of these follows:

• Dividends applied to the premium. Where the dividend option allows it, the policy's dividends pay or reduce the premium.
• An automatic premium loan. The insurer pays the premium from the cash value as a policy loan, which bears interest, adds to the balance and reduces what is paid at death.
• Reduced paid-up insurance. The policy becomes a smaller amount of coverage with no further premiums.
• Surrender for the net cash value. The contract ends and the owner receives the cash surrender value less any loans owing.
• Lapse. If none of those applies and nothing is paid, the coverage ends.

The Autorité des marchés financiers describes the first routes plainly: where a contract has a surrender value, the insurer can use it to pay the premium as an automatic advance, or may instead convert the whole life coverage to reduced paid-up insurance (AMF, in French). So a stopped premium does not mean everything paid into the contract disappears. What comes back depends on the values, the loans and the option the contract applies, and in the early years that can be far less than you paid.

A lapsed policy can sometimes be reinstated. Whether, and on what conditions, is set by the contract and provincial law, and the conditions can include evidence that the person insured is still insurable and payment of what is owed. In Quebec, a reinstatement starts the two-year contestability period and any suicide exclusion again (Civil Code, art. 2434). Before stopping, ask the insurer in writing for a stop-paying scenario at the year you have in mind, showing the coverage, the cash value and the loan balance under each option your contract offers.

When does a lapse with a policy loan create a tax bill?

It is one of the two endings that do the most damage. Interest on a policy loan is owed to the insurer and, depending on the contract, unpaid interest is added to the balance, so the balance grows even when no new advance is taken. When the balance and its interest overtake the value securing them, the contract can end under its terms.

For tax, that ending is a disposition of the policy. The proceeds are the cash surrender value less the policy loans owing, so a small cheque, or none at all, is not the figure that decides the result. Income arises only to the extent those proceeds exceed the adjusted cost basis immediately before the lapse (subsection 148(1)). Earlier loans matter here: each policy loan was itself a disposition and each one lowered the adjusted cost basis, so the basis at the moment of lapse is not the total of the premiums you paid. A tax bill can still arrive in a year with little cash and no coverage.

A narrow exception exists. The definition of "disposition" in subsection 148(9) leaves out a lapse caused by unpaid premiums if the policy is reinstated no later than 60 days after the end of the calendar year in which the lapse occurred (paragraph (g)). It is written for premium lapses. If a contract ends because the loan overtook the value securing it, ask the insurer and your accountant in writing whether the exception can apply; do not assume it does.

Before you surrender a policy with a loan, or let one end, ask the insurer in writing for the disposition proceeds, the loan settlement, the adjusted cost basis and the tax slip it expects to issue, and have an accountant review them even if little money changes hands. The federal rules apply in every province; Quebec residents also file with Revenu Québec, so the review should cover both returns. That is our reading of section 148, not a ruling.

How can a loan-driven lapse unfold?

Illustrative scenario. The stages below show one possible path, not a typical one. The timing, the notices and the remedies depend on the contract.

1. The premium is set on a strong year. Nothing looks wrong, and the first premiums are paid without strain.
2. A harder year arrives. Income falls or an expense lands. The premium is still paid, but from savings rather than surplus. This is the first real warning.
3. A policy loan pays the premium. The owner requests it, or the contract's automatic premium loan applies. The policy is now paying for itself with borrowed value.
4. Interest is added to the balance. Nothing is repaid, and the balance grows faster each year because interest is charged on a larger figure.
5. The insurer writes. The balance is nearing the value securing it, and the letter says what is required and by when, as the contract provides.
6. The choices narrow. Repay part of the balance, pay the interest, resume premiums, reduce the coverage, or let the contract end.

Illustrative example. Assume a policy loan of $40,000, no repayments, and interest at 5% a year added to the balance once a year. The insurer sets the actual rate and may change it, and the contract decides how interest is added; these figures are chosen for the arithmetic only. After one year the balance is $42,000. After ten years it is about $65,156, which is $40,000 multiplied by 1.05 ten times over. If the cash value securing the loan grows more slowly than that, the margin between them shrinks every year.

What are the warning signs?

Any one of these is a reason to call the insurer or your advisor. Several together are a reason to do it this month, while the choices are still wide.

• Premiums are being paid from savings rather than from surplus income.
• The loan balance is higher than last year although no new advance was taken, which means interest is being added to it.
• The net cash value has stopped growing, or is growing more slowly than the loan.
• The insurer has written about the loan margin, a missed premium or an automatic premium loan.
• A premium has been paid late more than once.
• The annual statement has gone unopened for a year or more.
• Nobody in the household can say who services the policy.
• A loan is about to be taken without anyone knowing the policy's current adjusted cost basis.

When the margin between the loan and the value securing it is narrow, do not wait for the next annual statement: ask the insurer for current figures, and ask again as often as the margin requires.

Who is owed what when you borrow against a policy?

Borrowing goes wrong when nobody is sure who lent the money, who receives the interest and who owes whom. There are two routes, and they are different transactions.

A policy loan is a disposition under paragraph (b) of the definition in subsection 148(9). The loan lowers the adjusted cost basis. Repaying it restores the basis and can give a deduction in the year of repayment, up to amounts previously included in income (paragraph 60(s)). That deduction is not a refund of the earlier tax, and it does not arise without repayment. An assignment of the policy as security for a loan other than a policy loan is not a disposition (paragraph (f)). The mechanics are at how policy loans work, and the tax at when a policy loan becomes taxable. The rest of the contract's mechanics are in policy basics.

The idea that nobody enforces repayment is only half true. Depending on the contract, a policy loan may have no schedule of principal repayments. But the balance and its interest reduce what the beneficiary receives, and a balance that overtakes the value securing it can end the contract. The insurer looks to the policy's values and the death benefit for what is owed. Access has terms too: ask for the loan provision in writing, including the maximum, how the rate is set, how interest is added and what notice the contract provides before termination.

A family loan creates two debts. If you take a policy loan and lend the money to a relative, you owe the insurer, with interest, whether or not your relative repays you. Your relative owes you only what your agreement says, so put the amount, the interest, the schedule and what happens on a death or a separation in a signed document. Interest can be deductible only when the borrowed money is used to earn income from a business or property, and then only as the insurer verifies it on CRA Form T2210. Whether that could apply, and whether attribution rules reach a loan to a spouse or a minor child, are questions for an accountant before the money moves. The wider approach is described at private family capital.

What happens if the person insured dies with a loan outstanding?

The coverage pays, less what is owed. The insurer deducts the loan balance and accrued interest from the death benefit, and the beneficiary receives the rest; the AMF page cited above says the same. Under a collateral loan, the lender, as assignee, can be paid from the death benefit. For income tax, a payment under an exempt policy because of the death of the person insured is not a disposition (paragraph (j) of the definition in subsection 148(9)).

For a corporation the calculation changes. When a private corporation receives life insurance proceeds as beneficiary because of a death, its capital dividend account is credited with the proceeds less the policy's adjusted cost basis immediately before the death (subsection 89(1), definition of "capital dividend account", paragraph (d)). A capital dividend is paid out of that account only if the corporation makes the election under subsection 83(2). Who owns the policy, who is the beneficiary and whether a loan or a collateral assignment is outstanding can all affect the credit, so the corporation's accountant should calculate it before anyone relies on it. The payment itself is described at paying a capital dividend after a death.

Where do corporate policies go wrong?

In a corporation the ways to get it wrong multiply: the wrong owner, the wrong beneficiary, a benefit conferred on a shareholder by accident, or a structure that no longer matches a company reorganised since. These are structuring failures rather than product failures, and they can stay hidden until a death or a sale, a poor moment to find them.

Review the arrangement whenever the corporate structure changes: a new shareholder, a holding company, an amalgamation, a sale. Bring the policy, the ownership and beneficiary records and the corporate minutes to the company's accountant and lawyer, and confirm the tax treatment on the company's own facts.

What changes if the policy loses its exempt status?

A policy keeps its tax treatment only while it stays exempt under the test in Regulation 306 of the Income Tax Regulations, which limits how much a policy can accumulate relative to its insurance. A policy that ceases to be exempt is deemed to have been disposed of at that moment (paragraph 148(2)(d)), which can create income, and it loses the treatment exempt status gave it. How the test works is set out at the exempt test.

The death benefit does not disappear with the status, and whether the remaining coverage is still worth keeping is a separate question for the insurer and a tax professional. The trigger to watch is a deposit larger than the design can absorb. Depending on the contract, the insurer may have steps it takes to keep a policy within the test; ask which ones yours provides, and ask before an unusual deposit rather than after it.

How can a designation or a separation become a failure?

The insurer pays according to a valid designation, the policy and the province's law, not according to what anyone meant. A designation made ten years ago describes the family of ten years ago, and the contract has no way of knowing that the family has changed.

In Quebec, two articles of the Civil Code govern the spouse. A designation of the married or civil-union spouse as beneficiary, made in a writing other than a will, is irrevocable unless the designation stipulates otherwise (art. 2449). An irrevocable designation can limit what the owner may do with the policy without that beneficiary's consent, so ask the insurer and a notary which transactions yours affects. A divorce, a nullity of marriage or the dissolution of a civil union makes a designation of the spouse as beneficiary lapse (art. 2459). A separation is not a divorce, so have a lawyer or notary tell you where yours stands. The Quebec rules are covered in more depth at the family patrimony and the beneficiary designation.

Outside Quebec, what a separation or a divorce does to a designation depends on the province's law and on any court order or separation agreement; do not assume it changes by itself. In every province, review the ownership, the designation and any promise in a separation agreement to keep coverage in force.

The quieter version is a household where only one partner understands the arrangement. It needs funding over decades, and a partner who never agreed to it may decline to continue. If the partner who managed it dies and the other does not know it exists, it may go unclaimed. A household that cannot talk directly about money is not ready to begin, and that is a suitability finding, not a moral one.

What can go wrong with the application?

A policy is only as sound as the application behind it. Start with what nobody may do: under the Genetic Non-Discrimination Act, no one may require you to take a genetic test, or to disclose the results of one, as a condition of entering into a contract, an insurance contract included. What an insurer may ask is at the Genetic Non-Discrimination Act and what an insurer may ask.

Then the duty. In Quebec, the applicant must disclose every fact they know that is likely to materially influence the insurer, not only the facts asked on the printed form (art. 2408). An application can be filled in quickly, with someone else typing while you answer. Read it before signing: what it records about health, occupation, travel, pursuits and other coverage.

In Quebec, absent fraud, a misrepresentation or concealment does not justify annulling or reducing insurance that has been in force for two years (art. 2424), and a reinstatement starts that period again (art. 2434). The other provinces' insurance statutes have their own two-year rules with a fraud exception; ask the insurer for the wording that applies to your province and your contract. The consequence of an omission can fall on a beneficiary years later, with no way to correct it. More at misrepresentation on an application.

What happens when nobody services the policy?

A policy of this kind can outlast the advisory relationship that placed it: a retirement, a career change, a move, a death. The contract is unaffected, the insurer's obligations are unchanged, and nothing lapses because a person left. What goes is the servicing: no annual review, nobody to explain a change in the dividend scale, nobody to prompt a designation update, nobody to help when the household needs an advance and does not know how to ask.

Contact the insurer to confirm who services your policy now and how its reassignment process works. Keep your address, email and telephone number current with the insurer, because notices of a missed premium or a loan margin go to the contact details it holds.

Once a year, read four figures on the statement:

1. The guaranteed cash value, against the contract's guaranteed schedule after any loans, withdrawals, premium changes or coverage changes. If they differ and nothing explains it, ask the insurer in writing to reconcile them.
2. The total cash value, against the illustrated column. Being below the illustrated column is not a failure; dividend scales move, and the illustration was never a promise.
3. The loan balance, against last year and against the net cash value securing it.
4. How the dividend was applied, against the option you chose and the purpose of the policy.

Separately, confirm once a year with the insurer your contact details, the premium arrangements and the beneficiary designation. The four figures cannot catch a notice sent to an old address or a designation that no longer fits your family; those two checks can.

What if the insurer itself fails?

The guarantees are obligations of the insurer that issued the policy, not of any government, and CDIC deposit insurance does not cover life insurance. Solvency supervision follows the insurer's charter: OSFI for a federally incorporated insurer, and the home province for a provincially incorporated one, which in Quebec means the AMF.

Every life insurer authorised to sell insurance in Canada must belong to Assuris. If a member fails, Assuris states that a whole life policyholder keeps up to $1,000,000 or 90% of the promised death benefit, whichever is higher, and up to $100,000 or 90% of the promised cash value, whichever is higher, both calculated on the net values after policy loans are deducted (Assuris, whole life). Values above those limits are the part at risk.

Who is most exposed?

Any one of these is enough to pause:

• Surplus income that is not durable: variable earnings, a young business, commission income, a budget already at its edge. The structure punishes interruption.
• A need for the money within the first several years, when the cash value is lowest against what you paid.
• Capital that does not exist yet. Nothing here works before there is money to put in.
• High-rate debt still outstanding.
• No wish for permanent coverage for its own sake.
• No clear answer to what the policy is for. Without a purpose, no design can be right.

Registered plans are a separate question. A TFSA, an RRSP or an FHSA does a different job from life insurance, but contributions and premiums can compete for the same surplus dollars. This practice is licensed to place insurance of persons and is not registered to advise on registered plans, so it gives no ordering between them and a policy; take that question to a professional licensed for it. Being on the list above is not a judgement of anyone. It means other tools suit you better today, and circumstances change.

What reduces the risk before you sign?

None of these is a product feature, and each is open to anyone:

1. Size the premium to an ordinary year, with room to spare, and ask which part is the contractual premium and which part is an optional deposit you can skip.
2. Get the guaranteed crossing year in writing, and look at the values at years 1, 3, 5 and 10.
3. Ask for a stop-paying scenario at year four or five, and a loan scenario both repaid and not repaid.
4. Decide the purpose first, and have the design and the dividend option chosen against it.
5. Know the underwriting result before building on it. A rating changes the cost of the whole structure and a decline ends it; the outcomes are at rated, postponed or declined.
6. Read the application before signing, and correct anything wrong.
7. Ask who will service the policy in ten years, not only who is selling it now.
8. Make sure more than one person in the household understands the arrangement and knows where the documents are.

Each question has someone who can answer it:

What can you do if something has already gone wrong?

Act early, because the choices narrow as the margin narrows. With a loan close to the value securing it, ask the insurer for current figures and compare repaying part of the balance, paying the interest, resuming premiums, reducing the coverage, or converting to reduced paid-up insurance where the contract allows it. Before any surrender or planned lapse, get the four tax figures in writing and an accountant's review. Before leaving a policy after a change in health, find out whether you are still insurable, because the policy in force was priced on your health at issue and may not be replaceable.

If a request or a claim was refused, or you believe the policy was sold on an inaccurate description, ask for the reasons in writing and for a copy of the application and the records relied on; a privacy access request can reach the rest of your file. Speak to a lawyer promptly, or in Quebec a lawyer or notary, because deadlines apply.

Who is describing these risks, and how are they paid?

Every risk above is a risk of this product, described by a firm that is paid by the insurer, by commission, if a policy is bought through it, as the author page states. Reading here is free. The right conclusion is not that a better contract solves these risks. A policy entered without stable cash flow, a clear purpose and a long horizon is likely to disappoint, and for a great many people the correct decision is not to buy one at all. Whole life insurance is insurance, not an investment, and a slow decision ages better than a fast one.