What a Lower Dividend Scale Does to a Real Estate Plan

An insurer's board reviews the scale of participations every year, and it can lower it. That single sentence is the whole subject of this page, and it belongs on an insurance practice's own site because an investor who plans to draw on a contract to fund a deal is depending on values that are not guaranteed. Participations are declared annually at the discretion of the insurer's board and are never guaranteed. A projection that assumes the current scale runs unchanged for four decades is arithmetic resting on that assumption, and the assumption is worth examining before any capital is committed to it.

What follows is technical and narrow on purpose. It sets out what a participation is declared out of, what moves it, what a reduction does mechanically to the values an investor would draw on, and what it cannot touch at all. The broader question of who should refuse the arrangement altogether is answered in when a rental portfolio should say no, and the silo pillar for real estate investors sets out what the arrangement does where it fits. This page assumes you have read both and are asking a narrower question than either of them answers.

What is a participation, and what is it declared out of?

A participation is a distribution from the insurer's participating account, declared annually at the discretion of the insurer's board and never guaranteed. It is not interest credited to your contract and it is not a share of company profit. It is what a board returns to participating policyholders out of that account's experience for one year.

The participating account exists because the Insurance Companies Act requires it. A federally regulated insurer maintains its accounts for participating policies separately from those it maintains for every other policy, in the form the Superintendent determines, and its directors must establish a policy for determining what is paid to participating policyholders. The account holds the premiums of participating contracts and the assets bought with them, and the claims, expenses and taxes attributable to those contracts are charged against it. What stands behind a participation is that pool and nothing else.

Two consequences follow, and an investor should hold both of them at once. The first is that a participation is a residual: it is what remains once the account has met the obligations charged to it, so the calculation happens after the fact and no part of it is promised in advance. The second is that a board exercises judgment every year, within the policy it has established, about how much of the account's experience to distribute and how much to retain. Neither of those describes a rate. Both of them describe a decision taken by somebody else.

Which four elements of experience move the scale?

Four of them. The investment return earned on the assets held in the participating account, the mortality experience of the insured lives in the pool, the expenses charged to the account, and the lapse experience of the contracts inside it. A change in any one of the four can move the scale in either direction.

Each of the four behaves differently and none of them sits under a policyholder's control. Investment return follows the assets the account holds, and Canadian participating accounts hold long-duration fixed income alongside other holdings, so the return reflects decisions taken years earlier by people the owner will never meet. Mortality experience reflects how the insured lives in the pool actually fared against what was assumed when the contracts were priced. Expenses reflect what it cost the insurer to administer and distribute the business charged to that account.

Lapse experience is the one people forget, and it matters because a participating contract is priced on an assumption about how many owners will stop paying. Owners who surrender early leave behind an account whose remaining experience differs from what was assumed, and that difference reaches the scale like any other. An investor reading an insurer's annual report on its participating account will find all four discussed there, because the insurer is explaining the same arithmetic to its own policyholders and has to do so honestly.

Which of those has moved most when interest rates changed?

The investment component, by a wide margin. Participating accounts hold long-duration assets, so when long-term interest rates fall the yield available on new money and on maturing holdings falls with them, and the account's return drifts down over years. Canadian scales have generally drifted downward with rates over recent decades.

The mechanism is slow, and understanding the slowness explains why a scale moves the way it does. An account holding long bonds does not reprice on the day a policy rate moves. It reprices as holdings mature and the proceeds are put back to work at whatever is available then, which means a rate change works through the account over a period of years and not inside a single quarter. The same slowness applies in the other direction when rates rise, which is why a good year for rates does not produce a good year for a scale.

This is the element an investor should watch, and watching it is a matter of reading rather than forecasting. Every Canadian insurer publishes an annual report on its participating account setting out the asset mix, the return and the declared scale, and anybody may ask for it. Read several years of it. One year on its own tells a reader very little. That document describes the pooled account and not your own contract, so it tells you the direction of travel without telling you what any of it does to your own anniversary.

What is guaranteed in my contract, and what is not?

The guaranteed elements are the ones written into the contract itself: the guaranteed cash value schedule, the basic death benefit, and the premium required to keep the contract in force. Everything above those depends on participations, which are declared annually at the insurer's discretion and are never guaranteed.

The distinction is contractual, and it is written into the document you signed. A guaranteed value is an obligation the insurer took on when it issued the contract, and it appears in a schedule that does not move because a board made a decision in a difficult year. A participation is not an obligation of that kind at any point before it is declared. It becomes a fixed part of the contract once it has been declared and applied, which is why paid-up additions already purchased do not evaporate when a later scale is reduced.

That last point deserves a plain statement, because it is where most of the confusion in this subject sits. A reduction changes what is declared going forward. It does not reach back and remove what was declared and applied in earlier years. An investor who has funded a contract for a decade holds a guaranteed schedule and a body of additions already purchased, and a lower scale slows what is added next without unwinding any part of what is already sitting there.

How do I hold those two apart on my own illustration?

Find the guaranteed columns and read them on their own, ignoring everything beside them. Then read the same page again with the non-guaranteed columns included. The difference between those two readings is the part of the document that rests on a scale an insurer's board declares each year and does not promise to anybody.

Canadian illustrations follow an industry guideline, and the document itself tells you what it assumes. It states that the non-guaranteed values assume the current scale continues unchanged for the life of the contract, and it prints an alternate scenario at a reduced scale so a reader can see the shape of the effect. The insurer states on the same document that the alternate scenario is not a worst case. Read that sentence carefully, because it is the most honest line on the page.

An investor can turn the whole exercise into a habit that takes a few minutes. Cover the non-guaranteed columns with a sheet of paper and ask whether the plan still works on what is left underneath. If it does, everything else is upside. If it does not, you have found out something important about the plan while it is still a proposal, which is the cheapest moment at which anybody ever finds that out.

What does a lower scale do to the value I can draw on?

It slows the growth of the accumulated value above the guaranteed schedule. A participation used to buy paid-up additions buys fewer of them, each addition carries its own smaller cash value, and the total available to support a policy loan grows more slowly than the projection showed. The guaranteed schedule continues exactly as written.

The mechanism compounds, and that is the part an investor should sit with for a moment. Additions purchased in a year become part of the base on which later participations are calculated, so a smaller purchase this year means a slightly smaller base next year, and the distance between the projected value and the actual one widens as the years pass and does not stay where it started. The effect is small at the beginning and it does not stay small.

What this means for drawing on the contract is direct. A policy loan is limited by what the contract holds, so a value that grew more slowly supports a smaller advance on any given date. Nothing has been taken away from the owner. Less arrives than the projection showed, and an investor who arranged a transaction around the projected figure discovers the shortfall at the moment the money is needed, which is the worst available moment to discover anything.

What does a lower scale do to the death benefit, and how soon does it show?

The basic death benefit written into the contract does not move at all. The total death benefit can grow more slowly, because the paid-up additions sitting on top of the basic amount are bought with participations, and a smaller participation buys a smaller addition. The change begins at the next anniversary and becomes visible over years.

The timing is the part most often misread. A scale reduction announced this year reaches a contract on its next anniversary, when the participation for that year is declared and applied. On that single anniversary the difference is modest and easy to wave away. Over a run of anniversaries at the lower scale the difference is not modest at all, and it shows up as a total death benefit and an accumulated value that both sit below the line the original document drew.

There is a second timing effect, and it strikes a funding plan harder than the first one does. Where an illustration showed premiums ending after a set number of years, that point was calculated on the current scale, and a lower scale pushes it further out or requires premiums to resume. An investor who had planned to stop paying in a particular year and redirect that cash flow into property finds the obligation still sitting there, in a year already committed elsewhere.

Why is an investor more exposed to this than a household is?

Because a plan that depends on capital being available on a date carries a timing dependency that a household plan usually does not carry. A household funding a contract for protection and long patient accumulation can absorb a slower year without noticing much. An investor who has committed to a closing cannot move the closing.

Set the two positions side by side and the difference is structural, and it has nothing to do with temperament. A household reads a reduction on an annual statement, notes that the projection has softened, and changes nothing about the way it lives. An investor has a deposit due, a conditional period running, a lender waiting on a confirmation, and a vendor under no obligation to be patient about any of it. The same reduction reaches both households, and only one of them has a calendar attached to the consequence.

The exposure is worse again where the contract is the only source of the capital. An investor holding a reserve, a credit facility and a contract has three ways to reach a closing and can absorb the one that came up short. An investor whose entire deposit was going to come from a policy loan on a single contract has one way, and a value that grew more slowly than projected is by itself enough to end the transaction.

What should an investor do about it?

Plan against the guaranteed column and treat everything above it as upside, and never as the plan itself. Ask what the contract holds on a guaranteed basis on the date the capital is wanted, and build the transaction around that figure. Anything the scale adds on top of it is welcome and is not load bearing.

That single discipline removes most of the risk this page describes, and it costs nothing to adopt. A plan built on the guaranteed schedule survives a reduction, because a reduction does not touch the schedule. A plan built on the projected column depends on a board deciding, every year for as many years as the plan runs, to do what it did last year. No board has undertaken to do that, and no Canadian insurer offers an undertaking of that kind to anyone.

Two habits follow from the discipline and both are ordinary. Open the annual statement on the day it arrives, because that document tells you what was actually declared and applied, and compare it against the guaranteed line and not against the projection you were shown at the outset. Then keep a source of capital that owes nothing to the contract, so a slower year inside the contract stays a disappointment and never becomes a failed closing.

What does a reduced scale not do?

It does not reduce the guaranteed cash value schedule, it does not reduce the basic death benefit, and it does not take back participations already declared and applied. Those are contractual obligations of the insurer and they do not move when a board revises the scale for the coming year.

This has to be said as plainly as the adverse case, because an investor who hears that a scale has been reduced and concludes that the contract has failed will often reach for the most expensive response available. Surrendering crystallises any gain, which can be taxable, ends the coverage, gives up the guaranteed schedule that did not move, and does all of it on a date chosen by somebody else's board and not by the owner of the contract.

The useful response to a reduction is a question rather than a transaction. Ask the insurer what the change means for this contract specifically, in dollars, on the next anniversary, and ask what the guaranteed column still shows on the date the capital is wanted. Those two answers tell an investor whether anything about the plan has to change at all. A reduction that leaves the guaranteed figure intact has not disturbed a plan that was built on it.

What protects me if my insurer fails?

Assuris, within its published limits. For a whole life policy, Assuris states that it protects the death benefit up to $1,000,000 or ninety per cent of the death benefit, whichever is higher, and the cash value up to $100,000 or ninety per cent of the cash value, whichever is higher.

Two things about Assuris should be stated precisely, because loose wording here misleads people. It describes itself as an independent, not for profit, industry funded compensation organisation, and membership is compulsory for every life and health insurance company authorised to sell in Canada. Its funding comes from those member companies. It is not a government guarantee. Nor is it deposit protection, which comes from a different body under a different statute. The difference is material, it is blurred in conversation constantly, and it is worth being exact about.

What all of that means for an investor is narrow, and it is worth knowing anyway. The guarantees in a contract are the obligations of the insurer that issued it, and they rest on that insurer's continuing financial strength. Assuris sits behind those obligations as a backstop within the limits above, and a contract whose values exceed the limits is protected up to them and not beyond them. Choosing which insurer issues the contract is part of the exercise and not a formality.

Who this suits, and who it does not

An investor who cannot survive a reduced scale has built a plan that was never sound, and the honest conclusion is that such an investor should not be relying on this at all. A funding plan that works only while a board repeats last year's decision for thirty consecutive years is a hope with a schedule attached to it.

It suits an investor who reads the guaranteed schedule first, builds the transaction on that figure, keeps a source of capital outside the contract, and treats participations as exactly what they are. It does not suit an investor whose closing depends on a projected value arriving on a particular date, because that investor has taken a timing risk and handed the decision that governs it to a board in another building.

This is insurance and it is not an investment, and every sentence above is written on that footing. The guarantees are real and they are contractual. The participations are declared annually at the discretion of the insurer's board and are never guaranteed, whatever any document has ever shown about them over any period. Holding those two facts apart is the whole of the competence this subject asks of a reader.

Nothing on this page is guidance for any particular reader and nothing on it promises a result. If a reduced scale would break your plan, the plan is the thing to repair, and it should be repaired before a contract is issued and not in the year the capital is needed. An investor who does that work in advance carries very little of what has been described here, which is the only reason it has been written down.