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Chapter 1

Insurance Industry



Insurance Industry

Role in the Economy
Risks that People Face
Distribution Options
The Insurance Agent’s Role
Types of Insurance Policies
• Life insurance
• Disability Insurance
• Group Insurance
• Annuities
• Critical Illness
• Accident and Sickness
• Long-Term Care
The Underwriting Process
Evolution of the Industry
Financial Ratings




Life is uncertain. The future is largely unknowable. Insurance helps people remove the risk
associated with going about their lives by compensating them when misfortune occurs.

Insurance is all about managing risk—the financial risk that death, illness or disability would
have on a policyholder as well as his or her dependants.
The insurance industry is of major importance in Canada. According to the Canadian Life and
Health Insurance Association (CLHIA)1, approximately 26 million Canadians own life or health
insurance. By the end of 2009, Canadians owned just over $3.47 trillion in life insurance.
As of the end of 2009, there were 96 life and health insurance companies in operation in this
country. The life and health insurance industry employs over 131,000 people—about 55,000
are full-time employees, and approximately 76,000 are independent agents who earn at least
part of their income from the life and health insurance industry.
Yet the Canadian life insurance industry, which has a long history in Canada, with some
companies in current operation having been in existence for more than a century, has
undergone some radical changes in recent years. Since the middle of the 1990s, powerful
forces such as industry consolidation, the rise of the Internet, historically low interest rates
and changes in the corporate structure of insurance companies themselves (e.g.,
demutualization), have affected this market.


After reading this section, you should be able to:
• Describe the history and philosophy behind insurance.
The life insurance sector is just one part of the Canadian financial services sector, which includes
banks, credit unions, finance companies, financial planning firms, investment dealers, money
managers, mutual fund dealers, trust and loan companies, and many other types of firms.
However, broadly speaking, for many decades Canada’s financial system was described as
having “four pillars”: banks, brokerage houses, trust companies, and insurance companies. Up
until the 1980s, these were all distinct segments of the financial services sector, with no cross-
pillar activity taking place. This started to change 20 years ago, as banks were permitted to own
brokerage subsidiaries, trust companies offered some banking services to their customers, and
later, other institutions were allowed to offer insurance through subsidiaries.

The source for many of the statistics in this chapter have been adapted from the Canadian Life and Health
Insurance Facts, 2010 Edition published by the Canadian Life and Health Insurance Association (CLHIA) Inc.



The result is that the financial world has changed, with the companies that make up these
broad financial pillars now offering a wider variety of products. Banks can offer insurance
products, for example, while insurance companies market a number of savings and
investment related products.


After reading this section, you should be able to:
• State and define three personal risks most people face.
Individuals face many types of risks in their day-to-day lives. The different types of insurance
that are available can ease the financial burdens associated with these risks. Property insurance
covers the risks of economic loss of such items as a person’s home or car due to fire, theft,
accident or natural disaster. Liability insurance provides against economic loss from the
policyholder being held responsible for harming others or their property. Personal insurance
provides against the risk of economic loss resulting from the three personal risks that people face:
death, poor health, and outliving one’s savings. Life insurance provides against loss from death;
critical illness, long-term care, disability, and accident and sickness insurance provide against
economic loss from poor health, and annuities insure against outliving a person’s savings.

Life insurance in its basic form promises to pay a benefit upon the death of the person who
is insured. Life insurance is purchased by people for many reasons, including a desire to
cover the costs of a funeral, to create an estate so that a family can be supported, to pay off
existing debts including a home mortgage, and to settle the expenses of an estate, including
the payment of taxes.
Life insurance is available on both an individual and a group basis, for example to an
employer for the benefit of its employees. Annuities are another product typically associated
with insurance companies, and are a guarantee of payments, often for a retiree, that continue
for either a fixed period of time, or a contingent period, such as the recipient’s lifetime.
Other types of insurance cover other risks that individuals face, not just those associated with
death. Critical illness plans pay a lump sum upon the diagnosis of an illness such as heart attack
and cancer, and as such help protect against any prolonged financial hardship associated with
these diseases. Long-term care plans pay an ongoing monthly benefit to a person if he or she
requires constant care for a prolonged medical condition. Disability insurance helps replace lost
employment income by making insurance payments if a policyholder is unable to work because
of disability. Finally, accident and sickness policies address medical services that are outside of
provincial coverage. Accident and sickness coverage may include the cost of semi-private or
private hospital rooms, vision care, ambulance services, hearing aids and other services.




After reading this section, you should be able to:
• Define the primary types of product distribution options in the Canadian life
insurance industry.
• Describe the changes in distribution methods that have evolved in the life
insurance industry (e.g., from “career” companies to “brokerages”).
When people think of how to buy life insurance, they typically think of the oldest and most
established route: personal contact with a life insurance agent. However, there are many ways
that insurance can be purchased in Canada, and through other providers of insurance products
than just the traditional insurance companies. Today’s suppliers, in addition to insurance
companies, include:
• Banks, which are allowed to both own insurance companies and sell insurance products,
subject to many restrictions. For example, bank employees can only sell life insurance if
they are separate from the rest of the bank’s sales force that sells other products (such as
mutual funds and savings products);
• Governments, that provide income protection programs (e.g., Canada Pension
Plan, Employment Insurance) as well as health insurance;
• Fraternal societies that can offer products to their members and, sometimes, to
their members’ families as well;
• Medical care plans that provide coverage in exchange for premiums, offered by groups
such as Blue Cross;
• Investment dealers, through their licensed Investment Advisors, can sell life
insurance products; and
• Mutual fund distributors can also sell insurance products through their
appropriately licensed registrants.
The ways of distributing life insurance to people are also changing. The basic route is
through the insurance agent, an individual authorized by an insurance company to represent
that company and its products to potential customers. Decades ago, insurance companies
looked at single means of distributing life insurance, typically through large teams of career
sales agents who represented that one company only in face-to-face contact with clients.
Today, a greater number of insurance firms are concluding that selling to the broadly based
middle-income market through the traditional channel of the career agent is not as profitable as it
once was. In an effort to adapt to today’s more competitive world, companies are looking at
multiple channels to distribute their products. Most firms have either disbanded or reduced their
groups of career sales agents and instead use a network of agents, dealers, brokers and other non-
traditional means of distributing their products. This can include sales through the mail, through
agents selling multiple products, online/web-based sales, or sales in non-traditional locations



(such as stores), all with a heavy reliance on firm advertising and brand recognition, as
opposed to an earlier, personal relationship.
Yet at the same time as companies explore new channels for distribution, they are facing the
challenge of eating into existing sales, thus “cannibalizing” the market. Still other companies
are finding that once promising outlets such as the Internet may serve the customer’s needs for
purposes of price comparisons, but are lacking in the advice and sales support areas, and thus
not generating as many sales as first thought.


After reading this section, you should be able to:
• Describe the life agent’s role in the sales and distribution process.
• State the major functions of the life agent.
• Explain the terms “pre-sale service” and “post-sale service” as they apply to the life agent.
Insurance agents are in the service business. Therefore, it is the role of insurance agents not
merely to sell a product, but also to fully and accurately meet the needs of their clients. This
is the concept of total needs planning: providing for meeting the needs of the client as they
face life’s risks. There are three types of personal risks people face: risks during life, risk of
death, and risk of disability. Thus, total needs planning includes understanding the needs of
the client, the products and services that the client already has, and the services that the
insurance agent has available to offer.
This process continues to be necessary as customers are becoming more sophisticated, requiring
integrated and independent advice. From the insurance company end, many companies
have downsized their career-agency forces, while at the same time setting higher
standards of productivity for those who stay. All of this is occurring in a world where the
traditional role of agents and brokers is constantly changing.
There are two basic points where the agent serves his or her clients:
• Pre-sale service includes the entire interaction with a client, from the time of
obtaining the initial referral or making the initial contact, through the assessment
of needs and application/documentation completion.
• Post-sale service includes the actions that the agent undertakes after the insurance
policy has been written. This includes delivery of the policy itself, explanation of
coverage review and answering any questions that the insured may have, and reviews
of other policies that the client may have and how this policy integrates with and meets
client’s needs. It could also include analysis of the client’s overall retirement and
financial needs. It extends to assisting in the settlement of either life or health claims.
Post-sale service is an ongoing process, as peoples’ needs change over a period of time. It is
not a one-time event for the life insurance agent.




After reading this section, you should be able to:
• Describe insurance products and their benefits, including Life Insurance, Group
Insurance, Annuities, Critical Illness, Long-Term Care, Disability Insurance, and
Accident and Sickness Insurance.
There are a wide variety of insurance products that can be offered, in an almost endless
variety of ways. However, the major types of insurance products include:

Life insurance
In its basic form, life insurance pays a benefit to a beneficiary upon the death of the life
insured. Though there are many types of life insurance that have been developed, they fall
into two basic categories: permanent and term insurance.
Permanent insurance, also known as whole life insurance, is characterized by level premiums
that are more than the actual cost of insurance protection in the early years of the policy. This
extra, or cash value, can be used for retirement, savings, or financial emergencies. If a policy
is given up, the purchaser of the policy is entitled to this cash value.
Term insurance provides a benefit upon the death of the life insured but does not provide any
cash value. While the premiums for this type of insurance are initially lower than for permanent
insurance, they rise over time to reflect higher mortality rates, as the life insured becomes older.
Within Canada, at the end of 2009, of the total amount of individual (non-group) life
insurance in force, 55% was term insurance, while 45% was permanent insurance.

Disability Insurance
Disability insurance helps replace lost employment income by making payments if a person
is unable to work because of disability. Benefits are usually integrated with those from
government plans such as the Canada/Quebec Pension Plan, Workers’ Compensation, and
Employment Insurance so that total benefits do not exceed a certain proportion of the
normal earnings of the individual covered.
In 2009, 11.6 million people in Canada were covered by short term disability plans (which
have benefits starting the first day off work or shortly after, and continuing for a limited
number of weeks) and/or long term disability plans (starting after a certain number of weeks
and continuing payment for a stated term or until a certain age is reached).



Group Insurance
Group insurance is issued, usually without a medical examination, on a group of people
under one contract—typically issued to an employer for the benefit of its employees. In most
cases, the dependants of the group members are also covered. Insurance companies provide
such group insurance to a wide variety of groups (such as professional or fraternal groups), in
addition to employers. Individual insurance is purchased on an individual basis, covering a
single policyholder or sometimes members of his or her family.

Annuities are a regular stream of payments, typically made to a retiree, at predetermined
intervals, such as monthly or annually. They last for either a set period of time (i.e. 20 years), or
a contingent period (i.e. the lifetime of the recipient). They include both registered and non-
registered group retirement plans, as well as individual contracts administered by life insurance
companies. Group retirement plans include group registered retirement savings plans (RRSPs),
deferred profit sharing plans (DPSPs) and group annuities. Individual contracts include life
annuities and registered retirement income funds (RRIFs).
In 2009, Canadians paid premiums for over $17.1 billion of individual annuities
and $19.3 billion of group annuities, for a total of over $36 billion.

Critical Illness
Critical illness insurance protects against the financial hardship caused by serious health problems
such as heart attack, stroke or cancer. It is sometimes referred to as dread disease coverage. This type
of policy pays a lump sum to the insured shortly after the diagnosis of the condition. Group or
individual critical illness plans covered about 1.1 million people in Canada at the end of 2009.

Accident and Sickness

Accident and sickness policies, as stated previously, address medical services that are outside
of provincial coverage. The coverage may include the cost of semi- private or private
hospital rooms, vision care, ambulance services, hearing aids and other services.

Long-Term Care
Long-term care policies pay an ongoing monthly benefit to a person if he or she requires constant care
for a medical condition. Long-term care includes a range of services that provides health and personal
care for individuals who are unable to care for themselves. Services range from providing care in the
individual’s own home and include part-time skilled nursing care to providing care
in chronic care hospitals, adult day care centres, or retirement lodges. Long-term care
insurance provides a source of funds to pay for these services.




After reading this section, you should be able to:
• Explain the insurance underwriting process and the agent’s role in the process.
Insurance is about, at its core level, identifying and correctly pricing certain risks. An individual
transfers risk by shifting the financial burden of the risk away from themselves to an insurance
company, in exchange for a fee. The insurance company, for its part, must set that fee at a level
to both reimburse it for the financial responsibility it undertakes and provide for a profit for
doing so, by correctly pricing risk. Underwriting is the process of both identifying the risks that
a proposed insured person presents, and classifying the degree of risk from this. The individual
at an insurance company who evaluates these proposed risks is known as an underwriter.
The life insurance agent plays a front-line role in the underwriting process. It is the agent’s job to
carefully and fully collect information from the potential client, and complete the medical history
and explanation of the applicant’s exact job duties component of the life insurance application, to
properly and speedily issue a policy. It is also the agent’s responsibility to inform the client about
the importance of providing accurate information to the agent.
Whether it is life insurance, or long-term disability insurance, underwriters have identified a
range of factors that either increase or decrease the likelihood that a policyholder will suffer an
insured loss. These include both medical and physical factors (medical history, age) and lifestyle
factors (smoking, dangerous recreational hobbies). Once these risks have been identified, they are
classified into categories for the determination of appropriate premium rates to be charged for the
insurance coverage that is requested. This is due to the fact that people in differing risk categories
are charged different premium rates for insurance that is otherwise the same.
There are three broad categories of risk: standard risks (average likelihood of risk loss),
substandard risks (still insurable, but with significantly greater than average likelihood of
risk loss) and declined risks (uninsurable as the risk is too great).
In 2009, approximately 96% of applications for individual life insurance were accepted either on
a standard or substandard basis. Of the 4% that were declined, about 20% were rejected for heart
disorders, 6% for diabetes, 4% for cancer, 50% for other serious health problems, and the rest for
non-medical reasons. Underwriting, issues and claims are covered in detail in chapter 6.




After reading this section, you should be able to:
• Describe the difference between federally and provincially chartered life
insurance companies in Canada.
• Explain the differences among stock companies, mutual companies and fraternals.
• Describe the size of the life insurance marketplace.
In Canada there is no single regulatory body that is responsible for the entire financial services
industry. Responsibility is divided between different organizations and between the federal and
provincial governments. For example, banks are federally regulated, while security dealers and
credit unions are provincially regulated. Insurance companies, along with trust and loan
companies, may either be federally or provincially regulated, depending on the location
where the company was registered or incorporated.
A provincially regulated insurer has the right to operate in a province other than its province of
incorporation as long as that insurer obtains the necessary licences from other provincial
insurance authorities. Typically, though, in this case only one of the provincial jurisdictions
will undertake the supervision of the provincially regulated insurance company.
Of the 96 active life insurance companies in Canada, 72 are registered under federal laws,
while 24 are provincial. Though 75% of all life insurance companies are federally
registered, they received 87% of the total premiums for all lines of business.
Well-known companies that are federally registered include Canada Life Assurance
Company (founded in 1847), Sun Life Financial (received charter in 1865), and Manulife
Financial (founded in 1887).
Insurance companies have their internal business affairs arranged in one of three ways. On
of the major ways is as a stock company. The individuals or institutions who have purchased
its shares own the insurance company, like other stock companies. The insurance company’s
profits, or earnings, may be retained by the company to fuel future growth, or can be
distributed to stockholders in the form of stockholder dividends.
Insurance companies can also be organized as mutual companies, which are owned
mutually by the policyholders themselves. Such companies tend to be older and fewer in
number than stock insurance companies. Profits made by the company can be distributed to
the company’s owners, the policyholders, in the form of policy dividends.
Beginning in 1999, a number of well-known names in the insurance field went through the
process of demutualization, where mutual companies reorganized themselves into companies
that issued stock, which then traded on stock exchanges. The result is that the ownership of the
insurance company changes from ownership by its customers, or policyholders, to one that is
owned by stockholders, who may or may not be customers. The benefits of demutualization to
insurance companies included an ease of raising future capital via the stock market, and the
ability to more easily merge with other insurance companies.



Companies that have demutualized include Mutual Life Assurance Company of Canada
(which changed its name to Clarica Life Insurance Company), Manufacturers Life Insurance
Company, Canada Life Insurance Company, Industrial-Alliance Life Insurance Company,
and Sun Life Assurance Company. Clarica is now a part of the Sun Life Financial group of
companies. Canada Life is a subsidiary of Great West Life Assurance Company and both of
them in turn are members of the Power Financial Corporation group.
Fraternals are organizations that provide a range of social benefits to their members,
which can also include insurance. Most fraternal benefits societies have members who
share the same type of occupation or ethnic, cultural, or religious background. Fraternals
historically have operated through a local lodge system, and only fraternal members and
their families are allowed to own insurance issued by the fraternal society.
Examples of fraternals operating in Canada include the ACTRA Fraternal Benefits
Society (for television, radio and stage performers), the Knights of Columbus,
Independent Order of Foresters and the Lutheran Life Insurance Society of Canada (Faith
Life Financial is the official trade name).
A number of changes has occurred within the life insurance industry. Consolidation of life
insurance companies has been a major trend within the industry. Between 1996 and 2009,
the number of active life insurance companies has decreased from 131 to the current level
of 96 companies.
In addition, as the insurance market has broadened, the people selling insurance have
changed as well. Insurance has moved from being sold by career agents who were selling
the products of one company only, to financial service representatives who offer a range of
financial savings and protection products, including life insurance.
As of the end of 2009, Canadians owned just over $3.47 trillion in individual and group
life insurance.

Year Total Life Insurance (Millions)

1980 $431,194

1990 $1,157,395

2009 $3,474,000

Geographically, about 41% of the total individual life insurance held in the country is owned
in Ontario, 22% in Quebec, 18% in the Prairie provinces, 13% in British Columbia, and 5%
in the Atlantic provinces.
Growth in individual insurance has been on an upward trajectory since 1980. At that time,
individual insurance accounted for just over 40% of the total life insurance owned by Canadians.
The remainder was accounted for by group insurance. By the year 2009, individual insurance had
grown to exceed group insurance, accounting for 55% of the total insurance ownership.
Excluding those Canadians not covered by insurance, the average amount of life insurance
per person was about $169,000 by the end of 2009.



In 2009, Canadians purchased $311.6 billion of life insurance: $205.7 billion in

individual insurance and $105.9 billion in group insurance.
About half of the individual life insurance policies sold in 2009 involved some component
of permanent life insurance, with the other half being term policies. Since term policies
tend to be for larger dollar amounts, they accounted for two-thirds of the total dollar value
of insurance purchased in 2009.
In 2009, total payments to policyholders of life and health insurance policies, as well as annuities,
amounted to $58.6 billion. Of the $58.6 billion, 45% was paid out under annuity contracts, 37%
under health benefit plans, with the rest from life insurance policies and dividends
to policyholders. To give a meaningful statistic regarding the scope and importance of
the life insurance industry, consider that benefits were paid out at the rate of a little
more than $1.1 billion a week.


After reading this section, you should be able to:
• Explain the process of evaluating the financial ratings of insurance companies.
In addition to regulation by the government, insurance companies are monitored by a number
of independent companies. These rating agencies assess the financial health of insurance
companies, and their creditworthiness with respect to the financial obligations they have due to
their outstanding insurance policies. This information is important to consumers, distributors,
regulators, stock and bond holders, and all participants in the financial marketplace.
For example, A.M. Best has been assessing the financial strength of insurance companies
worldwide for over 100 years, and reviews Canadian companies thoroughly through A.M.
Best Canada. Their ratings provide a useful benchmark to evaluate a company’s operations
and competitive positioning. While different rating agencies have slightly different
methodologies for assessment, A.M. Best, for example, assesses an insurance company’s
financial strength, ongoing operating performance (which can affect its financial strength),
and market profile which drives a company’s current and future operating performance.
A.M. Best has 16 different rating levels, ranging from A++ to S (representing a suspended
rating). These are grouped into descriptive categories. For example, “Superior” is A+ and A++,
“Excellent” is A and A-, and “Good” is B++ and B+. All of these ratings are considered to be
secure, in that insurance companies with these ratings are seen to be stable, and able to withstand
adverse changes in economic conditions. Companies with ratings below the B+ level are seen as
vulnerable to negative changes, and are considered to be higher risks.
In addition to A.M. Best, other ratings agencies, which cover a broad range of industrial
companies, also review insurance companies. These companies include Moody’s
Canada and Standard and Poor’s Canada.


Chapter 2

Individual Life
Insurance Products



Individual Life
Insurance Products


Needs Met by Life Insurance Products
• Personal Needs
• Personal Life Insurance and Taxation
• Business Needs Met by Life Insurance Products
• Business Life Insurance and Taxation
• Choosing a Life Insurance Policy to Suit Specific Needs
Term Life Insurance
• How Term Insurance Works: An Example
• Advantages and Disadvantages of Term Life Insurance for the Policyowner
• Level Term, Increasing Term, and Decreasing Term Insurance
• Renewable, Non-Renewable, and Convertible Term Insurance
• Choosing Term Insurance to Meet Specific Needs
Permanent (Whole) Life Insurance
• Term Insurance vs. Permanent Insurance
• Advantages and Disadvantages of Whole Life Insurance
• Participating vs. Non-Participating Whole Life Insurance
• Premium Offset Policies and Dividend Projections
• Guaranteed and Adjustable Whole Life Insurance


Universal Life Insurance
• Unbundling the Three Pricing Factors
• Yearly Renewable Term and Level Cost of Insurance Mortality Costing
• Guaranteed and Adjustable Mortality Costs
• Impact of Investment Choices on the Viability of a Universal Life Contract
• Early Withdrawals, Loans, and Leveraging
Choosing Permanent Insurance to Meet Specific Needs
Supplementary Benefits and Riders
• Waiver of Premium Rider for Disability Benefit
• Waiver of Premium for Payor Benefit
• Disability Income Benefit
• Accidental Death and Dismemberment
• Accelerated Death Benefit Riders and Common Accelerated Death Benefits
• Term Insurance Riders on Permanent Life Insurance Policies
• Guaranteed Insurability Benefit or Guaranteed Insurability Option
• Paid-Up Addition Rider
• Split-dollar Arrangements
Insurance Policy Limitations, Provisions, and Beneficiaries
• Standard Policy Provisions
• Additional Provisions in Permanent Life Insurance Policies to Access Accumulated Cash Value
• Primary and Contingent Beneficiaries
• Preferred Beneficiaries and Policies Issued Before 1962
• Revocable and Irrevocable Beneficiary
• Absolute Assignment of a Life Insurance Policy
• Policies Issued Before 1982
Individual Life Insurance Products to Meet Specific Client Needs




As an agent, your livelihood depends on your ability to prospect for clients and to provide those
clients with insurance. In doing so, your objective is not just to sell insurance products. Your
objective is to advise and offer solutions to your clients that entail the use of insurance products
to meet their financial and estate planning needs. To provide that service you must have a
thorough knowledge about the wide range of life insurance products on the market today and the
provisions and benefits they represent. That knowledge is important as you assist your clients to
plan for their future by establishing financial objectives and by addressing the personal risks that
could prevent them from meeting their goals. In this chapter, you will learn about the
characteristics and features of life insurance products. You will also learn about the ways in
which life insurance can provide financial and estate planning solutions in both a personal
and business setting.
Throughout this chapter and in other chapters also, you will come across the
following terms: “insured”, “policyowner”, “policyholder” and “life insured”.
Confusion arises because although most life insurance contracts are two-party
contracts, there are many instances of third-party contracts. Here is what these
terms ordinarily imply:
In a two-party contract, the insured, policyowner, policyholder and life insured is the same
person, the other party being the insurer. However, in a third-party contract, it is the insured or
policyowner who insures the life of another person (for instance, a spouse), and so there are three
parties to such a contract: the insured/policyowner/policyholder, the life insured and the insurer.
Policyholder and policyowner generally mean the same thing and refer to the person who owns
the policy. Again, in a two-party contract, the policyowner/policyholder is also the life insured.

Example: Ruston, a father of three and husband of Rita, buys a $100,000 life insurance policy
on his own life from Celestial Life Insurance Company.
Here Ruston is the policyowner, policyholder, insured and life insured. Celestial is the
second party, the insurer.
If Ruston instead decides to purchase a policy on the life of his wife, Rita, it becomes a third-
party contract where Ruston is the policyowner, policyholder and insured, Rita is the life insured
and second party, and Celestial is the third party, the insurer.




After reading this section, you should be able to:
• identify the personal needs met by life insurance products;
• discuss reasons why a business should purchase life insurance;
• explain the nature of business continuation insurance;
• explain how businesses might use a buy-sell agreement;
• explain the benefits to a business of purchasing key person life insurance;
• explain the tax-favoured treatment of the proceeds of a life insurance policy to
the beneficiary for both personal and business life insurance policies;
• explain the benefits of using life insurance proceeds to help defray the capital gains
taxes triggered by death for both personal and business life insurance policies;
• given several case studies containing specific client information, select the most appropriate
insurance product category: for example, life, disability, critical illness, accident and sickness;
• select the most appropriate individual life insurance products to match a particular
client’s situation and needs.

Personal Needs
Life insurance allows people to address the financial risks of dying too soon, living too long, or
becoming disabled. These risks mean that individuals cannot provide the necessities of life for
their surviving family members or repay mortgages, loans, taxes or other financial obligations.


Most individuals earn the financial resources they need to live comfortably and acquire assets
from a salary, commissions, or business income. These sources of income end when the
individual dies. If the individual dies too soon, he or she may not have met all of his or her
obligations, whether it is a loan or mortgage to be repaid, or building up sufficient financial
resources to allow family members to continue to live as they are accustomed to do. Life
insurance in its many different forms can help address the risk of dying too soon.
Life insurance can provide:
• an estate for someone who does not have many assets to pass along to surviving heirs;
• funds to provide a continuing income to the beneficiaries;
• the financial resources to help children pursue their education;
• funds to ensure that the family has free and clear possession of the family home or
other family assets;
• money to pay income taxes, probate fees or to pay off debts;



• an emergency fund for survivors after the death of an income earner;

• funds to pay final expenses such as funeral and burial costs and also cover legal and
executor fees.


Individuals who outlive their financial resources may face a life of poverty or may have to
rely on the goodwill of others to survive. Life insurance products, such as deferred and
immediate annuities, can address that risk by allowing individuals to put money aside so
that one day, they will have an income that is guaranteed for life with an annuity.
Life insurance companies offer a wide range of annuities to help individuals accumulate funds
to provide for an income during their retirement years. Deferred annuities offer individuals the
opportunity to contribute to plans that allow for the accumulation of savings using various
financial products, such as interest-bearing accounts or segregated funds that invest in equities.
When the individual retires, he or she can choose to receive a retirement income in one of
several ways.
The most common retirement income plan is an annuity policy that guarantees the holder a
regular income for a specific period or for life. Life annuities may have additional
guarantees available upon the annuitant’s death. Some pay the annuity for a specific period
and the payments continue to a named beneficiary if the annuitant dies during the
guarantee period. Annuities may also be offered on a joint-and-last-survivor basis,
whereby the annuity payments continue after the death of one of the joint annuitants.
Payments cease only upon the death of the surviving annuitant.

Life insurance products have been developed to address the needs of individuals who suffer a
critical illness, or who for health reasons cannot care for themselves. Life insurance
companies also offer disability income plans that provide a regular income to a policyholder
who has suffered a disability.

In addition to addressing the risks that everyone faces, life insurance can help people
achieve certain financial goals.
For example, Eva wants to make a significant contribution to her favourite charity. She does
not have the means to make a large gift, and her salary level does not allow her to
accumulate the kind of gift she has in mind. She can apply for a life insurance policy and
appoint the charity as the beneficiary. For a relatively small regular premium payment she
can ensure that when she dies, the charity she chose will benefit from her gift.



Personal Life Insurance and Taxation


Under the current Income Tax Act, death benefit proceeds from a life insurance policy
are not considered a taxable benefit to the person who receives them. Because of this
favourable tax treatment, individuals can carry out estate planning without having to
discount the amount to be paid because of tax owing on the benefit paid. Beneficiaries of
a life insurance policy can be assured that they will receive the proceeds of the policy in
their entirety, without tax consequences.
For example, a parent who has established an insurance program to meet the educational
needs of her children can be sure that when she dies, all the policy proceeds will be
available to set up a fund to provide for the children’s education. Similarly, if an individual
buys life insurance as a form of mortgage insurance, he knows that the entire death benefit
will be applied to the mortgage.


When an individual dies, the executor of the estate must complete a final tax return. In the final
tax return, all of an individual’s income from all sources, earned up to the date of death and not
previously taxed, becomes subject to income tax. At the same time, any capital property that an
individual owns is considered disposed of (that is, treated as if it had been sold) for income tax
purposes. The difference between its fair market value and its original cost is the capital gain or
loss. For any property that has a capital gain (that is, the fair market value exceeds the original
cost), the excess amount must be reported as capital gain income; 50% of that amount is taxable.
Although life insurance represents a valuable asset to an estate, the amount of the life
insurance benefit paid out either to the deceased’s estate or to a named beneficiary is not
considered a taxable amount for income tax purposes.
Life insurance is therefore a valuable tool for defraying the potentially large tax liability for
the capital gains realized upon a property owner’s death. Rather than the heirs of a deceased
property owner having to sell a property in order to obtain the funds necessary to pay the
taxes, they can use life insurance proceeds to pay the taxes.
The executor of an estate must ensure that all of the taxes owing on the income, assets, and
capital property of the deceased have been satisfied before the property can be delivered free
and clear to the beneficiary. In fact, the Income Tax Act makes both the executor and the
beneficiary “jointly and severally liable”(either the beneficiary, the executor or both
together) for any unpaid income taxes owing on assets that are transferred to the beneficiary
under the terms of a will, or directly, outside of the will, to a named beneficiary.
If the person who died had enough life insurance, the beneficiary can take possession of the
deceased’s property, without any current taxes owing. The assets will be transferred, and
their cost to the beneficiary will be deemed to be the fair market value of the property at the
time of the deceased’s death. The beneficiary will be liable only for the taxes owing on any
value that accrues after assuming ownership.
It should be noted that assets left to one’s spouse are deemed to have been sold
immediately before death at cost; therefore, no capital gains arise on the “rollover.” On
the spouse’s death, however, the entire capital gain based on the original purchase price
would be included for income tax purposes.



Business Needs Met by Life Insurance Products


In Canada most businesses are operated as sole proprietorships, partnerships, or
incorporated businesses owned by one or a small group of shareholders.
A sole proprietorship is owned and operated by one person. There is no distinction between
the assets and liabilities of the business and the individual. All of the individual’s assets and
resources are used to satisfy the debts and obligations of the business. If the sole proprietor
suffers a serious disability, the business will probably close, because its success depends on
the talents and efforts of the individual. If the sole proprietor dies, the business ceases.
A partnership is an association of two or more individuals who operate a business for
profit. As general partners, each individual is liable for the debts and obligations of the
other partner(s). Usually, each partner contributes capital or work effort to the business. If
one partner becomes disabled, the partnership may suffer, since the disabled partner may
continue to receive distributions from the partnership under the terms of the partnership
agreement. If one of the partners dies, the partnership ceases. The remaining liabilities of
the partnership are the responsibility of the surviving partner(s).
An incorporated business is an entity that is separate from the people who own it. When an
individual incorporates a business, he or she establishes a separate legal entity and limits his
or her liabilities to the amount of his or her investment in the business. The individual’s
personal assets and liabilities are not mingled with those of the corporation. Unless the
individual personally guarantees the debts and obligations of the corporation, the
corporation’s liabilities remain with the corporation. If the individual, as a major shareholder
of the corporation, dies, the corporation continues to exist.


Insurance can help address the needs of the individuals who engage in any of these three
forms of business.
Disability insurance can provide much needed income if the sole proprietor becomes ill or
disabled. Life insurance can also be used to fulfil any remaining obligations, such as business
loans and employee salaries, if the business is wound up on the death of the sole proprietor.

The disability or death of a partner usually has similar consequences to those facing a sole
proprietorship. A disabled partner cannot contribute his or her services to the partnership, even
though the partnership’s commitments remain. A partner’s death dissolves the partnership. In
addition to outstanding liabilities that must be satisfied by the surviving partners, the heirs
of the deceased partner may expect to receive some benefit from the deceased’s interest in the
partnership arrangement. Disability and life insurance can support the financial well-being of the
partnership and of the partners who are left when one partner becomes disabled or dies.
Although a corporation survives the death of its principal shareholder, he or she may have been
essential to the business. The shareholder’s shares are capital property that will pass to his or
her beneficiaries. Surviving shareholders may want to acquire the deceased’s shares to maintain
the day-to-day operation of the business without the involvement of the beneficiaries, who may
have no knowledge of the business and who may want to withdraw assets from the business in
the form of dividends without helping to maintain or grow the business. Life insurance, in this



situation, allows the surviving shareholders to buy the deceased’s shares from the beneficiaries
and provides capital to maintain the business after the loss of an important contributor.


Small businesses, whether sole proprietorships, partnerships, or private corporations, depend on
one or a few principal owners to ensure the continued operation of the business. If one of the
principal owners dies, the business will not only lose the revenues that that person generated,
but creditors may also require the repayment of any loans or liens that were guaranteed by
the deceased owner. The family of the deceased may insist on the disposal of business
assets to provide a legacy to the deceased’s heirs or payment from the surviving owners
in exchange for their ownership interest in the business.
Business continuation insurance is intended to ensure the survival and continuation of a
business by providing insurance proceeds to compensate in part for financial losses
resulting from an owner’s death.


Life insurance plans can be established in a number of ways, depending on the nature of
the business.

Sole Proprietorship
In a sole proprietorship, upon the death of the proprietor, all of his or her assets and liabilities,
including the assets and liabilities of the business, pass to the deceased’s estate. The estate must
repay any debts and obligations left by the proprietor. The executor of the estate may have to sell
the business assets to satisfy those obligations. The executor must also consider provisions of the
will that are intended to provide for the deceased’s family or other beneficiaries. Former
employees may also seek some financial compensation from the business. The pressure to
meet all these obligations may force the executor to sell off or liquidate the business assets at
prices lower than their fair market value, leaving the heirs, other owners, or employees with
far less than an unforced sale would have realized.
Under such circumstances, life insurance on the life of the sole proprietor can produce
liquid funds at the right time to repay creditors and provide for the needs of the family,
other beneficiaries, and employees. Insurance may even provide enough money to fund
the continuation of the business under the direction of the employees.

In a partnership, there are financial consequences after the death of one of the partners who has
contributed financial support or personal services to the success of the business. The surviving
partners may want to continue the business under a revised partnership arrangement. If so, those
partners must determine the financial interest that the deceased held in the partnership and
reimburse the deceased’s heirs for the value of that interest. At a time when the business may be
struggling to overcome the loss of one of its contributors, the surviving partners may not have
enough money to satisfy the interest owing to the beneficiaries of the deceased’s estate.
The proceeds of life insurance on the life of the deceased partner can be used to meet these
obligations. Life insurance can be owned by someone other than the person whose life is insured
provided there is a financial interest in the life of the insured person, and the owner can be the
beneficiary of the life insurance proceeds. The partners can therefore take out life insurance on



each other’s lives and be the beneficiaries of those plans. When a life insured partner dies, the
beneficiaries receive the insurance proceeds. They can apply those proceeds to maintaining
the business or acquiring the deceased’s interest in the partnership from his or her heirs.

In a corporation, the interest of any one of the owners is determined by the value of the
owner’s shares in the business. When one of the shareholders dies, the shares become part
of that person’s estate, subject to disposition under his or her will. The executor may be
authorized to sell the deceased’s shares or transfer them to a beneficiary named in the will.
Shares of a private corporation may have little liquidity. In other words, there may be no
one willing to buy the shares, since the shares may be of value only to the surviving
shareholders and the beneficiaries who inherit them.
The beneficiaries may continue to hold the shares and receive income in the form of
dividends, or they may benefit from an increase in the value of the shares over time.
However, the beneficiaries may have no interest in the day-to-day operation of the business,
nor may they have the right skills to contribute to its success.
If the deceased was the only shareholder, the shares will have little value, since the value of the
business relied on the deceased’s efforts. The business may have to be wound up and the assets
sold at less than their fair market value to pay off creditors and provide for family members.

If there are other shareholders, they may not want to use corporate earnings to pay dividends,
but may want to retain earnings in the company to keep it going.
Life insurance can help solve these problems. A shareholder can acquire life insurance on his
or her own life and name the business as beneficiary. As a corporation survives the death of a
principal owner or shareholder, life insurance proceeds paid to the corporation can be used to
maintain the business or to acquire the shares from the deceased’s beneficiaries.
Alternatively, the corporation itself can take out insurance on the life of a principal
shareholder and name itself as beneficiary. The corporation will receive the life insurance
proceeds, which can be used to acquire the deceased’s shares or invested in the corporation.

Businesses with more than one partner or shareholder must consider the following questions:
• What happens when one partner or major shareholder dies?

• How will the value of the deceased’s interest in the business be determined upon his
or her death?
• Will the life insurance proceeds be used for the purpose they were intended?
One way to address these concerns is by establishing buy-sell agreements that set out the
terms and conditions under which a deceased’s interest in a business will be transferred to
other interested parties. The buy-sell agreement will usually include, among other things, a
commitment by one person to purchase the financial interest of a second person in a business
following the second person’s death, and by the second person to direct his or her estate to
sell his or her interest in the business to the first person.



Sole Proprietorship
In this form of business, the most likely participant in any agreement to sell a business
interest is a key employee of the business. The buy-sell agreement may specify the method
of transferring the business and either assign it a predetermined value or stipulate some
formula for determining its value.
The employee agrees to buy the business from the estate. The employee purchases a life
insurance policy on the life of the sole proprietor. The policy names the employee as the
beneficiary. When the sole proprietor dies, the employee will use the insurance proceeds to
acquire the business interest as specified under the terms of the buy-sell agreement.

A partnership buy-sell agreement is usually described as a criss-cross agreement. Each
partner agrees to acquire a proportionate share of a deceased partner’s interest. The buy-sell
agreement states the terms and conditions of the purchase and commits each surviving
partner to abide by the terms of the agreement. The buy-sell agreement also establishes a
value or a formula for determining a value for the business at the time a deceased partner’s
interest is purchased by the surviving partner(s).
Each partner purchases life insurance on the life of each of the other partners. The purchasing
partner pays the premiums and is the beneficiary of the policy. Depending on the number of
partners, several policies may be required to meet the obligations to buy a deceased partner’s
interest. Partners may jointly own a policy on the life of one of the partners or establish a trust
that owns the policies and receives the funds to pay the premiums. In Canada, it is not a usual
practice for the partnership itself to own the life insurance policy.
John, Betty and David are equal partners in a manufacturing firm. If John died, it would
make the most sense for Betty and David to purchase John’s interest in the firm from his
estate. That way, John’s family has the money from the sale of the interest and Betty and
David can continue running the business as equal partners. Having a buy-sell agreement in
place will outline who will buy the interest, for how much, and how that sale will be funded.

A buy-sell agreement can be arranged among a corporation’s shareholders to purchase each
other’s shares, or the corporation itself can participate in a buy-sell arrangement to purchase
the shares of a deceased shareholder.
Each shareholder may own and be the beneficiary of an insurance policy on the lives of
each of the other shareholders, or the corporation itself can purchase life insurance on the
life of each shareholder and be named as beneficiary. In either case, the insurance proceeds
are used to purchase the deceased’s shares from his or her estate.


Key person life insurance addresses the financial risk to a business of losing the contribution of an
important employee, proprietor, partner, or shareholder through death. The revenues generated by
the key person’s efforts will cease and the business needs cash flow to meet its obligations.
Creditors will seek assurances that the business can continue to function without that person and,
in the worst case, will call in outstanding loans and liens. Key person life insurance provides a
temporary cash flow to the business to allow it to meet its liabilities and raise (or, at least,
maintain) creditors’ confidence that the business can survive the sudden loss of a key contributor.



Typically, the business takes out insurance on the life of the key person and the business is named as
beneficiary. Determining how much insurance is sufficient means estimating the value of the
contribution that the key person makes to the success of the business. The amount of insurance may
represent the present value of future earnings that the business would forgo because of the key
person’s death. Alternatively, the person’s bottom-line contribution to profits can be used
to calculate the amount of insurance required. For example, if the key person’s work
accounts for 30% of business profits, then a policy in that amount will be purchased and
payable to the business.
At the same time, the business must look for someone with adequate abilities to replace
the talents of the deceased. Life insurance can provide a financial cushion to allow time to
find and train a suitable replacement. The business can estimate these costs and buy a
policy in that amount that is payable to the business.
Key person insurance, like other forms of life insurance, is exempt from taxes. The business can
rely on the entire proceeds to address the financial loss expected from the key person’s death.

Business Life Insurance and Taxation


For shareholders of private corporations, life insurance has another important application. When
a shareholder dies, the fair market value of his or her shares, less their cost base (the amount that
the shareholder originally paid for them), is considered a capital gain to be reported in
the shareholder’s final tax return. The shareholder’s estate then takes ownership of the shares
at an adjusted cost base equal to their fair market value. In a share repurchase agreement, the
corporation agrees to purchase the deceased’s shares from the deceased’s estate. The
corporation may pay for the shares using the proceeds of a life insurance policy on the life
of the deceased shareholder in which the corporation is named as beneficiary.


Policy proceeds payable to the corporation as beneficiary, upon the death of a shareholder, are not
taxable (similar to what happens with personal life insurance). The method that the corporation
uses to acquire the shares from the estate affects the way in which the deemed capital gains from
the shares are treated in the deceased shareholder’s final tax return. The policy proceeds may be
distributed as a tax-free capital dividend using the corporation’s capital dividend account.
This is a complex application of the proceeds of a life insurance policy to defer a tax liability
in a business situation. It highlights the critical importance of a proper life insurance
program in planning for the transfer of assets for owners and shareholders of private
corporations. This topic will be covered in greater depth in Chapter 7 on Taxation.



Choosing a Life Insurance Policy to Suit Specific Needs

The following examples illustrate the importance of carefully assessing a situation in order
to choose the best possible product or combination of products for a client. In many cases,
the first product that comes to mind may be inadequate to cover the situations that might
arise. It is also imperative to review clients’ needs as their circumstances change.

Example 1: Young Parent Dying Suddenly with a Lot of Debt

Cameron and Anita had been married for fi ve years when Cameron was killed in an automobile
accident. They were the parents of twins born three years after their marriage. The year before the
accident, the couple had purchased a home and arranged for a $100,000 mortgage. At the time,
both Cameron and Anita were working and they felt comfortable with that size of mortgage.

The mortgage company had recommended that the couple insure the mortgage debt. They took
the advice and each acquired a term insurance policy for $100,000 face amount. When Anita
provided the appropriate documents to her insurance company, the company issued a cheque
for $100,000 to Anita as the beneficiary.

Anita was able to repay the mortgage, and take ownership of the family home free and clear.

Was this an appropriate solution?

This is an example of insurance planning to meet a single, specific need. The couple recognized
the risk of being unable to repay the mortgage if either of them died. Each of them purchased a
term life insurance policy for that purpose. The solution that was recommended was appropriate.
However, there were alternatives. They could have purchased a joint life policy with benefits
payable on the first death, rather than two separate policies.
Should they have considered other financial needs in addition to the single need to
cover their mortgage?
For example, what if either of them became disabled? Since they relied on both incomes to
make the mortgage payments and meet their other expenses, if one of them became disabled
and was unable to work for an extended period of time, they might not have been able to
maintain the mortgage payments. If they did not have long-term group coverage through
their employer, they should have considered applying for disability income insurance to
address the risk of becoming disabled.
Also, although the mortgage has been taken care of, Anita faces other short- and long-term
expenses. What about her financial goals for educating her children and her eventual
retirement? Perhaps Cameron and Anita should have completed a more comprehensive
insurance and financial needs analysis.

Example 2: A Family Member Who Contracts an Illness with a Poor Prognosis for Survival
After ten years of marriage, Waldo was diagnosed with cancer of the liver. He and his wife operated a
small business that required both their efforts. Because of Waldo’s illness, he was unable to devote much
time to the business. Martha, his wife, was distracted from attending to the business while she attended
to his needs. Unfortunately, the prognosis was poor and Waldo was not expected to live longer than one
year. Business revenues began to dry up and the couple were faced with bankruptcy.



Their life insurance agent offered a solution to the dilemma facing the couple. Waldo had a life
insurance policy that contained a living benefits provision under which a portion of the life insurance
benefit was payable if Waldo contracted a terminal illness that reduced his life expectancy to one
year or less. Waldo provided the appropriate claim information and the insurer paid a portion of the
death benefit. The couple were able to apply the funds to keep the business afloat. After Waldo’s
death, Martha was able to turn her attention to maintaining a business that was still a going concern
rather than one that had suffered serious financial problems.

What other options were available to Waldo and Martha?

Since Waldo and Martha’s efforts were critical to the success of the business, they should
have also considered disability income policies. Although Waldo’s life expectancy was short,
a disability income policy that provided a monthly income after a brief elimination period (30
days, for example) would have provided funds for running the business. Martha could then
use the full death benefit from the life insurance policy to take care of final expenses when
Waldo died and attend to other expenses of the business and in her personal life.

Example 3: An Individual Who Suffers a Disability with Hope for Recovery

Ingrid was a successful architect who operated her own business. A divorced mother of two
young children, she relied entirely on the income that she earned from her business to support
her family. One day on her way to her office, Ingrid sustained life-threatening injuries in an
automobile accident. She was treated in hospital for several weeks, followed by a number of
months of rehabilitation. During this period, she was unable to perform any of the functions of
her occupation and she was unable to earn any income.

Three years before her accident, her life insurance agent had recommended that she purchase
a disability income policy, to provide her with a monthly income in case she became disabled
and unable to work. Based on the income she was generating from her business, Ingrid
acquired a disability income policy that would pay her $5,000 a month if she became disabled
and unable to perform the duties of her occupation. The policy had a 30-day waiting period and
a maximum two-year payment period for any disability.

Ingrid began receiving a monthly income of $5,000 from the insurer beginning 30 days after the accident.
She was disabled for 18 months and continued to receive a monthly income during that time. She
recovered fully and was able to resume her career at the end of the 18-month recovery period.

Was this policy appropriate for Ingrid’s situation?

Since Ingrid’s disability lasted for 18 months, her benefits did not expire. If her disability
had continued for longer than two years, she would have been faced with serious financial
problems. Perhaps a five-year benefit period or a benefit period to age 65 might have been a
better choice when she applied for the policy. She might have also considered applying for a
partial/residual disability benefit provision, in case she was able to resume her career, but
only on a part-time basis.

Example 4: A Business Owner Who Is Injured

James owned and operated a small contracting business. He rented an office for fi ve full-time
employees. The business incurred regular monthly expenses that were managed from the
revenues generated by the business. Most of those revenues were the result of James’s efforts.
His life insurance agent suggested that he consider an office overhead insurance plan. Under
the terms, a benefit amount equal to monthly expenses incurred by the business, up to a certain
maximum, would be paid if James was unable to work.



James suffered a serious illness that left him completely disabled for several months. During
that time he was able to pay the regular monthly expenses for the business from the
disability benefit he received under the office overhead policy.

What other products would have been helpful to James when he became disabled?
In addition to the office overhead expense policy, James could have considered applying
for a disability income policy as well. In addition to meeting the regular expenses of the
business, he would have been entitled to receive a regular monthly income to meet his
personal and other business needs.

Example 5: An Older Individual Who Develops a Debilitating Illness

Imelda was a widow who owned her own home where she lived alone. She had three grown
children who visited her from time to time. Overall, she was able to take care of herself and to live
independently. Then Imelda began to show signs of Alzheimer’s disease. It soon became apparent
that she could no longer take care of herself. Her children did not feel that they could care for her
because she required constant attention. Imelda was moved to a chronic care facility.

The monthly expense for her care and shelter was $5,000. The children considered selling Imelda’s
home to defray these costs. Fortunately, Imelda had taken out a long-term care policy that provided a
monthly benefit in the event that she was unable to perform certain daily activities and required
regular care from an attendant. The benefit paid under the policy defrayed the cost of Imelda’s
ongoing care.

What would have happened to Imelda and her children if she had not had the long-term care policy?

• While Imelda’s family might have been able to place her in a provincially funded
nursing home, all Imelda’s assets, as well as any pensions she was receiving, would
most likely have been used up to provide her with the care she needed, especially if
Imelda lingered in this condition for many years.
• The provincially funded nursing home might not have provided the standard of care that
the family could otherwise afford with the available long-term care policy benefits.

• Depending on her condition, one of Imelda’s children might have had to take her into
his or her home. If she required constant monitoring and care, her family would have
faced a tremendous burden.

Example 6: An Older Individual Dies, Leaving a Large Estate

Several months before Roger and Susan were due to celebrate 40 years of marriage, Roger died,
leaving all of the assets they had both acquired during the marriage to Susan. In addition to a family
home, Roger and Susan owned a cottage in northern Ontario, a chalet in British Columbia, and a
condominium in Florida. Roger’s executor was able to transfer the property in such a way that no tax
became due on the value of the properties at the time of Roger’s death. When Susan dies, however,
all of the property will be considered disposed of and capital gains taxes will be calculated on all of
the property, except the family home which is exempt as a principal residence.

Several years before Roger’s death, Roger and Susan had purchased a whole life insurance policy for
$250,000 on a joint-and-last-to-die basis. When Roger died, the life insurance continued on Susan’s life.
When she dies, the life insurance proceeds will be paid to her estate. She has directed in her will that the
insurance proceeds should be used to pay the capital gain taxes owing on the properties.



The properties will be transferred to her surviving children.

What problems might arise from Roger and Susan’s plan?

• Since the insurance benefit will be paid to the estate, the amount will become part of the
estate assets and will be included in the amount on which probate fees are calculated.
Roger and Susan would have been better off naming a specific beneficiary.
• The three properties could be valued at Susan’s death at amounts that far exceed the
amount of life insurance. Although the insurance benefit may reduce the problem, the
estate may be faced with a larger-than-anticipated income tax bill. Some of the estate
assets that are to be distributed to the beneficiaries may have to be sold to satisfy the
income tax owing. The insurance should be increased as the property values increase.


After reading this section, you should be able to:
• explain how term life insurance works;
• explain the primary advantages/disadvantages and limitations of term life insurance
for the policyholder;
• differentiate among level term, increasing term, and decreasing term life insurance;
• differentiate between renewable and non-renewable term insurance;
• explain the term “convertible term insurance”.

How Term Insurance Works: An Example

Donna has worked hard to establish her fashion design business, making business attire for women
executives. She now wants to expand her business to other fashion lines. To do so, she needs
financing to hire qualified staff, carry out research, and acquire larger business premises.

She approached a number of financial institutions with a strong business plan; although
some have refused to provide financing, one or two banks are interested in her plans.
The banks are concerned that the success of the expansion relies directly on Donna’s efforts
and her continued ability to run the business. Her business plan anticipates that given financial
backing of $250,000, she can turn a profit by the beginning of the fourth year and bring in net
profits of $500,000 per year within 10 years. She will make interest-only payments on the loan
out of business revenues and will pay out the full $250,000 in 10 years.
One bank is prepared to offer Donna a $250,000 loan, but it seeks assurance that if she dies
before the business has started to generate sufficient revenues, her company can pay off the loan.
The most direct way to provide that guarantee is to insure Donna’s life. The company would
own the policy and be the beneficiary. A collateral assignment could be made under the policy



in favour of the bank, so that if Donna dies before the loan is repaid, the bank will
receive $250,000.
Level term life insurance may be the best choice in this situation. The liability is for a
limited period of time – 10 years. The liability is constant and does not change over the
loan period. Once the loan has been repaid, the liability no longer exists.
Term life insurance works best in circumstances like this, where there is a specific,
defined financial risk for a limited period of time.

Advantages and Disadvantages of Term Life Insurance for

the Policyowner
Among the range of life insurance products available to the consumer, term life insurance can be
the most cost-efficient way to insure a risk that will disappear over time. Term life insurance
can provide for repayment of a mortgage if the mortgagor dies or allow children to pursue
higher education if one or both of their parents die. In these cases, there is an identifiable
potential risk and a limited period of time over which the risk might be realized.
For example, if a mortgage is in place for 25 years, then the liability for that mortgage will
end in 25 years. Permanent life insurance is not required to meet the debt obligation.
When the insurance is purchased, depending on the age of the insured, the cost of a term
life insurance policy is most likely going to be less than the cost of a permanent life
insurance policy for the same coverage.
If the purpose of the insurance does not have an anticipated expiry date, then term life
insurance may not be the best solution. If, for example, an individual wants to bequeath an
inheritance but does not have the financial resources to provide the desired amount,
permanent life insurance may be the way to realize that goal. Term life insurance will not do
the job. The individual cannot predict when he or she will die, so the coverage period for a
term life insurance policy may expire well before the insurance proceeds are needed.
Under a term life insurance policy, the policyowner may not miss any premium payments
without the coverage lapsing. Each premium must be paid within the grace period to keep
the policy coverage in force. If any premium remains unpaid after the grace period expires,
the policyowner must apply to reinstate the policy. As part of this application for
reinstatement, the policyowner must not only pay all the premiums that are due (with
interest in many cases), but also submit evidence of the insurability of the person whose life
is insured. If the health of the insured person has deteriorated since the policy was first
taken out, the insurer may refuse to reinstate the life insurance coverage.

Level Term, Increasing Term, and Decreasing Term Insurance

A level term life insurance policy is one that provides a level amount of term insurance
coverage for a specific period of time. Insurance companies offer level term insurance
policies with durations of one year, five years, ten years, or twenty years, or for a period
ending when the insured person turns 65. This kind of insurance would be appropriate if the
amount of the obligation will not change over the term. For example, level term insurance
could be used to cover a demand loan, because the principal amount does not change and the
client makes interest payments only.



Many insurance policies with short durations contain an option to renew the policy for
an additional period. Usually, a policy can be renewed only until the insured person
reaches a maximum age.
Increasing term insurance provides a death benefit that increases on each policy anniversary by a
specific amount. The amount may increase by a fixed percentage or according to some variable,
such as the Consumer Price Index. The premium increases along with the coverage increase.
Increasing term would not be an ideal option to cover a tax liability at death. Increasing term
may be employed in situations where the liability being protected against is both temporary
and increasing. For example, this insurance could be used to protect the value of a key
employee in an organization where the employee’s salary is expected to increase every year..
Decreasing term insurance provides life insurance protection that decreases by a specific
amount on each policy anniversary. In most plans the policyowner pays the same insurance
premium for coverage that reduces over the term of the insurance coverage. The reduction
may be a specific amount applied on each policy anniversary, or, in the case of mortgage
insurance, the decreases may follow the reduction of the mortgage principal.

Renewable, Non-Renewable, and Convertible Term Insurance

Renewable term life insurance allows the policyowner to renew the insurance coverage for
an additional period without providing evidence of insurability (health questionnaire, blood
sample, urinalysis). A five-year renewable term policy usually allows the policyowner to
renew the coverage after each five-year term until some maximum age (often between 65 and
85). The renewal premium is based on the age of the person whose life is insured at the time
the policy is renewed. Most policies contain a table that lists the guaranteed renewal
premiums at each renewal age.
Non-renewable term insurance does not include the option to continue the insurance
coverage beyond the stipulated term of coverage. This restriction would apply to products
such as level term insurance to age 65. The only option available to the policyowner at that
age would be to convert the term insurance coverage to permanent life insurance.
If the term life insurance policy is approaching its term, but the insurance risk remains,
convertible insurance policies offer an opportunity to convert the coverage to a permanent
life insurance plan. If the policyowner wants to maintain the same level of insurance
coverage, the new premium may be very expensive, because the premium is usually
determined according to the current age of the life insured. The policyowner can either:
• lower the amount of insurance coverage; or
• convert the term insurance policy, but make the new insurance effective from the
original issue date of the term insurance policy. The permanent life insurance
premium will be calculated based on the life insured’s original age. The policyowner
will have to pay an amount equal to the reserve that would have accumulated if the
permanent life insurance policy had been in effect from the original issue date.
The premiums for renewable and convertible term life insurance plans are higher than those for
term plans that do not have these options. Since both options allow the policyowner to renew or
convert the policy coverage without providing evidence of insurability, an individual whose
health is deteriorating will likely elect both options, so insurers must charge a higher premium for
the options. Insurers also restrict the age at which these options can be exercised.



Choosing Term Insurance to Meet Specific Needs

Example 1: Level Term Insurance
Amelia holds a $100,000 line of credit for her small business, most of which she has used. She
had assigned certain business property to satisfy the line of credit, but she wants to insure the
line of credit amount to preserve the property for the business in the event of her death. She
intends to maintain the line of credit for a relatively short period and pay it off as her business
revenues grow. She does not have a specific period in mind for repayment, however, so she
decides to purchase a five-year term policy with a renewable feature.

Amelia feels that if she can reduce or eliminate the amount loaned under the line of credit
within fi ve years, she can allow the policy to lapse. Depending on business conditions, if the
loan amount continues in effect, she would like to have the choice of renewing the term life
insurance policy for another five years.

By having a $100,000 level term insurance policy in place, Amelia does not have to be
concerned about using the line of credit up to the limit. Even if the line is maximized when she
dies, the full $100,000 will be repaid.

Example 2: Increasing Term Insurance

XYZ Corporation has bought a key person term insurance policy on the life of its president,
Craig Lowe. Craig’s skills and leadership are essential to the organization’s success and the
$1,000,000 insurance plan was considered adequate to address the financial implications of
Craig’s death. The purpose of the insurance is to keep the company afloat while it seeks a
replacement with Craig’s talents. The policy proceeds would also be used to find and attract
someone with a level of expertise similar to Craig’s.

However, the company value and Craig’s value to it are increasing in terms of real dollars:
$1,000,000 in current dollars will depreciate over time in light of rising inflation.

XYZ has therefore bought a term plan that insures Craig until he turns 65, with an increasing term
benefit. The face amount of the policy will increase with the annual increase in the Consumer Price
Index. The increases are processed automatically by the insurer, without XYZ having to provide
evidence of Craig’s insurability. There is an overall cap of $5,000,000 on the face amount, but the
company feels that there is enough room to insure the risk of losing Craig, expressed in real dollars.

Example 3: Decreasing Term Insurance

Pat and Mary have recently bought a home together and taken out a $200,000 mortgage, to be
repaid over 25 years. They feel that it would be wise to purchase life insurance so that if either
of them dies, any remaining mortgage principal can be paid off.

A friend suggested that they each buy a $200,000 term life insurance policy, with a term of 25 years.
Their agent, however, gave them a life insurance quote for a decreasing term insurance plan whose
face value decreased along with the mortgage principal under the amortization schedule. The annual
premium cost of the decreasing term insurance plan is less expensive than a level term product.
Their agent also explained that they could purchase one plan that insures both their lives on a joint-
and-first-to-die basis. That is, if one of them dies before the end of the term, the death benefit will be
paid to the survivor and the proceeds can be used to pay off the outstanding mortgage.




After reading this section, you should be able to:
• identify the primary characteristics that distinguish term insurance from permanent
life insurance;
• explain the advantages and disadvantages of whole life insurance;
• explain the difference between a participating whole life contract, including
dividend options, and a non-participating whole life contract;
• explain how a changing dividend scale affects the completion of a premium offset policy;
• explain the differences between guaranteed and adjustable whole life insurance.

Term Insurance vs. Permanent Insurance

Most life insurance policies, whether term or permanent, are based on the level premium
concept. Without a level premium, the insured would at first pay a smaller premium that
reflects the anticipated mortality level for people of that age, based on the mortality table
used for that particular type of coverage. As the insured person ages, the premium would
increase, since the older one becomes, the greater is the likelihood of dying. Ultimately, the
annual cost to maintain coverage would become prohibitive.
Remember: the principle of life insurance is to have available sufficient funds to pay all the
death claims that are expected to occur for those in a particular age group. As the group gets
older, the number who die each year increases and the number of survivors left to contribute
premiums decreases.
Under the level premium approach, the premium that an insured person pays at first is more than
adequate to cover the claims of those in that age group that die. As the person grows older, the
premium is insufficient to cover the claims of those in the older age group that die. However, the
excess premiums paid in earlier years, together with investment return earned on those amounts,
provide sufficient funds to cover the anticipated claims expected to occur in any year. The excess
amounts, together with investment earnings, are known as a policy reserve.
For term insurance, the level premium applies to a coverage period that may be as short as one
year or as long as to age 100 for Term to 100 plans. Traditionally, the term coverage terminates
at some point, and the policyowner receives no further benefit after it expires. However, in many
Term to 100 plans, premiums are payable to age 100 at which time the policy becomes paid up
for the entire face value and coverage continues for the rest of the life insured’s life.
The reserve build-up for permanent life insurance continues to grow until, after many years, the
reserve equals the amount of life insurance that must be paid out under the policy. The insurance
coverage does not expire as long as the policyowner continues to pay the premiums on
schedule. For term insurance, the annual mortality charge is based on the full amount of coverage.
For permanent life insurance policies, the annual mortality charge is based on the net amount
at risk (face value of policy less the cash surrender value). Each permanent life insurance policy
accumulates a reserve as premiums continue to be paid. That reserve provides a cash value for the



policy. The policy offers certain options, including cash loans, loans to pay premiums, and a
cash surrender value option. If the policyowner exercises certain options, the policy will be
terminated. These options will be described in more detail later in this chapter.

Advantages and Disadvantages of Whole Life Insurance

One important advantage of whole life insurance is the fact that, as long as the policyholder continues
to pay the premiums, the insurance coverage will always remain in effect. Therefore, for any risk that
has no predictable expiry date, whole life insurance provides a guaranteed amount of money to address
the risk. If, for example, the estate of an insured person is required to pay heavy taxes when that
person dies, the death benefit will completely or partly cover these costs.

Whole life insurance also offers a cash surrender value. The policyowner can apply for a
loan against the cash surrender value of the policy. Therefore, a whole life policy can be
a way of financing a loan. A term life insurance policy has no such provision, simply
because it has no accumulating cash value reserve.
A whole life insurance policy may contain non-forfeiture provisions that can be used to keep
the policy coverage in force, even though the policyowner stops paying the insurance
premium. A standard policy allows the policyowner to pay the premium up to 30 days (the
grace period) after the date the premium is normally due without the policy lapsing. Non-
forfeiture provisions cover situations in which the policyowner does not pay the premium
within the grace period. The policyowner may choose from a range of options.
1. The automatic premium loan provision takes effect when the grace period
expires. The policyowner receives a loan against the policy’s cash value, which is
used to pay the premium. The policyowner is charged interest on the loan,
according to provisions contained in the policy.
2. The reduced paid-up non-forfeiture option means that the policy remains in force, even
though no more premiums are paid. The amount of coverage is the amount that the
current cash value will fund. The cash value will increase because of reinvestment, but
at a slow rate, since no more premium payments are made. For example, if an individual
has a policy with an original death benefit of $50,000, and cash surrender value of
$10,000, he or she could opt to change it to a fully paid-up policy with a death benefit
somewhere between the cash surrender value and the original death benefit. Paid-up
means the policy is fully paid for and no future premiums are required. The amount of
coverage provided by the paid-up policy would be determined based on the cash value
of the policy and the age and sex of the life insured at the time the option is exercised.
3. The extended term insurance option provides insurance coverage for the same amount as the
life insurance policy, but only for a limited period of time, such as three years. The amount of
time that the coverage remains in effect depends on the cash value available to fund
the new term policy, and on the age and sex of the life insured at the time the
option is exercised.
4. Finally, the policyowner can simply cash in the policy for the amount of the cash
surrender value and terminate the policy.



A term life insurance policy has none of these options. If the policyowner fails to pay an
outstanding premium within the grace period for its payment, then the term policy lapses.
Although the policy contains provisions allowing for reinstatement of the coverage, those
provisions require the payment of all premiums that are overdue, with interest, and the
submission of satisfactory evidence of insurability for the person whose life is insured under the
reinstated policy. If the insured person’s health or other circumstances have changed during the
time that the policy has been in force, the insurance company may decline to reinstate the policy.
One disadvantage of a whole life insurance policy is that the premiums for a similar amount
of coverage for applicants of the same age are considerably higher than the premiums for a
term life insurance policy. If an individual requires a specific amount of insurance for a
limited time, then term life insurance may be the more cost-effective alternative.

Participating vs. Non-Participating Whole Life Insurance

The owner of a participating life insurance policy may receive a policy dividend
periodically, whereas the owner of a non-participating life insurance policy will not. In
other words, the owner of a participating policy is entitled to share in the insurance
company’s distribution of any of the company’s surplus.
Insurers establish their premium rates based on estimates of mortality rates, expenses, investment
earnings, and other factors. If those estimates prove more conservative than actual experience, the
insurer will realize greater revenues than those required to meet its obligations. These obligations
include the requirement, established by regulators, to maintain an adequate level of reserves
to meet future insurance liabilities. If the insurer has excess revenues that are not required
to fund mandatory reserves, they can be distributed as policy dividends to policyowners
who hold participating policies.
Policy dividends are considered a refund of premiums to policyowners. Policy dividends are not
considered taxable income in the same way that a dividend from a stock is considered taxable
income. The owner of a participating life insurance policy will generally pay a higher premium than
the owner of a non-participating policy who has the same amount of coverage. Over time, however,
the comparative costs of non-participating and participating life insurance policies may be quite
similar, because of the policy dividends distributed to owners of participating policies.

Policy dividends are not guaranteed for participating policies. Insurance companies publish
tables of projected dividends for their participating policies, but every table is published with
the caution that these dividend assumptions are projections only, not guarantees. When
dividends are distributed, policyowners receive them on the anniversary of the day they took
out the policy. Annual dividends tend to increase for a policy over the years.
The policyowner may receive the dividend in one of a number of ways, according to the
options that are available under the policy provisions:
• Cash dividend option
Under this option, a cheque is issued to the policyowner for the amount of the
dividend declared each year.



• Premium reduction option

The insurer applies the policy dividend toward the payment of the annual premium. During
the early years of a policy, the dividend declared will be less than the premium due. The
policyowner receives a premium notice for the difference. For policies that have been in
force for a while, the dividend declared may exceed the annual premium. In this case any
balance of the dividend remaining can be received under one of the other dividend options.

• Leave on deposit to accumulate interest option

Dividends may be left on deposit with the insurance company. The policyowner can
withdraw the dividends, plus any accumulated interest, at any time. When the
insured person dies, the dividend accumulation is usually paid to the beneficiary
when the death benefit proceeds are paid.
• Paid-up addition option
Dividends may be used as a net single premium to acquire additional paid-up insurance
on the life insured’s life. The additional insurance is issued on the same plan as the basic
policy, for the amount that the net single premium will buy, considering the age of the
person being insured. The additional insurance does not require evidence of insurability.
Consequently a person whose health has deteriorated can acquire additional life insurance
that he or she might not otherwise be able to obtain. The additional insurance also has a
cash value, if the basic policy provides for a cash value.

• Additional term insurance option

Dividends may be applied as a net single premium to acquire one-year term insurance
on the life of the person being insured. Typically, the amount of term insurance will not
exceed the policy’s accumulated cash value in the year. The additional coverage
received would be based on the age and sex of the insured person. If the dividend
amount exceeds the amount required to pay for the term insurance, the excess may be
used under one of the other options.

Premium Offset Policies and Dividend Projections

A number of life insurance companies have faced lawsuits from policyowners who had
purchased life insurance policies under a premium offset payment plan. Essentially, the
insurance company projected a premium payment plan based on assumptions about future
policy dividends to be declared under a participating life insurance policy. Based on these
projections, a prospective policyowner could expect that a life insurance policy would be
fully paid up within a relatively short period of time. Depending on the rates of return
assumed under the projections, the policy could be fully paid for in as little as ten years. No
further premiums would be required to keep the policy in force.
Many such policy plans were sold at a time when interest rates were high and dividend
projections were generous. However, as interest rates fell and returns on investment failed to
fulfil the projections, policyowners whose premium paying periods were projected to end in a few
years were told that they would have to continue paying premiums for several more years.



Although the projections that were generated when these policies were sold were not
intended to be guarantees of performance, the selling methods used and the policyowners’
expectations implied at least some level of guarantee for these numbers. Some insurance
companies decided to abide by the projections under which these policies were sold.
Nevertheless, dividends and projected returns on dividends are not guaranteed. Insurance
companies’ assumptions about mortality, investment earnings, and expenses may not be
borne out by their actual experience. Companies have reduced their dividend scales, and
interest earnings on declared dividends have suffered from the very low investment rates
of return that have prevailed in recent years.

Guaranteed and Adjustable Whole Life Insurance

The premiums for traditional life insurance products are determined by projecting over the
life of the product all the components from which the premium rates are derived. Insurance
companies use pricing factors such as estimated mortality experience, investment earnings,
expenses, and other contingencies over many years to establish premiums for people of all
ages. Because the estimates must be made over such a long period of time, the assumptions,
particularly investment return assumptions, tend to be very conservative.
During the 1980s, the cash surrender values of permanent life insurance policies were much
lower than the investment returns for other financial products. Permanent life insurance
products lost popularity, even though insurance companies guaranteed that the premium rate
for each life insurance policy would remain the same for the life of the policy.
To compete with other financial products and to take account of changes affecting mortality and
expenses, insurance companies introduced products for which the premiums and benefits were
subject to adjustment from time to time. For example, an adjustable policy might guarantee the
premium rate and associated level of coverage for five years. After five years, the insurance
company would adjust the premium, the coverage, or both, after reviewing the product in light
of changes in mortality rates, investment returns, expenses, and contingencies. The premium
and coverage for the next five years might decrease, increase, or stay the same, depending on
the company’s experience with the product and on projections for the next five years.
Various adjustable life insurance policies were introduced to the market place, culminating
in the creation of the Universal Life Insurance policy.




After reading this section, you should be able to:
• explain the advantages and disadvantages of universal life (UL) insurance;
• explain the benefits to a policyholder of the universal life insurance feature of
unbundling the three pricing factors;
• explain and provide examples of the difference between yearly renewable term (YRT)
and Term 100 (T-100, also known as Level Cost of Insurance or LCOI) mortality
costing in a universal life product;
• explain and provide examples of the difference between guaranteed and adjustable
mortality costs;
• explain and provide examples of the impact of investment choices on the viability
of a universal life contract;
• explain the implications of early withdrawals, loans, and leveraging of a
universal life insurance policy.
Universal life insurance offers a great deal of flexibility compared to traditional life insurance
products. The degree of flexibility provided allows a UL policy to “mimic” any form of life
insurance. Many key policy features can be changed throughout the life of the policy. These two
aspects of UL often result in “universal” appeal to purchasers, policyholders and agents.
For example, if an individual aged 30 buys a $250,000 whole life insurance policy with an
annual premium of $2,000, he or she must continue to pay that premium for the duration of
the policy in order to maintain all the benefits it provides. The anticipated mortality costs,
investment earnings, and expenses are established for the life of the policy. The policyowner
has no contractual right to change any provisions of the contract that relate to the amount of
insurance coverage and the premiums.
A universal life insurance policy, however, allows the policyowner to make adjustments
to the insurance plan:

• The policy can provide different death benefit face amounts for up to five insured lives
and insured lives can be removed at will or added subject to underwriting;
• Four death benefit options can be offered that either keep premium payments low,
provide a maximum death benefit, maximize tax deferred/sheltered growth within the
policy, or achieve a balance of these;
• Contracted death benefits (face amounts) can be reduced at will or increased
subject to underwriting;
• Total death benefits may increase or decrease depending on the death benefit option
selected and the investments maintained within the policy account;



• Policyowners have a wide range of investment options from which to select to make-up
the investment account (also known as policy account, policy reserve, cash reserve,
cash value). Investment account options can be integrated to result in a custom portfolio
that can be changed throughout the life of the policy to meet the policyholder’s
changing risk tolerance or financial needs;
• Mortality costs for the policy can be based on Yearly Renewable Term (YRT)
insurance or Term-to-100 (T-100) insurance. A YRT mortality base can be
converted to a T-100 mortality base during the life of the policy;
• A range of premium payments is permitted between a required minimum and a regulated
maximum within which the policyowner is free to select and change as desired or needed.
The mortality costs, investment returns, expenses, and other costs for contingencies are subject
to periodic review within a UL policy and adjusted within certain limits defined in the contract.
So a policyholder who acquired a UL policy for a $2,000 annual premium may, after a period of
time specified in the policy, be able to maintain the same life insurance plan for a smaller annual
premium. The investment account portion of the universal life policy may result in sufficient
growth to allow a greater death benefit or lower premium payments. Mortality costs will be
reassessed based upon company experience and may be decreased or increased. The company’s
expenses will also be examined and that portion of the cost may be adjusted.
Although the policyowner selects the face amount of the policy when it is issued, the death
benefit payable may be greater than that amount, depending on the contract provisions and
death benefit option selected. There are often four death benefit options offered with the first
three being quite standard across universal life policies:

1. Level Death Benefit – the beneficiary receives either the contracted face amount or
the policy cash value, whichever is greater.
2. Level Death Benefit Plus Cash Value – the beneficiary receives both the contracted
face amount and the investment account.
3. Indexed Death Benefit – the beneficiary receives a contracted face amount that increases
annually based on a fixed percentage or a benchmark such as the Consumer Price Index.

4. Premium Advantaged Death Benefit – the beneficiary receives the contracted face
amount and the investment account with mortality costs being managed to allow for
maximum, tax deferred account growth within regulated limits.
In summary, a policyowner can choose, within certain limits, the policy’s face amount and death
benefit and the size of the premium, based on conditions existing when the policy is issued. The
policyowner can alter these choices during the life of the policy, although the company must
approve any changes that will increase the amount of risk covered by the policy.
One potential disadvantage of universal life insurance is that the factors that determine the
premium cost of maintaining a certain level of life insurance coverage may mean that the
premium increases over time. These costs depend on the number of claims submitted to the
insurance company, its expenses and other contingencies, and the investment returns on the
portion of each premium that is not applied to pay insurance costs. Much like premium offset
plans that anticipated a certain level of dividends, the initial projections of premium requirements
for a universal life insurance plan may prove to be inaccurate. Over time, a policyowner may be



obliged to pay more than the policyowner who has a traditional whole life insurance
policy for the same amount.
Another potential disadvantage of universal life insurance is that it may result in “analysis
paralysis” due to all the options that provide its flexibility and the elections that need to be
made to set up the policy. Universal life can be difficult to explain for the agent and
difficult to comprehend for the client.

Unbundling the Three Pricing Factors

One insurance company promoted its universal life insurance product as providing “a plan
for all reasons.” The slogan tried to convey the flexibility to the policyowner in designing
a custom program of life insurance using a universal life insurance policy.
A universal life insurance policy offers flexible amounts of coverage, flexible premiums,
and a wide range of investment options. This level of flexibility is made possible by the
separation or unbundling of the principal elements of life insurance.
The three principal elements that are unbundled are:
• mortality charges;
• investment earnings;
• expenses.
A universal life insurance policy operates in this way. The policyowner pays a premium to the
insurer. The insurer takes a small administration fee and then applies as much of the premium
as necessary to cover the costs of the contracted face amount. These costs include the mortality
cost based either on YRT or T-100, the provincial premium tax (about 3%), expense charges,
and a profit loading. These risk charges and the way they are calculated are described in the
policy contract provisions. The remainder of the premium is directed to the policy account
and invested in the different options based on percentages selected by the policyowner.
The accumulating cash value in the policy after risk charges and expenses have been
deducted becomes the investment account including investment returns that contribute to
the growth in value of the policy. See Figure 2.1 below for a pictorial depiction.




Policyowner Remits Premium Payment to Insurer

Minimum to Maximum Range
Policyowner May Vary the Premium within this Range a Number of Times Each Policy Year
The Required Minimum Only Pure Insurance Costs Leaves Nothing for the Investment Account
Any Premium in excess of the Minimum is directed to the Investment Account
The Maximum Allowed is established by the Policy’s Annual MTAR

Retains a Processing Fee

1. Pays 2. Invests

Mortality Cost Tax Deferred/Sheltered Investment Account

Death Benefit Based on YRT or T-100 Policy Reserve / Cash Surrender Value

Provincial Premium Tax

Approximately 3% Policyowner Selects Investment Option(s)

Expense Charges - Daily Interest Savings

Operating & Administrative Costs - 1, 3, 5, 10, or 20 Year GIAs2
- Index Linked Accounts or Portfolios
Profit Margin Loading - Segregated Funds or Portfolios
Industry & Product Competitive - Mutual Fund Based Accounts or Portfolios
- Managed Accounts or Portfolios

A single option may be chosen or premiums may be

directed to a number of options on a percentage basis
allowing for a customized portfolio. The investment
mix can be changed a limited number of times each
policy year.

Annually Taxable Side Account3
(For Holding Premiums in Excess of MTAR1 – Regulated Maximums)

Daily Interest Savings

Figure Notes:
MTAR = Maximum Tax Actuarial Reserve - a mathematical formula designed to replicate the premiums and growth required of a
20-Pay, Endow-at-Age-85, Whole Life Policy – the most aggressively funded policy prior to the appearance of Universal Life.
MTAR was put in place by the Canada Revenue Agency to prevent policyholders and taxpayers from taking undue advantage of
the tax deferred/sheltering nature of the investment growth within life insurance policies.
GIAs = Guaranteed Income Accounts (a.k.a. Deferred Income Annuities or DIAs). The life insurance industry’s equivalent of GICs.
The insurer closely monitors all UL policies to ensure regulated maximum premiums and regulated maximum growth within the policy is not
exceeded. If a UL policy is projected to exceed allowed limits, the insurer contacts the policyowner with options to restore the status of the
policy. If necessary, the insurer will request the policyowner to cease making premium payments and/or direct premiums to the Side Account
and/or shift investment dollars to the Side Account to maintain regulatory status. Once the policy is within regulated limits and status allows,
the insurer will move funds from the Side Account back into the Investment Account.



This component is usually expressed in a table of insurance charges contained in the policy
contract. Mortality (the risk of death) is commonly expressed in terms of deaths per thousand
people per year in a specified risk group. For an insured person, the mortality charge is
the amount needed to cover the risk of insuring that person, given his or her age and risk
classification. The mortality charge is one of the first items deducted from a premium payment.
The contract will usually express this mortality charge as a rate per thousand dollars of the
net amount at risk. The net amount at risk is normally the death benefit amount minus the
current cash value of the policy.
Most universal life insurance contracts specify that the mortality charge will never exceed
a specified amount. Most also allow the insurance company to lower the risk charge if the
company’s mortality experience is favourable (that is, if fewer people than expected in a
particular age group die and the company does not have to pay out as many claims as it
originally projected).

The most flexible component of a universal life policy is the alternatives available for the
investment of the premium contributions beyond what is used to cover mortality costs
and expenses. This amount forms the cash value of the policy. Most contracts specify that
the cash value of the policy will be credited with at least a minimum rate of interest.
Beyond that, the company will specify some standard by which prevailing rates of return
will be credited to the cash value account depending on the investment option(s) chosen.
The contract generally expresses the method of determining the rate to be credited by
reference to some standard, such as the rate earned by Government of Canada Bonds with
five years left to maturity.
Net premiums may be invested in much the same manner as guaranteed investment
certificates. The net premium is invested at the prevailing interest rate and the cash value is
the accumulation of net premium deposits and their accruing interest.
Many contracts offer the policyowner the choice of investing the net premiums in segregated
funds of the insurance company, index linked accounts, mutual fund based accounts, or
managed accounts. This method allows for investment in vehicles such as equities and the
creation of customized portfolios employing asset allocation principles.

Insurance companies levy charges against the policy to cover their costs of administration.
Expense charges can be applied as a percentage of the annual premium, as a monthly
administration fee charged against the cash value, or as a specific service charge to
cover the processing of changes, loans, withdrawals, and surrenders.



Yearly Renewable Term and Level Cost of Insurance Mortality

A universal life insurance contract specifies how the current mortality cost for the amount of
the death benefit payable under the policy will be calculated. The policy contract includes a
table of the mortality costs per thousand dollars of death benefit and the attained age of lives
insured under the type of policy.
The policyowner can choose how to determine the death benefit amount under the policy.
The death benefit amount is determined according to the face amount selected by the
applicant at the time that the policy is issued, and the cash value that has accumulated under
the policy. The policyowner may choose either a level amount equal to the face amount of
the policy, or the face amount plus the cash value that has accumulated under the policy.
In calculating the mortality risk charge for the level amount of death benefit in any period, the
company multiplies the current mortality cost by the net amount at risk. In the case of the level
death benefit, the net amount at risk is the face amount minus the current cash value.
In calculating the mortality charge for the face amount plus cash value death benefit, the
mortality cost is multiplied by the face amount. Expressed another way, the mortality cost is
multiplied by the face amount, plus the cash value, minus the cash value (i.e., without taking
the cash value into consideration). The net amount at risk remains level and equal to the face
amount throughout the life of the policy.
The policy contract offers a choice of yearly renewable term (YRT) costs or level cost of
insurance (LCOI) charges. Level cost of insurance is based on a Term-to-Age-100 policy. If
LCOI is selected at policy issue, there is no opportunity to convert to YRT. If YRT is selected
at policy issue, the policyowner can later elect to convert to LCOI.
Under the yearly renewable term option, the mortality costs to be charged increase at each
policy anniversary according to the age of the person being insured. Under the level cost of
insurance costing method, the mortality cost applicable to the life insured based on his or her
age at the time the policy is issued remains constant over the life of the policy.
In choosing one or the other alternative, the policyholder should know that YRT mortality costs
will be lower than LCOI mortality costs when the policy is issued. Over time, and depending on
the issue age (age of the life insured at the time the policy was issued), the YRT costs will
eventually exceed the LCOI costs. If the policyholder intends to keep the plan in force for a
specific period of time, then YRT charges may be more cost-effective than LCOI. If the universal
life policy is designed to operate like a whole life insurance plan, then LCOI charges may be
more cost-effective. Another option is to take advantage of the opportunity to convert from a
YRT cost base to a T-100 cost base. When an insured is younger, the lower cost of YRT
allows a greater amount of premium to be directed to the investment account. A cross-over
point is usually reached in the 45 to 50 age range when the cost of YRT approaches and
begins to exceed that of T-100. Switching to LCOI charges at that point would allow the
greatest amount of premium to continue being credited to the investment account.
With a universal life policy, death benefits can also be increased year after year based on a
certain set percentage. The indexed amount is often based on the Consumer Price Index (CPI) or
can be a set percentage chosen by the policyholder. There is a maximum allowable increase in the
death benefit set in the policy contract. The premium charge will reflect this kind of arrangement
and be more expensive than a regular universal life policy with a level death benefit. A client will
often choose this type of setup in order to combat inflation or if they have a life insurance need



that will continue to grow. Increasing capital gains exposure on a cottage property is a very
good example of this need.

Guaranteed and Adjustable Mortality Costs

Whether the mortality costs are chosen as YRT or LCOI, the policy contract will specify a
maximum mortality cost that will be charged according to the age of the insured. The
contract will also specify that current mortality costs charged may be less than the maximum
guaranteed charge, depending on the number and size of the claims submitted to the
insurance company for a particular product.
A policyowner may elect to have maximum mortality costs guaranteed for the life of the
policy at time of issue. This election will cost more at the outset than allowing the insurer to
vary mortality costs based on its claims and operating costs. However, it may cost less over
the long term if the insurer’s claims and operating costs are higher than projected.

Impact of Investment Choices on the Viability of a Universal

Life Contract
For many universal life insurance contracts, the policyowner can choose how the cash value
component of a universal life insurance policy will be invested. The usual choices are:

• A basic fixed interest account: the account is credited monthly with an interest rate
calculated on the basis of some benchmark e.g., 90% of the change in interest on 10-
year Government of Canada bonds with three years left to maturity. The cash value is
retained in the general funds of the life insurance company.
• A general fund investment to which current rates of interest are credited: the
policyholder selects an investment term, such as five years. Interest is earned on the
account based on prevailing investment rates for fixed-income investments of the same
investment term. The type of investment operates like a Guaranteed Investment
Certificate (GIC) or money market account.
• An index fund investment: interest is credited based on the performance of an index
fund which is a type of mutual fund that tracks the performance of a broad diversified
market index such as the S&P/TSX 60. Index funds are available that give the
policyholder exposure to domestic or foreign fixed-income investments and/or the
major equity markets of the world.
• A segregated fund investment: Segregated funds are investments or pooled funds
sponsored by insurance companies. They are considered insurance products. The
premiums paid, minus any front-end charges, are credited to a segregated fund account.
The investment choice within the segregated fund is broad. Policyowners can choose
among equity funds, bond funds, balanced funds, money market funds, or any other
investment choices available with segregated fund investments.

• A mutual fund based investment: Mutual funds the insurer is affiliated with are used as a
base from which the value of the policyholder’s account is derived and valued. A broad
range of mutual fund options is usually available within a universal life insurance policy
including balanced funds and fund-of-fund options.



All income and growth within the policy account occurs on a tax deferred basis as long as regulated
limits are not exceeded. When UL policies first appeared, there were no Canada Revenue Agency
limits on how much could be paid into the policies or how much growth could accrue within them.
Many wealthy taxpayers made excessive use of UL to avoid tax. The government moved quickly to
prevent this by using a 20-Pay, Endow-at-Age-85 Whole Life policy as the benchmark for maximum
premium payments and tax deferred growth. Until the appearance of UL in the insurance market, 20-
Pay, Endow-at-Age-85 was the most aggressively funded type of whole life policy available. Canada
Revenue Agency developed a mathematical formula called MTAR (Maximum Tax Actuarial
Reserve) to set the maximum premiums allowed each year to a UL policy and the maximum rate of
growth that could occur on a tax deferred basis. As long as the MTAR limits are maintained, the UL
policy will retain its exempt status for tax purposes. If MTAR is exceeded, the insurer and
policyowner have 60 days after policy year-
end to rectify the problem and retain exempt status. If exempt status is lost, it is lost
permanently, and all future growth within the policy will be taxable on an annual basis.
As long as MTAR limits are respected and the proceeds of the policy are paid out to a
beneficiary as a result of the life insured’s death, then true tax sheltering is achieved as all growth
within the policy along with the face amount can be received tax free by the beneficiary.

Early Withdrawals, Loans, and Leveraging

When an individual applies for a universal life policy, he or she must first decide on the
amount of coverage required, the type of death benefit desired, and the amount of premium
that can be afforded.
Then, the applicant must decide what investments to hold within the policy account. This
should be based on the policyowner’s risk tolerance as with any other form of investing. The
choice can range from a simple interest-bearing account to a segregated fund portfolio that
has an aggressive investment philosophy.
Once these choices have been made, a policy projection can be created depicting future death
benefits, investment account balances, cash surrender values, and premium payment options.
Projections assume that any accumulated money in the plan will remain to accumulate to
provide the projected returns.
A policyowner has some options to access policy value under the terms of the contract.

A universal life policy usually allows a policyholder to take a policy loan against the cash value
directly from the insurer. This provides a very quick way to borrow money at reasonable rates
without having to go through the credit checks and financial disclosure required by lending
institutions. The method of charging interest on such policy loans is described in the policy and
is usually a benchmark rate, such as the interest earned on Government of Canada bonds with a
certain maturity date. Policy loans will usually be granted within a week or two of application.
If the policyowner uses the loan for investments, the Income Tax Act permits the tax deduction
of the interest paid on the policy loan. The policyowner must determine the potential cost/benefit
trade-off of this course of action. The gross cash value of the policy will continue to enjoy the
returns generated from the investment vehicle(s) selected. If the insured person dies while there
is still a loan outstanding on the policy, the amount of the loan, plus the interest owing, will be
deducted from the amount of the death benefit paid to a beneficiary.



A policy loan will not affect the exempt status of the policy as there is no actual or
deemed disposition of any part of the policy.


The policyowner may also withdraw a portion of the cash value that has accumulated under
the policy. The cash value available for investment is reduced by the withdrawal.
Consequently, after a withdrawal, there may be less than enough value remaining in the
policy to attain the objectives anticipated at the time the policy was issued. The policyowner
may have to increase premium payments, adjust the death benefit, or replace the amount
withdrawn, plus interest, to achieve the initial objectives.
Withdrawing cash from a UL policy is considered a disposition by Canada Revenue
Agency and results in the policy losing its exempt status from the time of withdrawal.


A universal life policy can be used as collateral for a loan from a financial institution.
Borrowed funds can be placed in other forms of investment. If these investments realize a
higher after-tax return than the tax deferred investment account in the universal life policy,
the policyowner will benefit. However, the policyowner may have to increase the premium
contribution in order to maintain the life insurance policy according to the plan objectives
chosen when it was issued. Collaterally assigning a universal life policy is not considered a
deemed disposition for tax purposes and the policy will retain its exempt status. Absolute
assignment of a policy would constitute a deemed disposition and a loss of exempt status.



After reading this section, you should be able to:
• recommend the most appropriate permanent individual life insurance products to
meet specific client needs.
Example 1: Couple with Accumulated Assets and Property
Jack and Mae have just celebrated 25 years of marriage. Their three children have finished
their education, left home, and started their careers. Both Jack and Mae are in their mid-forties.
The couple are typical “empty nesters” and they are looking forward to this new stage of their
lives. Jack is a vice-president in the financial services industry and Mae is a high school
teacher. They both earn a better-than-average income and, other than a mortgage on their
home and on a condominium in Florida, they have no debts.
The couple jointly own their home, which is worth about $400,000. Mae inherited some
vacation property in northern Ontario, on which she had a cottage constructed. Although the
cottage cost $100,000 to build, the total value of the cottage and property is now about
$250,000. They rent out the condominium in Florida and intend to use it as a winter getaway
when they retire in about 20 years. The couple also owns two other properties in town that
they rent to students who attend the local university.



Recently, the couple met with their financial planner to discuss their retirement goals and to
review their current financial status.

Their planner made one point that disturbed the couple. Their assets and property holdings
represented a sizeable estate that, when they die, would be subject to heavy income taxes. If
they wanted to pass these assets and property along to their children, they would have to find
the resources for their executor to pay those taxes without having to dispose of some or all of
the holdings. As the planner explained, any asset that they owned that increased in value
would be subject to capital gains taxes when they die. This tax liability could be delayed until
the surviving spouse died, but payment of that tax liability was inevitable.

The planner suggested that one way of making sure that the estate held enough liquid funds to pay
the taxes was to acquire life insurance. Jack and Mae were both in excellent health and they could
expect to live well into their retirement years. The insurance benefit would have to be available once
both of them had died. That meant both of them would have to apply for life insurance.

Although they could calculate what the tax liability would be if they died immediately, they had no way of
knowing how much their holdings would appreciate over time. Ideally, the amount of life insurance they
acquired should increase in some way to keep pace with the growth in the value of their holdings.

They knew they needed permanent life insurance, since the need for the insurance was long
term. They also knew that upon retirement, they wanted to reduce any regular expenses as
much as possible. That included the expense of paying premiums for life insurance.

Which life insurance product would meet Jack and Mae’s insurance needs?
Jack and Mae may want to consider applying for a participating whole life insurance policy.
They could choose the paid-up additions option for the policy dividends. Dividends declared
under the policy would be applied as a single premium to buy additional paid-up insurance
for whatever amount that the dividend would purchase. Although dividends are not
guaranteed, the amount of dividend declared each year would presumably increase and larger
amounts of paid-up insurance would be added to the policy benefits.
They could also consider a universal life insurance policy and select a death benefit option
that would pay an amount equal to the face amount of the policy and the cash value.
Since they do not want to continue to pay premiums on the policy after they retire, they could
choose a policy with a premium paying period that ends at a specific time. For example, they
could choose a life paid up at age 65 policy. Although they would not have to pay premiums
after they turned 65, the policy would continue in force without a reduction in the policy’s
benefit provisions.
They could also choose a universal life insurance policy and establish a premium
contribution level that would be projected to have fully paid for the policy by the time they
turn 65. The important difference between a universal life insurance policy and a permanent
non-participating life insurance policy paid up at age 65 is that the benefits and premium
paying period of the permanent life policy are guaranteed. The universal life insurance policy
does not provide the same guarantee. Whether or not the universal life policy becomes fully
paid up depends on the performance of the investment fund in the policy.
Once the agent had explained the options and the implications of each one, it was up to Jack
and Mae to decide which policy best suited them.



Example 2: Charitable Bequest

Endora is single and is an active participant in a local charity. She wants to support its efforts as much as
possible, but she has limited resources. She lives modestly and has a pension plan through her employer
that will allow her to retire comfortably. She has heard that she can apply for life insurance and name the
charity as beneficiary. She has a family history of longevity and she is in good health. She cannot afford
large premiums, but she wants to make sure that the benefit is as large as possible.

What life insurance product would meet Endora’s needs?

Since Endora wants to provide a benefit to the charity when she dies, a permanent life
insurance plan is the most appropriate.
If she wants to acquire the largest amount of insurance possible, yet keep the premiums
affordable, then a permanent life policy payable for life will provide the most benefit
for the premium payment.
Since she appears to have the financial resources to keep paying the premium, even if she becomes
disabled, she may want to avoid adding any additional benefits such as waiver of premium.

She can choose between a participating and non-participating whole life policy. She would
pay a higher premium for the participating plan, but the dividends declared over time under
the participating plan may ultimately provide a larger death benefit. Since the dividends are
not guaranteed, she will have to choose between a guaranteed death benefit and a death
benefit that includes a guaranteed face amount plus the value of accumulated dividends.
Endora can also choose a universal life plan and select the largest face amount for the premium
she intends to pay. The premium term and ultimate values are not guaranteed, however, and
Endora must take that into consideration when she makes her choice of insurance plan.

Example 3: Creating an Estate

Wanda is a single mother who struggled to raise her two children, who are now married and
raising their own families. Wanda earns a good salary and is able to live comfortably, now
that her children are independent. Given the difficulties that she encountered raising her
children, Wanda wants to leave an inheritance to them that will help them raise their children
and give her grandchildren the opportunity for a university education.

She does not have a large estate and nothing of significant value to pass on. She wants to set
aside an amount each month to pay the premium on a life insurance policy. She is in good
health, and given her family history, she expects to live well into her retirement years. She
wants the largest amount of insurance she can get for her premium dollar.

What life insurance product would meet Wanda’s needs?

A term life insurance policy will provide a larger face amount of insurance than a
permanent life insurance plan. Wanda must consider, however, the likelihood that she could
outlive the term insurance coverage.
A permanent life insurance plan may be the better choice, since she wants to make sure that
her children receive a good inheritance upon her death.
If she wants the largest amount of life insurance that she can get for the premium that she
can afford, then a plan with premiums payable for life may be her best choice.



Wanda can choose between a non-participating and a participating life insurance policy. The
premium for the participating policy will be higher than that for the non-participating policy for
the same face amount of insurance coverage. She must consider whether the dividends projected
to be paid on a participating policy would provide a larger death benefit, considering both the
face amount and the dividends that could accumulate under the policy. Wanda must keep in
mind that the dividends projected to be paid under a participating policy are not guaranteed.
Wanda could also consider a universal life insurance policy. Although she must pay mortality and
expense charges through the premiums that she contributes, the balance of the premiums are
deposited to an investment fund. The deposits will earn current rates of return. If Wanda chooses
the face amount plus cash value option available under a universal life plan, the benefit ultimately
paid out upon her death may be larger than the death benefit under the non-participating plan, or
the death benefit plus dividend accumulations under the participating plan. However, the
investment returns under a universal life insurance policy are not guaranteed.
The insurance agent should explain all these options before allowing Wanda to choose the
plan with which she is most comfortable.

Example 4: Funding a Shareholder Buy-Sell Agreement

Craig, Pierre, and Darlene are the owners and sole shareholders of a closely held corporation.

Since the shares are property, when one of them dies, the shares he or she owns will pass to his or
her estate for sale or distribution to the heirs. Unlike publicly traded shares, the shares of this private
corporation are not very liquid. Their sale to a third party might not happen quickly and may not
attract the price that the heirs would seek. At the same time, the surviving shareholders might not
want to deal with the heirs of the deceased as shareholders or with new shareholders who might not
have the same objectives for the business as the surviving shareholders.

To address these concerns, the shareholders have drawn up a buy-sell agreement for the purchase of the
deceased’s shares. Under the agreement, the executors of the deceased shareholder’s estate agree to sell
the deceased’s shares to the surviving shareholders and the surviving shareholders agree to buy them.
The agreement specifies a price for the shares or a formula for determining their price.

Although the agreement resolves the problem of the disposition of the deceased’s shares,
Craig, Pierre, and Darlene are concerned about how they will pay for the shares when the time
comes. Since the surviving shareholders agree to purchase the deceased’s shares, they must
use business resources or their own resources. Their financial planner has recommended life
insurance on each of the shareholders’ lives as a way to meet that financial obligation.

What type of life insurance policy would be appropriate for Craig, Pierre, and Darlene?
The three must decide how long the buy-sell agreement will remain in place. For example,
if they agree that their respective shares will be sold to the remaining shareholders when
each of them retires, there is a limit to their need for life insurance. They may want to
consider term life insurance on each life for a term ending at age 65.
If they buy term insurance, they may want to consider increasing term insurance. Although
they know the value of the shares at present, the value may increase over time. The face
amount of a level term insurance policy may be inadequate to provide the funds necessary to
complete the buy-sell arrangement.
If the shareholders want to keep their shares indefinitely, permanent life insurance may be the
better solution. The insurance benefit must be large enough to meet most, if not all, of the cost



of acquiring the shares. If the value of those shares is determined by means of a formula, the
exact amount of the obligation may not be known when the insurance is acquired.
Non-participating permanent life insurance provides a guaranteed death benefit, but the
shareholders would not be able to increase the death benefit without paying a larger
premium and providing evidence of insurability for any increases in insurance coverage.
Therefore, they might consider participating life insurance. The dividends paid under the
policy could be deposited under the paid-up addition option to provide life insurance of the
same type as the basic policy. Under the option, each dividend would be applied as a single
premium to purchase the amount of insurance that the premium will support. That option
would provide for an increasing insurance benefit within the provisions of the policy. The
shareholders must keep in mind, however, that dividends are not guaranteed.
Alternatively, the three could apply for universal life insurance policies and choose the face
amount plus cash value death benefit option. The value paid out under the policy will be
larger than the face amount alone. The amount of the death benefit equal to the cash value
will depend upon the returns for the investment component of the policy.
A universal life insurance policy will allow the shareholders to increase their premium
contributions if they believe that the death benefit should increase to reflect an increase in
the value of the shares.


After reading this section, you should be able to:
• describe the supplementary benefits that may be purchased with a life insurance
policy, including accidental death and dismemberment (AD&D), monthly disability
benefit, and waiver of premium;
• explain the purpose of accelerated death benefit riders and the key provisions of three
common accelerated death benefits: the terminal illness (TI) benefit, the dread disease
(DD) benefit, and the long-term care (LTC) benefit;
• explain, using examples, the purpose of adding term insurance riders to permanent life
insurance policies, including additional term insurance coverage for the primary
insured person and coverage for additional persons, including spousal and children’s
term rider and children’s term rider;
• explain the guaranteed insurability benefit (GIB) rider, its benefits, and its appropriate use;
• explain the paid-up additions rider.



Waiver of Premium Rider for Disability Benefit

Aida owns and is insured under a universal life insurance policy with a face amount of
$50,000, a plan objective of whole life, and a planned premium of $500 per year, which she
pays monthly under a pre-authorized payment plan. The policy also includes a term
insurance rider of $25,000 and an Accidental Death Benefit.
Aida has developed a very serious illness and is unable to work at her job as a teacher. She
is now on long-term disability under the provisions of her employer’s group insurance plan.
Although she currently receives about two-thirds of her full employment income, she is
concerned about her expenses. She has contacted her agent to find out if she can reduce her
monthly premium obligation under the policy. Although she finds it a burden, she realizes
that her family will need the insurance benefit if she dies.
Her agent confirms that the policy includes a waiver of premium benefit. The waiver of
premium benefit would become effective if Aida incurred a total disability. Total disability
is defined as the inability of the insured person to perform the essential duties of her current
occupation, or any other occupation for which she is suited by education, training, or
experience. Aida must submit appropriate documentation to the insurer supporting any
claim for benefits, including a statement from her attending physician.
Once the insurer has recognized her claim, Aida must continue to pay premiums during a
waiting period stipulated in the benefit provisions. In this case, the waiting period is three
months. Some insurers require a six-month waiting period.
At the end of the waiting period, the insurer will waive all of the premiums that Aida paid since
the onset of her total disability and refund the premiums that she paid during the waiting period.
Some insurers waive premiums only from the conclusion of the waiting period onward.
The waiver of premium benefit waives not only the premium for her universal life policy, but
also for the term insurance rider and the accidental death benefit.
Effectively, the insurer pays the premium on Aida’s behalf, since she retains all her rights and
privileges under the contract during her disability. For example, her term insurance rider is a five-year
renewable term insurance plan. If Aida is still disabled when the term rider reaches its renewal date,
the coverage will renew automatically and the premiums will continue to be waived.
The term plan provides for a conversion privilege under which Aida can choose to convert the term
coverage to a permanent life insurance plan. Her waiver of premium benefit provides that if she is
still disabled on the last date that she is eligible to convert her term insurance coverage, her insurer
will automatically convert the plan to whole life insurance for the same amount of coverage and
continue to waive the premiums on that plan until she recovers, or dies.

This provision in Aida’s policy is more generous than the provisions available from some
other insurers. Some allow a conversion, but require the insured to pay premiums on the
conversion plan.

Waiver of Premium for Payor Benefit

Gerald owns and pays the premium on a juvenile life insurance policy that insures the life
of his two-year-old son Mark. The juvenile policy insures Mark for a sum of $5,000 until
he reaches age 21, at which time the insurance coverage automatically increases to $25,000.



Gerald pays for the policy each month by pre-authorized cheque. He wonders what would
happen if he dies, or becomes disabled and unable to maintain the premium payments on
his son’s policy. His agent suggests adding a waiver of premium for payor benefit to the
policy. This benefit provides that in the event that Gerald, as the owner of his son’s policy,
dies, or becomes disabled, the premiums due under the policy until Mark reaches age 21
will be waived by the insurer.
Gerald applies for the benefit and provides evidence of his insurability in order to qualify.
The application is accepted and the benefit is added to the policy.
Now, if Gerald suffers a serious disability because of accident or illness, then the premiums
falling due under the policy will be waived as long as his disability continues. If he dies, the
premiums will continue to be waived.
Gerald’s agent explains that if Gerald is disabled for three months or more, then the insurer
will begin to waive premiums that were due on and after the commencement of his disability.
According to the agent, this is a liberal approach to administering this type of disability claim.
Some insurers require that an applicant for the waiver of premium benefit must be disabled
for at least six months, and premiums will be waived only from that point on.
To qualify for the disability benefit, Gerald must suffer a disability that prevents him from
performing the duties of his regular occupation. If he continues to be disabled for two years
and is unable to perform the duties of any occupation for which he is suited by education,
training, or experience, the premiums will continue to be waived.
For example, Gerald is an accountant and is employed as a controller in a corporation. If he
suffered a disability, the insurer initially would consider him disabled if he could not
perform his duties as controller. If after two years, he is unable to perform the duties of an
accountant in any capacity, then the premiums would continue to be waived.

Disability Income Benefit

Norah is a mail clerk in a small company that has few employee benefits. Norah is concerned that
there is no salary replacement benefit in effect if she becomes disabled and unable to work.
Norah is a single mother of a five-year-old boy. She recently purchased a $50,000 term life
policy on her own life, because she wanted to provide money for her son if she died while he
was still a child. At the same time, she is concerned about providing for herself and her child
if she suffers a long-term disability.
She asks her agent about disability insurance. The agent informs her that she can apply for
disability income coverage as a benefit under her life insurance policy. If Norah provides
evidence of insurability and qualifies for the coverage, her insurer will add a disability income
benefit to her life insurance policy that will pay her a monthly income if she becomes disabled.
Disability insurance can also be purchased separately without owning a life insurance policy.
The benefit will provide $10 a month for every $1,000 of life insurance coverage. To qualify
for the benefit, Norah must have been totally disabled for at least three months. Total disability
is an inability to perform the essential duties of her own occupation or, after two years, of any
occupation for which she is reasonably suited by education, training, or experience.



Accidental Death and Dismemberment

Warren owns a farm and spends much of his time operating farm equipment. He has a good
life insurance program, but he wonders what will happen if he suffers a serious injury while
running the farm equipment.
Warren’s agent suggests that he consider adding an Accidental Death and Dismemberment
benefit to his life insurance coverage. Warren applies for and obtains Accidental Death and
Dismemberment coverage for a lump sum benefit of $100,000. If Warren suffers a serious
injury, the insurer will pay him the full $100,000 benefit. A schedule will be provided to
Warren listing benefit amounts payable for various types of injury.
For example, the full benefit would be paid if Warren lost both arms or the sight in both eyes.
He would receive a partial benefit if he loses one limb or the sight in one eye. Loss is defined
as either the actual loss of the limb or organ or the loss of use of the limb or organ (for
example, because of paralysis).
Accidental death insurance is defined under the Uniform Life Insurance Act as “insurance
undertaken by an insurer as part of a contract of life insurance whereby the insurer
undertakes to pay an additional amount of insurance money in the event of death by
accident of the person whose life is insured.”
[In 1925, the common law provinces (all except Quebec) first enacted uniform life
insurance legislation on insurance contracts and beneficiary rights. These acts, known
collectively as the Uniform Life Insurance Act, are updated periodically and apply to all
contracts made in the jurisdiction concerned. Similarly, accident and sickness insurance
legislation enacted over the years in the common law provinces is sufficiently similar that
it is referred to as the Uniform Accident and Sickness Act.]

Accelerated Death Benefit Riders and Common Accelerated Death

An important proponent for developing accelerated or living insurance benefits was Dr. Christian
Barnard, a heart surgeon who performed the world’s first heart transplant. He felt that those who
survived critical illnesses, even for a short while, would be able to afford special care or take care
of other expenses and liabilities if they received an insurance benefit while they were alive. Those
who did not die immediately from a critical illness might incur significant expenses for their
personal care, while at the same time losing their regular sources of income.
In the 1980s, Prudential of America introduced an informal living benefit program for its
policyowners, particularly those who were suffering the lingering illnesses caused by the
AIDS virus. Working outside the provisions of the policy contract, Prudential arranged for
advance payment of a portion of the life insurance death benefit. The remainder of the
death benefit was paid upon the death of the insured. This “living benefit” was intended
for those whose life expectancy was short, to allow them to pay for health care or palliative
care or to realize certain personal goals.
Other insurance companies followed suit in providing living benefits in circumstances where the
delay in receiving a death benefit caused hardship for the insured and his or her family. For
example, in one case, the husband in a husband-and-wife run business became terminally ill. His
wife was unable to give her full attention to the business while she attended to her husband’s
needs. The business was suffering and in danger of closing. Since the business would represent an



important source of the wife’s income after her husband died, it made sense to negotiate a
living benefit. With a portion of the death benefit, the couple was able to maintain the
business until the husband’s death.
Since the inception of living benefits, the coverage has been formalized within insurance
contracts to provide benefits while the insured is still alive.
Accelerated death benefit riders allow the policyowner to elect to receive a portion of the death
benefit before the insured person dies, if the insured person is diagnosed with a critical illness.
The illness would usually be sufficiently serious to reduce life expectancy to 12 months or less
and involve the need for special care of the sick person. The benefits include:

• terminal illness benefit;

• dread disease benefit;
• long-term care benefit.


Under this benefit, a portion of the death benefit is paid to the policyowner if the insured
person suffers a terminal illness. The definition of what constitutes a terminal illness is
stipulated in the contract provision. It usually requires that a physician certify that the
individual’s life expectancy is 12 months or less.
The amount of benefit varies, depending on the contract. The maximum benefit is usually a
percentage of the policy’s face amount up to a certain maximum. The amount paid out
reduces the final death benefit, so that after the insured person dies, the beneficiary receives
the difference between the terminal illness benefit and the policy’s face amount.
Example: Jerry has a $500,000 permanent life insurance policy which he purchased at age 32. Jerry is
now 47 years old and has been diagnosed with a terminal form of skin cancer. His doctors have given him
between 9 and 12 months to live. Jerry has an accelerated death benefit rider on this policy that covers
terminal illness. This rider permits Jerry to obtain 30% of the face amount up to a maximum
of $100,000 as a living benefit in case of terminal illness. In Jerry’s situation, 30% of the face
amount is greater than $100,000 so Jerry will be able to collect $100,000 from the life insurer.
He can use that money to do what he pleases; for instance, he could try out experimental
treatments and expensive drug regimes, he could go on an extended trip (provided his health
permits him to travel) or he could make a pilgrimage to a holy place and get spiritual succour at
a critical time in his life. When Jerry passes away, the life insurance company will deduct the
$100,000 already paid out from the face amount and his beneficiary will receive $400,000.


Under this benefit, a portion of the policy’s face amount is paid to the policyowner if the
insured person contracts one of a specific group of serious illnesses or suffers from certain
conditions, including, but not limited to:
• cancer;
• kidney failure;
• heart attack;



• stroke;
• coronary bypass surgery.
The benefit can be paid in a lump sum or in monthly instalments over a short period of time.


Long Term Care (LTC) insurance provides benefits to cover the expenses associated with care
received when a disability is so severe that an insured is unable to perform the Activities of
Daily Living (ADL). Benefits are usually paid out if the insured person is unable to perform two
or more ADLs, which include eating, bathing, dressing, or moving without assistance, or if the
insured suffers from conditions that affect ADLs, such as incontinence.
LTC coverage, which is most often associated with people at or near retirement age, pays for
a broad range of services that are not covered by medical insurance programs, including:
• adult day care;
• home health care;
• nursing home care;
• residence in a skilled nursing facility (nursing home);
• residence in an assisted living facility;
• residence in an Alzheimer facility;
• caregiver respite care.
Without this coverage, people who must pay for long-term care might have to liquidate
accumulated assets that were earmarked for another use. Coverage is most often renewable for
the lifetime of the insured person, or until the maximum lifetime benefits have been paid out.
As a rider to a life insurance policy, the Long-Term Care Benefit pays a monthly benefit to
the policyowner if the insured requires constant care for a medical condition. The monthly
benefit is usually a percentage of the base policy’s death benefit or face amount (the two are
synonymous). Many policies define eligibility for coverage by considering the inability of
the insured person to perform the Activities of Daily Living.

Term Insurance Riders on Permanent Life Insurance Policies


Why would a policyowner add a term insurance rider to a permanent life insurance plan,
instead of increasing the face amount of the permanent life insurance policy or applying for
a separate term life insurance policy?
The combination of a permanent life insurance policy and a term insurance rider is a convenient
way of organizing an individual’s and a family’s insurance plans. The cost of the term rider is
likely to be less than a separate term insurance plan for the same amount, because the policy fee
is smaller (or is waived entirely) for the term insurance rider. Also, the term insurance rider can
be maintained under the automatic premium loan non-forfeiture option of the permanent life
insurance policy. If the policyowner fails to pay the premium on a term insurance policy, the
coverage lapses. If the policy combines permanent life insurance with a term insurance rider,
failure to pay a premium will invoke the automatic premium loan provision. If there is sufficient
loan value in the policy, the coverage (both permanent and term) will continue.



In establishing a life insurance program, a policyowner should address needs that require a
permanent life insurance solution, such as capital gains taxes at death, and needs that require a
temporary solution, such as paying off a mortgage. The term insurance rider allows policyowners
to address a range of insurance needs. As circumstances change, the policyowner can adjust
his or her insurance plan, by terminating the term coverage, for example, or by
exercising the conversion privilege under the term insurance rider.


Since insurance planning affects all the members of a family, an insurance program can
include coverage for the spouse and children under one insurance policy.
Term coverage for a spouse can address the cost of providing care for children during their
minority if the spouse insured by the term rider dies. Term coverage on the children can
address the costs of burial and other costs associated with the death of a child.
This coverage is usually sold based on units of coverage. For example, each unit provides
$5,000 of term insurance coverage on the spouse and $1,000 of term insurance coverage on
each child. The children’s coverage does not require separate premiums for each child.
Every child in the family, including adopted children and newborns (beginning 15 days
after birth) are covered automatically at no extra premium.
The children’s coverage insures each child until he or she reaches a stated age, usually 21 or
25. Each child has the option to convert his or her coverage to an individual life insurance
policy on his or her own life without having to provide evidence of insurability. The
premiums would be based on the child’s attained age.

Example: Rodney Ramirez is a 40-year-old married man and a father of fi ve children ranging in age
from 3 years to 15 years. His wife, Mary, at age 36, is expecting their sixth child. Two years ago,
Rodney applied for and obtained a $250,000 whole life insurance policy on his life, naming Mary as
beneficiary. A friend of Rodney has recently advised him to purchase a term insurance policy on
the life of Mary and also on the lives of each of the kids and Rodney thinks that is a great idea.
He contacts his agent and outlines the situation. What should his agent recommend and why?

Rodney’s agent is likely to recommend that he add term insurance riders on his $250,000
policy, one on the life of Mary as well as a children’s rider. The benefit of the children’s rider is
that it will cover all fi ve children in the family and the sixth child will be covered automatically
(starting 15 days after birth) without Rodney having to pay an extra premium. Under the terms of
this policy, Rodney can purchase up to $10,000 of coverage on each child that insures the child
until he or she reaches age 21. For Mary, he can choose an amount between $10,000 and
$125,000 (i.e., up to 50% of the face amount of the main policy).

This arrangement neatly ties in all the insurance that Rodney needs on his family members in one policy
that also offers enhanced features and options available only with permanent life insurance policies.
Getting six other term insurance policies, one for Mary and one for each of the fi ve kids, is likely to cost
much more with policy fees and other administrative tasks. Also, Rodney would have to remember to
get a policy on the sixth child’s life and pay an additional premium if he did not add a children’s rider to
his whole life policy. Rodney will also have the option of exercising a conversion privilege under the term
rider if he wants to convert the term insurance, for whatever reason, to permanent insurance. Once
again, using riders allows a degree of flexibility to Rodney and his family that would not be available
through the purchase of separate term insurance policies.



Guaranteed Insurability Benefit or Guaranteed Insurability Option

The guaranteed insurability benefit (GIB) or guaranteed insurability option (GIO) is a benefit that
a policyowner can purchase to acquire additional life insurance without having to provide evidence
of insurability. In effect, a person can choose to pay a relatively small premium for the
opportunity to increase his insurance coverage in the future, even though he might not
otherwise qualify because he is no longer insurable. For example, a 25-year-old man who has
recently married may not need or be able to afford a large amount of insurance. He would
need more insurance later on in his life as his family grows and he takes on more obligations.
In the future, however, if his health deteriorates, he might not qualify for additional
insurance. He can acquire a GIB that allows him to buy additional insurance at certain
times before he reaches age 40 (some insurers offer the benefit until age 45).
The GIB specifies a number of dates on which the policyowner can elect to purchase additional
insurance, without providing evidence of insurability. The amount of insurance that the
policyowner can purchase on each option date may be the same type and amount as the basic
policy or some other amount of insurance of the same type as that of the basic policy.
The policyowner may also exercise the purchase option earlier than stipulated, for example,
upon his marriage or the birth of a child. The policyowner must make the election to
purchase the additional insurance and pay the premium. If he does not take advantage of the
option on the date it is available, he cannot make the election later, and that option is lost.
Some riders provide that if the policyowner dies within a short period (60-90 days) after
an option date without having purchased additional insurance, the insurer will pay the
additional insurance amount.
If the base policy contains a waiver of premium benefit and the insured person is disabled at
the time of an option date, the insurer will automatically issue the additional insurance
coverage. The waiver of premium benefit may specify that the premiums on the additional
coverage will be waived until the insured person recovers or dies.

Paid-Up Addition Rider

The policyowner can apply for this rider on the life of an insured person by providing appropriate
evidence of insurability. Once the addition of the rider is approved, the policyowner can buy,
on each anniversary of the establishment of the base policy, an additional amount of
insurance. The additional insurance, which is purchased by paying a single premium, is
usually whole life insurance that accumulates its own cash value.
The rider provisions limit the minimum and maximum amounts of paid-up insurance that
can be purchased by stipulating the minimum and maximum single premium that the
policyowner can pay when exercising this option.
The option of purchasing additional paid-up insurance can be used to complement insurance
planning programs. For example, the amount of paid-up insurance acquired each year can
approximate the yearly increase in a policy’s cash value (e.g. the cash value in the policy increases
by $100 so the policyholder buys an additional $100 of life insurance). The death benefit that is paid
out eventually will equal the face amount of the policy, plus the cash value, whereas normally, the
death benefit is the face amount of the policy. The cash value is not paid out



separately. The insurer’s liability is the face amount, less the cash value (or reserve) and that
is the net amount at risk.

Split-dollar Arrangements
In business insurance planning, a corporation and a key employee may set up a split-dollar
arrangement as part of a life insurance program. The corporation will pay a premium that
represents the accumulating cash value and the key employee will pay a premium that represents
the death benefit portion. Under the terms of the split-dollar arrangement, the corporation owns
the cash value and the key employee owns the death benefit. When the key employee dies, the
insurance company will pay the face amount under the provisions of the split-dollar arrangement.
Part of the payment represents an amount equal to the cash value, which belongs to the employer.
The balance belongs to the beneficiary of the deceased employee.
Since the cash value or reserve under a life insurance policy accumulates until it approaches
the value of the policy’s face amount, under a split-dollar arrangement, the part of the death
benefit that represents the employee’s interest will shrink as the cash value (the
corporation’s interest) grows. The employee can stabilize his or her stake in the insurance
plan by including a paid-up addition rider. This option effectively maintains the death
benefit payable to the employee’s beneficiaries at a level amount.
Split-dollar arrangements can be structured in numerous ways and can be most effectively
used within a universal life plan of insurance, primarily because of its flexible nature.



After reading this section, you should be able to:
• explain the impact to the client of the following standard policy limitations and
provisions: 10 Day Right of Rescission, Entire Contract, Suicide, Incontestability,
Grace Period, Reinstatement, Smoking Status, Misstatement of Age or Sex, Settlement
Options, Material Misrepresentation;
• list and describe the additional provisions of permanent life insurance policies that
build a cash value: the non-forfeiture provision and a policy loan provision;
• explain the difference between primary and contingent beneficiaries;
• identify and explain the features of a preferred beneficiary clause;
• explain the difference between a revocable beneficiary and an irrevocable beneficiary;
• explain the consequences of an absolute assignment;
• recognize that there are issues to address and that assistance may be needed with
policies issued prior to 1962;
• recognize that there are issues to address and that assistance may be needed with
policies issued prior to 1982.



Standard Policy Provisions

Most standard life insurance policies contain provisions that limit how they can be applied
and that give the policyowner certain rights and responsibilities. We will illustrate these
provisions using examples.


Margaret is a 24-year-old accountant who recently graduated from a university business
program. She has amassed a sizable student loan that she must begin paying off almost
immediately. She has also recently moved away from home and is renting her own apartment
for the first time. A friend suggested that she might consider buying life insurance to cover
her debt, so that if she died before her loan is repaid, her parents as next of kin would not be
faced with repaying her debts.
Margaret took the advice and applied for an insurance policy. She was approved, her agent
delivered the policy to her, and she paid the first premium. Five days after she accepted the
policy, she discovered that her student loan was insured and in the event of her death the debt
would be paid off. While Margaret realized that life insurance was an important part of her
financial and estate planning, she felt that her current financial obligations were daunting
enough without the added burden of a regular life insurance premium.
Her agent had clearly outlined the 10-day right of rescission provision of the policy and it
was also clearly described on the policy’s cover page. It gave Margaret 10 days (from the
date the policy was delivered to her) to change her mind and cancel the policy. Margaret
decided to exercise the rescission right and she contacted her agent. The agent took back the
policy and refunded Margaret’s initial premium.

Allan planned to buy a $100,000 term insurance plan, to be paid for monthly by pre-
authorized cheque. When Allan spoke to his agent, the agent described the waiver of
premium benefit that Allan could add to the plan at an extra premium and Allan agreed that
it would be a good idea to add the benefit. As they were filling out the forms, Allan was
distracted by a telephone call and when the agent placed the completed application before
him to sign, he did so without reviewing the form.
Shortly thereafter, his agent delivered the policy. Allan listened politely while his agent
explained the terms and conditions of the coverage but he didn’t fully take in the details.
Two years later, Allan suffered a serious disability that prevented him from working. He was
having trouble financially and he was considering cancelling his life insurance because he could
not afford the premiums. A friend asked Allan if he had a waiver of premium benefit on his
policy and suggested that Allan check his contract. Allan remembered discussing such a benefit
and he thought that he had agreed to its addition. When he checked with his agent, however, the
agent advised him that the benefit had not been included in his insurance policy.
Allan insisted that he had wanted to add the benefit and that the agent should have made sure
that it had been included. Although the agent apologized for a possible misunderstanding, the
insurance company was not willing to amend the contract and add the benefit.



Allan sought legal advice. Based on a review of Allan’s application, a copy of which was
included in the policy contract, and the provisions of the policy, it was clear that the waiver of
premium benefit had not been requested in writing, nor did the contract refer to the benefit.
The policy contract stipulated under its entire contract provision that the terms of the
contract were limited to the written application and the written provisions of the policy.
No oral statements could affect the terms of the policy.

Glen was a successful executive in a dot.com corporation. The company, in recognition
of his contribution to its success, bought an insurance policy on his life for $1,000,000.
Within one year, the company’s fortunes changed dramatically and its future prospects were
gloomy. Glen took the downturn personally and in a fit of desperation took his own life. The
company submitted a claim for the death benefit. After an investigation into the
circumstances of Glen’s death, the insurer declined the claim under the suicide provision of
the policy contract. The provision stated that if the life insured committed suicide within two
years of the policy’s issue date or within two years of its reinstatement, the policy would be
terminated. Only the amount of premiums, less any policy loan, would be payable.
The company sued for the benefit. The insurer was bound to prove that Glen’s death was
the result of suicide beyond any other explanation. The insurer proved its case.
If Glen had committed suicide two years or more after the policy was issued, the insurer
would have to pay the death benefit.

Applicants for life insurance policies answer application questions and provide information about
their current physical and mental health, as well as information about any medical or other
personal history that is pertinent to assessing the applicant’s qualification for life insurance.
The insurer relies on that information to determine if it is willing to issue a life insurance
policy on the applicant’s life.
As with any contract, the accuracy of the applicant’s written statements determines the validity
of the contract. If the insurer has relied on incorrect information to issue a policy, then it has the
right to rescind (that is, cancel) the contract. This right is laid down in contract law and in the
provincial insurance acts that define the rights and obligations of the insurer and the insured in
drawing up and implementing a life insurance policy contract. “Material” means that the
information that was omitted or not accurately stated was such that, had the insurer known
the information, it would not have issued the policy at all or would have issued the policy
on a different basis, such as for a higher premium.
In contract law, statements made by the parties who are negotiating the contract may
be considered either warranties or representations.
• A warranty is a statement that, when considered and found not to be completely
and literally true, will invalidate the contract.



• Representations are statements that are expected to be substantially true, that is, they
may contain inaccurate details, but the main part of the information is true. One party
to a contract can challenge its validity only if representations by the other party
during the creation of the contract are found to be substantially untrue.
For example, Judy, an applicant for life insurance, states that she has not been treated for a
medical condition within the last five years. She has forgotten that she had emergency
room treatment for a badly cut finger four years previously. She has therefore made a
statement that is untrue.
Was Judy’s statement a material misrepresentation? Her statement did not disclose all of her
medical treatment. If the insurer had known about Judy’s emergency room treatment, would it
have assessed her risk differently? In all probability, the treatment for the cut finger is not
material and the information, if it had been disclosed, would have had no bearing on the insurer’s
decision to accept or decline the risk. Therefore it is not a material misrepresentation.
If the contract provisions required that all of the statements put forward in an application
be treated as warranties, then the validity of the contract could be challenged, even for a
minor inaccuracy like Judy’s. In the early days of life insurance, insurers attempted to
treat every statement by the applicant as warranties. If any of the applicant’s statements
were not literally correct, then the insurer would take steps to rescind the contract.
Statutory law and case law surrounding life insurance contracts have established that
statements made on an application for insurance are considered representations, not
warranties. Judy’s statement on the application is substantially true, if not literally true.
The provincial insurance acts require insurance contracts to specify that the insurance company
can rescind a policy only if it discovers that the applicant for the policy has materially
misrepresented one or more facts contained in the application in a way that would prevent the
insurer from accurately assessing the risk of insuring that applicant. The insurer’s right to
rescind a contract is limited, however, to two years from the date a policy comes into effect.

When Gwen applied for a life insurance policy, she failed to disclose that she suffered from
high blood pressure and was on high doses of medication to control her blood pressure
levels. Her application was processed without a medical form and there was no indication on
the application that she was receiving any kind of medical care.
Within one year, Gwen died as the result of an automobile accident. Her executor applied for the
death benefit under the policy. Because Gwen’s death had occurred so soon after the policy had
been issued, the insurer conducted an investigation. The investigator found out that Gwen had
not disclosed the fact that she was being treated by a physician for high blood pressure. After
receiving a report from Gwen’s physician, the insurer concluded that if the information had been
disclosed at the time of the application, the company would not have issued a standard policy.
The claim was denied under the incontestability provision of the contract.
The incontestability provision states that “In the absence of fraud, the insurer will not contest
the policy after it has been in force for two years during the lifetime of the insured from the
time that the policy takes effect or two years from the date it has been reinstated, if later.”



This means that during the first two years that the policy is in force, the insurer can rescind
the policy if the applicant for the policy has made a material misrepresentation. After the
first two years are up, the policy becomes incontestable.
In this case, despite the fact that the life insured died as the result of an unrelated cause,
the insurer had the right to invoke the incontestability provision.
If Gwen’s death had occurred after the policy had been in force for two years, the insurer would
either have had to pay the claim or prove that the misrepresentation was fraudulent. To be
considered guilty of fraud, the applicant must have knowingly and intentionally misrepresented a
material fact about her insurability with the clear intent of getting the insurance company to issue
a policy it might not otherwise have issued. If Gwen’s heirs sued the insurance company for
failure to pay the claim, it would be the responsibility of the insurance company to prove that
Gwen knowingly and intentionally failed to disclose the material information.
The provision includes the stipulation “during the lifetime of the insured” in order to prevent
the pursuit of a claim more than two years after a policy has been issued, even though the life
insured died before the end of the two-year contestable period.

Section 182 (2) of the Insurance Act of Ontario states as follows:
Where a premium, other than the initial premium, is not paid at the time it is due, the
premium may be paid within a period of grace of,
(a) thirty days or, in the case of an industrial contract, twenty-eight days from and
excluding the day on which the premium is due; or
(b) the number of days, if any, specified in the contract for payment of an overdue premium,
whichever is the longer period.
Emmanuel owned a $200,000 term insurance policy on his own life for which he paid the
monthly premiums by pre-authorized cheque. Recently, he changed bank accounts, but forgot
to inform his insurance company. The next month, his pre-authorized cheque was returned to
the insurer as unpaid. The insurer immediately notified Emmanuel by mail that the payment
had not been honoured and sent him a premium notice for the overdue premium.
Emmanuel failed to pay the premium within 30 days of its due date. The policy lapsed, subject to
a provision that allows Emmanuel to apply for reinstatement of the policy by submitting evidence
of insurability and paying all due premiums, including late payment interest.
If Emmanuel had paid the premiums within the grace period, there would have been no
changes to his policy. The policy stays in force during the grace period. If Emmanuel were
to die after the end of the 30-day grace period, the insurer would not honour any claim for
benefits, because the coverage had lapsed.
It should be noted that some insurance companies include a 31-day period of grace.
Section 182(3) of the Insurance Act of Ontario states as follows:
Where the happening of the event upon which the insurance money becomes payable occurs
during the period of grace and before the overdue premium is paid, the contract shall be deemed
to be in effect as if the premium had been paid at the time it was due, but the amount of the



premium, together with interest at the rate specified in the contract, but not exceeding 6 per
cent per year, and the balance, if any, of the current year’s premium, may be deducted from
the insurance money. R.S.O. 1990, c. I.8, s. 182.
This provision indicates that if Emmanuel had died during the 30-day period of grace,
the insurance company would pay $200,000 less overdue premiums.

Upon learning that his policy had lapsed, Emmanuel contacted his insurer. The representative
explained that Emmanuel could apply to have his term life insurance policy reinstated under
a provision of his policy contract. The provision states that the policyowner can apply to
reinstate a lapsed policy within two years of its date of lapse by:
• completing a reinstatement application;
• providing acceptable evidence of the insured person’s insurability;
• paying all due premiums plus late payment interest at a rate of no more than
6% compounded annually.
Emmanuel complied with all of the conditions and the insurer reinstated his term life
insurance policy.
The benefits of reinstating a lapsed policy rather than applying for a new policy are either
to maintain a type of contract that is no longer available for purchase, or to preserve the
insurance age of the life insured so he or she does not have to purchase a new policy at an
older age and pay higher premiums and instead maintain the premiums that were specified
under the original policy.

Most insurers offer preferred premium rates to applicants who do not smoke. Some insurers
describe non-smokers’ premium rates as standard rates and the rates for smokers as sub-
standard rates.
In any event, applicants who stipulate that they have not smoked a cigarette, cigarillos, small
cigars, or marijuana or other tobacco products within the last twelve months are eligible for
non-smoker premium rates. However, some insurance companies waive certain kinds of
tobacco use such as occasional cigar or pipe smoking. An applicant for non-smoker rates
does not have to be someone who has never smoked.
Winston discussed the purchase of a life insurance policy with his agent. The agent showed
Winston the rates for non-smokers and smokers and Winston was impressed by the
difference in premiums. Winston decided to apply for a $100,000 term life insurance
policy. When his agent asked about Winston’s smoking habits, Winston indicated that he
did not smoke. In fact, Winston did smoke cigarettes on a regular basis. The policy was
issued on a standard basis with non-smoker premium rates.
The two-year contestable provision means that within the first two years of the policy, the insurer
can cancel the contract if it is discovered that the applicant made material misrepresentations
on the application. Failure to disclose a frequent smoking habit would be considered a material
misrepresentation. If the policy has been in force for more than two years, the insurer would



have to prove that the applicant acted with fraudulent intent to make the insurer issue the
policy under the terms available to non-smokers, rather than those available to smokers.
Some insurers include a provision in their contracts that stipulates that if the insured person’s
smoking habits are misrepresented in the application, the insurer will modify the coverage to the
kind it would have issued at any time that the misrepresentation is discovered.
This provision, however, may not be supported by current provincial legislation governing
insurance contracts. The life insurance acts of the provinces allow insurers a two-year
contestable period to cancel contracts that have been issued because of a material
misrepresentation. The acts allow insurers to modify the contract for two reasons only: if the
age or the sex of the applicant has been misrepresented. The acts do not allow for
modification of the contract for any other reason, so modifying the contract to reflect the fact
that the applicant is a smoker may not be upheld in law.


Eldon was born in a region of the country where birth records were not completely accurate.
When he applied for a life insurance policy, he informed the insurer that he was 30 years old.
The company issued a $100,000 term life insurance policy on Eldon’s life and charged a
premium based on age 30 rates.
Five years later, Eldon died as the result of a serious illness. His executor received
conflicting information about Eldon’s age and sought to confirm his true age. The executor
was able to confirm that Eldon was actually five years younger than was believed.
When the executor provided proof of Eldon’s true age to the insurer, the company revised the
amount of insurance to the amount that the same premium would purchase for a 25-year-old.
The provincial insurance acts have specific provisions relating to a misstatement of age. If at
any time the insurer discovers that the age of an insured person has been misstated, it has the
right to adjust the coverage accordingly.
“Where the age of a person whose life is insured is misstated to the insurer, the insurance
money provided by the contract shall be increased or decreased to the amount that would
have been provided for the same premium at the correct age.”
“Where a contract limits the insurable age and the correct age of the person whose life is
insured at the date of the application exceeds the age so limited, the contract is, during the
lifetime of that person, but not later than five years from the date the contract takes effect,
voidable by the insurer within 60 days after it discovers the error.”
Although the insurance contract does not have to contain any provision concerning a
misstatement of age, most insurers stipulate the manner in which misstatements of age will
be addressed under the policy. The provision may specify the insurer’s actions if the
misstatement is discovered during the life insured’s lifetime or after the life insured’s death.
Many insurers also include misstatement of sex in the same provision.



Randy is the beneficiary of his wife’s $200,000 life insurance policy. His agent has informed
him that he can either receive a cheque for $200,000 or deposit the money under one of the
settlement provisions of the policy. The agent describes the options available under the
settlement option provisions of the policy:
• Randy can leave the funds on deposit at interest. This option guarantees that a stated
minimum amount of interest will be paid on the funds. The interest will be paid
periodically, according to a schedule agreed upon between Randy and the insurer. Randy
can withdraw the funds at any time and he can name another person (a contingent payee)
who will receive the interest income after Randy himself dies.
• Randy can arrange to receive the principal and interest over a fixed period. The
provision will state a minimum amount of interest to be credited.
• Randy can elect to receive a fixed amount of money periodically. How long the payments
will continue depends upon the amount of the withdrawals and on the interest earned.

• Randy can set up a life income. Under this option, the death benefit is used to purchase a
life annuity. (A life annuity guarantees to provide a regular income to the annuitant for
at least the annuitant’s lifetime.) The amount of the periodic payments depends on the
size of the annuity that the death benefit will buy and on Randy’s age. Randy can choose
one of the following life income options:
– The straight life income option: the policy proceeds are used to provide an income for
Randy’s lifetime. Payments cease upon his death. This is a risky choice, since
Randy might die after receiving only a few payments.
– The life income with period certain option: Randy will receive annuity payments for his
lifetime. If he dies before the end of a certain period of time (ten years, for example),
payments will continue to the beneficiary he has selected for the balance of the period.

– Refund life income option: Randy will receive a lifetime annuity. Upon his death, the
insurer will pay the beneficiary any balance remaining from the purchase price of
the annuity.
– Joint-and-last-survivor annuity: the annuity benefit will be payable for the lifetimes of
two annuitants, usually spouses. In this case, since Randy’s wife is deceased, this
option may not be appropriate.
Each choice represents a different level of annuity payments. Randy would receive the largest
annuity payment by electing the straight life annuity, although he risks losing the purchase
amount if he dies prematurely. The other choices represent smaller payments, although more of
the principal paid to set up the annuity is preserved for Randy’s beneficiaries.



Additional Provisions in Permanent Life Insurance Policies to

Access Accumulated Cash Value
Permanent life insurance policies accumulate a cash value because of the level premium reserve
system. In traditional life insurance policies, the contract includes a table that lists the cash value
figures that are available at each anniversary of the policy. Most tables provide the year-by-year
values for the first ten years or so, then the values at every fifth anniversary, and finally the
values at significant anniversary dates, such as the year that the insured person turns 75.
Under the policy contract provisions, each policyowner has access to the accumulating cash
value for certain purposes.


An important provision is the automatic non-forfeiture provision. A life insurance policy that
accumulates a cash value generally contains an automatic premium loan non-forfeiture option
provision. This means that, if the policyowner fails to pay a premium within the grace period,
the insurer will issue a loan against the policy’s cash value for the amount of the premium
and will keep the policy in force. Interest will be charged on the loan at a rate stipulated in
the contract. Additional automatic premium loans will be granted for other unpaid premiums
until the loan amount equals the cash value. At that point, the policy will lapse.

The policyowner of a policy who stops paying premiums on a policy with a cash value has
other options.
• The policyowner may terminate the policy and receive the cash surrender value.
• The policyowner can elect the reduced-paid-up non-forfeiture option. Under this
provision, the insurer applies the current cash value as a net single premium to
purchase paid-up insurance of the same type as the base policy. The amount of the
paid-up insurance policy will be less than the amount in effect before the non-forfeiture
provision is exercised. The contract usually provides a table of paid-up insurance
amounts available at various policy anniversaries.
• The policyowner can elect the extended term insurance non-forfeiture option. The insurer
applies the current cash value to purchase term insurance for the full coverage amount
provided under the original policy for as long a term as the cash value can provide.


The policyowner can apply for a loan against the cash value of the policy. The maximum
amount of the loan is equal to the cash value less one year’s interest. Interest is charged
annually and billed to the policyowner on the policy anniversary. Any unpaid interest is
added to the amount of the loan principal.
The policyowner is not obliged to repay the loan. If the loan, plus accruing loan interest,
exceeds the cash value of the policy, the policy will lapse. If the insured person dies when a
loan is still outstanding, the value of the loan and any accrued and unpaid interest will be
deducted from the death benefit otherwise payable to the beneficiary.



Primary and Contingent Beneficiaries

All life insurance policies that pay a death benefit allow the policyowner to appoint a
primary beneficiary of the insurance proceeds. The beneficiary may be:
1. An individual, such as a spouse or a child.
2. The policyowner himself or herself. In this case, if the policyowner is not the same person
whose life has been insured, upon the life insured’s death, the policyowner receives the
death benefit. If the policyowner is the person whose life has been insured, then when the
policyowner dies, the death benefit is payable to that person’s estate.

3. A class of persons, such as “all my children”.

If there is only one named beneficiary and that person or group of persons dies before the
insured person, then when the insured person dies, the death benefit will be paid to the
policyowner or to the deceased’s estate if the insured person is also the policyowner.

A policyowner can select a contingent beneficiary; that is, beneficiary who will receive
the death benefit if the primary beneficiary dies before the person whose life is insured.
There can be a series of contingent beneficiaries. For example, a policy may identify the
beneficiary as: “My wife Brenda, if living, otherwise my son, Walter, if living,
otherwise my brother Vic, if living, otherwise my estate.”

Preferred Beneficiaries and Policies Issued Before 1962

In the common law provinces before July 1, 1962, certain beneficiaries were considered preferred
beneficiaries. This group consisted of spouses, children, adopted children, parents, grandchildren,
children of adopted children, and adoptive parents of the person whose life is insured.

If the beneficiary of the policy belonged to this group, the policyowner could not exercise
certain policy provisions, such as cancelling the policy or taking a policy loan, without the
written consent of the preferred beneficiary. The policyowner also could not change the
beneficiary to a class outside of the preferred beneficiary group without the consent of the
preferred beneficiary. The policyowner could, however, appoint another member of the
preferred beneficiary class without the consent of the previous preferred beneficiary.
Revisions to the provincial insurance acts have resulted in no distinction between
preferred beneficiaries and other beneficiaries for policies issued after June 30, 1962.
Nevertheless, some life insurance policies have been in effect for 45 years or more. The
beneficiaries appointed under these policies may belong to the preferred class of
beneficiaries. In fact, even very recent beneficiary appointments under these policies may
be considered preferred beneficiary appointments.
If a policyowner holds a life insurance policy that names a preferred beneficiary, the exercise of the
policyowner’s rights under the policy will require the written consent of the preferred beneficiary.
If your clients have old policies, make sure that they are aware of these restrictions.
If you cannot answer their questions about these old policies, you should ask a more
experienced agent or a specialist in this area.



Revocable and Irrevocable Beneficiary

Since July 1, 1962, a policyowner has had the right to name any person or group as
beneficiary without restricting his or her right to exercise any of the policy’s provisions.
The policyowner can also change the beneficiary at any time, without the previous
beneficiary’s consent. This means that beneficiary designations are revocable, unless the
policyowner chooses to appoint a beneficiary irrevocably.
“An insured may in a contract, or by a declaration other than a declaration that is part of a
will, filed with the insurer at its head or principal office in Canada during the lifetime of
the person whose life is insured, designate a beneficiary irrevocably, and in that event the
insured, while the beneficiary is living, may not alter or revoke the designation without
the consent of the beneficiary and the insurance money is not subject to the control of the
insured or of the insured’s creditors and does not form part of the insured’s estate.”
An irrevocable beneficiary, once named, must give his or her consent whenever the policyowner
wishes to exercise some of the options available under the policy, such as the policy loan provision,
surrender of the policy for its cash value, or the appointment of another beneficiary.

The document that appoints an irrevocable beneficiary must clearly indicate that choice.
One province, Nova Scotia, requires that the beneficiary appointment form clearly indicate
that the policyowner understands the restrictions placed on the exercise of the policy
provisions when an irrevocable beneficiary is named.
If a beneficiary is named in a will, the beneficiary is considered revocable, even if
the will provision intends to appoint the beneficiary irrevocably.
“A designation in favour of the ‘heirs’, ‘next of kin’ or ‘estate’ of the insured, or the use of
words of like import in a designation, shall be deemed to be a designation of the personal
representative of the insured.”

Absolute Assignment of a Life Insurance Policy

An assignment is an agreement under which one party transfers some or all of his ownership rights
in a property to another party. A life insurance policy is considered a property, therefore ownership
rights can be transferred to someone else. A life insurance policy contains a provision that outlines
the insurer’s obligations relating to the assignment of a policy. These provisions are:

• the insurer is not responsible for the validity of any assignment;

• the insurer must receive a copy of the assignment;
• the assignment must not contravene any actions taken under the policy by the insurer
before receiving the assignment: this means that if the insurer has made any payment or
taken any other action before receiving the copy of the assignment, it is not required to
rectify that action, if that action contravened the provisions of the assignment.
Under an absolute assignment, the policyowner transfers all rights, title, and interest in the
contract to the assignee. The absolute assignment is, in fact, a change of ownership. For
example, Fred owns a life insurance policy on his own life. His wife, Doris, is the
beneficiary. Fred decides to assign his policy to Doris and give her full control of the policy.
Fred is no longer a party to the contract, although he is still the life insured.



Why would someone assign a policy to someone else? Assignment may occur during a
divorce, for example. Suppose Doris gets a divorce from Fred. She is the beneficiary of the
policy and Fred is the life insured. As part of the divorce agreement, Doris has the policy
absolutely assigned to her and takes charge of the policy. This way she does not need to
worry about Fred cancelling the policy. As part of the divorce agreement, he might still be
responsible for paying the premiums, but if he does not, Doris will be made aware of this.
An absolute assignment constitutes a gift or a sale of the policy. If the policyowner gives the
contract to another party, there is a deemed disposition of the policy. The amount of the deemed
disposition is the cash value of the policy. If the cash value exceeds what the policyowner paid
for the policy, the transferring party must report the excess as income for income tax purposes.
If the policy is sold under the terms of the absolute assignment in an arm’s-length
agreement (an arm’s length transaction involves two parties who are not related by blood or
close financial ties), the disposition is the amount that has changed hands.
In some cases, the policy is considered to change hands at the value of the policy’s adjusted
cost basis (ACB), that is, the recipient takes over the policy at its current cost and there is no
deemed disposition. This rule applies when the policy is transferred from its owner to a
child, spouse or former spouse under certain conditions. This rollover of the policy is
considered to take place if the interest in a life insurance policy has been transferred free of
charge from the policyowner to the child, spouse, or former spouse, and a child of the
policyowner (or a child of the recipient) is the life insured.

Policies Issued Before 1982

Canada Revenue Agency (CRA) introduced a number of changes to the taxation of life
insurance policies issued after December 1, 1982. Life insurance policies in effect before
December 2, 1982 that have not undergone substantial increases in benefits and premiums
since that time are still subject to the tax rules that were in effect before that date.
The December 1, 1982 rules led to the distinction between exempt and non-exempt policies.
Exempt policies have to meet a certain definition specified in the Income Tax Act and are
intended mainly to provide benefits at death. The maximum tax actuarial reserve represents
the maximum amount that can be accumulated within an exempt policy while retaining its
exempt status. A non-exempt policy is, of course, one that does not meet the statutory
definition. Policies issued prior to December 2, 1982 are grandfathered (that is, not subject to
these rules) and treated as exempt policies.
Therefore, any request to replace an existing policy with a new contract must be reviewed
carefully in view of the changes in the taxation of life insurance policies. The policyowner
would forgo certain tax advantages by replacing a contract issued before December 2, 1982
with a new contract issued after that date.

• In the older policies, the adjusted cost base of the policy includes the entire premium
paid. For policies issued after December 1, 1982, premiums for additional benefits and
riders are not included in calculating the adjusted cost base and each year an amount
representing the net cost of pure insurance (NCPI) for the year is deducted from the cost.
Consequently, more of the policy’s surrender value will be taxable if the policy was
issued after December 1, 1982, since the cost base is smaller.



• For certain policies, such as endowment plans, issued after December 1, 1982, the
accumulating value is subject to accrual taxation, much like the accumulating value of
a GIC or Canada Savings Bond. The policyowner must pay tax on an accrued value,
even though he or she has not received any income. Endowment policies created before
December 2, 1982 continue to accumulate value on a tax-deferred basis.

• When the life insured dies, any life insurance policy issued after December 1, 1982
and taxed on an accrual basis will be subject to tax on any amount accrued that was
not previously taxed.
• For policies issued before December 2, 1982, the policyowner could withdraw part of the
cash surrender value tax-free, up to the limit of the policy’s adjusted cost base. For
policies issued after December 1, 1982, the amount of cash value that can be withdrawn
tax-free is reduced due to the NCPI serving to shrink the adjusted cost base.

• For policies issued before December 2, 1982, the cash value can be used to acquire
an annuity without attracting tax, that is, the transaction is not considered a taxable
disposition. For policies issued after December 1, 1982, buying an annuity with a life
insurance policy is considered a disposition and the excess of the cash value over the
policy’s adjusted cost base is taxable as income.
The income tax provisions relating to permanent life insurance policies are complex and the
taxation of each “in force” policy must be carefully considered in any review of an insurance
program, particularly for policy contracts issued before December 2, 1982. As an agent, you
may need to work with a tax specialist so that you can give clients the most up-to-date
information available.
Although most agents focus on bringing in new clients, you might have clients who own
old policies and want to understand them better. You must either be able to answer the
client’s questions or get the answers from a reliable source.



The following examples depict situations where different types of individual insurance
would be applicable.

Example 1: Providing for Child with Special Needs

Edwin and his wife Mary have cared for their mentally challenged son during his childhood. It
is likely that he will need lifetime care and he will not be able to support himself. Both parents
are concerned about what will happen if their son survives them. They have established a
trust for his benefit. The financial institution will administer the trust.

Although they can fund the trust with periodic contributions, they now want to make sure that
the trust has sufficient funds if one or both of them dies or becomes disabled and unable to
work. They are also concerned about having to finance the trust once they retire. Insurance can
help address their concerns.



What product(s) would you recommend that they consider?

Edwin and Mary could apply for life insurance on each of their lives, with the death benefits to
be paid to the trust for the benefit of their son. The type of life insurance should be permanent
(whole) life, since it is unknown how long Edwin, Mary, or their son will live.
If the trust relies on contributions from Edwin and Mary, then they should consider
disability income insurance on the life of the one who earns the most money, to make sure
that they will have the resources to continue to provide funds for the trust.
They could also consider setting up a deferred annuity plan to begin when the older of the
two retires. Once the annuity payments begin, they can be paid into the trust. The parents’
income after retirement may not be large enough to maintain their living expenses and
contribute to the trust.

Example 2: Planning for Serious Illness

Milton operates his own business as a sole proprietor. He is able to earn a good living from the business.
He relies solely on his own efforts to keep the business going. He is approaching 40 years of age. His
father and an uncle both contracted cancer at about the age of 40 and he is concerned that he might be
susceptible to the disease because of his family history. He wants to make sure that if he does become ill,
he will have some financial support if he is unable to continue to operate his business.

What insurance product(s) should Milton consider?

Milton might want to consider a life insurance plan that pays a benefit for a dread disease or
a terminal illness. If Milton develops a serious form of cancer, he will receive a lump-sum
payment that he can use as he sees fit. Milton should also make sure he has a personal
disability insurance plan in place. If he is unable to work, he still requires an income to pay
for his daily living expenses.


Chapter 3

Individual Disability and

Accident & Sickness



Individual Disability and

Accident & Sickness
Disability Insurance
• The Purpose of Disability Income Insurance
• Non-Cancellable, Renewable, and Cancellable Disability Contracts
• Defining Total Disability
• Benefit Periods of Short-Term Disability (STD) and Long-Term Disability
(LTD) Insurance
• Elimination Periods and Qualification Periods
• Establishing the Benefits Payable to a Disabled Person
• Other Policy Benefits and Provisions
• Exclusions and Limitations on Disability Coverage
• Specialized Types of Disability Coverage
• Federal Government - Sponsored Disability Benefit Programs
• Coordination of Benefits on a Disability Insurance Policy
• Tax Treatment of Individual Disability Insurance Policies
Accident and Sickness Insurance
• Provincial Health Insurance
• Provisions of an Accident and Sickness Policy


Critical Illness Insurance Policy
• Benefits
• Waiting Period
• Definitions
Long-Term Care Policy
Selecting an Appropriate Insurance Product for a Specific Client




For most people, the ability to earn an income is their most important financial asset. Take
away that ability and they will not be able to sustain their standard of living or repay their
debts. They may lose assets that they acquired through loans and mortgages. Statistically, the
odds of suffering a disability that lasts 90 days or more before age 65 is 1 in 8.
In this chapter, you will learn about the characteristics and features of disability and accident
and sickness insurance and how they can help mitigate the loss of employment income.


After reading this section, you should be able to:
• explain the purpose of disability income insurance and why a client might need this
type of coverage;
• define non-cancellable, guaranteed renewable, conditionally renewable,
optionally renewable, and cancellable disability contracts;
• explain the various definitions of total disability that are commonly used in
disability insurance policies;
• compare the benefit periods of short-term and long-term disability insurance;
• explain the meaning and purpose of an elimination period and qualification period;
• describe common methods used to establish the amount of disability benefits that
will be paid to a disabled person;
• describe, using examples, the use and advantages of the waiver of premium benefit,
the presumptive disability benefit, and optional benefits available with disability
insurance policies, including partial disability benefits, residual disability benefits,
future purchase option benefits, and cost-of-living adjustment (COLA) benefits;
• list the common causes of disability that may be excluded from coverage under a
disability insurance policy;
• distinguish among specialized types of disability coverage, including key person disability
coverage, disability buy-out coverage, and business overhead expense coverage;
• compare the federal government-sponsored programs that provide short-term and
long-term disability benefits, including Employment Insurance and CPP, to privately
available disability insurance;
• describe typical limitations and exclusions of a disability insurance contract;
• explain the impact of coordination of benefits on a disability insurance policy;
• describe the tax implications of various types of individual disability insurance policies.



The Purpose of Disability Income Insurance

People who work for companies or institutions may have group disability insurance through their
employers. Many people, however, are self-employed, or work for employers who do not provide
disability insurance through a group plan. If these individuals suffer a serious disability, even one
lasting only a few months, they may lose everything that they have worked for. Many people
have amassed large amounts of debt. If their ability to earn income is disrupted because of a
disability, even for a short while, they may not be able to cope with that debt. Individual disability
insurance is therefore designed to help meet the risk of losing the ability to earn income.
Let’s look at an example. Ella owns a successful florist shop in partnership with Samantha,
her close friend. Eldon, Ella’s husband, is a mechanic who works at a small repair shop. He
earns a reasonable salary. A year ago, the couple bought a new home and took out a large
mortgage. Their living expenses are high, because they have two young children in day care.
While Ella and Eldon took out life insurance to pay off the mortgage in case either one of
them died prematurely, neither of them considered applying for disability insurance.
Six months ago, both were seriously injured in an automobile accident. Eldon was permanently
disabled and Ella faces a long recuperation period. Although their friends and relatives are
sympathetic to the couple’s misfortune, none has the resources to take care of the expenses that
continue to fall due. The couple has no income from which to make mortgage payments, or
to maintain their lifestyle. They cannot take care of their children and rely on Ella’s parents
to supervise them. Eldon is unable to return to his job. Ella’s business is suffering and is in
danger of closing.
Ella and Eldon’s situation is typical of many people who have little or no disability insurance.
Although they may receive some benefits from automobile insurance or CPP disability benefits,
they have always relied on their ability to earn an income. If they had bought disability insurance,
they would have been able to survive their disability with a much lower level of financial loss.
Eldon could have obtained a disability plan to provide tax-free income of up to, say, 70% of
his earned income. Ella could have taken out a disability income policy to offset the loss of her
personal income. She might also have considered a Business Overhead Insurance policy to pay
for the ongoing expenses of her business, and a disability buy-out plan that would fund the sale of
her share of the business to her partner Samantha if her disability proves to be long-term.
Although this scenario may be unusual, it is quite possible. Many people do not have
adequate disability insurance to contend with the financial loss they will suffer if they
become disabled for even a few months. The remainder of this chapter describes the features
of disability and health insurance available to individuals.
The Uniform Life Insurance Act defines disability insurance as “insurance undertaken by
an insurer as part of a contract of life insurance whereby the insurer undertakes to pay
insurance money or to provide other benefits in the event that the person whose life is
insured becomes disabled as a result of bodily injury or disease.”

Non-Cancellable, Renewable, and Cancellable Disability Contracts

Unlike life insurance policies, disability income plans may be subject to cancellation
by the insurer or renewable at an increased premium rate at the insurer’s discretion.
Once a life insurance policy is issued and the insured pays the first premium, the insurer cannot
cancel or modify the coverage in any way, unless the insured fails to pay the premium and allows



the policy to lapse. The only disability income plan that provides a similar level of guarantee is
the non-cancellable disability plan. Under this plan, the insurer must renew the policy, as long
as the insured continues to pay the premiums, until the insured person reaches the age limit for
coverage stipulated in the policy. The premiums on this type of policy are guaranteed to remain
at the level that was established when the policy was issued and the policy provisions cannot be
changed. Some of these policies allow the insured to continue the coverage beyond the usual
maximum age, provided that the insured person continues to be gainfully employed; in these
cases, the insurer will determine the premium.
The guaranteed renewable policy requires the insurer to renew the policy, as long as the
insured person continues to pay the premiums, until the insured attains the age limit specified
in the policy (usually 60 or 65). The insurer may increase premiums for guaranteed
renewable disability insurance policies only if it increases the premiums for an entire class of
policies. (A class of policies is a group of policies with some similar characteristic, such as a
group of insured persons who are in a particular risk category.)
The conditionally renewable policy allows the insurer to refuse to renew the policy when it is
due for renewal for one or more reasons specified in the policy, such as the age or employment
status of the insured. The insurer may increase the premiums for any class of conditionally
renewable policies in which the insured is part of, thus raising the individual’s premiums.
The optionally renewable policy allows the insurer to refuse to renew the policy when it is
due for renewal. The insurer can also modify the provisions of the policy and increase the
premiums for a class of policies.
Cancellable policies are those that the insurer can cancel at any time, for any reason, by
notifying the policyowner that the policy is cancelled.
The risk classification of the person insured usually determines the kind of renewal provision
available. Risk classifications are generally related to the occupation of the insured person,
because the type of occupation has a bearing on the expected rate of sickness or injury. Using
statistical information on the types of disabilities associated with different occupations, insurance
companies rank occupations from the lowest to the highest risk of disability.
The levels of risk can be categorized as the following:
1. The lowest risk of disability is found among most professionals who work mainly in
offices, such as physicians or lawyers.
2. A low classification of risk applies to occupations such as office workers, librarians, and
bookkeepers and those who have some non-hazardous duties outside the office (e.g. research).
A medium-risk classification applies to those who are employed in non-hazardous occupations
that involve some clerical duties, but who do not work full-time at a desk. This group might
include plant supervisors and superintendents who oversee the work of others.

3. A high-risk classification applies to people who do light manual work of a skilled or semi-
skilled nature in a non-hazardous industry, such as mechanics, electricians, or plumbers.

4. The highest risk classification includes occupations such as truck drivers or taxi
drivers, positions that are physically demanding and are subject to outside
interventions such as traffic and violence and carry a high risk of injury and illness.



Some occupations, such as professional athletes or seasonal workers such as lumberjacks

and fishermen, fall outside of these classes. Individuals in unclassified occupations are
considered for disability insurance coverage on a case-by-case basis.
Someone who is assessed at the lowest level of risk will be offered the broadest kind of
coverage, usually non-cancellable or guaranteed renewable. Those whose occupations fall
within the highest risk classifications may be eligible for conditionally renewable or
cancellable insurance, because the insurer is likely to incur higher-than-anticipated claims for
people in this occupational group. If the insurer finds that the amount paid out in claims
exceeds the amount taken in through premiums, it will take steps to cancel a particular group
of policies, for example, those held by truck drivers.

Defining Total Disability

Insurers use different definitions of disability in the policies they issue, depending largely
on the occupational risk classes involved.
For the lowest-risk classes, the definition of disability is usually the own occupation
definition (also characterized as regular occupation). That is, if an insured person suffers a
disability that prevents him or her from performing the essential duties of his or her own
occupation, that person will be considered disabled, even if he or she is, or can be, gainfully
employed in a different occupation. For example, a surgeon who suffers a serious injury to
his hands will be considered disabled and eligible for benefits, even though he may be able to
teach or work as a medical professional in some capacity other than surgery.
For others, the definition of total disability may be the inability of the person insured to perform
the essential duties of any occupation. This means that after being disabled for a certain period
(usually two years), the person insured will be considered disabled only if he or she is unable
to work at any occupation for which he or she is suited by reason of education, training, or
experience. For example, a chartered accountant who is the vice-president of finance for a
large corporation may suffer a disability that prevents her from performing her duties as vice-
president. After two years of continuous disability, if she can work at any occupation for
which she is suited by education, training, or experience, such as a more junior position in the
finance department, or as a self-employed accountant, then her disability benefits will cease.
This definition is rather restrictive.
It should be kept in mind that insurers use different descriptions for the same definition. In
other words, the “any occupation” definition in one insurer’s contract could be quite different
from the “any occupation” definition in another insurer’s contract. Some insurers use
different terms altogether, such as “gainful occupation”. Therefore, the precise wording in a
contract needs to be examined.
Many policies provide “own occupation” coverage for a certain period (say the first two
years) of the disability, then switch to the more conservative “any occupation” definition for
the rest of the period of disability.



Benefit Periods of Short-Term Disability (STD) and Long Term

Disability (LTD) Insurance
Disability insurance is designed to provide replacement income for a person who
becomes disabled long enough to allow the insured to recover and resume normal work
activity, or, if the person is severely disabled, to provide replacement income during the
insured’s shortened lifetime.
The period during which benefits will be paid can vary from as little as six months to one year, to
the period between the date the insured person becomes disabled and the date the insured person
reaches the age of 65. Of course, the longer the benefit period, the higher the premium.
Short-term disability income plans offer disability benefits for a limited time, usually up to six
months or a year. LTD benefits begin after STD benefits end. Once the insured person becomes
disabled, he or she will receive disability payments until the end of the benefit period. Therefore,
an individual who buys a disability insurance policy with a two-year benefit period can expect to
receive payments for two years after becoming disabled. When the two years are up, the payments
will cease, even though the insured person may continue to be disabled.
Individual disability insurance policies are also available for longer terms of five years or
more, or up to age 65. Those who want the security of a longer period of benefit payments
can select a longer term. The premiums will be higher than those of the short-term plan for
the same benefit amount, since the insurer risks having to pay income benefits until the
disabled person reaches retirement age.
Benefit periods do not continue for life under disability plans. Their purpose is to replace the income
lost to the insured person who is unable to work and earn a wage. The longest period of coverage
extends to age 65. At that age, the individual would normally retire and begin receiving pension
payments from the government or through a private pension plan. Since the retiree would no longer
work to earn a wage, there is no further need for an income replacement plan.

Elimination Periods and Qualification Periods

Individual disability insurance policies contain an elimination period, also known as the
waiting period. This is the period after an insured person suffers a disability during which no
benefit payments are made. For example, Maurice has a policy that pays a monthly benefit
of $500 for a maximum of two years, with an elimination period of 30 days. If Maurice is
injured and submits the appropriate claim forms, his benefit payments will start at the end of
the 30-day elimination period and continue either until he recovers or until the end of the
two-year benefit period, whichever comes first. If his disability lasts less than 30 days, he
will not receive any benefit payments.
The elimination period saves the insurer from having to review and pay benefits for
disabilities that last only a short time.
The length of the elimination period in an individual disability income plan affects the premiums
that the insured person pays. The longer the elimination period, the lower the premium required
for the same amount of disability coverage. The elimination period might be as long as 365 days
or more, or as short as a day. If a plan offers first-day coverage, the benefits are payable from the
first day that the insured person becomes disabled. These plans are usually short-term and the
first-day coverage applies to disabilities caused by injury rather than illness. Such a plan might
provide a seven-day elimination period for disabilities resulting from an illness.



A qualification period (also referred to as probationary period) for disability coverage is a period of
time that an applicant must wait before applying for disability insurance. This restriction usually
applies to individuals covered by group insurance. Typically, a new employee will have to wait for a
certain period, such as three months, before becoming eligible for group disability insurance.

In individual disability insurance plans, the term qualification period applies to the period in
which residual benefits are payable under the policy. For occupations in the lower-risk
category, insurers offer coverage that includes full disability payments during the period in
which the insured person is totally disabled and unable to work at all, and reduced (residual)
benefits that cover lost earnings if the insured person returns to work but cannot earn income
at the same level as before the disability. The residual benefits may be available after the
insured has been disabled for a certain period, such as six months. If the insured returns to his
or her original occupation before six months have elapsed, he or she will not qualify for
residual benefits. This six-month period is the qualification period for residual benefits.
(Residual benefits are described in more detail later in this chapter.)

Establishing the Benefits Payable to a Disabled Person

Disability insurance is intended to indemnify the insured for the loss of earned income caused
by a disability. The insured person should not, however, be placed in a better financial state
after becoming disabled than he or she was before the disability. The benefit amount paid to a
disabled person should bear a relationship to the individual’s income before the disability.
Otherwise, the insured person would have no financial incentive to return to work and might
be tempted to prolong the period of disability.
For individual disability insurance products, the underwriting process involves establishing
a coverage level that approximates the potential economic loss that the applicant might face
in the event of becoming disabled.
There are two ways to determine a reasonable level of coverage.
1. Determine the amount of monthly income that the insured would need to cover
recurring expenses.
2. Determine an amount that addresses the insured’s needs but that does not act as a
disincentive to return to work, by calculating an amount of monthly income that does not
exceed a reasonable percentage (e.g., 75%) of the earned (primarily wages/salaries) and
investment income that the insured received prior to the onset of the disability.
From the perspective of the insured person, the disability income benefit must be
adequate to provide for all his or her regular monthly expenses.



For example, Jason and his family have the following monthly expenses:

Expense Monthly Amount

Mortgage $ 800

Car $ 350

Food $ 1,200

Clothing $ 500

Utilities $ 500

Gas $ 150

Insurance $ 250

Telephone $ 50

Emergency Expenses $ 200

Total $ 4,000

If Jason becomes disabled and no longer able to earn income, he and his family will still be
faced with about $4,000 of expenses every month. A disability income policy that provides
a monthly income of $4,000 would address those expenses.
An insurer considers a number of factors in setting a benefit amount.
• The level of earned income that the applicant is currently receiving. Earned income
consists of salary, commissions, fees, or other income earned because of business
activity. The insurer assesses the applicant’s gross employment earnings before tax, or,
for self-employed persons, business income minus business expenses. Since most
disability benefits are tax-free, the insurer does not pay 100% of earned income. The
insurer may offer monthly benefits of up to 75% of earned income, depending on the
income level. If the insurer replaced 100% of a disabled person’s income, the insured
person would have no incentive to go back to work, because he or she would be in a
better financial situation than before the disability.
• Income that continues after the applicant becomes disabled. Dividends and interest
from investments are one source of income that would be unaffected by the recipient’s
disability, for example. The insurer may reduce the amount of monthly benefit to reflect
unearned income.
• Other potential sources of disability benefits. An applicant’s private plan
coverage is a factor, as well as payments under Employment Insurance (EI), CPP
and Workers’ Compensation.
Consider Jason’s situation from the insurer’s perspective.
• If Jason earns $5,000 a month before tax, the insurer might consider providing Jason
with a disability income policy of about 75% of his gross earned income, or $3,750.



• If Jason has a regular investment income of $500 a month, the insurer will factor that
into the amount of disability income payable.
• If Jason is covered under Workers’ Compensation (also known by other names such as
Workplace Safety and Insurance Board), the insurer might reduce the available benefit
further. In Ontario, for example, Jason could receive 85% of his take-home pay (up to a
ceiling of 175% of the average industrial wage for Ontario) if he suffers a job-related injury
or illness. The insurer will factor that into the calculation, or offer Jason non-occupational
coverage, that is, coverage for an injury or illness sustained away from the job.

• The insurer would consider EI benefits that Jason is entitled to receive if he is injured
and unable to work. EI pays a maximum benefit of $468 per week for 15 weeks.
Rather than reduce the amount of monthly benefit available, the insurer might offer
an elimination period that recognizes the EI benefits that Jason is entitled to receive.

• The insurer will also consider other disability insurance that Jason carries, including
group long-term disability and other personal disability insurance on Jason’s life.

Other Policy Benefits and Provisions


The waiver of premium benefit for a disability income policy operates in the same way as the
waiver of premium benefit in a life insurance policy. If the insured suffers a disability that
qualifies as a total disability under the terms of the policy, the insurer will waive premiums
that fall due during the period that the insured is disabled. Unlike life insurance, in which this
benefit is optional and requires a higher premium, the disability insurance waiver of premium
benefit is a standard policy provision.
The waiver of premium benefit becomes effective when the insured has been disabled
continuously for a specified period of time, usually three months. Once the insured has
satisfied the waiting period, premiums falling due from the date of the disability are waived.
If the elimination period for the commencement of disability payments is less than the
normal waiting period for the waiver of premium benefit, premiums will be waived at the
conclusion of the elimination period for disability benefits. For example, if a policy has a 60-
day elimination period but has the usual 90-day waiting period for the waiver of premium
rider to take effect, the waiting period would be reduced to 60 days. In addition, if the
insured person pays any premiums during the waiting period, these premiums will be
refunded once the waiting period is over.
For example, Ingrid is insured under a disability insurance policy with an elimination period of
365 days. If she is disabled for a shorter period, her income is covered under Workers’
Compensation. Ingrid suffers a serious disability that will probably keep her from working for
at least two years. The waiver of premium benefit under her policy has a waiting period of three
months. During those three months, Ingrid must continue to pay the premiums for the policy.
Once she has satisfied the three-month waiting period and is still disabled, the insurer will
waive premiums that have fallen due from the date of onset of her disability.



A presumptive disability is one of a specific number of conditions identified in a policy
contract, such as total and permanent blindness, loss of the use of any two limbs, or loss of
speech or hearing in both ears. If the insured suffers a presumptive disability, the insured will
be considered totally and permanently disabled.
Once an insurer is satisfied that the insured has suffered a presumptive disability, no additional
periodic claim forms will be required and the insured will receive disability benefits under the
policy for the length of the benefit period. Even if the insured is able to return to full-time
employment in an occupation for which he is suited by education, training, and experience, the
disability benefits will continue until the benefit period expires.
Andrew worked as a graphic designer at XYZ Corporation. He was involved in an automobile
accident that left him a paraplegic and wheelchair-bound. After eight months of care and
intensive rehabilitation, Andrew was able to resume his occupation on a full-time basis. Andrew
was insured under a disability insurance policy that paid $500 a month for a two-year period.
The insurer received full claim information from Andrew and his attending physicians.
Andrew began to receive monthly payments at the conclusion of the 30-day elimination
period specified in the policy, and without further claim requirements, continued to receive
$500 a month for two years.


In the early days of disability insurance, insurers only recognized a state of total
disability; one was either fit enough to work in some capacity or one was unable to
pursue any gainful employment. This resulted in two issues:
1. Disabled individuals receiving benefits would delay returning to work (malinger) until
confident they could resume their job/career full time for the rest of their working
years, or until their benefits ran out. If they returned to work for any period of time,
they were no longer considered disabled and benefits were immediately terminated.
2. Disabled individuals, who returned to work and found they could not perform most of
their normal duties, or could not perform them for a full day, often received substantially
reduced pay. These individuals would then have to rely on the recurrent disability clause
of their policy (if included) and re-initiate the claim with significant processing
requirements by both the insured and the insurer; a time consuming and costly process. If
the policy did not include a recurrent disability clause, the insured was at a loss.
To address these issues, most policies now contain a partial disability clause for all risk
classifications and policy types to encourage individuals to try returning to work as soon as
possible. An insured may be considered partially disabled if attempting to return to work,
but unable to work at full capacity. There is no requirement to show a loss of income as the
clause is based on loss of time and/or duties. This is particularly useful for newly employed
individuals who have limited prior earnings (e.g. someone just entering the work force).
Most disability policies provide a schedule for the level of benefits that the insured would
qualify to receive under different conditions when attempting to return to work. Normally,
partial disability benefits are limited to a maximum of 50% of the total disability benefit and are
provided for a limited period such as 3, 6, 12 or 24 months. Some policies pay a fixed 50% of
the total disability benefit until full recovery or for the period covered by the partial disability



clause. Some policies also offer a continuing 25% of the full benefit after the partial period
has expired for the duration of the long term coverage (e.g. 5 years, 10 years or to age 65).
Partial disability clauses do not usually contain any requirement to prove loss of income
during the claim. This is important if the claim is of a short term nature or the insured
cannot prove a residual loss.
The partial disability clause was introduced to address the difficulties of malingering and of
the insurer having to deal with multiple recurrent disability claims. The insured could be
confident that trying to return to work would not immediately result in benefits being
terminated and that income could be maintained.


For occupations that fall into lower risk classifications, a residual disability clause is
available that provides for payment of part of the full disability benefit if the insured
resumes some, but not all of the duties of his or her occupation, or resumes work on a
reduced work schedule as part of his or her recovery efforts.
Most insurers that offer residual benefits require the insured to have been on claim for total
disability before applying for the benefit and/or to have been on claim for the full period of
a partial disability clause. Some insurers do not require the insured to have received (or been
eligible to receive) total benefits before claiming for residual benefits. This provision could
be very important as most disability claims are not for total disability, but for long-term
partial or long-term residual disability. Many types of sickness or injury do not result in total
disability yet can seriously limit the ability to earn income and be long lasting (e.g., back
problems, dialysis, certain types of cancer).
Residual benefits are calculated by comparing the insured person’s earned income before the
onset of the disability to the income earned after resuming some work duties or returning to
work part-time. The difference in amounts is divided by the person’s normal earnings to
establish a percentage earnings loss. Usually the residual benefit pays a portion of the full
disability benefit amount based on the percentage earnings loss. If the percentage earnings loss is
80% or greater, the full benefit will be paid; if it is 20% or less, no residual benefit will be paid.
For example, Nora, a physician who suffered a serious ailment, may be able to take on a
modest workload by seeing a limited number of patients while she is recovering. Most of her
income can be attributed to her own efforts through the fees she charges for medical
procedures. Assume Nora had a disability insurance policy that pays her a monthly benefit
of $7,000. If she earned $10,000 a month before she became disabled and later went back to
work seeing fewer patients and earned only $4,000 a month, she would be entitled to a
residual benefit of $4,200 a month from her disability policy; ($10,000 - $4,000/$10,000) =
60% × $7,000 monthly benefit = $4,200 residual benefit.
Without going into the technicalities of partial and residual disability benefit clauses, disability
definitions, occupation classes and related policy provisions, it is generally understood that partial
disability payments are made for a restricted period of time (usually 3, 6, 12, or 24 months) when
a disabled insured returns to work but cannot perform all of the important duties of the job or
cannot put in a full day’s or week’s work. If the disability is deemed to be long term (beyond the
partial disability coverage period) or permanent, or if the partial disability period is exhausted and
the insured is still incapable of performing their full duties or working on a full time basis, then
the residual benefit would apply and be paid until full recovery or for the duration of the policy
benefit period (e.g., for 5 years, 10 years or to age 65).



This happens more often than one would suspect. A person becomes disabled, recovers from the
disability and resumes work only to become disabled again. That’s when a recurrent disability
provision comes into effect. Basically, it says that for a person with a recurrent disability, within a
specified period of time (say 6 months), from the same or related cause, the waiting period will be
waived. The individual will, in effect, be considered to have been continuously disabled.


Like the guaranteed insurability option available under a life insurance policy, the future benefit
option allows someone insured under a disability income policy to purchase additional disability
insurance on certain dates without having to provide evidence of insurability.
Unlike life insurance benefits, however, the person with disability insurance must prove that his
or her income has increased to a level that will justify the additional disability insurance. This
requirement is necessary, because a policy that offered an insured the opportunity to receive a
benefit that exceeded his or her earned income might invite unfounded claims.


The cost-of-living benefit can be made available in two ways.
1. If an insured person becomes disabled, the benefit can be indexed to provide an
increase in income based on some standard that measures increases in living costs.
Typically, that standard is the Consumer Price Index (CPI). The benefit is calculated
by comparing costs for the current month with costs for prior months and applying the
percentage increase to increase the monthly benefit being paid to the insured.
2. COLA can also be applied to the calculation of residual benefits. To reduce the effect of
inflation, the insured’s income is calculated in a way that takes into account the change in
value of that income. For example, if the Consumer Price Index has increased by 4% since
the insured person became disabled, then a person who used to earn $5,000 a month would
be deemed to have earned $5,200 a month in current dollars. If the insured is now able to
earn $2,000, the residual percentage loss is calculated as ($5,200 – $2,000) $5,200 =
61.5%. If the person’s original earnings had not been restated in current dollars, then
the residual percentage loss would be calculated as ($5,000 - $2,000) $5,000 = 60%.
This may not seem like a significant difference, but if a residual disability continues
for a long time, the depreciation of the value of prior income can severely diminish
the value of the benefit payable.

Exclusions and Limitations on Disability Coverage

Insurers establish premium rates based (in part) on morbidity tables that estimate the
likelihood of disability for each risk class. In order to ensure the accuracy of these estimates,
insurers usually exclude certain causes of disability. These exclusions include:
• injuries or sickness that are a result of war, declared or undeclared, or any act of war;
• intentionally self-inflicted injuries;
• injuries received because of active participation in a riot;



• disability resulting from normal childbirth or pregnancy; however, complications of

pregnancy are covered (these are physical conditions that doctors consider distinct
from pregnancy, even though they may be caused or worsened by pregnancy);
• occupation-related disabilities or sickness for which the insured is entitled to
receive disability income benefits, such as Workers’ Compensation.
Also, if the underwriting process reveals that the applicant cannot be offered a standard
policy based on normal criteria for age, sex, and occupation, then a disability contract
may be issued with specific limitations or exclusions.
For example, Wayne, a vice-president in a public relations firm, has applied for personal
disability insurance coverage of $3,000 a month. He has requested a benefit period to age 65
with an elimination period of 30 days.
During the underwriting process, the insurer notes that Wayne has suffered from “lower back
pain” from time to time. Each episode of back pain has been very debilitating, leaving Wayne
unable to move for a few days. In each instance, he has recovered completely and has been able to
resume all of his regular activities. The cause of the pain has not been positively diagnosed. It
may be muscle-related (Wayne likes to play recreational hockey) or related to a degenerative disc.
The insurer may charge an extra premium rating that allows the coverage as applied for,
but recognizes that Wayne has a higher probability than normal of suffering a long-term
disability. The insurer has several options.

• It could offer Wayne disability insurance coverage, with an exclusion rider. The rider
would exclude from coverage any disability resulting from a back problem.
• It could offer Wayne coverage with a qualified condition exclusion rider; this is often
used for certain conditions where it is possible to forecast the length of time required to
recover. The rider specifies a certain elimination period and benefit period for the
particular condition, and a more generous elimination period and benefit period for all
other illnesses or injuries. If Wayne’s experience with back problems has been very
short periods of debilitating pain, the insurer may consider covering both back injuries
and illnesses relating to the back, but with a longer elimination period and a shorter
benefit period than for other disabilities that Wayne might suffer.
• If the insurer feels that the back condition may have a long-term impact on Wayne’s
overall health, it can offer coverage that is more restrictive than the coverage that Wayne
originally wanted. Rather than charge an increased premium or issue coverage exclusions,
the insurer can offer coverage with a longer elimination period and/or a shorter benefit
period or a lower level of coverage. For example, the insurer may offer Wayne coverage of
$1,500 a month with a 60-day elimination period and a two-year benefit period.

• The insurer may deny any optional benefits applied for by Wayne.
Other limitations include:
• Obesity. The applicant’s height and weight are a factor in determining whether
standard coverage will be offered. An insurer will consider premium adjustments if
an applicant’s weight falls outside the normal weight for people of his height.



• High-risk activities. The insurer may offer disability coverage on a modified basis if the
applicant engages in an activity that presents more than usual hazards. For example, the
insurer may offer a policy that excludes coverage for a disability suffered from
activities, such as hang gliding, private flying, or motor vehicle racing.
• Financial considerations. Insurers also attempt to avoid overinsurance by considering
coverage based on financial considerations as well as health considerations. Income
limits are based on the total amount of coverage that the insurer will issue for a given
level of earned income that the applicant receives. The insurer will not allow someone to
get more money while they are disabled than while they worked.
• Other sources of coverage. Insurers reduce the amount of coverage they would otherwise offer
for a given level of earned income by the amount of coverage that the applicant has from other
sources of insurance. Insurers set upper coverage limits for each occupation class.

Specialized Types of Disability Coverage


Key person disability income coverage is different from disability income insurance that
provides a monthly income to an individual during the period that he or she is disabled. A key
person plan pays a monthly income during the time that the insured is disabled, but it is the
company, which employs the individual, that receives the payments.
The key person is not usually the owner of the business, but an employee who contributes
significantly to the fiscal well-being of the company. An owner of a company who is also a
major contributor to its success can get individual disability insurance on his or her own life
and receive the monthly income benefit while disabled. The owner can also get business
overhead expense insurance to pay the regular expenses of the company while the disability
continues. A key person will usually have his or her own disability income plan that pays a
regular monthly income during a disability to replace income he or she would have earned
otherwise. Under a key person disability plan, the company owns the disability insurance
plan on the employee and receives any benefits payable under the plan.
The purpose of the coverage is to restore, at least to some extent, the income that the business is
losing as the result of the key employee’s disability. At the same time, the company must look
for a replacement for the key employee, particularly if the disability is expected to last for a
long time. The coverage provides the financial resources to find, hire, and train a replacement
and to recapture the revenues lost because of the key employee’s disability.
The benefit amount under a key person plan is usually based on the key person’s monthly
salary and is designed to replace lost revenues and pay for the search for a replacement.
Usually, the company values the key person for insurance purposes at twice his or her
monthly salary. The company will provide an individual policy that will pay the insured an
income while disabled. An additional key person policy is obtained for a similar amount of
coverage with benefits payable to the company.
The key person plan meets a short-term need. The company should know early on if the key
employee will be able to return to work within a reasonable time, or if a replacement must be
found. Once a replacement is hired and trained, the company can anticipate a return to higher



income levels within a number of months. Benefit periods for key person plans are typically
6, 12, or 18 months. Elimination periods are relatively short, usually 30, 60, or 90 days,
because the company needs to replace lost revenues as quickly as possible.
The definition of total disability is usually the own occupation definition of disability. The
employer needs to replace the income of someone who is unable to perform the essential duties
of his or her specific occupation, so a more conservative definition of disability might not provide
the coverage at the time it is needed. The specific work done by the key person is essential to the
success of the business. Since the coverage is short-term, an insurer’s risk exposure is limited
with the “own occupation” definition and will not have potential long-term effects.


Disability buy-out coverage addresses the problem of a major shareholder or partner in a
business who becomes disabled.
Partnerships and private corporations handle the risk of the death of a partner or shareholder by
establishing buy-sell agreements that spell out the way in which the interest of a deceased partner or
the shares of a deceased shareholder will be transferred to the remaining partners or shareholders. A
comprehensive buy-sell agreement addresses the following questions: What will happen to the
partner’s or shareholder’s interest in the business? Will that interest be transferred to the deceased’s
heirs, who may not be qualified to contribute to the business’s success? Will the
interest be sold to a third party who may not have the same plans for the business as the surviving
partners or shareholders? How will the value of the deceased’s interest be measured?
To fund the buy-sell agreement the business can obtain the requisite funds to compensate
fairly the deceased’s heirs for the value of his interest by acquiring life insurance on each
partner or shareholder’s life. Typically, the beneficiary provisions of a life insurance policy
on a shareholder or partner direct the proceeds to the surviving partners or shareholders (or
to the corporation for corporate share repurchases). The buy-sell agreement then directs the
payment of the insurance proceeds from the surviving associates to the deceased’s estate as
compensation for the deceased’s interest.
But what happens if a partner or shareholder becomes disabled? A disabled partner or shareholder
presents the same dilemma as one who dies. In addition, the business has to be concerned about
the continued presence of the disabled partner or shareholder. Presumably, the disabled party will
look to the business for income even though he or she is not contributing to its successful
operation. The organization therefore must address the following problems:

• the reduction in business income while an active partner or owner is disabled;

• the need to buy out the disabled person’s interest if his or her disability
continues indefinitely.
Like buy-sell agreements that take effect when a partner or shareholder dies,
organizations can also establish buy-out agreements that take effect when a partner or
shareholder suffers a disability. The disability buy-out agreement must address the
following issues, which should parallel the provisions in the disability insurance policy:
• Determining the disabled individual’s value to the business. If each partner’s or shareholder’s
value to the business can be estimated, then a disability plan can be established to pay a specific
periodic or lump sum amount established under the provisions of the agreement.



• Establishing a specific period of time for which the partner or shareholder must be
disabled before the buy-out occurs. When this period is defined, an elimination period
can be specified in the policy to determine when benefits will start.
• Defining what conditions constitute a disability. The definition must be reflected in
the disability policy that is used.
• Determining the method of funding the buy-out.
• Defining how the payment will be made.
A disability buy-out policy should therefore contain the following provisions.
1. Coverage amount. If each partner’s or shareholder’s value has been estimated at the
time the disability buy-out agreement is created, the coverage amount can be established
within the underwriting practices of the insurer.
2. Elimination period. The elimination period in the policy will usually be a period that
allows for some certainty that recovery from the disability is remote. Many insurers set
the elimination period at a minimum of twelve months, but may provide for elimination
periods of 18, 24 or 36 months. Again, the purpose of this type of policy is to provide the
funding when a buy-out becomes the most appropriate action. The policy is not designed
to provide an income to the disabled person until he recovers.
3. Definition of total disability. The definition will most likely require that the insured be
unable to perform the essential duties of his own occupation. The purpose is to buy out
the interests of a partner or shareholder who is unable to perform the work of the
position he or she occupied in the organization. At the same time, the definition might
be extended to require that the individual does not continue to work within the
organization. This modification makes it clear that the policy is intended to provide the
means to buy out the insured’s interest completely and that the disabled person will no
longer have any interest in the organization.
4. Trigger date. This is a unique feature in disability buy-out insurance. Under an individual
disability income policy, once the elimination period has been satisfied, disability benefits
continue to the claim applicant until he or she recovers or the benefit period ends. Under a
disability buy-out plan, once the elimination period has ended, the benefit is paid out.
There is no need for the claimant to prove continued disability beyond that point. The
buy-out takes place and the full benefit specified in the policy is paid.
5. Payment of benefits. The disability buy-out plan offers the claimant the option of
receiving the benefit in a lump sum, in instalments over a specified number of months,
or in a combination of both.
6. Renewability. Some contracts guarantee that the policy can be renewed at a guaranteed
premium, or guarantee that it can be renewed, but at an increased premium.
The disability buy-out plan is unlike an individual disability income plan. First, once a claim
is accepted under the disability buy-out plan, the benefit paid out completes the insurer’s
obligations under the contract. The claim payment, which can be made either in a lump sum
or through a series of payments, completes the contract and the policy expires. Second, if the



insured’s relationship with the partnership or corporation ends, the coverage will cease,
because the purpose of the coverage no longer exists.


Sole proprietors, partners, and principal shareholders of private corporations who become
disabled face the loss of income for personal and family expenses. At the same time, they
have to contend with the ongoing expenses of the business. The business overhead
expense policy provides a monthly payment to cover business expenses incurred during
the insured business owner’s disability period.
Business overhead expense policies are usually issued for relatively short benefit periods,
from 12 to 24 months. The benefit period should not be longer than two years. If a disability
lasts that long, the insured will not likely recover to return to the business. Elimination
periods may be 30 to 90 days. A 30-day elimination period is typical, since most businesses
do not have the cash flow to cover overhead expenses for a longer period.
The amount of money available each month under this type of policy depends on the
insured’s occupation and the type of business he or she conducts. For example, a lawyer who
relies primarily on the fees he or she bills to maintain the business will qualify for a higher
monthly benefit than the head of an organization who relies on the efforts of more than one
individual to bring in business. In this case, while a disability to the head of the company
may depress the cash flow, it will not have the same critical effect as a disability suffered by
someone who is the major contributor to the business.
Most plans define total disability as the inability to perform the duties of the insured’s
regular occupation. That makes sense, since it is the insured’s inability to earn income
that puts the company’s ability to pay its overhead expenses at risk.
BOE policies usually cover expenses such as:
• employee salaries;
• employee benefits and payroll taxes;
• rent;
• heat;
• water;
• electricity;
• telephone and telephone answering services;
• interest on business debts, including interest on mortgage loans for premises
used in operating the business;
• association dues;
• accounting, billing, and collecting fees;
• depreciation of furniture and equipment;
• premiums for business insurance;
• postage and stationery;
• laundry, maintenance, and janitorial services;
• other fixed expenses normally incurred in managing and operating a business.



Expenses that are not covered include:

• salary, fees, or other compensation for the owner;
• payment on the principal of any debts;
• cost of equipment, furniture, or merchandise.
These items are not covered because they are really investments, rather than expenses.
Although the policy specifies a maximum monthly benefit, once the insured becomes
disabled, the whole amount may not be paid every month. Many policies reimburse the
insured only for the monthly overhead expenses actually incurred up to the monthly limit.
Once the benefit period expires, no additional benefits will be paid, even though the
expenses incurred were less than the cumulative monthly benefits. For example, if the
policy provides a monthly benefit of $4,000 for a 12-month benefit period, the maximum
benefit amount payable for any one disability is $48,000. If actual expenses incurred over
the 12-month period are $30,000, that is the amount the claimant will receive.
Some plans take a different approach. If, under the same policy described above, the insured
was still disabled at the end of the 12-month benefit period, the insurer would continue to
reimburse the claimant for actual business expenses each month to a monthly maximum of
$4,000 until the total benefit of $48,000 was paid out. Other plans reimburse the claimant for
the actual amount of overhead expenses incurred in any month (which might be more than
$4,000 in a given month) until the maximum total under the policy is paid out.

Federal Government–Sponsored Disability Benefit Programs

The Employment Insurance (EI) program is administered under the federal Employment
Insurance Act. The program provides financial assistance to people who lose their jobs through no
fault of their own because of a work shortage, seasonal unemployment, restructuring or mass
layoffs. EI is also available to those who are unable to work because of illness or injury.
To qualify for sickness benefits under EI, the employee must have a decrease of 40% or
more in weekly earnings and must have accumulated 600 insured hours in the previous 52
weeks or since his or her last claim. Insured hours are paid hours of employment on which
the employee paid EI premiums.
The basic benefit is 55% of the employee’s average insured earnings to a maximum of
$468 a week. Insured earnings are those on which EI premiums are based. Maximum
insurable earnings for the purposes of EI premiums and benefits are $44,200 a year.
Sickness or injury benefits are paid for a maximum of 15 weeks.
EI sickness or injury claims will be reduced by the amount that the employee receives as:
• income, including wages or commissions from employment;
• payments for lost wages owing to an accident or work-related illness from sources
such as Workers’ Compensation;
• income from group insurance for sickness or loss of income;
• accident compensation for loss of wages under a motor vehicle accident insurance plan;



• retirement income from an employment pension, including Canada Pension or

Quebec Pension plan benefits, based on employment income.
The following types of income will not reduce an EI claim for sickness or injury benefits:
• disability benefits from Canada Pension or Quebec Pension plans;
• Workers’ Compensation payments from a permanent settlement;
• supplemental insurance benefits under a private plan approved by Service Canada
for sickness benefits;
• private sickness or disability wage-loss insurance programs;
• retroactive increases in the employee’s wages or salary.
There is a two-week waiting period before benefits are paid. The first payment of any
claim is made within 28 days of the start of the claim and every two weeks thereafter.


The Canada Pension Plan (CPP) [or Quebec Pension Plan (QPP)] pays a monthly benefit to
anyone who has contributed to CPP (or QPP) and who is considered disabled according to
the plans’ guidelines.
To be considered disabled, an individual must be suffering from a severe or prolonged
physical or mental disability that prevents him or her from working regularly at any job.
The disability must be long-term or one that may shorten the individual’s life.
An individual must have a minimum level of earnings to make contributions to the CPP.
For 2011, the minimum level of earnings to qualify for disability benefits is $4,800. This
figure is adjusted annually.
To qualify for disability benefits, an individual must have contributed to the CPP in four of
the last six years at or above the minimum level of earnings. If an individual has contributed
to the CPP for 25 or more years and applied for a CPP disability benefit on or after March 3,
2008, he or she needs to have made contributions in three of the last six years, at or above
the minimum level of earnings.
However, under certain Canada Pension Plan provisions, an individual may still qualify
if he or she:
• worked in another country with which Canada has a social security agreement
and contributed to the pension plan of the other country;
• delayed applying (that is, if the individual qualified when he or she first became
disabled, but did not apply immediately and now, having decided to apply, no longer
qualifies as having contributed to CPP in four of the previous six years);
• stopped contributing to Canada Pension Plan or reduced his or her contributions
while raising children who were under seven years of age;
• obtained enough Canada Pension Plan credits from a former spouse or common-law
partner through credit splitting;
• was medically unable to apply.




Disability payments stop when the recipient:

• is no longer disabled, according to Canada Pension Plan rules; or
• reaches the age of 65, when a Canada Pension Plan retirement pension begins (or
between 60 and 65, if the recipient takes early retirement); or
• dies.
The disability benefit is made up of two parts: a flat-rate amount and a variable amount based
on how much, and for how long, the applicant has paid into the Canada Pension Plan. There
is a maximum amount that can be paid. If the Canadian cost of living index rises, disability
payments are increased as of the following January.
In December 2010, the average Canada Pension Plan disability benefit was $809.50 a
month. The maximum amount in 2011 is $1,153.37 a month.
The Canada Pension Plan disability benefit is not a permanent benefit. From time to time,
representatives from the Canada Pension Plan may check to see if the recipient has
recovered sufficiently to return to work. The program also provides services and return-to-
work incentives. You may attend school or do volunteer work without fear of losing
benefits as long as you have not regained the capacity to work. CPP will also provide
vocational training if they determine that you would likely be able to return to work with a
vocational rehabilitation program. The disabled person’s condition must be stable and their
physician must approve. CPP benefits will not be stopped while attending the program.
Recipients can earn up to a certain maximum from working ($4,800 in 2011) without informing
Service Canada and without losing their benefits. This amount changes from time to time.
Once a recipient earns more than the maximum specified amount from work, Service Canada
must be informed. Service Canada may choose to discontinue the disability payments or
continue them if the recipient is unable to work on a regular basis. There is no fixed dollar
amount at which benefits are automatically stopped. Because everyone’s medical condition
and capacity to work are unique, each person’s circumstances are considered individually.
If the recipient is able to work on a regular basis, Service Canada may offer a vocational
rehabilitation program, which allows the recipient to re-train and provides a three-month work
trial period, during which the recipient continues to receive CPP benefits while working.
The Canada Pension Plan will provide vocational rehabilitation if all the following
conditions are met:
• the individual is receiving a Canada Pension Plan disability benefit;
• the recipient would likely be able to return to work after participating in a
vocational rehabilitation program;
• the recipient is willing and able to undergo a vocational rehabilitation program;
• the recipient’s medical condition is stable;
• the recipient’s doctor approves.
If the recipient is eligible for a survivor’s pension, the Canada Pension Plan combines it with
the disability benefit. The combined benefit comes as one monthly payment. The maximum
combined survivor/disability amount is the same as the maximum disability benefit.



The federal government does not pay disability benefits after the recipient turns 65. The
Canada Pension Plan retirement pension is based on the recipient’s pensionable income at
the time he or she became disabled. The maximum CPP pension amount in 2011 is $960
and is fully indexed to inflation as measured by the Consumer Price Index. A disabled
person can also apply for an Old Age Security pension beginning at age 65.

Coordination of Benefits on a Disability Insurance Policy

In underwriting a disability application, the insurer examines all of the applicant’s sources of
income to justify the amount of monthly disability benefit that the applicant is requesting. The
insurer will look at actual earnings, other disability income plans that the applicant participates
in, and any potential benefits available under government income plans such as Workers’
Compensation, Employment Insurance, or CPP. The insurer wants to make sure that the
applicant will not be able to claim a disability income that exceeds his or her actual earnings.
Many insurers add a provision to disability insurance policies stipulating that if an insured person
presents a disability claim, the benefit amount payable, together with all sources of income,
including disability benefits from other plans, will not exceed 100% of the insured’s earnings
before the onset of the disability. Although the insurer analyzes the applicant’s other sources of
income during periods of disability, once the insurance is issued, there is nothing to prevent the
insured from seeking to receive money from other disability income plans or sources of income
that are not interrupted during periods of disability. The coordination of benefits provision allows
the insurer to reduce the benefits payable under the policy if it discovers during the claims
assessment process that the insured is entitled to benefits that total 100% or more of his or her
income before he or she became disabled. The insurer will refund any premiums paid towards the
coverage that is excluded from the claim benefit. The purpose is to make sure that the claimant is
not better off on disability than he or she was while working.

Tax Treatment of Individual Disability Insurance Policies


If the policyholder is also the insured, he or she pays premiums from after-tax dollars, so the
premiums are not deductible for tax purposes. Benefits paid out under the plan are not taxable.
For example, Gord, a musician with a traveling band, purchases a disability insurance policy
and pays premiums of $1,000 a year. He is entitled to disability income payments of $4,000
a month (66% of monthly income of $6,000). If Gord falls off the stage at one of his spirited
performances and injures his back badly, he will get $4,000 a month from the insurer. Since
Gord is paying the $1,000 in premiums using after-tax dollars (i.e., the premiums are not tax-
deductible), the disability income benefit of $4,000 a month is also not taxable.


If an employer pays all or part of the premiums for an individual (as opposed to group) disability
income insurance policy, the employer can deduct the amounts paid for tax purposes. Premium
amounts paid by the employer are a taxable benefit for the employee, but any benefits paid
to the employee under the plan are tax-free. For example, Wendy is insured under a disability
income insurance policy for monthly disability income benefits of $3,000 (66% of monthly salary
of $4,600). Her employer, Ivanhoe Inc., pays the premiums for this policy. Assume that the
premiums add up to $700 a year. Ivanhoe can deduct the $700 in premiums for tax purposes.



Wendy will declare $700 as a taxable benefit received from Ivanhoe and, in the event that
she becomes disabled and gets the monthly income benefit of $3,000, that amount will be
received tax-free by Wendy.


If a policy is owned and paid for by the employer to insure a key employee, and the benefits are
payable to the employer, the premiums paid by the employer are not deductible, but any benefits
received are tax-free. For example, Amy is a marketing VP at Global Finance Corp and a member
of the senior executive team. She is considered a key person by Global Finance and the company
purchases a key person disability insurance policy for Amy. The premiums are $2,000 a year and
Global Finance pays them. The beneficiary of the policy is Global Finance. If Amy gets disabled,
the company would start receiving disability income benefits from the key person policy on Amy.
In this case, Global Finance is the owner of the policy, pays the premiums and receives the
benefits. The $2,000 annual premiums will not be tax-deductible by Global Finance; by the same
token, the monthly income benefits that Global Finance receives will be tax-free.


The insured under the policy is entitled to deduct the premiums from taxable income as a
business expense. The benefits paid out under the policy are taxable income to the insured.
However, since the benefits are used to pay regular business expenses, which are deductible
from taxable income, there is no net tax liability.


The policyowner of such a plan may be a partner or shareholder in a business other than
the person insured, a trust that is overseeing the buy-sell arrangement, or the business
entity itself (corporation or partnership). The premiums paid by the owner are not tax
deductible, but the benefits paid are tax-free.
Since the payments under the disability buy-out plan are used to compensate the disabled
partner or shareholder for his or her interest, that interest is considered disposed of (that is,
sold) for income tax purposes.
The taxation of the disposition of a partnership or shareholder interest can be very complicated.
If the benefits under the plan are paid to a disabled partner to compensate him or her for
the partnership interest, and if the payment exceeds the individual’s cost for the business
interest, he or she may incur a taxable capital gain. This may occur whether the payments
are made in a single lump sum or over a period of time.
For corporations in which shareholders hold buy-out insurance on each other’s lives, the
benefit paid out is considered a payment for the purchase of the disabled shareholder’s
interest. The payment could generate a capital gain if the proceeds exceed the disabled
shareholder’s costs. If the payments are made over a period of time, the capital gain may be
deferred over several years under the reserve provisions of the Income Tax Act.
For corporate share repurchases, the benefits paid out are tax-free up to the limit of the
shareholder’s paid-up-capital. Any excess is deemed a dividend to the disabled shareholder.




After reading this section, you should be able to:
• explain the rationale for and coverage provided by individual A&S (health or
travel) insurance policies to supplement provincial or territorial coverage;
• describe the provisions generally included in individual A&S insurance policies and the
potential impact of these provisions on a disability claim, including renewal, grace
period, incontestability, pre-existing conditions, claims, physical examination, change of
occupation, and over insurance;
• describe the tax implication of an A&S insurance policy.

Provincial Health Insurance

Each province provides health care coverage in conjunction with the federal government.
The federal government helps fund provincial health insurance plans that meet the
following standards:
1. Public administration: The program must be administered on a non-profit basis
by a public authority appointed and accountable to the provincial government.
2. Comprehensiveness: The program must cover all necessary hospital and medical
services and surgical-dental services provided in hospitals. In addition to these
insured health services, the provinces are encouraged to provide certain extended
health care services as defined in the Canada Health Act such as prescription drugs.
3. Universality: 100% of the province’s legal residents must be entitled to insured
health services.
4. Portability: Coverage must be portable from one province to another. The waiting
period for people who move from one province to another must not exceed three
months. Insured health services must also be made available to Canadians when they
travel to other provinces or other countries. In these cases, payment for services within
Canada is made by the home province at the host province’s rates; payments for services
outside Canada are made at the home province’s rates.
5. Accessibility: Insured services must be provided on uniform terms and conditions for all
residents. Residents must have reasonable access to insured services, and their access must
not be prevented or hindered, either directly or indirectly, by charges or other barriers.
Reasonable compensation must be paid to physicians and dentists and adequate
payments made to hospitals for insured services.
Some provinces have extended their health insurance programs to cover certain individuals
for some dental services, including routine services performed in a dentist’s office. Some
provincial plans also cover certain drugs prescribed by physicians.



Government health insurance is mandatory coverage, which means that a person or group
cannot opt out of the provincial health care plan and sign up with a private insurer for
services that are already covered by provincial plans. The government does, however, allow
private insurers to cover medical services that are not covered by provincial plans.
These extended health care plans may cover costs such as semi-private or private hospital rooms, eye
care, drug prescriptions, ambulance services, or hearing aids. Although provincial health insurance
plans do cover some medical expenses for Canadians who travel outside the country, the coverage is
based on the rates that would be charged for the same medical procedure or hospital coverage in the
province, whereas the actual costs for those medical services may be much higher in another country
(e.g., in the United States). Therefore, private insurers can provide medical coverage for provincial
residents who travel outside Canada that will reimburse them fully for medical expenses in other
countries. The cost of such coverage depends on the applicant’s age and the length of time the
applicant intends to remain outside Canada.

Private health insurance, in the form of accident and sickness insurance, rounds out the medical
coverage available under provincial health insurance plans. Provincial health plans usually
cover basic expenses like hospital stays and prescription drugs while in the hospital. However,
provincial plans are very limited in the coverage they will provide for Canadians while
outside the country.
Private health care plans can provide emergency health and travel insurance above and beyond
what the provincial plans will cover. These plans often cover things such as paying for a
companion to travel with a sick or injured party, paying emergency travel costs such as an air
ambulance, trip cancellation insurance, and accidental death insurance.
Some conditions and restrictions apply to health insurance plans that may affect the
availability of health coverage, the continuance of existing coverage, and the
administration of claims submitted under a private health care plan.
The Uniform Accident and Sickness Insurance Act defines accident insurance as “insurance
by which the insurer undertakes, otherwise than incidentally to some other class of insurance
defined by or under this Act, to pay insurance money in the event of accident to the person or
persons insured, but does not include insurance by which the insurer undertakes to pay insurance
money both in the event of death by accident and in the event of death from any other cause.”
Sickness insurance is defined as “insurance by which the insurer undertakes to pay
insurance money in the event of sickness of the person or persons insured, but does not
include disability insurance.”

Provisions of an Accident and Sickness Policy

The renewal provision of a health insurance plan specifies the insurer’s right to renew
existing coverage or to charge a higher premium for the same level of coverage when a
premium is due for renewal. The type of policy that has been issued classifies the insurer’s
rights under these plans. (These are similar to the renewal provisions for disability insurance
described earlier.) The policy may be:
• Cancellable: The insurer has the right to cancel the plan at any time by notifying
the policyowner and refunding any premiums that the owner has paid.



• Optionally renewable: The insurer has the right to cancel the policy on the policy
anniversary or on any date when a premium is due. The insurer can also change the limits of
coverage and increase the premium rate for any class of policy. (A class of policies consists
of all policies of a particular type or all policies issued to a particular group.)

• Conditionally renewable: The insurer has the right to cancel a policy at the end of a
premium payment period, for any of the reasons stipulated in the policy, such as the
age or employment status of the insured.
• Guaranteed renewable: The insurer is required to renew the policy as long as the
insured continues to pay premiums, until the insured reaches a certain age. However, the
insurer has the right to increase the premium rate for entire classes of policies.
• Noncancelable: The insurer is required to renew the policy until the insured reaches a
certain age, as long as the insured continues to pay the premiums that fall due. The
insurer cannot increase the premium specified in the policy.

Under the grace period provision, the policyowner can pay the premium within a certain
period of time after the due date. The coverage remains in effect during the grace period. If
the policyowner pays every month, the grace period is usually 10 days. If the owner pays less
frequently, the grace period is usually 31 days.

The incontestability provision limits the insurer’s rights to challenge or deny a claim because
of material misrepresentation made in the application. Misrepresentations are omissions or
incorrect statements made by the applicant that the insurer relied upon in deciding whether or
not to approve the coverage. Material misrepresentations are omissions or incorrect
statements that, if they had not occurred, would have led the insurer to refuse coverage or to
issue coverage on a more restrictive basis.
The incontestability provision limits the time in which the insurer can challenge or deny a claim
because of a material misrepresentation on the application to two years after the policy has been
issued and has remained in force. However, if the material misrepresentation was fraudulent,
there is no time limit. For further information on fraud and misrepresentation, see chapter 10.

A pre-existing condition is an injury or illness (sickness) that an insured experienced
within a specified period (e.g., two years) before the policy was issued.
Insurance applications require a potential insured to disclose all material information that
would, or could, influence the issuance of a policy, or affect a policy’s terms and conditions,
and/or result in a non-standard premium. This is in addition to requiring an applicant to
answer all questions on the application to the best of their knowledge and ability.
A disclosed pre-existing condition may be admitted by the insurer resulting in no adjustment to the
coverage applied for or the premiums required. Otherwise, the insurer will adjust the premium to
compensate for the increased risk, limit the benefit amount or benefit period for the specific pre-
existing condition or related conditions, and/or exclude coverage for any illness



or injury directly or indirectly related to the pre-existing condition. If a pre-existing

condition is dealt with at the time of application by the insurer, the insurer cannot vary the
terms of the coverage at a later time.
If an applicant fraudulently does not disclose a pre-existing condition, the insurer can deny a
claim for benefits at any time in the future if it can prove that the illness or injury is directly or
indirectly a result of the pre-existing condition. If an applicant innocently misrepresents (by
legitimately forgetting or believing the condition to be so minor as to be not material, and/or
by not understanding the agent’s questions/directions during the application process), the
insurer only has a 2-year period during which it could deny a claim based on the pre-existing
condition. After 2 years, the prior existence of the disease or physical condition is not
available as a defence against liability (except in the event of fraud).

A health policy’s provisions specify the obligations of the insured and the insurer as they
apply to claims made under the policy. Usually, the insured is required to notify the insurer
of a claim within 30 days after the injury or sickness has occurred and to furnish proof of
the injury or sickness to the insurer within 90 days. The insurer must pay benefits within 60
days of receiving proof of a medical claim.

After an insured person submits a claim, the insurer has the right to have the insured
undergo a physical examination by a doctor chosen by the insurer. This examination is
paid for by the insurer.

This provision gives the insurer the right to modify the coverage if the insured changes
occupations, because a person’s occupation can affect the likelihood of suffering an illness or
injury. For example, if a woman who has held a desk job changes careers to become a ski
instructor, her risk of injury is increased. If a construction foreman takes on a job in
telephone sales, his risk of injury or illness decreases.
If the insured takes on a more hazardous occupation, the provision usually allows the insurer to
reduce the benefits payable under the policy. If the insured takes on a less hazardous occupation,
the insurer will reduce the premium rate to the level charged for the new occupation.

Health insurance policies may contain a provision that reduces the benefits payable under a
policy if the insured has other insurance policies to cover the same medical condition. An
over insured person is someone who receives more in benefits from two or more policies
than the actual costs incurred for treatment. Insurers factor in other coverage to reduce the
benefits payable. Any premiums paid relating to the excess coverage will be refunded.


For private health services plans (both individual and group) under which the benefits are payable
to the employee, premiums paid by the employer are tax-deductible for the employer and are
not considered taxable benefits to the employee. If the employee pays the premiums,
they are deductible as part of the medical expense tax credit.



Benefit payments to the employee are not taxable, but any medical expenses covered by the
health insurance plan cannot be deducted under the medical expense tax credit.


After reading this section, you should be able to:
• describe the advantages of a critical illness policy;
• describe and provide examples of the conditions that are generally covered under a
critical illness policy;
• explain the circumstances that will result in a payment of benefit under a critical
illness policy;
• explain the importance of different medical definitions used in critical illness policies.
Critical illness insurance provides a “living benefit.” The critical illness policy pays a tax-free lump
sum to the insured person a certain number of days after the insured has been diagnosed with one of a
specific group of potentially life-threatening medical conditions. These may include:

• heart attack;
• stroke;
• cancer;
• paralysis;
• conditions leading to coronary artery bypass surgery;
• multiple sclerosis;
• coma;
• Alzheimer’s disease;
• Parkinson’s disease;
• HIV infection;
• loss of speech;
• severe burns;
• loss of limbs;
• Lou Gehrig’s disease (ALS)
• benign brain tumour
• kidney failure;
• conditions requiring an organ transplant.
A critical illness policy is designed to provide a benefit while the insured person is alive. This is
important when someone suffers a serious illness that affects his or her ability to earn income and
may reduce his or her life expectancy. The financial consequences of a serious illness can often
be worse than those of dying suddenly. The insured person must continue to pay living expenses,



but usually cannot earn income. In addition, the insured’s family may face unusual
expenses to provide special care and treatment for the person who is ill.

The benefit under a critical illness policy is paid out in a lump sum and the policy expires
when the insured person contracts a serious illness of the type covered under the policy. The
benefit can be used at the insured’s discretion. It can be used to replace earned income that
may be reduced or disappear entirely, depending on the severity of the insured person’s
condition. It may be used to pay for medical services and treatments that provincial medical
insurance plans do not cover or to renovate a home to make it wheelchair-accessible. It can
also be used to finance a business to which the disabled insured was a key contributor. It can
even be used to take a final vacation if the critically ill person is expected to die. The insured
person and his or her family do not have to wait until the insured person dies before receiving
the benefits and the insured can use the money to do whatever he or she wants to do.

Waiting Period
There is usually a waiting period after the illness is diagnosed before the benefit is paid.
That is, the insured must have suffered from one of the prescribed illnesses for a specific
period of time, without having recovered or died. This waiting period is usually 30 days, but
with some policies, it can be shorter, 14 days, and some policies have no waiting period at
all. If the insured dies during the waiting period, the premiums paid under the policy will be
refunded to the person named as beneficiary. If the person survives the waiting period and
continues to suffer from the medical condition, the insurer will pay the policy benefit to the
insured. Once the insured has qualified for the benefit, the benefit will be paid whether or
not the insured person recovers or dies from the effects of the illness.

To qualify for the policy benefit, the insured person must contract one of the medical
conditions listed in the policy and exhibit the symptoms of the illness that are defined in the
policy. For example, the insured may suffer a stroke, as diagnosed by a physician. If the
critical illness policy provision defines a stroke as a covered illness, it will specify the
symptoms that must be present to qualify for a payment of the policy benefit. The policy
might read, “The stroke must be evidenced by neurological deficit persisting for at least 30
days.” If the insured exhibits these symptoms, or more severe symptoms, the insurer would
release the benefit, once any waiting period has been satisfied.
Policies may exclude certain conditions that do not qualify for coverage. For example, in
determining that the insured has contracted a form of cancer that qualifies as a covered illness,
one insurer uses the following exclusions: “Excluding early stage (stage T1N0M0/stage A)
prostate cancer, non-invasive cancer in situ, tumours in the presence of HIV, skin cancer other
than malignant melanoma with 0.70 mm depth or deeper, chronic lymphocytic leukaemia stage
1 or 2, Hodgkin’s disease, pre-malignant lesions, benign tumours, polyps.”
There is no standard definition of the qualifying symptoms stipulated in a critical illness policy.
Each insurer has its own criteria for acknowledging the presence of one of the qualifying
illnesses. For example, qualifying symptoms for paralysis differ among insurers. One policy
states, “Paralysis, as evidenced by complete and permanent loss of use of two or more limbs for



a continuous period of 180 days,” while another specifies, “Paralysis as evidenced by

total loss of voluntary movement of both arms, both legs or one arm and one leg as a
result of injury or disease of the nerve supply.”
Alzheimer’s disease may qualify in some policies as a critical illness only “if the individual
requires a minimum of 8 hours of daily supervision.” Other policies recognize the diagnosis
of Alzheimer’s as a covered condition without specifying any qualifying symptoms.
In summary, the agent must be sure that the insured person understands how the policy contract
defines an illness for the purposes of a claim. For example, the insured might suffer a medical
condition that is diagnosed as cancer, but may not exhibit the symptoms described in the policy.
The insured might also contract a form of cancer that is diagnosed in an early stage and treated
quickly. If so, it may not constitute a qualifying illness and therefore no benefit would be paid.


After reading this section, you should be able to:
• describe the advantages of a long-term care policy;
• describe and provide examples of the conditions that are generally covered under a
long-term care policy;
• explain the circumstances that will result in a payment of benefit under a long-term
care policy.
A long-term care (LTC) policy is designed to pay for personal care and medical services for
someone who has suffered a debilitating illness that leaves the individual unable to care for
himself or herself and in need of special attendant care at home or nursing home care. Without
long-term care insurance, families of a person with a serious illness would face an unexpected,
large, continuing expense that would seriously deplete or exhaust their financial resources.
A long-term care insurance policy provides coverage for conditions that result in a disability
to the insured that makes him or her unable to perform two or more of the Activities of Daily
Living (ADL) without assistance. These activities include:
1. Walking or managing a walker or wheelchair.
2. Eating - the ability to consume food that has been prepared.
3. Bathing - the ability to wash oneself.
4. Using the toilet - including getting to the toilet and on and off the toilet.
5. Getting into and out of bed -can use equipment to aid themselves.
6. Dressing - the ability to put on and remove clothing.
7. Personal grooming.



Impairments that trigger the payment of benefits may include such conditions as
Alzheimer’s disease, senile dementia, or advanced arthritis.
The provisions of the long-term care policy determine the conditions under which benefit
payments will be paid out under the policy. The LTC contract may require that the insured
be receiving treatment that is medically necessary. Some contracts may require that the
insured be hospitalized for a specific period; others may simply require that a physician
approve personal care for the disabled insured.
The most common measure for determining if benefits are payable is the insured’s
inability to perform the Activities of Daily Living. Insurers may use a variety of methods
for assessing the degree to which the insured is unable to perform the Activities of Daily
Living. The insurer may rely on a physician’s diagnosis, the assessment of a firm that
specializes in such analyses, or develop its own assessment criteria.
The severity of the impairment may dictate whether the contract pays benefits for nursing home
care or home care only. It is assumed that nursing home care is more expensive than home care.
Benefits are paid out when the following types of personal care are required.
• In-Home Health Care: home health aides, homemakers, or personal care
attendants provide health care in the insured’s own home to help the insured
person perform the activities of daily living.
• Adult Day Programs: These programs provide health, social, and other support
services on a part-time basis when a care provider cannot be present.
• Assisted Living Care: Assisted living care facilities promote independent living to
the best of the resident’s ability. The resident must be able to get into and out of bed
on his or her own.
• Nursing Home Care: Nursing home care provides the highest level of services. Care
provided in a nursing home can be defined in three different levels; custodial, intermediate,
and skilled. Custodial care provides assistance with the activities of daily living.
Intermediate and skilled care is provided by nurses and medical attendants trained to care for
patients who cannot care for themselves or whose health condition needs to be monitored.
Long-term care insurance reimburses the insured person for expenses incurred while
receiving these health care services. The benefits are in the form of a daily benefit, such as
$100 per day or $150 per day. Coverage usually ranges from $50 to $400 per day. Payments
may start as soon as the insured person qualifies, or may take effect after a waiting period of
up to one year. Benefit payments may be made for one or two years, a period of several
years, or for life. The applicant selects the length of the waiting period and the length of
time that the benefit payments will continue.





After reading this section, you should be able to:
• given a case study containing information on a specific client, select the most
appropriate products from among disability, accident and sickness, critical illness,
and long-term care insurance to match the client’s situation and needs.

Example 1: Employee with Group LTD Coverage Seeks Advice on Additional Individual
Voice mail from Imelda Inquisitive:
Hello. A client of yours suggested that I contact you. My best friend recently suffered a
serious disability and has been unable to keep up financially. His problems have caused me
to consider what might happen if I became ill or was injured.

My employer has a long-term disability plan that pays 70% of my salary if I’m disabled, but
I’m not sure if that’s enough. Can you recommend some coverage that will pay me enough
money to maintain my current lifestyle? Please call me as soon as possible.

How would you respond to Imelda and what type of coverage would you recommend?
Imelda has provided very little information about her personal circumstances and you
must interview her to obtain much more detail. For example, you need answers to the
following questions.
• What kind of coverage does she have with her employer? Under what circumstances
will benefits be payable under her company’s plan and for how long? If the plan pays
her about 70% of her earned income for a long term such as to age 65, she may not
need income replacement through a disability income plan.
• Where does Imelda live? Presumably she has provincial medical insurance coverage, so
A&S coverage may not be needed if her employer provides A&S coverage to address
medical expenses that provincial insurance does not cover.
• What is Imelda’s family history? Have other family members suffered serious illnesses? If
Imelda were to suffer a serious illness, would a lump-sum benefit payment, under a critical
illness policy, help to resolve any financial problems that might arise?

• How old is Imelda? Considering her family’s medical history, is there a possibility that
she could suffer a debilitating illness that would require close attendant care for some
period of time? If so, long-term care insurance may be advisable.



Example 2: Business Owner Requests Disability Income Coverage

Good morning. My name is Matthew Macro. One of your clients gave me your name. I am looking
for information about insurance coverage for illness or injury. I own a software corporation that
employs ten people. I have operated the business for ten years and it was incorporated two years
ago. My role in the organization is to attract new business and to act as the general manager for
the company. The employees develop the software applications that our clients request.

While I have both personal and business life insurance in place in the event of my death, I have no way
of dealing with the consequences of my inability to work if I get sick or injured. I’m 40 years old and in
general good health. My parents are both alive and continue to enjoy good health in their old age.

A friend who operated a business similar to mine recently suffered a heart attack that has left
her unable to attend to her business. Her company recently went bankrupt. I don’t want the
same thing to happen to my business. Would you please contact me to discuss how I can make
sure that if I get sick or injured, my business will not be in danger?

How would you respond to Matthew and what type of coverage would you recommend?
While it is important to gather more details about Matthews’s insurance needs, he has provided
some valuable information. It appears that he has addressed his life insurance needs, but has done
nothing about his risk of becoming disabled. It is also clear that he is an essential part of his
business. If he gets sick or injured, the business would suffer almost immediately.
Once you have conducted a formal needs analysis, you may find that Matthew is a candidate
for disability insurance to replace the income he and his company will lose if he is unable to
work. The details of the coverage will need to be worked out.
• How much monthly disability insurance does he need? To determine the amount, you
need to know the income that Matthew is able to earn currently and other sources of
income that Matthew may receive that will continue even if he becomes disabled. You
must also consider if Matthew has other insurance in place that he would receive if he
became disabled. A government plan, such as Workers’ Compensation, may be
available if Matthew becomes disabled at work.

• How long should the waiting or elimination period be before monthly benefits
commence and how long should the benefit period be? Matthew must consider how
soon after any disability begins he would need to replace his earned income and how
long he would need to receive monthly income benefits.
• Who will own the policy and who will receive the policy benefits? This is for Matthew
and his company to decide. It may be appropriate for the company to own the policy and
be the recipient of the monthly income benefits. The income could then be applied to the
business, and a portion could be paid to Matthew for his personal needs. It might also be
worth considering two policies, one owned by the company and another owned by
Matthew to meet his personal requirements.
Since Matthew is a principal in the business, he may want to consider applying for a
Business Overhead Insurance plan as well. The plan will reimburse the business for
qualifying monthly business expenses if Matthew is disabled.
Matthew is young and healthy, and has no apparent family history of serious medical problems.
So, it might be premature to consider Critical Illness insurance or Long-Term Care insurance.



As for accident and sickness insurance, Matthew and his employees are covered under a provincial
health insurance plan. Matthew did not mention if he and his employees had an extended health care
plan in place. He might want to consider such a plan for all of the company employees.

Example 3: Employee Near Retirement Concerned About Meeting Costs of Critical Illness and
Long-term Care
Hello, my name is Earl E. Retirement. I work for Matthew Macro’s company and he
suggested that I talk to you about my own insurance needs.

I am 55 years old and I have the resources to retire this year. I have worked for Matthew for the
last five years. Before that I worked for a large software company for 30 years and I have
earned a substantial pension. I established a life insurance program when I was in my early
thirties and I feel that my estate plan is in good shape in the event of my death.

I am married and my wife and I recently celebrated 30 years of marriage. We have two
children who are pursuing their careers in another part of the country. My wife and I plan to
travel extensively, at least in the first few years of our retirement.

We hear stories of couples who have encountered serious financial problems because one or both of them
became seriously ill and all of their financial resources have been exhausted because of the cost of special
health care. My wife and I would like to see you to discuss how we can avoid these kinds of problems.

How would you respond to Earl and what type of coverage would you recommend?
Although you will need to spend time with Earl and his wife to assess their long-term
needs, based on the information that Earl has provided so far, you may be able to make
some assumptions about the kinds of insurance plans that may be appropriate.
Earl has indicated that his retirement needs and his life insurance needs have been
addressed. He and his wife are entering their “golden years” and will probably enjoy a
comfortable lifestyle, as long as they both remain reasonably healthy. Provincial medical
insurance will help them address the less serious health problems attendant with aging. But
what would happen if one or both of them contracted a serious illness?
You may want to suggest that Earl and his wife consider a variety of different ways to
address this problem.
Critical illness insurance is a possibility. With this insurance in place, if Earl and/or his wife
were to suffer a critical illness as defined in the policy, they would receive a lump sum
amount of insurance. For example, if Earl contracted a form of cancer, one of the critical
illnesses covered under a typical CI policy, he would receive the insurance benefit upon
satisfying any waiting period. Earl and his wife could decide how to spend the insurance
amount. The funds could be used to finance a special form of treatment not covered under
the provincial health insurance plan; or, the couple might decide to spend the money on
travel or to realize other personal plans, particularly if Earl’s life expectancy is uncertain.
The couple might also consider long-term care insurance plans. If they are currently healthy and likely
to survive to old age, they could set up long-term care insurance plans today in anticipation of the
personal health care they might need as they approach the end of life. If Earl were to suffer a
debilitating stroke in his later years and become unable to care for himself, for example, his wife and
family would have to provide the personal care that Earl would require or find the financial resources
to have someone else provide that care, either at home or in a medical facility. If Earl lived for several
years in a condition that made it impossible for him to care for himself, the cost



of his personal and medical care could drain the family’s resources. Long-term care
insurance would provide a monthly benefit to defray the cost of such care.
Finally, if Earl and his wife plan to travel extensively outside Canada, they might also consider
travel medical insurance. Provincial health insurance plans limit the amounts payable for hospital
care and medical treatment. If Earl or his wife were to suffer an injury or illness while travelling
abroad, the local cost of medical care might significantly exceed the limits of the provincial
health insurance coverage and begin to deplete the couple’s financial resources.


Chapter 4

Group Insurance Products


Group Insurance Products


Group Insurance
• Definitions
• Individual vs. Group Insurance Products
• Contributory and Non-Contributory Plan
• Deductible and Co-Insurance
• Group Insurance Eligibility Requirement Terms
• Methods for Determining Premiums
• Refund Accounting, Non-Refund Accounting, and Administrative Services Only (ASO)
• Coordination of Benefits Guidelines
• The Agent’s Role in Marketing Group Insurance
Group Life Insurance
• Types of Coverage under a Group Life Insurance Plan
• Key Group Life Insurance Policy Provisions
• Tax Treatment of Group Life Insurance
• Basic AD&D and Voluntary AD&D Plans
• Creditor’s Group Insurance

Group Disability
• Short-Term and Long-Term Income Replacement Plans
• The Use of an Elimination Period in Pricing Group Disability Plans
• Features and Coverage of a Group Disability Plan
• Short-Term Disability Plans and Employment Insurance
• Employee-Paid Premiums for Group Long-Term Disability Plans
• Coordination of Benefits and Subrogation on a Group Disability Insurance Policy
Group Accident And Sickness Insurance And Extended Health Plans
• Medical Services Covered by Provinces and Territories
• Medical Services Included in Employer-Sponsored Plans
• Deductibles and Co-Insurance
• Limitations and Exclusions in Employer-Sponsored Group A&S and Extended Health Plans
• Group Dental Plans
• Employee Assistance Program



Group insurance or a group insurance plan is one under which a group policyholder provides
insurance, such as life insurance, disability insurance, or accident and sickness insurance, for the
members of that group. Group plans can also be established to provide members with benefits such as
Employee Assistance Programs or pre-paid legal services.
In this chapter you will learn about the generic features of group insurance before moving on to the unique
features of group insurance in life, disability and accident and sickness products.


After reading this section, you should be able to:

• define the following: group insurance, member, group policyholder, waiver of premium benefit,
disability income benefit;
• compare and contrast individual and group insurance products;
• distinguish between a contributory and non-contributory plan;
• explain the terms “deductible” and “co-insurance” and how they affect benefit payments;
• distinguish among the following group insurance eligibility requirement terms: actively-at-work
provision, probationary period, eligibility period, and waiting period;
• explain the relationship of credibility to the choice of manual rating, experience rating, and blended
rating methods;
• explain the features of non-refund accounting, refund accounting, and administrative services
only (ASO);
• explain the Coordination of Benefits guidelines developed by the Canadian Life and Health Insurance
Association (CLHIA);
• determine how a primary and secondary carrier would coordinate benefits;
• discuss the agent’s role in marketing group insurance.


The essential ingredient of any group insurance program is that an organization contracts with an insurer
for insurance coverage on the lives of the organization’s members. In most cases, the organization is a
company and, as an employer, contracts for insurance benefits on behalf of its employees. Groups may
also consist of multi-employer groups covering employees who are members of a union whose
membership spans many companies. Trustees who administer these group plans on behalf of members are
typically union members.

Associations can also apply for and establish group insurance plans on behalf of their
members. They can be an association of employers such as the Canadian Automobile Dealers
Association, or a professional association of individuals such as the Canadian Bar
Some creditor groups may arrange group insurance between an insurance company and a
lender, whose borrowers are insured under the group arrangement.

A member is an individual who belongs to a group. For group insurance purposes, a
member is someone who, because of his or her relationship to the insured group, is entitled
to participate in the group insurance program. The member may be an employee, a union
member, a member of an association, or a creditor.
To qualify for group insurance, a member and the organization to which he or she
belongs cannot have established the relationship solely for the purpose of establishing a
group insurance plan. For example, a member of the Canadian Bar Association
participates because of his or her status as a lawyer and not in order to take advantage of
a group insurance plan offered through the Association.

The group policyholder is the organization that contracts with an insurance company to
provide group insurance benefits to its members. In any group insurance arrangement, the
insurance contract is between the entity that represents the group members (an employer
or an association, for example) and the insurance company.


Under the waiver of premium benefit, premiums that fall due while an insured person is
disabled are waived by the insurer. This also applies to premiums paid by the employer or
the employee for the group insurance plan that offers the waiver of premium benefit.
The waiver of premium benefit is available for life insurance coverage and for long-term
disability coverage.
Under this provision, the insurance plan is continued while the insured person remains
disabled. The waiver of premium benefit terminates when the insured recovers from his or
her disability or when the period of coverage ends, whichever comes first.
To qualify for the waiver of premium benefit, the insured must be totally disabled. In some
plans, total disability is defined as the inability to be gainfully employed in any occupation for
which the employee is qualified because of education, training or experience. Some group plans
define total disability as the inability to perform the insured’s own occupation for the first 24
months of disability and any gainful occupation after 24 months, while the insured continues to
be disabled.


Group insurance disability benefits may be classified as short-term or long-term.
Short-term benefits commence almost immediately once the member becomes disabled
and continue for only a short time. Short-term disability plans can be issued in conjunction
with Employment Insurance benefits. If the short-term plan is properly registered with

Canada, it can reduce the premium requirements for EI. The benefit is stipulated as a percentage of the
disabled person’s earned income.
Long-term disability plans (LTDs) generally commence after a significant period of disability (such
as 180 days). For LTDs, the benefit is based on the disabled member’s monthly earnings, perhaps
60%, up to a maximum such as $5,000 a month.
Disability payments under an LTD plan can continue until age 65, assuming that the insured
member remains disabled under the provisions of the plan.

Individual vs. Group Insurance Products

Life, disability, and accident and sickness products provided under group plans are similar to individual
insurance products, in that they pay a specific benefit upon the happening of the insured event, such as
the death of the person covered under the plan, the onset of a disability, or the need for medical care as
the result of an illness or injury.
Individual and group products, however, have a number of important differences.

Individual contracts are negotiated between the policy owner (who is often the person insured) and the
insurance company. The contract defines the rights and obligations of the policy owner, the insured, and
the insurer. Group contracts are negotiated between a group policyholder (usually an employer) and an
insurance company. The coverage is provided for the benefit of persons insured under the group plan,
usually employees of the group policyholder.
The rights of an insured person under the terms of the group contract may include:
• the right to appoint or change a beneficiary of a life insurance benefit;
• the right to convert the group coverage to individual coverage if the insured person leaves the
organization that holds the group contract, or if the group contract terminates.


An individual insurance policy is issued only after the insurer has had the opportunity to confirm that
the individual who has applied for insurance coverage is an acceptable risk. Group insurance contracts
are issued once the group underwriter is satisfied that the members of the group who will be insured
under the group plan fit an acceptable risk profile.
The coverage available under the group plan is not negotiated with each member of the insured group.
Instead, the insurer and the group policyholder negotiate methods of determining the amount of coverage
available to each insured person. For life or disability insurance, the amount may be a percentage of the
individual’s salary. In both cases, the coverage may differ among different classes of employees within the
group policyholder’s organization. For example, the coverage limits may be higher for managers than for
clerical workers.
For group insurance contracts, the insurer usually does not require evidence of insurability for any of the
insured persons, unless it is a small group, or unless a member joins after the eligibility period expires.
This is the period during which a member of the group can apply for coverage, and sign an authorization for
payroll deduction of the insurance premiums (if it is a contributory group plan). The insurer will consider the
mortality (risk of death) or morbidity (risk of

disability) expectations for the insured group as a whole and set premium rates accordingly. A
group insurance plan that insures factory workers represents a higher level of risk than a group
of clerical workers. A group plan that insures a mix of blue-collar and white-collar workers
requires another risk profile that the insurer will assess to establish coverage levels and
premium rates.

Although the premiums for individual insurance contracts are predetermined by the applicant’s
age and risk classification, group insurance premiums are calculated based on the make-up of
the members of each group and on any previous claims from the group to be insured.
Unlike individual insurance plans, in which the insurer cannot increase the premium during the
term of the contract, each group insurance contract is revised and the premium is recalculated when
the coverage is renewed each year. The insurer considers the group’s claims for the previous year
and any change in the composition of the group when offering to renew the group coverage.

The group insurance contract stipulates the rights and obligations of the group
policyholder and the insurer. The provisions usually include:
• the policyholder’s obligations to pay the premium within the grace period provided;
• the methods of determining the premium requirements;
• the policyholder’s obligations to notify the insurer about new members covered by the plan;
• in some cases, the policyholder’s obligations in administering the plan;
• an incontestability provision that allows the insurer to contest the validity of a group
insurance policy for a period of two years after the contract has been issued;
• when and how the group policyholder or the insurer can terminate coverage under the
group plan.
Persons insured under the group plan are entitled to information about the nature of the
coverage and their rights under the plan. Usually the group policyholder or the insurer
prepares a booklet that describes the coverage and the method of determining the amount of
coverage for each member of the group under the plan. The booklet also describes the
insured’s rights under the plan, such as the right to appoint a beneficiary or the right to
convert the coverage upon leaving the company.


A person insured under a group plan may not be required to pay any premiums for the
coverage. The employer may pay all of the group premiums for the insured members. The
insured member may apply for optional coverage available under the plan, such as
coverage for a spouse or dependants.
When an individual joins a group that is covered by group insurance, he or she may have
to satisfy a probationary period before becoming insured. Under group insurance, the
insured has access to the insurance coverage only because of his or her status as a
member of the group that holds the policy contract.

Contributory and Non-Contributory Plan
A contributory group plan requires the employee or group member to pay some or all of the
premium for coverage. In most groups that offer a combination of life, disability, and accident and
sickness benefits, the group policyholder pays the premiums for part of the coverage, such as life
insurance, and the insured members pay for disability coverage. Alternatively, the group
policyholder pays the premium for basic coverage and the insured may apply for extended coverage
for himself or herself or for family members.
A non-contributory plan is one under which the group policyholder pays the entire premium for the
group coverage. For non-contributory plans, group insurers require full participation by all eligible
employees in the group, in order to avoid confusion about entitlement to benefits. For contributory
plans, the insurer will not insist on full participation, but will insist on a high participation level
(perhaps 75%) to make sure that the group’s mortality and morbidity profile includes a significant
cross-section of the group and not just those who present a sub-standard risk.

Deductible and Co-Insurance

A deductible and co-insurance provision generally applies to group insurance under which the insured
person is reimbursed for medical or dental treatment covered under the group plan. A deductible is a
dollar amount that the insured must pay before the plan will reimburse the insured for the
covered expense. For example, the insured may be required to pay the first $300 of any covered
medical treatment during the calendar year; the insurer will reimburse the group plan member for any
additional costs.
Co-insurance limits the amount that the insurer will reimburse the insured to a percentage of the
actual health care cost.
For example, Fred has been billed $1,000 for medical costs that are insured under his group plan. His
insurer has a calendar year deductible of $300. Therefore, Fred must pay $300 and submit a claim for
the remaining $700. If the insurer also has a co-insurance provision under which it is required to
reimburse only 80% of the cost, Fred will be reimbursed for $560, that is, 80% of the $700.

Group Insurance Eligibility Requirement Terms

When a group plan is first established and from time to time thereafter, the group policyholder and
insurer may hold an enrolment drive to register group members for the coverage. The purpose is to
make sure that the insured group is large enough to provide a satisfactory mortality and morbidity
Under the terms of the enrolment drive, individuals who apply for coverage will be insured
immediately if they satisfy one important criterion: they must be actively-at-work. That means, to be
eligible for the coverage, the employee must be working on a regular basis and not away ill or on
leave. An employee who does not satisfy the “actively-at-work” requirement becomes eligible for
coverage once he or she returns to work on a full-time basis. Enrolment periods are limited; after the
end of the enrolment period, new registrants for coverage are not eligible for coverage immediately.
If the group policyholder is not holding an enrolment drive, new employees or new members of the
group being insured must satisfy a probationary period before they qualify for coverage.

This is the time that a new group member must wait before becoming eligible to enroll in the group
insurance plan.

For non-contributory plans, once the member has satisfied the probationary period, he or she is
entitled to coverage under the plan.
For contributory plans, the probationary period is followed by an eligibility period
(usually 30 days), during which a member of the group can apply for coverage and sign
an authorization for payroll deduction of the insurance premiums. If an eligible member
chooses not to apply for coverage during the eligibility period, he or she may apply later,
but will be required to submit evidence of insurability and be approved for coverage.
A waiting period is the period of time that a covered member must wait before being entitled
to receive benefits under the coverage. This restriction applies primarily to disability income
plans that pay the disabled insured a monthly income, once he or she has been disabled for a
certain period. The waiting period is described in Chapter 3 on disability insurance products.
The concept of group insurance is based on five fundamental principles. Without
adhering to these five principles, group insurance would not be a viable product for the
insurer to offer because of the uncertainty of the risks involved, or it would be much more
expensive for the employer to provide. The five fundamental principles of group insurance

1. Each employee in the group must be actively at work on a full-time basis. The rationale
for this first and most important principle is that an individual who can work full-time is
likely to be in reasonable health. While all employees may not be in good health, as a group,
they will exhibit a level of mortality or morbidity lower than the population as a whole.
Therefore, all eligible employees can be insured under the plan regardless of their health.

2. The employee cannot determine the amount of their coverage. This principle prevents the
employee from selecting coverage at the expense of the plan. The amount of insurance is
determined according to the schedule in the master policy. For example, the schedule may
illustrate that the amount of coverage an employee would be eligible for would depend on
whether they were a factory worker, clerical staff or management staff.

3. Employee contributions must be made through payroll deduction. The employer then
remits a single sum each month to the insurer. This principle also helps address the
“actively at work” requirement.
4. There must be an employer contribution. Often, the employer pays a minimum of 50%
of the plan cost. The employer contribution reduces the cost to the employees, and
thereby increases participation rates. This serves to spread the risk more broadly.
5. There must be a spread of risk. There must be both a sufficient number of lives in the
group as well as a sufficient percentage of employees who participate in the plan.
Wherever there is a deviation from any of these five principles, there should be a
compensating element. For example, where the group is small (i.e. less than 25 lives) and
the spreading of risk principle is not met, evidence of good health may be requested
individually from each employee wishing to join the group.
Brar Manufacturing is a relatively small 15-year-old business based in Brampton, Ontario that makes
precision parts used in mining excavators. Its customers are a handful of large mining machinery
manufacturers. The President is Mr. Sunny Brar and he has been requested (repeatedly

over the last few years) to set up a group insurance and benefits plan by the employees of Brar
Manufacturing; he is finally looking into setting one up. The firm is non-unionized and the
employees are paid competitive wages and salaries.
Here are some features of the group of 30 employees:
• 20 employees are under 35 years of age; 5 employees are between 40 and 45, and the other 5 employees
are between 50 and 55 years old.
• 25 employees work in the plant, four are in sales and on-site service, and one runs the office. All
employees are permanent full-time employees.
• All employees are male, except for the one who manages the office and does the bookkeeping and
payroll. Mr. Brar has already told her that if a group plan is set up, she will be collecting employee
contributions through payroll deduction.
• One employee is currently on long term disability, having injured his back on the job, but he is expected
to return to work shortly after a successful recovery and rehabilitation.

• The five employees over 50 years of age have been with Mr. Brar from the early days of the business;
they have requested Mr. Brar to be allowed to decide how much coverage they want, especially for
life insurance.
• Mr. Brar is a habitual penny pincher and does not want Brar Manufacturing to make any
contributions to the group plan; he is willing to offer a plan that his employees can join, provided
they agree to pay all the premiums.
Based on the information given above about Brar Manufacturing and the five fundamental
principles of group insurance, let us examine if this idea of Mr. Brar’s is going to become reality
and what accommodations may be needed to institute a group insurance plan at Brar
• The group fulfills the “actively at work” principle. Except for one employee who is currently on LTD
but is expected to return to work shortly, everyone else is actively at work on a full-time basis.
• Mr. Brar will have to inform the 5 employees who have been with his firm since the early days that
while they cannot choose the amount of coverage for themselves, the group can be set up such that these
5 employees could be put in a different class which would be provided with greater benefits. So, for
example, if other employees get life insurance coverage worth the amount of their annual earnings,
these 5 employees could get life insurance coverage worth 2 (or ever 3) times their annual earnings.

• Employee contributions will be made through payroll deduction at Brar Manufacturing and that
satisfies another fundamental principle of group insurance.
• Mr. Brar will have to loosen the purse strings because a group insurance plan cannot be set up at Brar
Manufacturing without an employer contribution. He may decide to pay a percentage of the premium
costs, say 50%, and let his employees pay the other 50%.
He could conceivably negotiate a reduction in their wages or salaries and give back those reductions in the
form of group premiums. But Brar Manufacturing, as the employer, must contribute to the cost of the group
insurance plan otherwise it cannot be set up.



• The group composition and size (i.e., 30 employees) is such that there is a good spread of risk with
the majority of employees being under the age of 35. The group insurer is likely to seek 100%
participation in the group plan by the employees of Brar Manufacturing; this would not be a problem
if Mr. Brar offers a fair and reasonable benefits package to his employees and agrees to pay at least
half the cost.
In conclusion then, it would be possible for Brar Manufacturing to set up a group insurance and
benefits plan for its employees once a few adjustments and accommodations are made.

Methods for Determining Premiums

The most important difference between group and individual insurance administration is the way that
premium rates are determined.
Insurance companies establish premium rates for individual products, including life, disability, and accident
and sickness plans using methods that were described in Chapters 2 and 3. For individual life insurance
policies, premiums are developed for every age; once a policy has been issued, the premium rate is guaranteed
to remain the same while the policy remains in force. (There are a few exceptions, such as annual renewable
term insurance and five-year convertible and renewable term insurance, for which premiums do change over
the life of the policy.)
For disability income policies, the premium rates for some plans, particularly those issued to those
employed in professional occupations such as doctors, executives, and lawyers, are
guaranteed not to increase while the policy remains in force. For other occupations, the premium rate for a
policy may increase at the insurer’s discretion. Any premium rate increases are applied to a particular class
of policy, that is, policies covering a certain class of risk.
Individual accident and sickness plans are closer in design to group insurance plans. The premiums
for medical expense plans may increase at the insurer’s discretion, depending on the claims and
expenses incurred by a particular class of policyholders.
The premiums for group insurance plans are calculated for each group based on the insurer’s
assessment of the group’s risk profile. A group insurer is likely to charge a higher premium for long-
term disability insurance for a group of factory workers than for a group of office workers. The group
insurer establishes a premium rate for group coverage in a group that is sufficient to pay all of the claims
that the group is likely to incur, along with the costs of administering the group plan. To make sure that
premium rates are adequate for claims and expenses, the group insurance company sets premiums for one
year at a time and recalculates the premium each year.

When a group insurer is asked to insure a group for the first time, the group insurer uses a manual rating
method to determine the first year premium rates for the insurance coverage issued to the group. Under
the manual rating method, the insurer compares the composition of the new group to similar groups it
has insured before in setting premium rates for the new group. The insurer may also rely on the
experience of other insurers for groups of a similar composition when establishing premium rates for a
new group.
Group insurers also use the manual rating method to establish initial and renewal premium rates for
small groups. In a small group, a few claims more or less during a single year could skew the statistics;
therefore, the claims experience in one year might be significantly different from that in the next or later

The danger for the group insurer in setting premiums for a small group is to rely on a particularly good
claims experience in one year to set the premium rates for the following year. If there is a higher than usual
number of claims the following year, the premiums will be too low. In this case, the experience for small
groups is not considered credible and the insurer has to rely on statistics compiled for other similar groups
to set adequate premium rates.
Take the case of Brar Manufacturing described earlier. Here is a relatively small group of 30 employees.
The business is looking at having its first-ever group insurance plan. So there is no prior history of claims
that a prospective group insurer can examine. In such a situation, the group insurer, in setting the premiums
for Brar Manufacturing, will look at its own experience in insuring similar sized groups with similar
composition in terms of gender and age, and also look at other factors such as type of business, geographic
location, etc. In the event that it cannot find anything relevant within its own client base, it may turn to
other group insurers in order to get proper information. For instance, if the group insurer finds in its
investigation that mining machinery manufacturing firms and their suppliers have relatively more LTD
claims than other manufacturers, then it can adjust the LTD premiums it quotes accordingly.

In contrast to manual rating, group insurers rely on experience rating to set renewal premiums for groups
that are large enough to provide reliable claims experience statistics. Because of the size and composition
of the group, the claims and expense amounts experienced in any one year can be expected to remain
within the same limits in the following year.
If the insurer is establishing the initial premium rates for a new group insurance plan for the group, it
can rely on its experience with other, similar groups, or the group insurance provided for the same
group by a different insurer.
Assume that a large company, such as Hudson’s Bay Co., is seeking quotes on its group insurance plan from
providers. Most companies, big and small, “shop” their group insurance plans
every few years so as to ensure that they are paying competitive premium rates and securing
comparable benefits for their employees. Obviously, HBC has had a long history of providing group
insurance to its employees. So a prospective insurer will go by the “experience” of HBC in quoting
premium rates. It can do so by relying on the previous experience of the HBC group in terms of claims
and in knowing that just because HBC switches insurers does not mean that its group claims
experience will radically change. The large size of the group ensures that there will not be dramatic
changes in the expenses incurred and claims made by HBC employees. In other words, HBC is likely
to have 100% credibility, i.e., the larger the group, the more predictable its potential claims would be.

Some groups are not large enough to demonstrate claims and expense statistics that are entirely
credible, but are large enough to display experience statistics that are partially credible. In these
cases, the insurer will use a blended rating method. That is, the insurer will consider the group’s
actual experience and the experience of other similar groups in setting initial and renewal premiums
for the group coverage. In short, the insurer will use both an experience and manual rating method to
arrive at a premium rate.

Refund Accounting, Non-Refund Accounting, and Administrative

Services Only (ASO)
Group insurance is a competitive business. Insurers must offer premium rates that are adequate to cover
claims and expenses, yet competitive with rates available through other group insurance companies.
Therefore, in establishing premium rates for each type of coverage within a group plan, the insurer and
the group policyholder may enter into an arrangement whereby the insurer refunds a portion of the
premium paid in the year if the group’s actual claims and expenses are lower than anticipated when the
premium rate for the year was established. If actual claims and expenses exceed the expected level, the
insurer does not request an additional premium for the year just concluded, but will factor in its losses in
setting the premium rate for the following year. This arrangement is known as refund accounting. The
amount refunded to the group policyholder is known as an experience refund or a dividend.
Group plans that do not use this approach are subject to non-refund accounting. The insurer sets
the premium rate for the year and, at the end of the year, retains any amount that exceeds the actual
claims and expenses. However, the insurer will most likely consider any favourable experience in
setting the renewal premium rate.
Instead of obtaining group insurance coverage for their employees through an insurance company, some
employers self-insure certain types of group benefits for their employees. This approach is most suitable
for large groups with reliable experience and an employer with the resources to fund the benefits payable
under the plan. For self-insured plans, employers may enter into administrative services only (ASO)
contracts with an insurance company or third-party administrator for a fee. Under the ASO contract, the
insurer or third-party administrator manages the plan on behalf of the employer by keeping track of those
eligible for the self-insured benefits and other services, such as confirming that the plan funding is
adequate to pay all of the benefits anticipated (actuarial services). Under an ASO arrangement, the
insurer has no responsibility to pay any benefits.

Coordination of Benefits Guidelines

An individual may be covered under more than one group benefits plan that pays for health care or dental
expenses. In most cases, the duplication occurs because two spouses are covered under separate group plans
for health care and/or dental care benefits. Sometimes two different employers cover the same individual,
because he or she has a full-time position with one employer and a part-time position with another. Since any
health or dental insurance plan is designed to reimburse the insured person for costs incurred in
receiving treatment, no insurer will allow an individual to be reimbursed for more than 100% of the
cost of any health or dental
treatment. Consequently, most group contracts contain a coordination of benefits clause that limits
the total benefit amount that will be paid for any one eligible expense to 100% of the cost. If an
individual is covered under more than one group plan, only one of the insurers will pay the bulk of
the claim. The other insurer may pay for any balance of the claim amount not paid by the primary
The Canadian Life and Health Insurance Association (CLHIA) is a non-profit organization that represents the
interests of life insurance companies. Through consultation with member insurance companies, CLHIA has
developed guidelines to standardize the manner in which insurance companies determine how claims are
coordinated between insurers when an individual is covered

by more than one insurer for the same benefits. The guidelines set criteria that determine which
insurer will be the primary payor and which will be the secondary payor.
The primary payor assesses the claim and pays benefits as though the claimant was insured under only
one plan. The secondary payor will pay the lesser of the following amounts:
• the amount that would be paid if it were the primary insurer; and
• 100% of the eligible expenses, less the benefit amount paid by the primary insurer.
The following guidelines are used to determine the primary and secondary payors:

1. Any group benefits plan that does not contain a coordination of benefits provision is always the first
2. The plan under which the claimant is covered as an employee is the first payor.
3. If the individual is covered under plans with different employers, the plan covering the group in which
the employee works full-time is the primary payor; the plan for the group in which the employee works
part-time is the secondary payor.
4. If a claimant is covered under his or her own and a spouse’s plan, the plan under which the
individual is covered as an employee is the primary payor; the plan under which the individual is
covered as a spouse is the secondary payor.
5. For dental accidents, health care plans that provide for accidental dental coverage pay first.
For claims for dependent children, the plan of the parent with the earlier birth date (month/day) in the
calendar year is the first payor. If both parents’ birthdays fall on the same month and day, the plan of the
parent whose first name begins with the earlier letter in the alphabet becomes the primary payor. If the
parents are separated or divorced, the plans pay in the following order:

• the plan of the parent with custody of the child;

• the plan of the spouse of the parent with custody of the child;
• the plan of the parent not having custody of the child;
• the plan of the spouse of the parent not having custody of the child.
If the guidelines do not satisfy a particular situation, then benefit payments are pro-rated between the
insurers according to the actual portion of the total amount that each insurer would have paid if it were
the only coverage provider.

Example 1: Coordination of Benefits – Prescription Drug Claim

Xenia is an employee of ABCL Company and is covered under a group Benefits plan at work. She is a regional call centre
manager and her job is highly stressful. Xenia’s husband, Trey, is an employee of
TRWO Inc. and is also covered under a group Benefits plan at work. He is an industrial engineer there. Both
are listed as dependants on each other’s plans.

ABCL’s plan has a deductible of $100 and an 80% co-insurance factor. TRWO’s plan has no deductible and a
70% co-insurance factor.

Xenia files a drug claim for $500 for ulcer medications prescribed by her gastroenterologist.

This is how Xenia’s claim will be handled:

ABCL’s plan is the primary payor and, as per the terms of that plan, Xenia will be paid $320 [$500
amount of claim - $100 deductible = $400 x 80% = $320].
Trey then submits the claim to TRWO’s group insurer, which is the secondary payor in this
situation. TRWO’s group insurer will pay the lesser of the following amounts:
i. the amount that would be paid if it were the primary payor, i.e., 70% of $500 = $350
ii. the eligible expenses, less the benefit amount paid by the primary payor, i.e., $500 -
$320 = $180
So, TRWO’s group insurer will pay $180 [the lesser of (i) and (ii)]
The drug expense of $500 initially incurred by Xenia will be reimbursed fully:
$320 by the primary payor and $180 by the secondary payor
It should be noted that this is not always the result that transpires. There can be situations where a claim
even after being submitted to two insurers (primary and secondary) is not reimbursed in full. This happens
because of different deductibles, co-insurance factors, benefit maximums, etc.
Secondary payors are entitled to receive copies of the receipts confirming the actual cost incurred by
the individual and the first payor’s written explanation of its determination of the amount payable.

Example 2: Coordination of Benefits – Family Claims for Prescription Drugs, Dental and
Extended Medical Services
Fred and his wife Kathy are both employed full-time. Both are covered under a group benefi t plan through
their respective employers. James and Lisa, their children, are dependants covered under the plans. Fred’s
birthday is January 28 and Kathy’s birthday is April 7. Therefore, according to the coordination of Benefits
guidelines, Fred’s plan is considered the primary insurer for any health and dental costs incurred for the

Fred’s group benefit plan contains the following provisions:

• Dental coverage: the plan covers basic services and major restorative services, but not orthodontic
services. There is a calendar year deductible per family of $200 for dental treatments. The plan pays
80% of the balance of the cost of covered dental services during the year.
• Prescriptions: the plan has a calendar year $100 deductible per family. The plan pays 80% of the
balance of prescription costs for the year.
• Extended medical services: The plan pays for massage therapy treatments prescribed by a physician.
The plan has a limit of $300 for treatment for any one individual.
Kathy’s group benefit plan contains the following provisions:
• Dental coverage: the plan covers basic services, major restorative services, and orthodontic services. There
is no deductible. The plan pays 80% of the cost of covered dental services during the year, except for
orthodontic treatments, for which the plan pays 50% of the costs
• Prescriptions: The plan pays 100% of prescription costs.



• Extended medical services: The plan pays for massage therapy treatments prescribed by a physician.
The plan has a limit of $500 for treatment for any one individual.

Medical and dental charges for the family during the year are as follows:

Prescriptions for pain relief and relaxants for back problems $ 500.00
Dental care for a check-up and one filling $ 200.00
Massage therapy treatments $ 800.00

Prescription for antibiotic $ 50.00
Blood pressure medication $ 300.00
Prescription for antibiotic $ 50.00
Dental care for a check-up $ 94.00

Dental care: orthodontic services (braces) $ 700.00

Fred prepared and submitted the following claims to his group insurer:

Dental treatments:
Fred $ 200.00
James $ 94.00
Lisa $ 700.00
Total $ 994.00

His group insurer processed the claim as follows:

Total bill $ 994.00
Exclusions – Orthodontic care $ 700.00
Deductible $ 200.00
Net amount $ 94.00
Pay 80% - $94 × 80% $ 75.20

Fred $ 500.00
James $ 50.00
Total $ 550.00

His group insurer processed the claim as follows:

Total cost $ 550.00
Deductible $ 100.00
Net Amount $ 450.00
Pay 80% - $450 × 80% $ 360.00

Medical treatments:
Fred: Massage Therapy $ 800.00

His group insurer processed the claim as follows:

Total cost $ 800.00
Limit $ 300.00
Pay $ 300.00

Once Fred’s insurer processed the claims, the group claims area issued a payment
along with a statement that provided details concerning the deductions and exclusions
and the net amounts payable.

Kathy then submitted these documents, along with receipts and invoices, to her
group insurer. She also submitted her own claim for her prescriptions.

Dental care
Total costs for the family $ 994.00
Paid by Fred’s insurer $ 75.20
Kathy’s insurer processed the claim as follows:
Cost of basic dental services $ 294.00
It would pay the lesser of (i) and (ii):
(i) Amount paid if it were the primary payor –
$ 235.20
80% of $294
(ii) Eligible expenses less benefit amount paid by
$ 218.80
primary payor $294.00-$75.20
It would, therefore, pay $ 218.80
Cost of orthodontic services $ 700.00
It would pay the lesser of (i) and (ii):
(i) Amount paid if it were the primary payor –
$ 350.00
50% of $700
(ii) Eligible expenses less benefit amount paid by
primary payor $700 – 0 (primary payor $ 700.00
excluded orthodontic services)
It would, therefore, pay $ 350.00
Total payment made by Kathy’s insurer: $218.80 + $350.00 = $ 568.80

Prescription costs submitted to primary carrier $ 550.00
Primary carrier paid $ 360.00
Net submission $ 190.00
Kathy’s prescription costs $ 350.00
Total claims submitted $ 540.00
Kathy’s insurer paid 100% of the claim = $ 540.00

Medical treatment:
Kathy submitted a claim for Fred’s massage therapy treatments. Since his insurer had paid $300 of
the total $800 cost, Kathy’s insurer assessed the claim for the remaining $500. Since the maximum
amount payable for any individual was $500, Kathy’s insurer issued a payment for

Kathy’s insurer paid all of Kathy’s health insurance costs. There were no claims
submitted to Fred’s insurer for Kathy’s prescription costs.

The Agent’s Role in Marketing Group Insurance

For individual insurance sales, an agent works to find new clients and takes the client
through the needs analysis process. The culmination of this process is the completion of
an application or applications for insurance on the prospect. The applicant deals directly
with the agent in establishing an insurance program.
For group sales, the agent also prospects for new clients among employers who want to
establish a new group insurance plan for their employees or to revise an existing plan. The
process of establishing a group insurance plan is more complex than setting up a program of
individual insurance for one person or a family.
For group insurance programs, the agent helps a prospective client prepare a request for
proposal (RFP) that invites group insurers to bid on establishing a group plan. The bidding
insurers’ group sales representatives may participate in the discussions. The agent works
with the employer to compile pertinent information to give prospective insurers so that they
may assess the composition of the group, its claims experience under current or previous
group plans, and the types of group benefits that the employer is considering. The agent also
helps the employer distribute the RFP for bidding among prospective insurers.
Group sales representatives for group insurers respond to the employer’s RFP for a group
insurance program. The sales representatives’ role is to acquire enough information for the
insurer to make an accurate quote for group benefits, review proposed plans, and prepare and
present a group insurance proposal to the employer.
In other words, the agent is a generalist who helps the employer create and distribute the RFP to
interested insurers. The group sales representative plays a specialist’s role in compiling enough
information about the group to be insured to allow the group insurer to make a sound decision
to make a bid or decline to bid.
Once the bidding process is completed, the agent helps the employer assess the bids and choose
the insurer that offers the best program according to the criteria set by the employer with the
agent’s assistance. The criteria may include the best price, for example, but may also include
qualitative assessments of the insurer’s level of service or the insurer’s financial strength.
Once an insurer has been selected, the agent works with the group sales representative to
explain the provisions of the plan to the employees and enroll them into the plan. The agent
continues to work with the group sales representative to provide service and monitor the
group’s experience with a view to renewing the group plan every year.


After reading this section, you should be able to:
• define and explain the following types of group life insurance: term life, dependant
life, survivor income benefit, optional group life, accidental death and
dismemberment (AD&D);
• explain the key group life insurance policy provisions established under the CLHIA
Group Life Guidelines, including benefit amounts, beneficiary designation, conversion
privilege, misstatement of age, settlement options;
• describe the favourable tax treatment of group life insurance for both employer
and employee;
• compare Basic AD&D and Voluntary AD&D plans and how employees qualify for each;
• describe the exclusions usually included in basic accidental death and
dismemberment (AD&D) plans;
• describe the features, benefits, and administration of creditor’s group insurance.

Types of Coverage under a Group Life Insurance Plan

Term life insurance is the basic kind of life insurance offered to members of the insured
group. In many instances, the group policyholder pays the premium for all members of the
group, such as in an employer-sponsored group plan. The amount of insurance provided for
each member can be determined in a number of ways including:
• a schedule based on earnings: for example, an employee earning up to $50,000 may
be covered for $50,000 of insurance; one earning $100,000 or more may be covered
for an amount in excess of $200,000.
• a schedule based on position: for example, all salaried employees below executive level
might be entitled to coverage equal to 2 times earnings, while executives enjoy coverage
of 3 times earnings;
• a flat benefit schedule under which each member receives the same amount of coverage;
• a schedule of benefits based on years of service, in which employees with a longer
record of service are covered for higher amounts of insurance;
• a pension schedule in which the amount of life insurance is determined by the
member’s projected pension at retirement;
• a combination of factors such as earnings and position.
The premium rate is reviewed each year when the group plan is renewed and is adjusted
based on the group’s claim experience and the composition of the group. For example, the
premium may decrease when newer younger members join the group, or increase if the group
is made up of increasingly older members.


Dependant life insurance coverage is optional term insurance coverage offered to dependants
of a group member. It is paid for by the member on the lives of the member’s dependants.
A dependant is defined as:
• a member’s married or common-law spouse, or a partner of the same or
opposite sex who has been living with the member for at least 12 consecutive
• unmarried children, including adopted and stepchildren between the ages of 14
days and 21 years of age who depend solely on the member for financial support;
coverage for
dependants who are in full-time attendance at school or university continues until age
Some plans offer coverage to newborn children from the date of birth. Dependent children
insured under the plan, who become mentally or physically disabled, may continue to be
covered under the plan beyond the usual age limits, if they continue to be wholly dependent
on the member for support.


An optional life insurance program allows the group member to apply for additional life
insurance over and above the amount provided under the basic life insurance program for
the group. To be eligible for optional life insurance coverage, the member must already be
covered under the basic group life insurance plan. The benefit available may be based on
a multiple of salary or on units of $10,000 of insurance, for example. In both approaches,
the maximum benefit is limited, depending on the group plan provisions.
The process of issuing optional life insurance is different from that of basic life insurance.
For optional life insurance, the member chooses the amount of coverage. The applicant is
usually required to supply evidence of insurability. In most plans, the member pays the
entire premium for the benefit.
Evidence of insurability is usually required because without it, only individuals in poor
health would be likely to apply. Sometimes, a group insurer holds an open enrolment
period during which members may choose the optional life benefit without providing
evidence of insurability. This usually happens when a new group plan is established, and
the members have only a short period in which to sign up for the optional benefit.
If evidence of insurability is required, the insurer will include a suicide provision under
which payment of the death benefit will be refused if the insured commits suicide within two
years after the issue date of the coverage.


Accidental death and dismemberment (AD&D) insurance provides an insurance benefit if
the member dies or suffers a severe injury because of an accident.
Coverage may be issued on a full-time basis or on a non-occupational basis. Full-time
coverage means that the member is covered for accidents at any time. Non-occupational
coverage means that the member is covered only for accidents that occur while he or she is
away from the job. Non-occupational coverage is usually issued if the members of the group
are also insured through Workers’ Compensation.

If the insured dies from injuries caused by an accident, the death benefit is paid to a designated
beneficiary, usually in a lump sum. The provisions of the typical AD&D benefit stipulate that
death from an injury must occur within a certain period, usually 365 days following the accident,
because as time passes, it becomes more difficult to ascertain that death was caused directly by
the injuries suffered in an accident or from some other cause. Consequently, if an insured survives
365 days after an accident and then dies, no benefit will be paid under the AD&D coverage.
The dismemberment benefit is paid to the insured member. The benefit is paid for the loss
of, or the loss of the use of, a part of the body. For example, the full benefit is paid if the
insured loses both hands or both feet, or the use of both arms or both legs. A lesser amount is
payable if the insured loses one arm or one leg, or the use of one arm or one leg. The benefit
payable may be stipulated as a percentage of the principal sum insured.
AD&D coverage is usually automatically added to basic group life insurance. In many cases,
the AD&D amount is equal to the basic life insurance amount. The premium rate is a single
rate per thousand dollars of insurance that is applied to all members covered by the benefit.


Survivor income benefits provide a member’s survivors with a monthly income benefit in
addition to a lump sum death benefit under the basic life insurance coverage. A survivor is a
dependant, as defined for dependant life insurance. The benefit amount can be a flat amount
or a percentage of the member’s salary at the time of his or her death.

Key Group Life Insurance Policy Provisions

Employers and other organizations that negotiate group insurance plans on behalf of their
members consider costs and services as well as benefits when they select group insurance
plans. Since group plans are subject to annual renewal at premium rates that factor in the
group’s composition and claims experience, group policyholders may consider alternative
group insurers for more cost-effective products.
Since group plans can be replaced, the CLHIA, insurers, and regulators have established
guidelines to define and protect the rights and interests of group members who rely on this type
of insurance to address their life and health risks. The guidelines consider the following issues.

The guidelines require group policyholders to consider benefit amounts when one group
insurance plan is replaced by another. If a group policyholder decides to change insurers, the
guidelines ensure that a plan member of the original group who continues to be a member of
the plan does not lose any coverage or benefits because of the change in insurers. This is
particularly important if the member is receiving benefits under the original group and does
not satisfy the “actively-at-work” condition to qualify for coverage under the new group plan
at the time the change in insurers takes place.
Any member or member’s dependant who was insured under the original plan is entitled to
insurance under the new plan, as long as he or she is eligible for insurance under the new plan. A
particular class of member that was covered under the original plan might not be included in the
negotiations for the new plan coverage. For example, a company might have maintained group
insurance by class for its factory workers and separately for its office staff. In negotiating a new

group plan, the employer might decide to cover each class under a different plan. Consequently,
the factory workers would not be entitled to coverage under the new plan that insures office staff.
If the new plan continues to cover the class of member covered under the original plan, the
member is entitled to coverage under the new plan equal to the lesser of the amount to which the
member is entitled under the new plan and the amount for which the member was insured under
the original plan. For example, if Joe was insured for $150,000 of basic group life insurance under
the original plan and the new plan offers insurance of $200,000 for Joe’s member class, then the
new insurer is obliged to insure Joe for only $150,000 under the guideline provisions.
If the insured member is disabled at the time the original contract is replaced, the guidelines
specify the original and new insurer’s responsibilities with respect to that member. If the
member became disabled under the original contract before it was replaced, the original
insurer must consider the claim, as long as it has received proper notice of the claim within
at least 180 days after the member became disabled.
The guidelines take a similar approach to waiver of premium claims. That is, the original
insurer is responsible for any waiver of premium claim for a disability that occurred while
the original contract was in force, as long as it received proper notice of claim within 180
days after the disability began. In addition, if the claimant dies because of the disability, the
original insurer is responsible for the death claim.
The continuance of all of a member’s coverage under the original plan is not guaranteed
under the replacing plan. The replacement contract can be negotiated on different terms from
those of the original contract. For example, the new insurer is entitled to ask for evidence of
insurability before providing coverage on any member. Some types of coverage, such as
dental coverage for orthodontic treatments, may not be available to the group members once
the replacing plan takes effect.
In summary, the guidelines are intended to make sure that members of the original plan
who would be entitled to coverage under the terms of the replacement plan as new
members must be included in the new plan coverage. If a member is disabled when the
replacement plan takes effect, he or she must not be excluded from coverage, simply
because he or she is not actively at work.

Under an individual life insurance plan, the policyholder has the right to appoint a
beneficiary or to change the beneficiary designation. The policyholder of a group insurance
contract is usually an employer who has acquired a group plan on behalf of its employees.
The regulations affecting group life insurance give the insured employee the right to
designate a beneficiary for the benefits payable upon the insured employee’s death.
Some group insurance benefits restrict the beneficiary designation. For example, if the employee
takes out life insurance coverage on the life of his or her spouse or dependent children, the
employee is the beneficiary. For survivor benefits that become payable on the death of the insured
member, the member’s spouse or dependent children are the beneficiaries.

When an insured member’s group life insurance coverage terminates because he or she stops being a
member of the insured group, the group contract allows that person to convert the group life insurance
coverage to an individual life insurance plan without having to provide evidence of insurability. The
conversion privilege allows the insured to apply for an amount of individual life insurance equal to the
amount of the insured’s group coverage, up to a maximum of $200,000. The premium rate for the
individual plan is based on the insured’s attained age on the date of the conversion.
The insurer is required to offer at least a term insurance plan with premiums renewable annually or a
level premium term to age 65. However, insurers may choose to allow the individual to covert to any
other type of individual life insurance plan that it normally offers to individuals. For example, the insurer
may offer the insured member the opportunity to purchase a whole life insurance plan if it regularly
issues such a type of plan.
The insured has 31 days after his or her group coverage expires to exercise the conversion
The conversion privilege is also available when the group plan itself terminates. The amount available
under the conversion privilege is the amount of the group life coverage, less any amount of group
insurance that the insured becomes entitled to under any replacement group plan. The maximum amount
of life insurance available to be converted is $200,000.
For example, Alice was a member of XYZ Company’s group life insurance plan with Group Co. Insurance.
Under the schedule of benefits, she was entitled to $400,000 of basic group life
insurance. XYZ cancelled the plan and acquired a replacement plan with New Group Assurance. Under
the terms of the new group plan, Alice is covered for $300,000 of basic group life insurance. Alice can
therefore apply for individual life insurance coverage with Group Co. for up to $100,000. She has 31
days from the date the Group Co. plan terminates to apply for the individual coverage without having to
provide evidence of insurability.
Note: If the New Group plan provided Alice with only $150,000 of coverage, Alice would be able to
apply for only the maximum of $200,000 of individual life insurance with Group Co.
Group insurance plans usually allow coverage on the insured’s spouse to be converted in a similar

The provincial insurance acts require that if the life insured’s age has been misstated on an insurance
application, any benefits payable will be adjusted to provide for the amount of insurance that would be
payable to someone of the insured’s actual age for the amount of premium being paid under the plan.
There is a similar provision for certain types of group life insurance coverage, such as optional life
Under this coverage, the member can apply for additional group life insurance. The member must
provide satisfactory evidence of insurability and the premium payable is based on the member’s attained
age. If the member’s age has been misstated, the benefit amount is adjusted to the amount available to
people of the insured member’s actual age and the premium is adjusted to coincide with the premiums
payable for the benefit at the true age.

Some plans state that the benefit will be adjusted based on the amount of the premium that the
insured member has been paying. For example, Gary applied for $50,000 of optional life
insurance, stating his age as 40. He paid a premium of $200 per year. If his actual age when the
insurance was issued was 45, the insurer could adjust the plan in one of the following ways. It
could adjust the premium to the age 45 rate of $300 and charge Gary for the premium in
arrears, or it could reduce the benefit amount to a level that a $200 annual premium would
purchase for a 45-year-old male.

Like the options available to policyholders and beneficiaries under individual life insurance
policies, group life insurance plans allow an insured member or his or her beneficiaries to
receive the insurance benefit in some manner other than in a lump sum. These options may not
be specified in the group insurance contract, but insurance companies typically provide the
following alternative options for receiving life insurance proceeds:

• the death benefit can be left on deposit to earn interest;

• the death benefit can be paid out in instalments over a period of time;
• the death benefit can be paid out in equal instalments until the proceeds are exhausted;
• the death benefit can be paid out in the form of a life or term-certain annuity.

Tax Treatment of Group Life Insurance

The most important consideration in the taxation of group life insurance is the death benefit
paid to the beneficiary of a deceased member. The death benefit is tax-free to the
Under group life insurance plans for which an employer pays the premiums, the premiums
contributed during the tax year are tax-deductible for the year by the employer. On the other
hand, an employee who is insured under a group life insurance plan for which the employer
pays the premiums must report the premiums as a taxable employee benefit on his or her
income tax return.

Basic AD&D and Voluntary AD&D Plans

Basic AD&D insurance provides a death or disability benefit following an accident to an
insured member. Usually the benefit amount is equal to the benefit payable under the
member’s basic group life insurance.
Voluntary AD&D is similar to basic AD&D coverage. However, because it is optional, the
insured member usually pays the entire premium. The benefit usually provides coverage on
both an occupational and non-occupational basis (around-the-clock coverage).
An insured member can apply for any benefit amount up to a maximum. Since the benefit is
payable only in the event of an accident, no evidence of insurability is required.

Here is one illustration of AD&D benefits payable.

Description of Loss % of Principal Sum

Paralysis (Quadriplegia, Paraplegia, or Hemiplegia) 200%
Loss of Life 100%
Loss of Two Hands, Two Feet or Sight of Both Eyes 100%
Loss of One Hand or Foot and the Sight of One Eye 100%
Loss of One Hand, One Foot or Sight of One Eye 75%
Loss of One Arm or One Leg 75%
Loss of Thumb and Index Finger of the Same Hand 25%
Loss of Hearing in One Ear 25%


Most AD&D policies have the following exclusions:

• intentionally self-inflicted injuries, including those associated with suicide or

attempted suicide, whether the person is sane or insane;
• injuries sustained during a declared or undeclared war or any act of war;
• injuries sustained during full-time active duty in the armed forces of any
country or international authority;
• injuries sustained while flying as a pilot or crew member of an aircraft.
In addition, if a significant length of time elapses between the occurrence of the accident and
the death of the insured person, the death benefit may not be payable. The length of time is
generally 365 days after the accident.

Creditor’s Group Insurance

Creditor’s group insurance is an arrangement between a money-lending institution and an
insurance company to provide insurance on the life of the institution’s borrowing clients. The
insurance may be life insurance, disability insurance, or, in some cases, unemployment insurance
(to cover a situation in which a borrower cannot repay a debt because of unemployment).
The insured is the individual borrower who pays the entire premium for the coverage.
The beneficiary is the money-lending institution.
• For life insurance, the benefit is the amount of the insured’s outstanding debt to the
money-lending institution.
• Disability benefits take the form of payments to maintain a repayment schedule for
the loan. Once the insured recovers, he or she resumes full responsibility for
repayment of the outstanding debt.

• Benefits for unemployment are similar to disability benefits. A specific maximum

amount of benefit is stipulated for benefits resulting from unemployment.
Creditor’s group insurance is available for mortgages and other types of personal loans. The
lender, through an arrangement with an insurance company, offers its borrowers the
opportunity to purchase life, disability or unemployment insurance against the loan.
The Canadian Life and Health Insurance Association, in conjunction with the provincial
regulators and its member insurance companies, has developed guidelines for the
administration of creditor’s group insurance. These guidelines are intended to protect the
interests of borrowers. Under the guidelines, the borrower is entitled to the following written
information about the insurance coverage:

• a statement that the insurance is voluntary and is not required as part of the loan
approval process;
• a statement that the borrower has a period of at least 10 days after purchasing the
coverage to cancel the insurance and receive a full refund of the premium paid;
• all terms and conditions that might limit or exclude coverage;
• a statement that coverage is subject to acceptance by the insurer and specifying any
further steps the borrower must take to complete an application for creditor coverage;
• the insurer’s obligation to notify the borrower if the coverage is declined;
• the terms upon which the coverage is to commence if the application is accepted;
• instructions on how to contact the insurer to obtain further information or clarification
of any terms and conditions of the coverage.
When coverage is approved, the insurer must issue an insurance certificate that
provides the following information:
• the insurer’s name and head office in Canada and identification of the creditor’s
group contract;
• the borrower’s name;
• a description of the coverage, including the amount, duration, and conditions
concerning eligibility, exceptions, limitations, and restrictions;
• the premium for the coverage, or sufficient information to the borrower to calculate
the premium;
• the circumstances under which the insurance commences;
• the circumstances under which the insurance terminates;
• the procedures to be followed in making a claim;
• a statement that the benefits will be paid to the creditor to reduce or cancel the unpaid debt;
• a statement that the duration of the insurance is less than the term of the loan, or that
the amount of insurance is less than the loan amount, if that is the case;
• a contact for the borrower to call to receive more information about the provisions of
the coverage;
• information on how premium refunds are calculated and on how to apply for a refund.


After reading this section, you should be able to:
• compare the definitions of disability used by short-term income replacement plans and
long-term income replacement plans;
• describe the rationale for the use of elimination periods in pricing group disability plans;
• describe the features and coverage of a group disability plan and how the plan functions;
• describe the characteristics that a short-term disability plan must have to qualify for
registration under the Employment Insurance (EI) Act for premium reduction purposes;
• describe the advantages to employers of having a short-term disability plan registered
with Service Canada for premium reduction purposes;
• explain the rationale for having an employee pay the premiums for group long-
term disability (LTD) plans;
• explain the impact of coordination of benefits and subrogation on a group
disability insurance policy.

Short-Term and Long-Term Income Replacement Plans


Short-term income replacement plans usually define disability as the insured’s inability to
perform the duties of his or her own occupation. Some plans, however, define disability
as the inability to perform the duties of any occupation that the disabled person is able to
perform because of his or her education, training and experience.
Under the short-term income replacement plan, for disabilities caused by illness, payments
begin very soon (3 to 7 days after the onset of the illness). For disabilities caused by an
accident, payments usually begin on the first day of disability. Benefit payments are a
proportion of the disabled member’s earned income. Many plans base the benefit percentage
on the plan member’s length of employment.
For example, someone who has less than 6 months of service may be entitled to receive
66.6% of salary over the short term disability (STD) period, which may range from 15 weeks
to one year. Someone with more than one year of service might be entitled to 100% of salary
for six weeks and 66.6% of salary for the remaining coverage period.


Under long-term income replacement plans, disability is defined slightly differently. During the
first 24 months of disability, total disability is considered as the inability to perform the essential
duties of one’s own occupation. After 24 months of disability, total disability is considered as
the inability to perform the essential duties of any occupation for which the insured member is
qualified by reason of education, training, or experience. The disability benefit is calculated as a
percentage of earned income and can be 60% or higher, depending on the plan.

Example: Andrea is employed at Big Corporation as a tax accountant. She has been in the work force for
fi ve years, the last three with Big Co. As a full-time employee, she is entitled to all company group
Benefits, including short-term disability (STD) and long-term disability (LTD) Benefits.

The STD plan provides a benefi t equal to 66.6% of weekly salary. STD Benefits begin after 7
days for a disability caused by an illness. The benefi t begins immediately if the disability is the
result of an accident that requires hospitalization. STD Benefits are payable for up to 17 weeks.
The LTD plan offers 60% of pre-disability gross earnings. Benefits begin when the insured has
been continuously disabled for four months.

Andrea falls ill and is diagnosed with muscular dystrophy. The symptoms of the illness are acute
and leave her unable to fully control some of her major muscle groups. Under the terms of the
STD and LTD plans, Andrea is considered totally disabled. Muscular dystrophy has been known to
enter a remission stage and Andrea’s physicians are treating her to control the symptoms and
maintain her muscle strength as much as possible in the hope that her condition will improve.

Andrea was earning $60,000 a year at $2,307 every two weeks. Federal income tax is
withheld at a rate of 26% or $600 per pay period.

Big Co. pays the premium for the STD plan, so the benefit is taxable income to Andrea.
Andrea’s gross weekly salary is $1,153. During the STD period of 17 weeks, Andrea receives
66.6% of her gross weekly salary, or $770.

Andrea’s disability continues after the end of the STD period and the LTD Benefits begin. Andrea and
her physician hope that she can resume work on a part-time basis within a few months. In the
meantime, she is entitled to full Benefits under the LTD plan. She was paying the premium for the LTD
plan, so the income is tax-free. The plan pays Andrea a monthly benefit equals to 60% of her
gross earnings. Since her gross annual salary was $60,000, her monthly equivalent will be
$5,000. Her benefit will be 60% or $3,000.

After a few months, her symptoms abate and she feels well enough to resume her job on a
part-time basis. She is able to earn about one-half of her pre-disability salary. Her LTD plan
contains a partial disability benefit. Under this provision, the LTD Benefits do not end because
she has returned to work. Instead, the insurer considers the difference between the income she
is able to earn at this point, compared to the income she was earning before her disability.
Since Andrea is able to earn only a portion of her original salary, partial LTD Benefits continue
until she is able to return to the level of salary she earned before her disability.

Another four months go by; Andrea’s symptoms return and she is unable to work at all. Under
the terms of the LTD contract, Andrea’s current disability is considered a recurrence of her
original illness. She will not have to serve another waiting period before becoming eligible to
receive LTD payments. Her full LTD Benefits resume immediately.

The Use of an Elimination Period in Pricing Group Disability Plans

The elimination period in group insurance plans is also known as the qualifying period
or waiting period. This is the period after the onset of a disability that must pass before
benefit payments commence. For both short-term disability plans (STD) and long-term
disability plans (LTD), the elimination period affects the premium levels for the
In STD plans, the elimination period excludes claims for injuries or illnesses that last only a few
days. STD benefits usually have a seven-day waiting period for illnesses. For accidents that
require hospitalization, there may be no elimination period and benefits are payable from the
first day of disability. By eliminating claims for very short-term disabilities, the insurer saves
claim administration costs as well as claim costs.
For LTD plans, the longer the elimination period, the cheaper the premiums will be. An
LTD plan with a six-month waiting period will provide benefits for disabilities of a serious
long-term nature. Disabilities of less than six months can be covered under an STD plan.

Features and Coverage of a Group Disability Plan

A group disability plan replaces earned income when an employee becomes disabled for a
significant period of time. Group disability plans may offer short-term disability coverage as
well as long-term coverage.
Short-term disability (STD) plans may be used to offset Employment Insurance (EI)
premiums. The benefits begin once the insured has been disabled because of an illness or
injury for a short period of time (typically seven days for an illness and immediately for an
accident that requires hospitalization). Benefits are calculated as a percentage of salary,
usually 2/3 of weekly earnings. Benefits under STD plans are paid for periods ranging from
15 weeks to 12 months, depending on the plan.
For coverage purposes, disability is usually defined as the employee’s inability to
perform the duties of his or her regular occupation. Some plans may define disability as
the employee’s inability to perform any occupation for which he or she is qualified by
education, training or experience.
Long-term disability (LTD) plans are designed to complement STD plans and EI benefits.
Benefits under LTD plans commence after an elimination period of six months to a year and
can last up to age 65 (i.e., normal retirement age).
The definition of disability for most LTD plans has three distinct components.
1. During the first 24 months of disability, an insured person will be considered disabled
and entitled to LTD benefits if he or she is unable to perform the essential duties of his
or her occupation.
2. After 24 months of disability payments, the claimant will be considered disabled if he or
she is unable to perform the duties of any occupation for which he or she is qualified by
reason of education, training, or experience.
3. While the insured may be employed in an occupation and still meet the requirements
for a disability claim, the insurer will assume that the claimant is no longer disabled if
he or she is able to earn an income that is equal to or greater than the amount of the
monthly LTD benefit.

The LTD benefit is a percentage of pre-disability monthly earnings. Under plans for which the
employer pays the premium, the disability benefits are taxable to the claimant. These plans may
pay as much as 75% of pre-disability before-tax earnings. Depending on the employee’s tax
bracket, monthly benefits could represent 80% to 85% of pre-disability net after-tax earnings.
Many LTD plans place a cap on the amount of monthly benefit payable. So, for example, a
plan could pay 70% of gross monthly earnings to a maximum of $5,000 a month. A person
earning a salary of $8,000 a month would get an LTD benefit of $ 5,000 (not $5,600, which
is 70% of $8,000).
If the employee pays the premium, the monthly benefits are not taxable. The employer has no
financial responsibility in these circumstances. Consequently, the size of the monthly benefit
depends on the size and composition of the group, the type of work performed by the group,
and an affordable rate of premium. The monthly benefit cannot exceed the claimant’s pre-
disability net income. A non-taxable monthly benefit that equals or exceeds the claimant’s
pre-disability after-tax income is a disincentive to return to work. Most plans stipulate that
the LTD benefits plus income from all sources must not exceed a certain percentage (usually
80% to 85%) of the claimant’s pre-disability after-tax net income.
LTD plans usually state that the monthly disability benefit will be reduced by other benefits
that the claimant is entitled to receive because of his or her disability, such as:
• Workers’ Compensation;
• Canada/Quebec Pension Plan disability benefits;
• any provincial motor vehicle accident insurance benefits;
• any employer-sponsored salary continuance or short-term disability plan benefits
whose payment schedule coincides with the LTD payment schedule.
For example, Amelia earns a gross monthly income of $5,000. Her after-tax net income is
$3,500. Her LTD plan provides a benefit of 60% of pre-disability gross earnings, or $3,000
(which is slightly over 85% of her after-tax net income of $3,500). Although Amelia is
employed in a job sector that exempts her from participating in Workers’ Compensation, she
is entitled to CPP disability benefits if she qualifies.
Amelia suffers a disability that leaves her totally and permanently disabled. She is eligible
for benefits under her LTD plan as well as CPP. Under the terms of her LTD, her monthly
benefit of $3,000 will be reduced by her monthly CPP benefit of $1,010.23. Her LTD insurer
will pay her $3,000 – $1,010.23 or $1,989.77.
Some plans increase LTD payments over time by applying a cost of living adjustment (COLA) to
the monthly benefit calculated at the time the disability commenced. The adjustment is usually
based on any year-over-year increase in the Consumer Price Index, up to a stated maximum.
Many LTD plans provide for partial or residual disability benefit payments if the claimant
returns to work in his or her regular occupation, or one for which he or she is qualified, but
on a part-time basis. Under either partial or residual disability provisions, the benefit is
based on the reduction in earnings that an employee experiences because he or she cannot
work full-time and earn an income equal to his or her pre-disability earnings.
LTD plans usually include a recurrent disability provision, under which the qualifying
(elimination) period is waived when a disability recurs. For example, Fiona is covered under an
LTD plan with a 180-day waiting period. She is disabled for three months, returns to work for

25 days, and suffers the same disability again. She does not have to satisfy the qualifying period
again. Her current disability is considered to have started at the beginning of the first occurrence.
Once a qualifying period has been satisfied and a claimant begins to receive the LTD benefit,
if he recovers and returns to work and suffers a recurrence of the disability within 6 months,
he will not have to satisfy another qualifying period. His current period of disability will be
considered a continuation of the original period.

Short-Term Disability Plans and Employment Insurance

Employment Insurance benefits were described in Chapter 3 on Individual Disability and
Accident and Sickness Insurance. A brief summary of EI benefits for illness or injury follows.

Every employed person in Canada is required to contribute to the federal government’s

Employment Insurance program. In 2011, the amount required from each employee is
$1.78 per $100 of insurable earnings, to a maximum of $44,200 in insurable earnings. The
maximum annual employee contribution is $786.76. Employers are required to contribute
1.4 times the employee contribution rate, or $2.49 per $100 of insurable earnings. The
maximum annual employer contribution is $1,101.
The basic benefit rate is 55% of average insured earnings up to a maximum of $468 per week.
Employers who offer STD plans may qualify for a reduction in EI premiums, if they register their
plans with Service Canada. For an STD plan to qualify it must have the following characteristics:

• it must offer benefits that are at least equivalent to those that the EI program offers;
• employees who qualify under the STD plan must be covered under the plan within
three months of hiring;
• the waiting period to begin receiving benefits under the STD plan must not be longer
than 14 days;
• the benefits cannot be coordinated with EI benefits; that is, the STD plan must be the
first payor of benefits;
• coverage must be full-time; it cannot be just “on-the-job” coverage;
• the benefit must be payable for a minimum of 15 weeks.


Employers can establish an STD plan with benefits that they consider appropriate for their
employees. For example, an employer in an industry that competes for the services of
highly skilled employees may want to establish a better-than-average disability benefit
program, including an attractive STD plan. If the plan qualifies for registration with
Service Canada, the employer and the employees enjoy a reduction in the EI premium
rates that employer and employees would otherwise pay.
For a qualifying STD plan, the employer’s contribution can be reduced from 1.4 times the
employee rate to 1.180 times the employee rate. If the plan meets the standards, the employer
must demonstrate that employees covered by the plan will receive their portion of the reduction.
The amount to be passed on to the employees must be at least five-twelfths of the total reduction.

Here is an example. An employer’s standard rate per $100 of annual insurable earnings
is 1.4 times the employee rate or 1.4 $1.78 = $2.49. If the employer’s STD plan
qualifies, the employer multiple is reduced to 1.18 times or 1.18 $1.78 = $2.10. The
total employer reduction is $2.49 – $2.10 = $0.39.
The employee’s rate of contribution is reduced by 5/12 of $0.39, or $0.16. Given that the
amount of maximum insurable earnings on which contributions are based is $44,200, the
total employer reduction in EI contributions would be ($0.39 $44,200) ÷ 100 = $172.38.
The portion to be returned to the employee would be $172.38 5/12 = $71.83.

Employee-Paid Premiums for Group Long-Term Disability Plans

The advantage of an employee-pay-all LTD plan is the fact that benefit payments under the
plan are tax-free to a disabled employee. The employer and the insurance company can
negotiate a plan that pays the disabled employee a benefit based upon gross pre-disability
earnings. If the insurer stipulates that the benefit payable under the LTD plan cannot exceed
60% to 70% of the insured’s pre-disability gross earnings, it is easier to compare benefits on
a gross basis than to factor in the taxation of pre-disability gross earnings and post-disability
non-taxable benefits, for all employees covered under the group.
Because the employer is not obliged to pay premiums for the LTD plan, the employer and the
insurance company can offer fair disability benefits that are affordable to the insured employees.

Coordination of Benefits and Subrogation on a Group

Disability Insurance Policy
Coordination of benefit provisions and subrogation provisions are designed to control claim
costs (and consequently the premium costs for the plan) and to make sure that an insured
does not receive more in benefits than income earned before the onset of disability.
Most plans also stipulate that payments would be adjusted to ensure that payments from all
sources will not exceed 80% to 85% of the claimant’s pre-disability after-tax earnings.
To satisfy this requirement, insurers consider benefits from the programs identified above as
well as benefits from other group plans, disability income from CPP/QPP, and income from
any type of employment.
If an employee’s disability is caused by the actions of a third party and the disabled person receives
compensation from another source, the disabled employee must reimburse the LTD carrier
for any benefits paid under the plan. The amount reimbursed must equal the compensation
received from the other source or the amount paid under the LTD plan, if less. This is
known as subrogation.
Under the subrogation provision, an LTD insurer can also pursue an action against a third
party and his or her insurer and require that the LTD claimant participate in the suit fully,
including participation as a witness in any trial. Subrogation, therefore, permits an insurer to
“step into the shoes” of the party that it compensates and sue a party that the
injured/compensated party could have sued.

Example: Sunil, a computer scientist working for Alpha Corp., is driving to work one morning in early April.
The highways are slick with ice and rain and visibility is poor. Suddenly, out of nowhere, Sunil’s car is hit
by an out-of-control tractor trailer going well over the speed limit. Sunil is severely injured and is
considered totally disabled. Optima Life, Alpha Corp’s group insurance provider, begins paying Sunil
$6,000 a month under the LTD plan (once the elimination period of 6 months has ended). After conducting
its own investigation into the circumstances of Sunil’s accident, Optima Life sues Fortuna Insurance, the
insurance company that covered the owner of the tractor trailer that was involved in the accident. The case
goes to trial, Sunil appears as a key witness, the truck driver is ruled to be responsible for causing Sunil’s
injuries and Fortuna is ordered by the court to pay Sunil a lump sum of $50,000. Now, Optima Life has
made 15 payments (at $6,000 a month) to Sunil by the date of the court decision, i.e., $90,000. When
Sunil gets paid $50,000 by Fortuna, he, under the terms of the subrogation provision, would - in turn –
have to hand over that $50,000 payment to Optima Life.



After reading this section, you should be able to:
• explain the medical services generally covered by provinces and territories, including
hospital services, physician services, and surgical/dental services;
• describe the types of medical services usually included in employer-sponsored group
A&S plans;
• explain the rationale for including deductibles and co-insurance in employer-
sponsored group A&S plans;
• identify the limitations and exclusions usually mentioned in employer-sponsored
group A&S plans;
• describe a typical dental plan, including coverage and coordination of benefits;
• describe a typical extended health plan, including coverage and coordination of benefits;
• describe the primary features of a typical Employee Assistance Program.

Medical Services Covered by Provinces and Territories

Before explaining the services covered by employer-sponsored group insurance plans, it is
helpful to understand the services covered by government health programs.
Each province in Canada, in partnership with the federal government, covers certain medical
expenses for its residents. The federal government contributes funding to each province’s
health insurance plan, provided that the provincial health plans meet the following standards:

• Public administration: The program must be administered on a non-profit basis

by a public authority appointed by and accountable to the provincial government.

• Comprehensiveness: The program must cover all necessary medical, surgical-

dental, and other services provided in hospitals. In addition to these services, the
provinces are encouraged to provide certain extended health care services defined in
the Canada Health Act.
• Universality: 100% of the province’s legal residents must be entitled to insured
health services.
• Portability: Coverage must be portable from one province to another. The waiting
period for new residents must not exceed three months. Health services must also be
covered for Canadians who are temporarily absent from their own provinces. In such
cases, payment for services within Canada is made by the home province at rates
established by the host province; payments for services out of Canada are made at the
rates established by the home province.
• Accessibility: Insured services must be provided on uniform terms and conditions for
all residents. Reasonable access to insured services must not be impeded, either directly
or indirectly, by charges or other barriers. Reasonable compensation must be paid to
physicians and dentists and adequate payments made to hospitals for insured services.
Provincial government health insurance is mandatory. No person or group may opt out of
the provincial health care plan and contract with a private insurer for services covered by
provincial plans.
Although each province follows the standards set by the federal government, each
province sets different limits for the types of medical services covered by its health
insurance plan. The main services provided under provincial health insurance plans are
described below. Details are available from the health ministry in each province.

Essential hospital care services are covered. Provincial plans pay for all physician and
nursing care that an insured receives in hospital as well as prescription drugs and diagnostic
services done in hospital, such as laboratory tests and X-rays.
They pay for the cost of care in a hospital ward. Private insurance plans may pay the fees for
more expensive semi-private and private rooms.
Provincial plans also pay for any home care services or follow-up care at hospital ordered
by an attending physician.

Provincial health insurance plans pay for essential diagnostic and treatment services
provided by a physician. This includes home visits, services provided in hospitals, and
services provided at the physician’s offices.
Certain physician services are not covered by provincial plans. The physician may bill the
patient directly for uninsured services, such as transferring files to another physician, telephone
consultations, preparing certificates of fitness to work, filling out medical forms, conducting
physical examinations for schools or camps, and doing certain cosmetic procedures.

Provincial health insurance plans pay for some dental surgery done in hospital,
including fractures or medically necessary jaw reconstruction.

The following services may be covered by one or more provincial health insurance
plans, but coverage is not universal and may be subject to several restrictions:
• ambulance services;
• laboratory tests and X-rays;
• treatment by chiropractors, physiotherapists, podiatrists, naturopaths, osteopaths,
and optometrists;
• vision care;
• drug prescriptions, including a pharma care program exclusively for seniors (all
provinces provide this service);
• nursing care services;
• nursing home or chronic care;
• out-of-province or out-of-country coverage, within certain limits.

Medical Services Included in Employer-Sponsored Plans

Group insurance plans provide coverage for those hospital and medical services that
are not covered under provincial health insurance plans, including:
• the cost of a stay in hospital beyond the provincial health insurance limits;
• prescription drugs;
• private-duty nursing;
• paramedical services such as chiropractic and massage therapy;
• professional licensed ambulance services;
• out-of-country health care services;
• travel assistance in medical emergencies;
• vision care;
• hearing aids;
• accidental dental coverage;
• medical supplies and services.

Deductibles and Co-Insurance

A deductible is an amount that the insured must pay before the group insurer will begin
paying the cost of a medical service. For example, a drug plan may have a calendar year
deductible for the cost of prescriptions of $50. If a claimant pays for only one prescription
that costs $40, the drug plan pays nothing, but the annual deductible is reduced to $10. If,
later the same year, the insured pays for a prescription that costs $100, the deductible is
satisfied and the insurer will consider $90 for payment under the plan.

The drug plan may also have a co-insurance provision. Using the example above, if the plan
has a co-insurance feature under which it pays only 80% of a claim, only 80% or $72 of the
$90 claim will be reimbursed to the claimant.
Deductibles and co-insurance provisions are designed to reduce or prevent the casual use of
the group coverage for minor medical conditions and the administration of claims for small
amounts. These limitations allow an employer to share costs with the employees for some
medical services. Also, these cost containment initiatives help to keep claims costs under
control and keep premium rates affordable for the employer and the employee.

Limitations and Exclusions in Employer-Sponsored Group A&S

and Extended Health Plans
Each medical service covered under a group plan is subject to limits on the total amount
payable. Certain services are excluded from coverage.

Most group plans offer coverage for semi-private rooms in hospital. Although some plans
offer unlimited coverage for semi-private rooms, other plans may have a maximum daily
limit on the costs.
Convalescent hospital care (treatment and therapy/recovery and rehabilitation for a
specific medical condition) may be subject to a daily maximum and a limited number
of days of treatment.

Group plans provide reimbursement only for drugs that:
• are considered by a physician to be medically necessary;
• carry a drug identification number;
• have been dispensed by a registered pharmacist.
Since the cost of prescriptions represents the highest proportion of health care claims costs,
insurers and employers are taking specific steps to contain costs. These actions include:

• limiting the amount of coverage for the dispensing fee charged by the pharmacist for
filling a prescription; for example, if the pharmacist charges a dispensing fee of $12.00,
the drug plan may cover only $7.00;
• substituting generic equivalents for prescribed drugs that offer the same benefits as
brand-name drugs;
• specifying a list of drugs that are covered under the plan; new drugs that are not on the
list are not covered until the drug plan renewal is negotiated and coverage for a new
drug is added to the list.
Examples of drug products that are often excluded are vitamins, steroids, infertility drugs,
erectile dysfunction treatments, smoking cessation products, hair growth/restoration drugs
and weight-loss medications. However, some plans, particularly those for unionized
employees, cover some of these products as part of the enhanced benefits obtained through
the collective bargaining negotiation process.

Private-duty nursing is home care nursing recommended by a physician for a covered
employee who is not confined to hospital. Most plans pay a maximum amount based on a
yearly or lifetime maximum. The maximum amount of coverage may be limited to between
$5,000 and $25,000 a year.

Paramedical practitioners include, among others, physiotherapists, speech and massage therapists,
acupuncturists, chiropodists/podiatrists, osteopaths, psychologists, naturopaths and chiropractors.
Paramedical services are eligible for coverage under private group plans only after benefits for
these services have been exhausted under provincial health insurance plans. Some provincial
plans have discontinued coverage of certain paramedical services. For example, chiropractic
services are no longer covered under OHIP (Ontario Health Insurance Plan).
Covered benefits under many group plans are those considered medically necessary. Costs
may be limited to a maximum dollar amount for each visit, a specified number of visits, or a
maximum dollar amount annually for the class of practitioners as a whole or, more typically,
for each type of covered practitioner.

Private group plans may provide coverage for emergency health care services incurred
outside Canada. Many plans set limits on the coverage either on the amount payable for
any individual medical treatment or a maximum amount overall.

Travel assistance programs offer support and assistance to covered employees who suffer a
medical emergency while outside Canada. Benefits may include the costs required to return
to Canada for treatment or accommodations for family members in another country while the
afflicted person receives treatment in that country.
Limits may include maximum amounts for family meals and accommodation such as $150
per day. The cost of return to Canada of a deceased’s remains may be reimbursed to a
maximum amount such as $3,000.

Eyeglasses or contact lenses may be covered under the plan, with limits on the frequency
of new eyeglasses or lenses and on the amount spent. For example, for adult vision care,
coverage is limited to every 24 months and each covered item is subject to a maximum
dollar amount usually between $75 and $300.

Group plans usually impose a maximum benefit such as $500 for hearing aids and limit
repair and replacement costs to every five years.


Devices such as canes, walkers, respiratory equipment, or orthopedic equipment,
recommended by an attending physician may be covered by the plan. The amount of the
cost covered for any device or service may be limited. The kind of device that the plan will
cover may be limited as well. For example, if a walker is prescribed, the plan may cover the
cost of a basic walker, rather than one with special features.

Group contracts exclude coverage of certain costs including those:
• payable under Workers’ Compensation;
• incurred as the result of self-inflicted injury;
• incurred as the result of war, rebellion, or hostilities of any kind, whether or not the
insured person was a participant;
• incurred as the result of participation in a riot or civil disturbance;
• incurred as a result of committing a criminal offence or provoking an assault;
• incurred as part of cosmetic treatments.

Group Dental Plans

Dental plans typically offer services in three distinct categories: basic, major
restorative, and orthodontic.
Basic Services include:
• diagnostic procedures to evaluate an insured’s condition and determine treatment;
• X-rays and laboratory reports;
• preventive procedures such as teeth cleaning, fluoride application, oral hygiene instruction;
• dental surgery, including the removal of teeth;
• fillings;
• periodontal services to treat bone and gum problems;
• endodontic services to treat tooth roots and nerves;
• repairing dentures, crowns or bridgework.

Major Restorative Services include:

• procedures to restore tooth function using crowns, inlays, and onlays (metal or
porcelain casts placed on the surface of the tooth);
• prosthodontic services to replace missing teeth with dentures, bridgework, crowns,
and veneers.

Orthodontic Services include:

• preventing or correcting dental and oral irregularities and jaw defects with devices
such as wires, tooth bonding, braces, and space maintainers.

Group dental plans usually provide higher levels of coverage for basic services and lower
levels for major restorative services. Although every dental plan offers coverage for basic
services, not every plan covers major restorative or orthodontic services.
Typically, a dental plan pays for covered services based on the provincial Dental Association
Suggested Schedule of Fees for General Practitioners. The plan pays 80% to 100% for basic
services up to a calendar year maximum. If the plan covers major restorative or orthodontic
services, the limit may be 50%, with a calendar year maximum for major restorative services
and a lifetime maximum for orthodontic services. Maximum calendar year benefits for basic
and restorative services generally range from $1,000 to $2,000 a year. The lifetime maximum
for orthodontic services ranges from $1,000 to $3,000, depending on the plan.
If a member of a group dental plan is also covered under another employer’s plan, any
benefits payable will be considered by the primary insurer and any unpaid amounts will be
considered by the second carrier. Duplication of coverage usually occurs because an
individual has dental coverage under his or her own group dental plan and is also covered as
a dependant under his or her spouse’s plan. Treatment for dependent children, who are
covered under both spouses’ plans, will be reimbursed under only one plan as the primary
carrier, and any unpaid balance will be considered for payment under the second plan. An
example of the coordination of benefits was provided earlier in this chapter.

Employee Assistance Program

An employee assistance program (EAP) allows employees to take advantage of professional
counselling services to deal with personal problems. At the heart of every EAP program is
its confidentiality. Any employee who takes advantage of the services provided through an
EAP program is assured that no information will be made available to his or her employer
concerning the problem or the fact that the employee has requested any EAP service.
Programs vary from group to group. EAP services may include:
• crisis interventions such as telephone counselling services and self-help groups
such as Alcoholics Anonymous;
• outpatient services for treatment of alcohol or drug dependency, or professional
counselling for marital, family, or emotional problems;
• in-patient services for serious emotional or dependency problems in hospital, at home,
or in a shelter or halfway house.
EAPs are intended to reduce the cost of employee absenteeism and increase job effectiveness by
helping employees resolve family crises, chronic personal problems, or debilitating emotional
problems that compromise the employee’s ability to perform his or her job effectively.

In a sense, an EAP offers preventive maintenance to help an employee cope with or

overcome personal problems before they lead to dismissal or a long period of disability.
Chapter 5A

Investment Products



Investment Products


Overview of Investment Capital
• What Is Investment Capital
• The Role of Financial Intermediaries
• Regulatory Organizations
Brief Overview of Economics
• Economic Principles
• Economic Factors Affecting Security Prices
Security Selection and the Client
• Primary Investment Objectives
• Know Your Client Rule
Risk and Return
• Introduction
• The Risk/Return Trade-off
• Risk – “The Other Side of the Coin”
• Asset Allocation


Types of Securities Trading in Capital Markets
• Debt Securities
• Debt Security Risk
• Debt Security Terminology
• Types of Debt Securities
• Debt Security Pricing Principles
• Other Fixed-Income Products
• Preferred Shares
Common Shares
• Introduction
• Rights and Benefi ts of Common Share Ownership
• Tax Treatment of Common Shares
• Stock Market Indices
• Introduction
• Rights
• Warrants
• Options
• Futures and Forwards
Managed Products - Mutual Funds
• Introduction to Mutual Funds
• The Structure of a Mutual Fund
• Pricing of Mutual Funds Units or Shares
• Mutual Funds Fees
Redeeming Mutual Fund Units or Shares
• Calculation of the Redemption or Selling Price
• Tax Consequences
Mutual Fund Regulation, Types, Comparable Risks and Returns
• Self-Regulatory Organizations (SROs)
• Types of Mutual Funds
• Comparing Risk and Return of Different Types of Mutual Funds




Capital markets are essentially the “engine” of the Canadian economy. They provide a forum
that allows savers and users of capital to meet and transform savings into investments that
ultimately drive the growth of the country. In this chapter you will learn about different types
of investments including equities, debt securities, common and preferred shares, options and
managed products that help formalize this transfer of capital.


After reading this section, you should be able to:
• List the types of investment products available from insurance companies and other
financial institutions.
• Define what is meant by the power of compounded returns over time.
• List the major types of financial institutions.
• Define various types of investment returns: net versus gross

What Is Investment Capital

In general terms, capital is wealth – both real, material things such as land and buildings
and representational items such as money, stocks and bonds. All of these items have
economic value. Capital represents the savings of individuals, corporations, governments
and many other organizations and associations. It is in short supply and is arguably the
world’s most important commodity.
Capital savings are useless by themselves. Only when they are harnessed productively do
they gain economic significance. Such utilization may take the form of either direct or
indirect investment. Capital savings can be used directly by a couple investing their savings
in a home, a government investing in a new highway or hospital, or a domestic or foreign
company investing in a plant to produce a new product.
Capital savings can also be harnessed indirectly through the purchase of such
representational items as stocks or bonds or through the deposit of savings in a financial
institution. Indirect investment occurs when the saver buys the securities issued by
governments and corporations, which in turn use the funds for direct productive investment
in plant, equipment, etc. Such investment is normally made with the assistance of the retail
or institutional sales department of the advisor’s firm.
In the case of indirect investment through a financial intermediary or financial institution, the
individual, corporation or government may deposit funds in a savings account at a financial
institution. This is a non-contractual commitment because funds can be readily withdrawn



on short notice. Savings may also be deposited in contractual accounts such as pension or life
insurance plans where withdrawal is less easy or perhaps not permitted until a fixed future
date. In either case, the financial intermediary attempts, in the meantime, to reinvest the
deposited funds profitably until they must be paid back to the original saver. The institutional
sales department and the money market department of the advisor’s firm assist financial
intermediaries in profitably investing the pooled savings of their thousands of depositors.


What is a compounded return? Simply put, it’s getting a return on a return. Compounding
takes place when an investment, for example a premium savings account, gives the investor a
return on the original amount invested and on the interest already earned.
For example, say you deposit $10,000 into a premium savings account that provides a 5%
annual rate of return. Here’s what would happen:
At the end of the first year, there would be $10,500 in the account ($10,000 at 5% = $500).
At the end of the second year, there would be $11,025 ($10,000 + $500 interest earned in
the first year = $10,500 at 5% = $525).
If this savings account kept paying 5% a year on a compounded basis, at the end of 20
years, there would be $26,530. The original deposit of $10,000 would grow through the
power of compound returns to $26,530.
Advisors talk about a snowball rolling down a hill to visually portray the magic of compounded
returns (and for Canadians, with our harsh winters, that is a very easy visual to imagine). The
longer the hill (i.e., the investment time horizon), the more time the snowball spends rolling and
the more extra snow (i.e., investment returns) it accumulates along the way. And the steeper the
hill (i.e., the rate of return), the faster the snow can be collected on the way down. So instead
of 5% in the example above, if you invest $10,000 in something yielding 10% a year, then
the investment will “snowball” to an amazing $67,270 in 20 years - more than six times the
original investment.


Gross return indicates a return before anything is deducted. So, for example, if you invest
$1,000 in XYZ stock on January 1 and on July 1, upon sale, it is worth $1,100, then your
gross return is $100 or 10% during this six-month period. Net return, on the other hand, is the
rate of return on an investment after related expenses such as commissions and trading fees
have been deducted from the gross return. So, in the previous example, while gross return is
10%, if trading fees amounted to $60 (and assuming there are no other related expenses),
then the net return would be $100 - $60 = $40 or 4%. As such, an investor should pay greater
attention to net returns on an investment instead of gross returns.



The Role of Financial Intermediaries

In this section, we turn our attention to another of the key components of the financial
system, the intermediaries. The term “intermediary” is used to describe any organization
that facilitates the trading or movement of the financial instruments that transfer capital
between suppliers and users. Traditionally, banks and trust companies have concentrated
on gathering funds from suppliers/investors in the form of saving deposits or GICs and
transferring them to users/borrowers in the form of mortgages, car loans and other lending
instruments. Other intermediaries, such as insurance companies and pension funds, collect
premiums and contributions and then invest them in bonds, equities, real estate, etc. to
meet their customers’ needs for financial security.
Investment dealers, which also act as financial intermediaries, serve a number of functions -
sometimes acting on their clients’ behalf as agents in the transfer of instruments between
different investors and, at other times, acting as principal.
The Canadian financial services industry was characterized by what were known as the “four
pillars”: namely, banks, trust companies, insurance companies and investment firms. Each pillar
offered different products and services. For instance, insurance companies did not offer term
deposits and GICs while banks could not issue life insurance policies. In the 1980s and 1990s,
the pillars started to crumble and regulation was loosened up with the deliberate intention
of creating financial powerhouses that could compete not just within Canada but also in the
international sphere. Thus began a wave of consolidation, mergers and acquisitions that resulted
in the trust sector practically being absorbed by the big banks, and investment firms, like Wood
Gundy and Nesbitt Burns, also coming under the umbrella of the big banks. Life insurance
companies started offering all kinds of investment products, including GICs, while banks set up
insurance subsidiaries that could underwrite life insurance and automobile insurance. Mutual
funds are now available through numerous outlets including banks, insurance companies, credit
unions and wealth management companies like CI Funds and Mackenzie Financial Corporation.
Having said this, for purposes of classification, we could say that banks, trust companies and
securities/brokerage firms offer savings instruments including term deposits and GICs,
mutual funds, individual bonds and stocks and RRSPs, RRIFs, and other registered plans.
Securities firms tend to specialize in the more esoteric securities such as derivatives, options,
futures, etc. Life insurance companies offer universal life insurance products, annuities,
including deferred annuities (which are similar to savings instruments), and segregated funds
as well as RRSPs, RRIFs and other registered products. Only life insurers can issue life
annuities while term certain annuities – annuities that make payments over a specific (i.e.,
“certain”) period of time - can be issued by other financial institutions.
Investors’ confidence in Canadian financial institutions is high. It is based on a long record of
integrity and financial soundness reinforced by a legislative framework that provides close
supervision of their basic activities. It is not surprising that deposit-taking and savings
institutions have experienced strong growth in the past decade.
The expansion of chartered bank assets has been facilitated by several factors including:
• Increased international activity
• Changes in the Bank Act that permit banks to compete vigorously in new sectors of
the financial services industry



• The creation of more banks, notably the Schedule II and Schedule III banks. Schedule II
banks are foreign bank subsidiaries (e.g., ICICI Bank Canada) authorized under the Bank
Act to accept deposits, which may be eligible for deposit insurance provided by the Canada
Deposit Insurance Corporation. Foreign bank subsidiaries are controlled by eligible foreign
institutions. Schedule III banks are foreign bank branches (e.g., Rabobank Nederland-
Canada Branch) of foreign institutions that have been authorized under the Bank Act to do
banking business in Canada. These branches have certain restrictions.

Regulatory Organizations
In this portion of the chapter we will examine the regulatory role played by a federal
regulator, the provincial securities regulators, the Canadian Investor Protection Fund
(CIPF), and the various Self-Regulatory Organizations (SROs).


The Office of the Superintendent of Financial Institutions (OSFI) is responsible for
regulating and supervising banks, insurance, trust and loan companies, fraternal benefit
societies and co-operative credit associations that are chartered, licensed or registered by
the federal government. OSFI also supervises over 1,200 federally regulated pension plans.
It does not regulate the Canadian securities industry.
OSFI was established in 1987 by legislation that amalgamated the Department of Insurance and
the Office of the Inspector General of Banks and broadened the powers and responsibilities
related to supervising federally regulated financial institutions. OSFI’s enabling legislation
provided for a single regulatory body for all federally regulated financial institutions.
OSFI’s mandate is to:
• Supervise institutions and pension plans to determine whether they are in sound
financial condition and meeting minimum plan funding requirements respectively,
and are complying with their governing law and supervisory requirements;
• Promptly advise institutions and plans in the event there are material deficiencies and
take or require management, boards or plan administrators to take necessary corrective
measures expeditiously;
• Advance and administer a regulatory framework that promotes the adoption of policies
and procedures designed to control and manage risk;
• Monitor and evaluate system-wide or sectoral issues that may impact institutions negatively.

In Canada, the regulation of the securities industry is a provincial responsibility. Each
province is responsible for creating the legislation and regulation under which the industry
must operate. In several provinces, much of the day-to-day regulation is delegated to
Securities Commissions. In other provinces, securities administrators, who are appointed
by the province, take on the regulatory function.



The provincial regulators recognize that their task is a complicated one so they work with
the other regulators, such as the Canadian Investor Protection Fund (CIPF) and the self-
regulatory organizations (SROs) to maintain high standards.


The securities industry offers the investing public protection against loss due to the financial
failure of any of 200 investment dealers across Canada. To foster continuing confidence in the
firm-customer relationship, the industry created the Canadian Investor Protection Fund.
The assets of the Fund are contributed by the securities industry through regular assessments
paid by member firms based on their gross revenues and risk profile relative to their peers.
The Fund also has access to a substantial line of credit.
The CIPF Board sets the size of the fund to be maintained for the client assets it protects.
Since its inception in 1969, CIPF has made payments, net of recoveries, totaling $36 million
to eligible customers of 17 insolvent members.
All accounts of a customer are covered either as part of the customer’s general account or as a
separate account, to a maximum of $1 million. CIPF does not cover customers’ losses that result
from changing market values of their securities, unsuitable investments or the default of an issuer
of securities. More information about the CIPF is available at http://www.cipf.ca/homepage.aspx


The Canada Deposit Insurance Corporation (CDIC) is a federal Crown Corporation. It was
created in 1967 to provide deposit insurance and contribute to the stability of Canada’s
financial system. CDIC insures eligible deposits up to $100,000 per depositor in each
member institution (banks, trust companies and loan companies) and reimburses depositors
for the amount of any insured deposits if a member institution fails.
To be eligible for insurance, deposits must be in Canadian currency and payable in Canada.
Term deposits must be repayable no later than five years from the date of deposit. The
maximum amount includes all the insurable deposits with the same CDIC member. Deposits
at different branches of the same member institution are not insured separately.

Accounts and products insured by CDIC

• savings accounts and chequing accounts
• GICs and other term deposits that mature in 5 years or less
• money orders, certified cheques, travellers’ cheques and bank drafts issued by
CDIC members
• debentures issued by loan companies
Accounts and products must be held at a CDIC member institution and in Canadian dollars.

Accounts and products NOT insured by CDIC

• mutual funds and stocks
• GICs and other term deposits that mature in more than 5 years
• bonds



• Treasury bills
• Principal Protected Notes issued by corporations, including banks or other CDIC members
CDIC does NOT insure any accounts or products in U.S. dollars or other foreign currency.
CDIC does NOT insure any accounts or products held in banks or other institutions that
are NOT CDIC members.
CDIC insures up to $100,000 in each of the following categories.
• Savings held in one name
• Savings held in more than one name (joint deposits)
• Savings held in trust
• Savings held in an RRSP
• Savings held in a RRIF
• Savings held for paying realty taxes on mortgage payments
• Savings held in a Tax Free Savings Account (TFSA)
To date, CDIC has provided protection to depositors in 43 member institution failures. As
of October 2010, CDIC insured around $600 billion in deposits. More information about
the CDIC is available at http://www.cdic.ca/e/index.html.

A number of organizations within the securities industry are considered to be self-
regulatory organizations (SROs). These organizations include the Bourse de Montreal, the
Toronto Stock Exchange, the TSX Venture Exchange, the Investment Industry Regulatory
Organization of Canada (IIROC), and the Mutual Fund Dealers Association (MFDA). All
firms in the industry must belong to an SRO.
The exchanges’ role in regulation covers many areas including member regulation, listing
requirements and trading regulation. IIROC monitors member firms throughout Canada in
terms of both their capital adequacy and conduct of business. The qualifying and registering
process of these firms is also IIROC’s responsibility. The MFDA oversees the regulation of
the distribution side of the mutual funds industry (the funds themselves remain the
responsibility of the securities commissions).




After reading this section, you should be able to:
• List the major effects of economic activities on investments.
• List the effects of inflation on investments.

Economic Principles


The growth of the economy is measured by gross domestic product (GDP). GDP is the
value of all goods and services produced in a country in a year. The real GDP of the
Canadian economy grew on average at about 3.8% per year since 1961. This growth is not
uniform throughout the period as indicated in Figure 5.1.
Economic fluctuations present a recurring problem for policy makers as downturns in
economic growth are directly related to rising unemployment. Moreover, the real
investment sector accounts for the bulk of fluctuations in real GDP. Real GDP is inflation-
adjusted GDP that shows the value of all goods and services produced in a specific year,
using base-year prices. Such fluctuations in output and employment are called the business
cycle and directly affect the value of investments over time


Growth %

'65 '70 '75 '80 '85 '90 '95 '00 '05 '10

Source: Adapted from Statistics Canada, http://www.statcan.gc.ca, 2010



Any description of economic activity must include an explanation of interest rates. Interest
rates are an important link between current economic activity and future activity. For
consumers, interest rates represent the gain from deferring consumption from today to
tomorrow via saving. For investors, interest rates represent one component of the cost of
capital. Thus, the rate of growth of the capital stock, which determines future output, is
related to the current level of interest rates.
Interest rates are one of the most important financial variables that affect securities markets.
Interest rates are essentially the price of credit. Thus, changes in interest rates reflect and
affect the demand and supply for credit and debt.
Interest rates are differentiated according to the duration of the borrowing, the terms of the
loan and the creditworthiness of the borrower.
Money can be borrowed from terms ranging from one day to 30 years (and sometimes
longer). Rates on terms of one year and less are considered short-term, while rates longer
than one year are considered long term. The term structure of interest rates refers to the
pattern of short term through long term rates at one point in time when only the term to
maturity of a financial instrument changes.
Rates also vary from one borrower to another. Governments usually enjoy the lowest rates
because of their low risk of default as a result of their enormous revenue-raising capability.
Central governments usually have the lowest rate of all due to their ability to order the central
bank to print money, if necessary, to repay their debt. Thus in Canada, federal government
treasury bills and bonds represent the benchmark rate. The riskiness of all other borrowers is
compared to the default risk of the federal government.
Rates are higher for borrowers with a greater default risk (i.e., risk of not meeting interest
and/or principal repayments). Among private borrowers, large, diverse and well-established
companies enjoy the lowest rates. Individuals with little collateral and borrowers with a
history of default are charged the highest rates, assuming they are extended any credit at all.

Inflation is an important economic indicator for securities markets because it is the rate at
which the real value of an investment is eroded. Inflation in an economy-wide sense is a
generalized, sustained trend of rising prices. A one-time jump in the inflation level caused by
an increase in the price of oil or the introduction of a new sales tax is not true inflation, unless
it feeds into wages and other costs and initiates a wage-price spiral. Likewise, a rise in the
price of one product is not in itself inflation, but may just be a relative price change reflecting
the increased scarcity of that product. Inflation is ultimately about money growth. It is a
reflection of “too much money chasing too few products”.
The role of inflation expectations is particularly important in determining the level of
nominal interest rates. The real interest rate is the nominal interest rate minus the expected
inflation rate over the term of the loan. Since it is difficult to measure investors’ inflation
expectations, the realized inflation rate is often used as a proxy for the expected inflation
rate. The nominal and ex post (historical) real rates are shown in Figure 5.2.




Real Rate
Nominal Rate

T- Bill Rates (%)


1980 1985 1990 1995 2000 2005 2010

Source: Adapted from Statistics Canada, http://www.statcan.gc.ca, 2010

Nominal interest rates have been trending downwards since the early 1980s. Real rates
fluctuated between 5% and 7% for many years but in recent years dropped below 1%.
If the progress of future inflation is uncertain, then so are expectations of future nominal
interest rates. Bond prices reflect both a change in expectations and any uncertainties
associated with such expectations. In an environment with consistently low inflation, the
pricing of financial instruments, such as government bonds, is more reliable.
Inflation imposes many costs on the economy:
• It erodes the standard of living for people on fixed incomes and those who lack
wage bargaining power. It rewards individuals that are able to increase their income
either through increased wages or changes to their investment strategy in response
to inflation. Consequently, inflation aggravates social inequities.
• Inflation reduces the real value of investments such as fixed-rate loans since the loans
are paid back in dollars that buy less. This can be good for the borrower if his or her
income rises with inflation. But, more likely, inflation results in lenders demanding a
higher interest rate on the money that they lend.



• Inflation distorts the signals prices send to participants in market economies where
prices are critical for balancing supply with demand. Rising prices draw resources into
areas of scarcity and falling prices move funds away from glutted areas. When inflation
is high, it is difficult to determine if a price increase is simply inflationary or if a genuine
relative price change has taken place.
• Accelerating inflation usually leads to rising interest rates and a recession. Thus,
high inflation economies usually experience more severe booms and busts than
low-inflation economies.
In recent years, central banks throughout the world have become more acutely concerned
with the effects of inflation and have increased their commitment to price stability.


An exchange rate is the rate at which the currency of one country is exchanged for the
currency of another country. Although the United States dollar (US$) exchange rate is the
most important rate for Canada because so much of our business is carried on with the U.S.,
an official exchange rate exists between the Canadian dollar and every other convertible
currency in the world. For example, the impact of a rise in the Canadian dollar against the
US$ might be offset by a fall against the Euro.
The value of the Canadian dollar relative to other currencies influences the economy in a number
of ways. The most important influence is through trade. A higher dollar makes Canadian exports
more expensive in foreign markets and imports cheaper in Canada. Suppose a machine made
in Canada costs $1,000. With the Canadian dollar at US$0.65, it sells for US$650 in the U.S.
If the exchange rate rose to US$0.80, the machine would now sell for US$800, making its
manufacturer less competitive and decreasing sales and probably corporate profitability.
Likewise, a U.S. company that made a similar machine for US$650 in the U.S. would sell it
for $1,000 in Canada with the exchange rate at US$0.65, but only $812.50 with the exchange
rate at US$0.80 which could take sales away from the Canadian company. Large swaths of
the manufacturing sector in Ontario, for example, suffered enormously in 2007 and 2008
because of the rise of the Canadian dollar to par with the US dollar. Many plants ceased
operations and thousands of jobs were lost.
Since many Canadian exporters price their products in U.S. dollars, they often elect to keep
US$ prices unchanged when the value of the Canadian dollar rises even though it results in
less revenue. Such a decision forces the exporter either to accept lower profits or find a way
to reduce the costs of making the product.
A lower exchange rate would have the opposite effect, making Canada’s exports cheaper
and imports more expensive. An exporter that kept its US$ price unchanged would
pocket higher profits or allow costs to rise.



Economic Factors Affecting Security Prices

In general, investors are considered to be rational, profit-seeking individuals who react
quickly and try to anticipate the impact that new information or changes in economic
conditions will have on their investments. As a result, security prices should constantly
adjust to new information.
Making decisions to buy, sell or change an asset mix requires an understanding of the
economy, the business cycle, how industries change over time and the relative strength of
individual companies. The following sections review each of these areas and relate them to
investment decisions.

Inflationary price pressures create widespread uncertainty and a lack of confidence in the future.
These factors tend to result in higher interest rates and lower corporate profits. Inflation brings
higher inventory and labour costs to manufacturers which, in turn, must be passed to the
consumer in the form of higher selling prices if profitability is to be maintained. But higher costs
cannot always be passed on as buyer resistance eventually develops. The resulting squeeze on
corporate profits is reflected in lower common share prices.
As inflation drives interest rates up, fixed income securities lose value. This is detrimental to
all investors, particularly those holding fixed income securities. Retired individuals on fixed
pensions find their purchasing power declines when inflation rises (government pension
benefits, though, are fully indexed). Workers on fixed long-term wage contracts are also
affected if inflation begins to outpace their wage gains. In addition, higher interest rates on
loans to new businesses can make these businesses unprofitable.
Recessions or contractions result in higher levels of unemployment and fewer purchases.
With declining sales, companies may downsize and undertake fewer new projects.
When an economy grows (GDP rises), unemployment decreases and the market prices of
equities (i.e., shares) rise. Stable growth is required to ensure a continual rise in our standard
of living. Through the use of monetary policy, the Bank of Canada plays a key role in
attempting to control economic growth and inflation. Monetary policy involves controlling
interest rates and the money supply to stabilize our economy.
The government also employs fiscal policy which can help level out the effects of the business cycle.
The two most important tools of fiscal policy are government expenditures and taxation. These policy
tools are important to market participants because they can affect investment policies, investment
holdings and an investor’s asset mix. Government fiscal policies are disclosed in government
budgets. With changes in fiscal policy, investors and their advisors must re-evaluate their holdings
and possibly alter their investment strategy in response to major changes.
Corporations are also affected by tax changes. Higher taxes on profits, generally speaking,
reduce the amount businesses can pay out in dividends and/or spend to expand plant
facilities. This can lead to lower share prices. On the other hand, a reduction in corporate
taxes can mean increased earnings and higher share prices.




Investment decisions are forward-looking. Any decision to purchase a security is based on
expectation about the future return from the security. Increased optimism in the market can
generate a rise in stock prices. Consumer pessimism can stall economic growth and decrease
share prices. Moreover, government economic policies may work only through their impact
on people’s expectations. For example, the Bank of Canada makes considerable effort to
maintain the credibility of its commitment to low inflation.
Higher interest rates affect the economy by:
• Raising the cost of capital for business investments. An investment should earn a
greater return than the cost of funds used to make the investment. Higher interest rates
reduce the potential for profits. This, in turn, reduces business investment.
• Increasing the cost of borrowing. Higher interest rates discourage consumers from spending,
especially those intending to buy houses and major durable goods like cars, appliances and
furniture on credit. This encourages consumers to defer spending and save more.

• Increasing the portion of household income needed to service debt, such as mortgage
payments, and reducing the income available for spending on other items. This effect
may be offset by the higher interest income earned by savers.
Lower interest rates, as may be guessed, have the opposite effects. For instance, the housing sector in
Canada has benefited enormously from historically low interest rates in the 2003-2008 period.


While both monetary and fiscal policies seek to control economic growth, the Canadian
economy has a tendency to move in waves. Figure 5.3 illustrates the connection between the
business cycle and securities selection.
The economy moves from a low point called a trough to a higher point called a peak and then to
another lower point. Over time, the cycle tends to repeat itself. The rise from the trough to the
peak is called an expansion and the decline from the peak is called a recession or contraction.
In a trough, interest rates and security prices are both low since the economy has been in a
recession. At this point, investors may decide not to invest in debt securities since interest rates
are very low. However, in anticipation of a turn-around in the economy, investors may decide to
purchase equities or equity funds or shift their portfolio mix to a heavier weighting in equities.




Sell short-term bonds, sell common shares

and begin buying long-term bonds

Begin buying Peak

short-term bonds
Rising Trend in GDP


Contraction Recovery

Expansion Trough Begin buying common stocks and

sell long-term bonds


During the expansion phase, the economy recovers and GDP increases. Employment goes
up and demand for goods rises. As consumers increase their spending, company profits
increase and share prices rise. As the economy nears the peak, the competition for funds
drives up interest rates. Higher interest rates make further expansion difficult. Consumers
are also faced with higher credit card costs, mortgage rates and bank loan costs. At this point
in the business cycle, consumer spending starts to slow or decline.
As the economy approaches the peak, the strong growth in equity prices allows investors to
take profits on their holdings. If investors can recognize that the economy is moving into the
peak, they will begin to move their holdings into higher-rate debt securities. After the
economy reaches the peak of the business cycle, the expansion comes to an end and the
economy begins to slide into a recession. The combination of higher interest rates and
inflation at the peak creates lower consumer demand for goods and services. Corporate
profits start to decline and share prices start to fall.
The economy enters a recession when the level of economic activity (measured by GDP)
actually begins to decline. Slower growth, rising unemployment and falling consumer
spending lead to a fall in the demand for bank loans and consumer credit.
In time, interest rates and prices begin to fall. As interest rates fall, the prices of fixed income
securities rise. Those investors who purchased fixed income securities at the peak experience a
rise in the value of these securities. As mentioned, knowledgeable investors who see a trough
approaching will take their profits on fixed income securities and begin to switch to equities.



In the trough, interest rates decrease which helps spur new confidence in the economy.
Consumer demand rises, stock prices rally and investors start to ride the wave once again.
While it appears that following the wave may be an easy way to make money, there are
some pitfalls:
• It is extremely difficult to predict the exact top and bottom of a business cycle.
• Business cycles vary – some are short and others are several years long.
• Some industries or stocks within an industry may lead while others lag.
• There is no one economic indicator that definitively predicts the future. To help get
a picture of what the future holds, many successful advisors and investors look into
quantitative analysis, which is a study of the economy and how industries and companies
react to changes in the economy. Economic information required to conduct a quantitative
analysis can be obtained from several sources, including Statistics Canada.


After reading this section, you should be able to:
• List the general considerations in evaluating investments.
• Define the “know your client” rule.
• Describe the three statutory rights for the purchasers of securities.

Primary Investment Objectives

Organizations and individuals that are the source of a society’s capital have a tremendous range
of investments in which they may place their savings. This choice among investments is guided
by three primary investment objectives – (1) Safety of Principal, (2) Income and (3) Growth of
Capital and the two secondary objectives – (4) Liquidity and (5) Tax Minimization.

An investor who requires safety will probably invest in fixed income securities or fixed income
funds. Although money market instruments offer safety, their returns tend to be lower than other
types of securities. Safety with higher returns can be achieved through the purchase of longer-term
fixed income securities. The trade-off is that interest rates have a greater effect on longer-term
securities (i.e., increase or decrease in value) than on money market instruments.

If cash flow (income) is required, perhaps as a supplement to a person’s other income, fixed
income instruments or fixed income funds may also be the proper choice. It is important to
realize that although many large, well-established companies pay dividends on their common
shares, dividends are not a contractual obligation and could be passed over or omitted.



Capital appreciation, or growth, is usually associated with equity investments or investments in
equity funds. Debt securities pay contractual interest and repay the amount lent at maturity, with
no increase in value. While debt securities may rise in value in the short term, an investor would
not typically use debt securities as a means of generating long-term growth.
The following summary, in very broad terms and disregarding inflation and its effects,
lists the three major types of securities and evaluates them in terms of the three basic
investment objectives:

Safety Income Growth


Short-Term Best Very Steady Very Limited

Long-Term Next Best Very Steady Variable

Preferred Stocks Good Steady Variable

Common Stocks Often the Least Variable Often the Most

If clients require liquidity, it is usually because they require funds in the near future, perhaps to
make a major purchase. As such, the investor does not want to put his or her funds at risk and
wants the funds available on request. In this situation, money market instruments or money
market mutual funds may be the most appropriate choice. The trade-off for liquidity, however,
is lower returns. Nowadays, several financial institutions offer high-interest personal savings
accounts which tend to provide returns greater than money market instruments.

While most people want to pay as little tax to the Canada Revenue Agency (CRA) as
possible, tax becomes an issue when you make money from investing. Investment products
can generate three types of income: interest income, capital gains and dividend income. Each
of these income sources is taxed differently in the Canadian tax system. Dividend income
received from taxable Canadian corporations, for example, is taxed at a lower rate than
interest income received from bonds. The tax treatment of investment income is one issue to
consider when creating a suitable product mix for a client. It tends to assume greater
importance as the investor’s income level, and marginal tax rate, rises.
The above discussion provides a very simplistic categorization of investment objectives and
may be misleading if the advisor uses it to sell only one security or fund. Clients can and will
have multiple objectives but not all may rank on an equal basis. One client may require some
liquidity to meet some short-term expenditures with the remainder of the funds being
invested for long-term growth. Yet another may want to balance growth and safety. It is the
advisor’s responsibility to assess the client’s needs and objectives and create an asset
allocation based on the client’s propensity for risk.



Know Your Client Rule


An ethical advisor must ensure the suitability of investment recommendations for his or
her clients. The focus of the advisor’s daily business hinges on this all-important matter.
Suitability means ensuring that:
• All recommendations take into account the client’s unique situation and
investment objectives.
• Recommendations are based on personal and financial knowledge of the client
and knowledge of the investment products being recommended.
The Know Your Client (KYC) rule states that the advisor must use due diligence to learn the
essential facts relative to every client and every order. A concerted effort must be made to know
the client – to understand the financial and personal status and aspirations of the client. Thus,
the advisor will make recommendations for the client to invest his or her funds in securities that
reflect, to the best knowledge of the advisor, these considerations. The advisor, having provided
sound advice, will therefore be above reproach for potentially unsuitable purchases and sales of
securities if the client does not heed the advisor’s recommendations.


To effectively match the appropriate investment with the client’s needs, the advisor must
understand the financial and personal status of the client. In general, the KYC rule implies
that the advisor has gathered at a minimum:

• Information on the client’s personal circumstances - his or her investment knowledge

and tolerance for risk.
• Information on the client’s financial circumstances - approximate salary and net worth.
• Information on the client’s investment objectives.
• The client’s age.
Based upon this and other information that has been gathered, the advisor can intelligently
decide upon suitable investments. Client account documentation should reflect all material
information about a client’s current status and should be updated to reflect all material
changes to the client’s status to ensure suitability of investment recommendations. This
information, gathered by the advisor, is usually recorded on a New Client Application
Form. Exhibit 5.1 provides a sample of this form.
Advisors must also be pro-active in regularly updating information about their clients to ensure
that they do not ignore relevant changes in their clients’ circumstances. As clients move through
their life cycles, investment objectives and investment mixes should change. As life events
(birth of a child, divorce, retirement, etc.) occur, the client’s objectives may also shift. The best
protection from regulatory censure for an advisor is to keep updated files.




Canadian legislation provides three statutory rights for the purchasers of securities
issued in Canada under prospectus requirements.

Right of Withdrawal
The relevant securities legislation usually provides purchasers during a distribution by prospectus
with the right to withdraw from an agreement to purchase securities within two business days after
receipt or deemed receipt of a prospectus and any amendment by giving notice to the vendor or its
agent. If a distribution that requires a prospectus is done without a prospectus, the purchaser in most
provinces can revoke the transaction, subject to applicable time limits.

Right of Rescission
Most provinces give purchasers during a distribution by prospectus the right to rescind or
cancel a contract for the purchase of securities if the prospectus or amended prospectus
offering the security contains a misrepresentation (e.g., an untrue statement of a material fact
or an omission of a material fact). In most provinces, a purchaser alleging misrepresentation
must choose between the remedy of rescission and damages. In Quebec, rescission or
revision of the price may be sought without affecting a purchaser’s claim for damages.

Right of Action for Damages

The acts of most provinces provide that the issuer, the directors of an issuer, the seller of a
security, the underwriter who signs a certificate for a prospectus and any other person who signs
a prospectus may be liable for damages if the prospectus contains a misrepresentation. The
same applies to an expert (such as an auditor, lawyer, geologist or appraiser) whose report or
opinion or a summary thereof containing a misrepresentation, appears with his or her consent in
a prospectus. Experts are not liable if the misrepresentation did not appear in their report or
opinion. For example, liability will not arise against the underwriter or the directors if they act
with due diligence by conducting an investigation sufficient to provide reasonable grounds for
a belief that there has been no misrepresentation. If the person or company can prove that
the purchaser of the securities had knowledge of the misrepresentation, the claim may be
considered invalid. The acts also provide certain limitations with respect to maximum
liability that may be imposed and time limits during which an action may be brought.

Criminal Offence
A misrepresentation in a prospectus may also be a criminal offence for both the issuer
and any of its directors or officers who authorized, permitted or acquiesced in the
making of the misrepresentation.





(to be completed by Advisor) O

(1) (a) Name Mr.

......... ...... ....... ...... ...... ....... ...... ...... ....... ...... ....... ...... ...... ....... .
......... ...... ....... ...... ...... ....... ...... ...... ....... ...... ....... ..

Phones: e
Please Print B
Home address s
Street .....


City Province Postal Code .....

Date of Birth ................................................................. Client’s Social Insurance Number............................................. Client’s Citizens hip ........................................................................ ................

Type of Account Requested :

(b) Is Advisor registered in the Province or Yes .................. Cash .................................................................. RRSP/RRIF U.S. Funds ....................................

Country in which the client resides? No .................. Margin ............................................................... Other .......................................................
D.A.P. ................................................................. Pro ............................................................ CDN Funds .................................

(2) Special instructions ........................................................ Hold in Account .................................................... Registered and Deliver ............................................................ DAP...................................................
Duplicate Confirmation ................................................ And/Or Statement ...............................................

N a m e: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Name: .....................................................................................................................................................

A d dr e s s: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Address: .................................................................................................................... ............................

............................................................................................ Postal Code ........................................................... ............................................................................Postal Code ..............................................................

(3) Client’s Nam e ..... ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ... Type of Business...................................................................................................................................

Employer: A ddre s s ..... .......... .......... ......... .......... .......... ......... .......... .......... ......... .......... .......... ..... .... ... Client’s Occupation................................................................................................................... ..........

(4) Family Information:

Spouse’s Name ........................................................................................................................................... No. of Dependants ..............................................................................................................................
Occupation........................................................................................................................................... Employer ................................................................................................................................................
Type of Business...................................................................................................................................

(5) How long have you known client?..................................................................... Advertising Lead .... .................. Phone In ........................................ Have you met the client face to face?
Personal Contact ..................... Walk In .......................................... Yes ..................... No .....................
Referral by: ..................................................................................................................................... (name) (if customer, give account no.) ...................................................................................................................
(6) If yes for Questions 1, 2, or 3, provide details in (11).
1. Will any other person or persons : (a) Have trading authorization in this account? Yes ................ No ...............
(b) Guarantee this account? Yes ................ No ...............
(c) Have a financial interest in such accounts? Yes ................ No ...............
2. Do any of the signatories have any other accounts or control the trading in such accounts? Yes ................ No ...............
3. Does client have accounts with other Brokerage firms? (Type: ) Yes ................ No ...............
4. Is this account (a) discretionary or (b) managed ................(a) ...............(b)
Insider Information
5. Is client a senior officer or director of a company whose shares are traded on an exchange or in the OTC markets? Yes ................ No ...............
6. Does the client, as an individual or as part of a group, hold or control such a company ( ) Yes ................ No ...............

(7) (a) General Documents Attached Obtaining (b) Trading Authorization Documents: Attached Obtaining
– Client’s Agreement .................. ................. – For an individual’s Account ........................ .........................
– Margin Agreement .................. ................. – For a Corporation, Partnership, Trust, etc. ........................ .........................
– Cash Agreement .................. ................. – Discretionary Authority ........................ .........................
– Guarantee .................. ................. – Managed Account Agreement ........................ .........................
– Other .................. .................

......... (Cash and securities less loans
Limited................. .............................................
........... outstanding against securities) .....................
............. PLUS
Income .................. % Low ................... % (Fixed assets less liabilities EQUALS
Medium ................... % outstanding against fixed assets)
Capital Gains .................. % High ................... % EST. TOTAL NET WORTH (A + B = C) ....................
Short Term .................. % 100 % APPROXIMATE ANNUAL INCOME FROM ALL
Medium Term .................. % SOURCES .......................
100 %
EST. SPOUSE’S INCOME ....................

(9) Bank Reference : .................. ...... Bank credit check-acceptable? Yes .............. No ..............
...... Or Credit Bureau check-acceptable? Yes .............. No ..............
Refer to
...... Above credit checks considered unnecessary
.... Explain in (11)

Deposit and/or Security

(10) .................................
Initial Buy Solicited Amount
............................................. .......................................... ............................................... .................................................................................
...... ............... . ...............................
Order Description
............................................ Sell.................................... Unsolicited .................................................................................
..... ...................... .......................................... .........................

Advisor’s Signature
(11) ....................................... Designated Officer, Director or Branch Manager’s
............................................... Date of Approval
............................ .....................................................................................................................................
Client’s Signature
............................................... Date
............................................... .......................................................................................................................................
............................................ ...................




After reading this section, you should be able to:
• Define the role of a portfolio manager.
• Describe what the term “guaranteed” means when discussing guaranteed
investments, including guarantee of investment capital and guarantee of income.
• Describe the decision-making process to be used when determining the appropriate
investment option to meet the risk tolerance of the client. Use examples to support
your explanation.
• Define the risks associated with investing, including market risk, business risk, interest
rate risk, liquidity risk, currency risk, and inflation risk.
• Draw and explain a risk/reward graph placing investment products appropriately along
the graph.

Economists would say that most individuals give up present consumption for future
consumption. Individuals recognize the need to save a portion of their earnings for both
emergency purposes and to fund such future events as retirement or their children’s
education. Most individuals also realize that if they have savings, they must put those
savings to work in order to maintain their purchasing power. This, in turn, means
investing (hopefully) to earn a positive real rate of return. The financial sector services
this need by offering a wide range of products.

Most investors are risk averse, preferring securities offering the least risk. To entice
individuals to invest in higher-risk securities, there must be the expectation of higher returns.
This is known as the risk/return trade-off. However, since future returns are not usually
guaranteed, all things being equal, investors would prefer to reduce risk.
Henry Ford was alleged to have said that the public could have any colour car it wanted, as
long as it was black. The market reality is that consumers want variety – variety in the colours
offered and the features offered. Investors make the same demands. What may have started as
strictly stocks and bonds has led to variations on the initial themes and to the development of a
whole new range of financial products. It is, therefore, important that an advisor understands
the products and the features related to each product, in order to match the appropriate
product with the client’s needs.



Risk can be reduced through diversification, but what does diversification mean? The most
obvious analogy is to not “put all your eggs in one basket”. If an investor’s money is spread
over a variety of investments, the loss of part of it does not constitute a financial disaster.
Risk reduction through diversification can be accomplished in many ways:
John diversified his holdings by investing in several asset classes, including
stocks, bonds and money market instruments.
Jill diversified her portfolio by investing in the common shares of companies in
several different industries.
Marsha had only a small amount to invest. To diversify her holdings, she invested in a
balanced Canadian equity mutual fund.
Diversification works because the prices of different stocks and assets do not move in
tandem. The benefit of diversification can be easily seen in Figure 5.4.



Number of Securities / Investments

As the number of securities or investments held increases, the exposure to risk falls. By
spreading risk over a variety of investments, the fall in value of one investment will not put
the entire portfolio at risk.
The concept of diversification is one of the cornerstones of the insurance industry. Insurance is
founded on the concept of the law of large numbers which holds that accidents or losses do not
occur to all policyholders at the same time. An insurance company using statistical techniques
can estimate the expected losses from a homogeneous group such as smokers or non-smokers.
Each group is charged a different premium reflecting the coverage for the potential losses and
also a profit for the insurance company. If the potential losses are greater than what a single
insurer is willing to accept, the insurer seeks out other insurers, sharing the premium and sharing
the risk through reinsurance. Again, this reduces risk through diversification.



The concept of diversification is also used in the securities industry when underwriting or
bringing new securities to market. By definition, underwriting means buying a new security
and assuming the risk of not reselling that same security at a higher price. If an underwriter
believes that the risk of reselling the new security is high, the underwriter will form a selling
group or syndicate. As with insurance, each member of the syndicate receives a portion of
the selling or underwriting profits but also assumes a portion of the reselling risk.

While risk reduction through the pooling of investment funds has been around for decades, it
did not gain major prominence in Canada until the 1980s. In the early 1980s, financial
institutions in Canada realized that smaller, unsophisticated investors wished to participate in
the markets but were both risk averse and financially challenged. Recognition of these two
basic characteristics gave rise to a rapidly growing industry based on the principles of risk
reduction through diversification and professional management.
By far the most common type of investment pooling method is the open-end investment
fund, more commonly known as a mutual fund. The term “open-end” is used because these
funds continuously sell their own treasury shares or units to the investing public. The shares
are continuously available for purchase – not from other shareholders, but from the fund
itself. This type of fund has been extremely popular with the investing public.
Other managed products aimed at retail investors, such as segregated funds offered by insurance
companies, wrap accounts and pooled funds, have also experienced strong growth. Behind this
explosive growth is the demand of many investors for a diversified package of investments and
related services and for a fee-based rather than a transaction-based approach.

The Risk/Return Trade-off

It is every investor’s dream to be able to get a very high return without any risk. The reality,
however, is that risk and return are interrelated. To earn higher returns investors must
usually choose investments with higher risk. The ultimate goal of investing is to choose
investments that maximize returns while minimizing risk.
Given a choice between two investments with the same amount of risk, a rational investor
would always take the security with the higher return. Given two investments with the same
expected return, the investor would always choose the security with the lower risk. Figure 5.5
demonstrates this relationship.






Investors are risk averse, but not all to the same degree. Each investor has a different risk
profile. This means that not all investors choose the same low-risk security. Some investors are
willing to take on more risk than others, if they believe there is a higher potential for returns.
In general, risk can have several different meanings. To some, risk is losing money on an
investment. To others, it may be the prospect of losing purchasing power if the return on
the investment does not keep up with inflation. Risk could also refer to not meeting return
objectives. For example, a retail investor may need to earn a 10% return in order to maintain
a certain lifestyle. Institutional investors may have a target rate of return that they must meet
each year. They may be investing to meet anticipated future cash flows. Thus, risk to an
institutional investor may result from investing inappropriately and, consequently, not being
able to meet anticipated future cash flows. Most retail investors feel that the prospect of
losing money is an unacceptable risk. Institutional investors, on the other hand, are more
concerned with the long-term rate of return on the portfolio and less concerned about the
prospect of losing money on one security.
Given that all investors do not have the same degree of risk tolerance, different securities
and different funds have evolved to service each market niche. Guaranteed investment
certificates (GICs) and fixed income funds were developed for those seeking safety and
equities and equity funds were developed for those seeking growth or capital appreciation.
With reference to guaranteed investments, what does the term “guaranteed” signify? Generally
speaking, the notion of guarantee arises with (i) repayment of the principal amount invested and
(ii) payment of an investment return on the principal amount invested. So, for example, when a
chartered bank issues a Guaranteed Investment Certificate, it is guaranteeing to the investor
that the principal amount will be repaid at maturity and interest at a specified rate will be paid at
specified intervals during the term of the investment. One thing to keep in mind is that such a
guarantee is only as good as the institution that is behind it. However, in Canada, as mentioned
earlier in this chapter, there is an additional layer of guarantee in the form of Canada Deposit
Insurance Corporation. In case a financial institution cannot pay back the principal amount at



maturity and/or the interest accrued on the investment, then CDIC will step in and act as the
guarantor/insurer of last resort (up to a maximum limit and subject to several conditions). This
assumes, of course, that the financial institution is a member of CDIC. It should be noted that
mutual funds, even fixed income and money market funds, do not come with a similar guarantee.
Few individuals would invest all of their funds in a single security. This being the case, a portfolio is
designed around an asset allocation based upon the client’s propensity for risk. The creation
of a portfolio or an asset allocation approach allows the investor to diversify and reduce risk
to a suitable level. The advisor, in turn, needs to understand how risk and return are related
so that the client’s questions can be answered intelligently.
To maintain and increase their purchasing power, investors “rent out” their money. In other
words, they expect some sort of compensation for the use of their money. If investors did not
expect some kind of return, it would not be classified as an investment – it would be a
“donation” without a tax receipt!
Consider the following possible investments and the types of return generated:

Canada Savings Bonds – interest income

Common Shares – dividend income, capital gain
Gold Bars – capital gain
Rental Property – rental income, capital gain

An investor who buys Canada Savings Bonds expects to earn interest income (cash flow). An
investor in common shares expects to see the stock grow in value (capital appreciation) and
may also be rewarded by dividends (cash flow). An investor in a gold bar hopes the price of
gold will rise (capital appreciation) and an investor who purchases a rental property expects
to receive rental income (cash flow) and an increase in the value of the rental property
(capital growth). The caveat on all this is that returns on many investments are somewhat
uncertain or unknown and that is why they are often referred to as “expected returns”.
While an investment may be purchased in anticipation of a rise in value, the reality is that
values can decline. A decline in the value of a security is often referred to as a capital loss.
Therefore, returns can be reduced to some sort of combination of cash flows and capital
gains or losses. The following formula defines the expected return of a single security:


Expected Return = Cash Flow + Capital Gain (or – Capital Loss)

Cash Flow = Dividends, interest, or any other type of income

Capital gain/loss = Ending Value – Beginning Value

Beginning Value = The initial dollar amount invested

Ending Value = The dollar amount the investment is sold for




Returns from an investment can be measured in absolute dollars. An investor may state that she
made $100 or lost $20. Unfortunately, using absolute numbers obscures their significance. Was
the $100 gain made on an investment of $1,000 or an investment of $100,000? In the first case,
the gain would be considered as decent, while in the latter it could signal a dismal investment.
The more common practice is to express returns as a percentage or as a rate of return yield.
Within the investment community it is more common to hear that “a fund earned 8%” or “a
stock fell 2%”. To convert a dollar amount to a percentage, the usual practice is to divide the
total dollar returns by the amount invested.
Return % = Cash Flow + / - (Ending Value -Beginning Value) ´100
Beginning Value

The following example illustrates:


a) If you purchased a stock for $10 and sold it one year later for $12, what would be your
rate of return?
Rate of Return = Zero Cash Flow + ( $12 -$10) ´100 =
20% $10

b) If you purchased a stock for $20 and sold it one year later for $22, and during this
period you received $1 in dividends, what would be your rate of return?
$ 1+ ( $22 -$20)
Rate of Return = ´100 =15%

c) If you purchased a stock for $10, received $2 in dividends, but sold it one year later for
only $9, what would be your rate of return?
$ 2 + ( $9 -$10)
Rate of Return = ´100 =10%

The above examples illustrate that cash flow and capital gains or losses are used in calculating
a rate of return. It should also be noted that all of the above trading periods were set for one
year and hence the percent return can also be called the annual rate of return. If the transaction
period were longer or shorter than a year, the return would be called the holding period return.
Adjustments would have to be made to the formula to convert it to an annual rate of return. The
above generic formula will form the basis of yield calculations described later in this chapter.
Choosing a realistic expected rate of return can be a very difficult task. One common method
is to use the T-bill rate plus a certain performance percentage related to the risk assumed in the
investment. Corporate issues with a higher risk profile would be expected to earn a higher
rate of return than more secure federal government issues.



An understanding of historical returns is important to the investor. Insights into the
market can be gained by studying historical data. These insights are used to determine
appropriate investments and investment strategies.
Consider the following rates of return in Table 5.1:


Annual Total Return (% Change in Value Indices, December to December)

T-Bills Long-Term S&P/TSX

Annual 91-Day Bonds Composite Stocks
Returns (%) (%) (%)
1990 13.48 4.32 -14.80
1995 7.57 26.34 14.53
2000 5.49 12.97 7.41
2001 1.95 6.06 -7.07
2002 2.63 11.05 -15.56
2003 2.57 9.07 25.39
2004 2.47 10.26 11.49
2005 3.37 13.84 21.91
2006 4.16 4.08 10.69
2007 3.86 3.44 10.87
2008 0.83 2.10 -33.25

Source: Bloomberg

A study of Table 5.1 reveals that the highest rates of return were typically achieved by
securities that had the greatest variability or risk. The above historical information serves to
illustrate that risk and return are related. Figure 5.6 demonstrates this relationship graphically.





Expected Return

Common Shares

Preferred Shares



Treasury Bills

Low High

While historical returns provide insight into the long-term performance of the market, it is
obvious that past performance is not necessarily indicative of future performance. Since it is
extremely difficult to predict the future, an investor could employ the concept of
diversification – diversification among asset classes – to reduce risk.


So far we have looked only at a simple rate of return, what economists call the nominal rate.
For example, if a 1-year GIC reports a 6% return, this 6% represents the nominal return on the
investment. However, investors are more concerned with the real return – the return adjusted
for the effects of inflation.
A client earned a 10% nominal return on an investment last year. Over the same period, inflation
was measured at 2%. What was the client’s approximate real rate of return on this investment?
The approximate real rate of return is calculated as:
Real Return = Nominal Rate – Annual Rate of Inflation

The client in the above example earned a real rate of return of 8% on the investment,
calculated as:
Real Return = 10% – 2% = 8%


A study of historical returns reveals that there is an investment that usually keeps pace
with inflation and, therefore, provides a positive return. This investment is called a
Treasury bill or T-bill. Since T-bills are considered essentially risk free, all other
securities must at least pay the T-bill rate plus a risk premium to entice clients into
investing. For example, 90-day T-Bills in June 2008 were yielding approximately 2.55%.



Risk – “The Other Side of the Coin”

As has already been pointed out, there is no universal definition of risk. In a statistical sense,
it is defined as the likelihood that the actual return will be different from the expected return.
The greater the variability or number of possible outcomes, the greater is the risk. This can be
illustrated in a simple fashion. If an investor purchases a $500 Canada Savings Bond (CSB)
and cashes the bond one year later, the investor will receive exactly $500 (plus any accrued
interest). However, suppose the same investor purchased $500 worth of common stock at $25
per share in the expectation that the price would rise from $25 per share to $40 one year later.
The investor may receive much more than $40 per share or much less than the original $25
per share. Common stocks are considered much riskier than Canada Savings Bonds since
the future outcomes are much less certain.

Financial media mention a great variety of risks including inflation rate risk, business risk,
political risk, liquidity risk, interest rate risk, foreign exchange risk and default risk. These
types of risks (the list is not all-inclusive) are defined below.

Inflation Rate Risk

As explained previously, inflation reduces future purchasing power and the real
return on investments.

Business Risk
This risk is associated with the variability of a company’s earnings due to such things as
the possibility of a labour strike, introduction of new products, the state of the economy
and the performance of competing firms, among others. The uncertainty regarding a
company’s future performance is its basic business risk.

Political Risk
This is the risk associated with unfavourable changes in government policies. For example, a
government may decide to raise taxes on foreign investing, making it less attractive to invest in
the country. Political risk also refers to the general instability associated with investing in a
particular country. Investing in a war-torn country, for example, brings with it the added
risk of losing one’s investment.

Liquidity Risk
A liquid asset is one that can be bought or sold at a fair price and converted to cash on short
notice. A security that is difficult to sell suffers from liquidity risk, the risk that an investor
will not be able to quickly buy or sell a security due to limited buying or selling opportunities.

Interest Rate Risk

When an investor purchases a fixed income security for example, he or she expects to
earn a certain return or yield on the investment. If interest rates rise, the investment will
fall in value; on the other hand, it will rise in value if rates fall. Interest rate risk is the risk
that investors are exposed to because of changing interest rates.



Foreign Exchange Risk

Investors who invest abroad or businesses that buy and sell products in foreign markets run
the risk of a loss whenever the exchange rate changes against foreign currencies.

Default Risk
When a company issues more debt to finance its operations, servicing the debt through interest
payments creates a further burden on the company. Default risk is the risk associated with a
company not being able to make interest payments or repay the principal amount of a loan.

Certain risks can be reduced by diversification. Systematic risk (or market risk) cannot
be eliminated as it affects all assets within certain classes. Systematic risk is always
present and cannot be eliminated through diversification. This type of risk stems from
such things as inflation, the business cycle and high interest rates.
Systematic or market risk occurs as a result of being in each capital market. When stock
market averages fall, most individual stocks in the market tend to fall. When interest rates
rise, nearly all individual bonds and preferred shares fall in value. Systematic risk cannot be
diversified away; in fact, the more a portfolio becomes diversified within a certain asset
class, the more it ends up mirroring that market.

Non-systematic, or specific, risk is the risk that a specific security or a specific group of
securities will change in price to a different degree or in a different direction from the market
as a whole. U.S. Steel Canada, for example, may rise in price when the market index falls, or
U.S. Steel Canada, Arcelor Mittal Dofasco and Essar Steel Algoma Inc. (all steel companies)
as a group may fall more than the market index.
Diversifying among a number of securities can reduce this type of risk. Taking diversification
in the equity asset class to the extreme, this type of risk could theoretically be completely
eliminated by buying a portfolio of shares that consists of all the shares in the S&P/TSX
Composite Index (as some pension funds do by using index funds or buying i60s). The fund
manager could also be asked to create a fund that mirrors an index.

Asset Allocation
Once you have a better understanding of the client’s financial objectives and tolerance for risk,
you will need to determine the broad categories from which investments will be selected.
Investment assets can be grouped into three main categories: cash or near-cash equivalents,
fixed income securities and growth (equity) securities. Near-cash items ensure some liquidity
and can include savings accounts, money market instruments and money market funds. Fixed
income securities offer safety and income and include bonds, preferred shares and fixed income
funds. Growth securities usually include common shares and various types of equity funds. As
their name implies, growth securities provide potential for growth or capital gains.
Asset allocation involves determining the optimal division of an investor’s portfolio among
the different asset classes. Portfolio managers perform the same function for mutual funds and
institutional clients. For example, depending on the client’s tolerance for risk and investment



objectives, the portfolio may be divided as follows: 10% in cash, 30% in fixed income
securities, and 60% in equities.
Consider the following examples:
Jenny is a young, healthy, single professional with good investment knowledge, a high
risk tolerance, a moderate tax rate and a long time horizon. She might benefit from the
following asset mix:
Cash 5%
Fixed Income 25%
Equities 70%

Ahmed is a retired individual in a low tax bracket with no income other than
government pensions, a medium time horizon and a low risk tolerance. He requires
income from his portfolio. He might benefit from the following asset mix:
Cash 10%
Fixed Income 60%
Equities 30%

It should be noted that clients’ needs and objectives will change over their lifetimes.
Asset allocation will have to be adjusted to take these shifting needs into account.
Portfolio managers and investors will also alter asset allocations to take advantage of changes in
the economic environment. For example, when the economy enters a period of rapid growth, the
portfolio manager must decide how to best take advantage of the market. He or she would likely
decide that a heavier “weighting” in equities would generate better returns than holding more of
the portfolio in fixed income securities or cash. Alternatively, if the portfolio manager believes
that the market is entering a recession, a heavier weighting in cash or fixed income securities
could be pursued to generate higher returns. This process of altering a portfolio’s asset allocation
to take advantage of changes in the economy is one example of market timing.


Investment returns are derived from:

1. The choice of an asset mix
2. Market timing decisions
3. Securities selection
4. Chance


The expected return on a portfolio is calculated in a slightly different manner from the
rate of return of a single security. Since the portfolio contains a number of securities,
the return generated by each security must be calculated.




The return on a portfolio is calculated as the weighted average return on the securities held
in the portfolio. The formula is as follows:

Expected Return: R1(W 1) + R2(W 2) + … Rn(W n)


R = The return on a particular security

W = The proportion (weight or %) of the security held in the portfolio based on the
dollar investment


The following example illustrates rate of return on a portfolio:

A client invests $100 in two securities – $60 in ABC Co. and $40 in DEF Co. The expected
return from ABC Co. is 15% and the expected return from DEF Co. is 12%. To calculate the
expected return of the portfolio an advisor or investor would look at the rate expected to be
generated by each proportional investment.

Since the total amount invested was $100, ABC Co. represents 60% ($60 ÷$100) of the portfolio and
DEF represents 40% ($40 ÷ $100) of the portfolio. The expected return on the portfolio is:

Expected return = (0.15 x 0.60) + (0.12 x 0.40)

= 0.09 + 0.048
= 0.138 (or 13.8%)


While diversification is important, investment managers must also guard against too much
diversification. When a portfolio contains too many securities, superior performance may be
difficult to achieve and the accounting, research and valuation functions may be needlessly
complex and expensive. It is estimated that virtually all non-systematic risk in an equity
portfolio is eliminated by the time 32 securities are included in the portfolio.




After reading this section, you should be able to:
• Define the various types of investment returns: current yield and yield to maturity.
• Define the term “time value of money.”
• Describe the benefits and limitations of Guaranteed Investment Certificates (GICs)
and Index-linked GICs, and the institutions that issue them.
• Describe the features, benefits and source of Treasury Bills (T-Bills), Canada Savings Bonds,
federal government bonds, provincial government bonds, and municipal government bonds.

• Define the major types of securities trading in capital markets: bonds and debentures.

Debt Securities
Debt securities are contractual obligations between a company or a government and an
investor who has lent money to that company or government. The issuer of the debt security
promises to pay a stipulated amount of interest, known as the coupon rate, over a stipulated
number of years and repay the principal or face value at the maturity of the contract.
As one can imagine, the types of debt securities can vary greatly. Some debt securities can
be for short periods of time, others for a longer period of time. Some can have low coupon
rates, others can have high rates. Some may pay interest annually, others semi-annually and
some even in currencies other than the Canadian dollar.
Investors seeking relative safety or interest income (cash flow) purchase debt securities. Debt
securities rank ahead of preferred shares and common shares in the event of a business failure
which makes them less risky. The payment of interest on debt securities is a contractual
arrangement, meaning it must be paid. A company that defaults on an interest payment will
suffer serious consequences. The company will lose credibility in the marketplace, making it
more difficult when it tries to issue debt in the future. More importantly, missing an interest
payment leads to default of the debt issue. When this happens, the entire debt issue becomes due
immediately. If the company cannot pay, it can be forced into bankruptcy.

Debt Security Risk

As an investment, debt securities tend to have a lower level of risk than equity securities.
However, risk is present with all types of securities. If an investor were to invest in only one
corporate debt security, he or she would be subject to multiple risks. The company may run
into financial difficulty and default on its interest payments or be unable to repay the
principal at maturity.
If interest rates change, the price of the bond will change. If the investor sells the security
prior to maturity, it may be worth less than what the investor originally paid for it. This
relationship between debt securities and interest rate changes will be explained shortly.



Debt Security Terminology

This section deals with the terms needed to understand how debt securities are constructed.
Most of the following terminology would be found in the agreement between the borrower and
the investor. This agreement is called a trust deed, bond contract or bond indenture. The bond
indenture is the detailed legal agreement that states the amount of interest paid, when it will be
paid, when the security matures and any other details that may affect the investor.


Debt securities that are secured by a specific pledge of real assets, such as property, are
generally known as bonds. Debt securities that are unsecured, or secured only by the
general credit worthiness of the company, are known as debentures. Other than this
technical difference, they are alike in most other respects. Both have coupon rates,
maturity dates and similar par values. Investor confusion often arises because governments
issue “bonds” when, in fact, they are technically issuing debentures. However, since the
government has almost unlimited taxing powers, there is practically no default risk, so the
term “bonds” has been accepted. Throughout the text, the terms “bonds” and “debentures”
are used interchangeably to denote senior debt securities.
All bonds and debentures rank as senior securities over preferred and common shares. Bonds
are safer than debentures as there are designated assets that can be seized and sold if the
issuer fails to make an interest payment or repay principal at maturity.


The coupon rate is the interest rate the borrowing organization offers on a bond when it is first
issued. Coupon rates are quoted as an annual rate but most bonds and debentures pay interest
semi-annually. Coupon rates are different from market interest rates. For example, ABC Inc.
issued a 5-year bond that pays a coupon of 7%. This 7% rate is fixed for the term of the bond.
However, market interest rates do change as a result of the supply and demand of capital and
other factors. Over the five-year term of the bond, market rates can fluctuate substantially. This
risk of rising and falling rates does not affect the coupon payments on the bond. As interest rates
change, however, bond prices will also rise and fall. This represents interest rate risk.
Bond prices have an inverse relationship with interest rates. As interest rates go up, bond
prices go down. Conversely, as interest rates go down, bond prices rise. Figure 5.7 illustrates
this inverse relationship.


Interest Rates

Bond Prices



If interest rates rise, for example, from 6% to 8%, we know the coupon rate on a bond cannot
change. The problem is that if a bond pays 6% while new debt instruments are paying 8%,
rational investors will not purchase the 6% bond when they could purchase an 8% bond. The
only way that the 6% bond will be sold is if the market offers the bond at a discount or at a
price that is less than par value. As a result, the price of the bond will decrease.
Investors who buy this 6% bond will miss out on the higher coupon rate, but will make a
capital gain when they receive the principal at maturity. If interest rates keep climbing, the
bond’s price will keep falling. Conversely, if interest rates fell below the 6% coupon rate,
say to 4%, investors will be willing to pay a premium (more than par) to earn the 6% coupon
rate offered by the bond. Consequently, the price of the bond will increase. Bond prices
continually change in reaction to changes in interest rates.


Par value or face value is the amount of money that the issuer promises to pay at maturity.
Nearly all bonds have a $1,000 par value or are in multiples of $1,000. About the only bonds that
have par values of less than $1,000 are Canada Savings Bonds and provincial savings bonds.


ABC Co. issues a 5-year, $1,000 par value bond with a 10% coupon and interest paid semi-
annually. Investors should know that if they purchased the bond, they would receive $1,000 at
maturity and payments of $50 every six months. Interest is calculated as: Coupon Rate x Par
Value. In this case 10% x $1,000 = $100 annually. Since interest is paid semi-annually or twice
a year, the investor would receive, $100 ÷ 2 = $50 every six months.

The price at which the bond is offered for sale is known as the ask price and the price a
buyer is willing to pay for the bond is known as the bid price. Standard practice in the
industry is to quote market prices as a percent of par. For example, a bid of 97 means that
the offering price is 97% of par, or $970. An ask price of 99 would mean that the
bondholder is willing to sell at 99% x $1,000, or $990. The difference between the bid and
ask price is known as the dealer’s spread or profit.
Bonds that trade at less than the $1,000 par value are said to trade at discount. Bonds that trade
for more than $1,000 are said to trade at a premium. For example, an investor purchases a bond
at a price of $970. This bond is said to be trading at a discount to par. Another investor, who
purchases a bond at a price of $1,050, is purchasing the bond at a premium.

With very rare exceptions, all bonds have a maturity date which is the date when the
borrower will repay the debt in full. Maturities can range from less than one year to longer
than 20 years. Debt securities of one year or less are considered to be money market
instruments. Short-term bonds have a maturity of up to three years; medium-term debt,
three to ten years and long-term debt, more than ten years.



In all instances when maturities are quoted, it represents the time from the present to the
maturity date. For example, a bond issued five years ago with a 12-year maturity date
would be referred to as a seven-year bond. When it was issued it was a long-term bond,
but is now considered a medium-term bond. Table 5.2 shows these categories.


Money Market Short-Term Bonds Medium-Term Bonds Long-Term Bonds

Up to Up to 3 years From 3 to 10 years Greater than 10 years
one-year term remaining to maturity remaining to maturity remaining to maturity


Most corporate bonds carry a call or redemption provision that allows the issuer to call or take back
the debt security prior to its maturity. While there may be a number of reasons for calling in the debt,
the main reason is to allow the issuing company to refinance at a lower cost. For example,
a company issued a 20-year bond with a 10% coupon rate. Interest rates in the market
have subsequently fallen to 5%. Rather than continue to pay a coupon at the higher 10%
rate, the company would sell a new issue at 5% and retire the higher-costing issue.
The call feature is a disadvantage to the investor since the company will only use it when
interest rates have fallen. The call provision forces the investor to relinquish the higher-
paying bond and then reinvest in lower-paying securities. To compensate for that
disadvantage, the investor will likely be offered a premium when the bond is called.

Types of Debt Securities

Just as there are many types of investors, there are many types of debt securities and various
methods of classifying these securities. Debt securities may be classified according to the type
of securities pledged, the place of issue or the currency of issue. The following section describes
the most common types of debt securities that are currently available in the market.


The Government of Canada is the largest issuer of long-term, marketable bonds in
Canada. These debt securities are usually purchased and sold by investors and institutions
through brokerage firms and other financial institutions. Most Government of Canada
bonds are non-callable. Long-term Government of Canada bonds are similar to long-term
corporate debt securities but carry a lower risk.


In 1991, a new type of marketable bond was issued. The federal government issued $700 million
worth of Government of Canada Real Return Bonds with a nominal return that was linked to the
Consumer Price Index. Both the semi-annual interest payments and the final redemption value of
each bond are calculated by including an inflation factor. For example, if inflation (as measured
by the CPI) increased by 1½% over the first six-month period after it was issued, the value of a
$1,000 Real Return Bond at the end of the six months would increase to $1,015 ($1,000 x .015).
The interest payment for the next half-year would then be based on this amount rather than the



original bond value of $1,000. To calculate the maturity amount, the original face value of
the bond would be adjusted for inflation that has occurred since the issue date of the bond.
In other words, at maturity, the principal would be repaid in inflation-adjusted dollars.


Treasury bills are short-term government obligations. Every two weeks the Minister of Finance
through the Bank of Canada sells treasury bills (T-bills) at an auction. T-bills have original terms
to maturity of three months, six months and one year. Originally, they were available in large
denominations only. As a result, they appealed only to large institutional investors such as
banks, insurance, trust and loan companies and wealthy individual investors. To attract retail
investors, the government now offers T-bills in denominations as low as $1,000.
T-bills do not pay a stipulated rate of interest. Instead, they are sold at a discount (below par)
and mature at 100 or par. The difference between the issue price and par value at maturity
represents the investor’s return. Under the Income Tax Act, this increase is taxable as interest
income not as capital gain.


The Government of Canada also issues a slightly different debt security geared for the
smaller investor. These are known as Canada Savings Bonds (CSBs). Unlike other bonds,
CSBs can be cashed by the owner at any bank in Canada at any time. Since they are not
transferable and hence have no secondary market, CSBs do not rise and fall in price and may
always be cashed at their full par value plus (eligible) accrued interest. This means that CSBs
are not subject to interest rate risk and may be an excellent choice either as a short-term
investment or as an emergency source of funds. Purchasers must be Canadian residents with a
Canadian address for registration purposes. Although ownership of a CSB cannot be
transferred or assigned, they may be used as collateral for loans.
Canada Premium Bonds (CPBs) are similar to CSBs but offer a higher rate of interest when
they are issued. They can be redeemed only once a year, without penalty, on the anniversary
of the date of issue and for 30 days thereafter.


CSBs pay regular or compound interest. If the bond pays regular interest, the investor will
periodically receive a cheque for the interest owed. If the bond is a compound bond, the interest
will accrue. This means that although the investor has earned interest, it will not be paid out. It
is added to the value of the bond each time it is earned. The bond increases in value as a result
of this accrued interest. After the first period, the interest is calculated not only on the principal
originally invested, but also on the accrued interest that continually builds up. The bond, in
effect, earns the investor interest on interest. Compounding returns can be a powerful
investment tool, as we have seen earlier in this chapter.


Just like a federal government bond, a typical provincial bond or debenture issue is used to
provide funds for program spending and to fund deficits. In the same manner that individuals
borrow funds to purchase a house today, provincial expenditures are made today in anticipation
of benefits to be received in the future. Today’s incurred debt is funded through future taxes. In
addition to directly funding public projects, there are numerous provincial guarantees that cover



municipal loans and school board issues. In some instances, provinces extend their guarantee to
industrial establishments, usually as an inducement for a corporation to locate in that province.
Most provinces (and some of their enterprises) also issue T-bills. Investment dealers and
banks purchase them, both at tender and by negotiation, for resale. Most provinces also
issue savings bonds similar to CSBs and CPBs.

Today, the instrument that most municipalities use to raise capital from market sources is the
instalment debenture or serial bond. A portion of the debt of an installment debenture or
serial bond matures in each year during its term. For example, a debenture issue of $1
million may be arranged so that $100,000 becomes due each year over a ten-year period. At
the end of ten years, the entire issue will have been paid off. Some municipalities issue term
debentures that have only one maturity date but these are generally confined to larger cities
such as Montreal, Toronto and Vancouver. Present practice is to pattern issues according to
the market preference for terms and repayment schedules.

The strip or zero coupon bond first appeared in Canada in 1982. Strip bonds are created by
a dealer who acquires a block of existing high-quality bonds. The dealer then separates or
“strips” the individual interest coupons from the principal amount of the bond. The
coupons and the principal are then sold separately at a discount to their par value.
Holders of strip bonds do not receive annual interest payments from the bond. Instead, the
strips are purchased at a discount and mature at par. The difference between the purchase
price and the maturity value is interest income for the investor. Canada Revenue Agency
deems the discounted amount to be interest income, not a capital gain, and as such, a
proportion must be reported each year.


Convertible bonds and debentures possess the characteristics of bonds and debentures
because they carry a fixed interest or coupon rate and a maturity date. However, they also
offer the potential for capital appreciation through the right to exchange the debentures or
bonds for a fixed number of common shares of the same company at stated prices during a
certain period of time.

Debt Security Pricing Principles

When a company or government issues a debt security, it contracts to pay a fixed interest
rate for a fixed period of time and at maturity, repay the par or face value. Given this
definition, the current price of the debt security is a function of the coupon rate, the time to
maturity and current interest rates in the market. Since most bonds have a par value of
$1,000, the price at maturity per bond is constant.
Of the three pricing variables, only the coupon rate does not change. As time goes by, the
time to maturity obviously grows shorter. Interest rates, however, fluctuate during the life of
the debt security and are subsequently responsible for changes in the price of all outstanding
fixed income securities. As pointed out earlier, market interest rates are beyond the control
of the investor or fund manager and, therefore, are deemed to be a type of systematic risk.



For investors who expect to hold a bond to maturity, price fluctuations are not a concern.
However, if the investor sells the bond prior to maturity, changes in interest rates and bond
values may mean that the investor will receive a price greater or lower than par or the price
originally paid for the security.


In the investment industry, fixed income securities are traded on the basis of yield, not price.
Debt securities can be viewed in two ways. They can be viewed as both a short-term and a long-
term investment (purchased and held to maturity). As a short-term investment, investors are
interested in the yield generated by the interest (cash flow) relative to the price paid for the bond
(the current yield). The short-term yields allow investors to compare short-term investments in
bonds with other short-term investment opportunities (GICs, savings accounts, T-bills, etc.). In
the long run, the investor must consider both the cash flow (annual interest) and the fact that he
or she may realize a capital gain or loss if the bond is purchased at a premium or at a discount,
and held to maturity. The long-term yield on a bond is called yield to maturity.

While bonds and debentures are usually considered long-term investments, they can be also
used as shorter-term investments. To compare short-term bond investments with other short-
term investment opportunities, the investor needs a comparative measure. One comparative
measure is referred to as the current yield and is calculated as:
Current Yield = Annual Cash Flow ´100
Amount Invested

Annual Cash Flow = the dollar amount of annual coupon payments

Amount Invested = market price at time of purchase (quoted as a percent of par)


An investor is considering two one-year investment alternatives. A one-year GIC with a

yield of 4.80% or a bond with a 4.75% coupon selling for 97½. Based only on yields,
which would be the better choice?

The current yield (CY) on the GIC is obviously 4.80%.

The current yield on the bond:

4.75%´$1, 000
CY = ´100 =
4.87% $975
Based strictly on current yield, the one-year bond has a slightly better rate of return (4.87%)
than the GIC yielding 4.80%.

Current yield is also used when assessing the dividend yield of a preferred or common stock.
Annual Dividend
CY = ´100
Market Value of Common Share



A stock with a current market price of $60 that pays an annual dividend of $6, therefore,
yields 10% ($6 divided by $60 times 100).


Approximate yield to maturity (AYTM) is the rate of return an investor will receive if the bond
or debenture is held from the purchase date to maturity. Unlike current yield, AYTM not only
reflects the investor’s return in the form of interest income but may also include a capital gain (or
loss). A capital gain occurs if the bond is purchased at a discount to par and held to maturity. A
capital loss, however, is incurred if the bond is purchased at a premium and held to maturity.
Current yield and AYTM also differ as a result of the definition of the price that is used in
each formula. In the current yield calculation, the market price (at time of purchase) is used.
However, a more precise yield can be calculated on long-term bond investments by
averaging the purchase price with the redemption price which is always par or 100.
In addition, the generic rate of return formula has to be adjusted to take into account that the
investor is trying to arrive at an “annual” rate of return for a bond or debenture that covers a
number of years. To do this, the calculation uses the annual interest in dollars, not the total
interest received over the term, and an annual portion of the total capital gain or loss.
The formula for the approximate yield to maturity is:
AYTM = Annual Cash Flow in Dollars + Annual Portion of Capital Gain (or Loss) ´100
(Price Paid +Price at Maturity)

This can be summarized as:

Annual Interest Income + Annual Price Change ´100
(Purchase Price +100)

Bond yields are usually based on a $100 par value (or $1,000). Therefore, the yield is not
affected by the actual amount of the bond as interest income, change in price, and purchase
price are all always based on either a $100 par value or a $1,000 par value.
Bond yields are usually rounded off to two decimal places which is accurate enough for
most purposes. The exception is Treasury bills and other money market instruments where
yields are sometimes rounded to three or more places.
While speaking of accuracy, it should be remembered that yield to maturity is an
approximation. A financial calculator or spreadsheet using the present value method is
required to achieve a precise yield. As expected, bond traders use this more precise method.




An advisor is asked for the approximate yield on a 10%, $1,000 bond due to mature in eight
years and purchased at 92.

The contractual interest obligation on this bond is 10% of par, and so $100 (10% x $1,000) of
interest income will be paid each year per $1000 of par. Interest income, or cash fl ow = $100.

The bond was purchased at $920 (0.92 x $1,000), and will mature at 1,000. Therefore, it will increase over
the remaining life of the bond by $80 ($1,000 - $920). Since there are eight years remaining in this bond’s
term, the bond will increase in price by $80 over eight years, for an annual gain of $10.

The purchase price was $920. The redemption or maturity value is $1,000. The average price is $960:
($920 +$1, 000) =
$960 2
Therefore, the approximate yield to maturity on a 10%, $1,000 bond maturing in eight years and
purchased at 92 is:
$100 +$10 ´$100
($920 +$1, 000)
= 11.4583%


The value of any security is dependent on its expected future cash flows. For example, when
investors purchase a bond or debenture, they expect to receive interest payments for a
prescribed period plus its principal value at maturity. To determine what an investor should
pay for a bond today, we need to determine its present value using a mathematical technique
called the time value of money. This concept recognizes that future returns are not as
valuable as present values. A dollar received in the future is worth less than a dollar received
today. Or, a dollar in your hand today is worth more than a dollar likely to be in your hand
tomorrow or next month. Given a choice of $1,000 today or $1,000 in one year’s time, a
rational investor would choose the $1,000 today. Why? The $1,000 could be invested today
at the prevailing interest rate and, therefore, would be worth more than $1,000 in one year’s
time. As such, future cash flows must be reduced or discounted to arrive at a present value.
The formula for calculating the present value (today’s market value) of a bond can be
summarized as:
Present Value of Bond = Present Value of Interest Payments +
Present Value of Par Value at Maturity

While mathematical formulae can be used, financial calculators are quickly able to
provide the present value of a bond.




Treasury bills (T-bills), as already mentioned, are very short-term securities that are issued at
a discount and mature at par. No interest is paid in the interim, so the return is generated
from the difference between the purchase price and the sale (or maturity) price.
When an investor purchases a T-bill, no capital gain or loss is expected because it is a short-
term debt instrument and its price does not usually fluctuate in value. Canada Revenue
Agency deems the difference between the price paid and the maturity value to be interest
income (a cash flow), not a capital gain. Because T-bills mature in less than a year and yields
are expressed as an annual rate, a further adjustment must be made to the generic formula.
The formula for the yield on a T-bill is:
T-bill Yield = Cash Flow ´ 365 ´100
Amount Invested Term


An investor purchased a 30-day T-bill for $99,000 that matures at $100,000. Calculate the
annual yield on this investment.

T-bill Yield = $100, 000 -$99, 000 ´ 365 ´100

$99, 000 30
= 0.12289´100
= 12.29

The client will generate $1,000 on an investment of $99,000, or $1,000 ÷ $99,000 = 0.0101. But
this transaction is only over 30 days. To annualize the yield: 0.0101 x 365 ÷ 30 = 0.12289.
Multiply it by 100 to turn it into a percentage.

Other Fixed-Income Products

Other fixed-income products offered by banks, trust companies, caisses populaires, insurance
companies and credit unions tend to have safety as their prime objective. As the financial
services industry becomes more integrated and investors become more sophisticated, new
products are entering the market and traditional offerings are being customized to suit the
diverse needs of investors.

Term deposits offer a guaranteed rate for a short-term deposit (usually up to one year).
Usually there are penalties for withdrawing funds before a certain period (for example, the
first 30 days after purchase).


GICs offer fixed rates of interest for a specific term (longer than a term deposit). Both principal
and interest payments are guaranteed by the financial institution issuing the GIC (and also
insured/guaranteed by the Canada Deposit Insurance Corporation, subject to certain rules). They
can be redeemable or non-redeemable. Non-redeemable GICs cannot be cashed before maturity,
except in the event of the depositor’s death or extreme financial hardship. Interest rates on



redeemable GICs are lower than standard GICs of the same term since they can be cashed
before maturity.
Recently, financial institutions have been customizing their GICs to provide investors with
more choice. For instance, investors can choose a term of up to ten years depending upon the
amount invested (for less than a month, it must be a large amount). Investors can also choose
the frequency of interest payments (monthly, semi-annual, annual or at maturity) and other
features. Many GICs offer compound interest.
GICs with special features include:
• Escalating-rate GICs: The interest rate increases over the GIC’s term.
• Laddered GICs: The investment is divided into equal terms (for example, a five-year $5,000
GIC can be divided into five one-year terms of $1,000 each). As each portion matures, it can be
reinvested or redeemed. This diversification of terms reduces interest rate risk. The objective is
to eventually have a ladder of 5-year GICs, with some maturing every year.

• Instalment GICs: An initial lump sum contribution is made with further

minimum contributions made weekly, bi-weekly or monthly.
• Index-linked GICs: Index-linked GICs are hybrid investment products that combine
the safety of a deposit instrument with some of the growth potential of an equity
investment. They guarantee a return of the initial investment (i.e., principal amount) at
maturity and offer some exposure to equity markets. Most financial institutions offer
these GICs. They have grown in popularity, particularly among conservative investors
who are concerned with safety of capital but want yields greater than the interest on
standard interest-bearing GICs or other term deposits. The main selling feature of an
index-linked GIC is the guaranteed return of the principal amount at maturity even if the
index to which the GIC is linked moves downward during the term of the GIC.
Yields may be a blend of guaranteed interest payments and a percentage of the returns of a
specific market index. Some GICs have returns tied to domestic markets, while others are
tied to global market indices or a combination of benchmarks.
Performance comparisons are difficult; however, some features can and should be compared
in determining whether to invest in index-linked GICs. Along with having different
underlying benchmarks, the terms of these securities will vary. Some tie returns to the level
of the index on a particular date. Some base the return on the average return posted by the
index for a number of periods during the GIC’s term. Others offer “locking-in” provisions
that allow investors to protect (i.e., lock-in) the returns earned as at a specific date, regardless
of what happens afterwards to the performance of the index.
CDIC insures index-linked certificates against issuer default just as it does for conventional
fixed-rate GICs. However, this insurance underlines the fact that returns on index-linked
GICs are considered interest income and are fully taxable.
Although the primary risk to holders of these securities in a market downturn is the forgone
interest that would have been earned by a conventional GIC, this limited risk also implies limited
potential for gain. Holders of these instruments do not necessarily participate fully in the returns
earned by equity markets. Issuers may cap the return of an index-linked GIC at a level below the



potential return of the index. For instance, if the GIC has a 25% cap on returns over a three-year
term and the underlying benchmark goes up by 35%, the investor would get a maximum
of 25%.
• Interest-rate-linked GICs: Interest rates are linked to changes in other rates such as
the prime rate, the bank’s non-redeemable GIC interest rate or money market rates.
Some financial institutions have also developed GICs with specialized features, such as
the opportunity for redemption in a medical emergency or as a vehicle to save for a
home, where regular contributions accumulate towards a down payment.

Preferred Shares
Preferred shares are a hybrid of bonds and common shares. Preferred shares are similar to
bonds in that they offer shareholders a fixed income by paying a regular fixed dividend.
Unlike a bond, however, dividend payments are not guaranteed. It is up to the company’s
board of directors to decide if its preferred dividend payment will be made for that period.
Typically, preferred shareholders rank between the company’s creditors and common
shareholders. They are better protected than the common shareholders but junior to the
claims of the debtholders. It is important to keep in mind that bond and debenture holders are
creditors and preferred shareholders are part owners (as are common shareholders). As noted,
debtholders rank first, preferred shareholders rank second and common shareholders rank
last in the event of a company’s dissolution.


After reading this section, you should be able to:
• Define the major types of securities trading in capital markets: stocks and stock
market indices.

Common shareholders are the owners of a company who initially provide the equity capital
required to start the business. If the venture prospers, the shareholders benefit from the
growth in value of their original investment and from the flow of dividend income. The
prospect of a small investment growing to many times its original value attracts many
investors to common shares. On the other hand, if the business fails, the common
shareholders may lose their entire investment. This possibility of total loss explains why
common share capital is often called venture or risk capital.
Although considered to be a part owner of the business, the common shareholder is in a relatively
weak position, as senior creditors (such as banks), bond and debenture holders and preferred
shareholders all have prior claims on the earnings and assets of the company. Unlike debt interest,
dividends are payable at the discretion of the directors. In many companies, dividend payments



are a routine matter and regularly anticipated by shareholders. Some companies

reinvest all earnings in the business; others lack sufficient earnings to pay dividends.

Rights and Benefits of Common Share Ownership

Common share ownership includes the right to:

• Elect directors, vote on major issues that affect the company and approve
financial statements and auditor’s reports.
• Receive copies of the annual and quarterly reports and other mandatory
information pertaining to the company’s affairs.
• Examine certain company documents such as the by-laws and the register of
shareholders at specified times.
• Question management at shareholders’ meetings.
• Have limited liability.
Benefits of common share ownership include:
• Potential for capital appreciation.
• The right to receive any common share dividends if declared by the company.
• Voting privileges.
• The possibility of enhanced returns through the dividend tax credit.
• Marketability – shares in most public companies can easily be bought or sold.
For many investors, the prospect of capital appreciation is the main attraction of common
shares and, over time, such an attraction has been justified although not all common shares
fulfill this expectation. However, historical returns also indicate that common share prices
can be highly volatile.
As companies earn profits year after year, whatever money is not paid out to shareholders in the
form of dividends will remain in the company as retained earnings. Since retained earnings
form part of common equity, a growth in retained earnings will add to the value of
shareholders’ equity. Assuming a fairly constant number of shares outstanding, the amount
of equity that belongs to each share will increase.
An increase in earnings can lead to an increase in the dividend rate and since yield is
another factor that investors take into account when evaluating stocks, dividend growth can
also lead to an increase in the price of the stock.
Voting rights are an important benefit of common share ownership. However, companies
sometimes have two (or even three) different types of common shares, often designated as Class
A or B. Because all classes may not have voting rights and may differ in other respects such as
dividend entitlement, it is important to know their respective features. Policies have been adopted
to avoid possible investor confusion regarding the rights associated with different voting classes.



Tax Treatment of Common Shares

Investors purchase common shares in anticipation of earning capital gains, which is an
increase in the share price over time (also referred to as capital appreciation). Capital gains
receive preferential tax treatment. Only 50% of any capital gain is added to income and
taxed at the investor’s marginal rate.
Some common shares also pay dividends. If the dividends are from a Canadian company
(i.e., eligible dividends), the investor benefits from the dividend tax credit mechanism —
dividends received in 2011 are “grossed up” by 41% (i.e., 41% is added to the amount of
dividends received) and the grossed-up amount is shown as dividend income on the tax return. A
compensating dividend tax credit equal to 16.44% of the grossed-up amount can be claimed. The net
result is a relatively lower rate of tax on dividend income than what’s payable on interest income. For
example, in BC, at the top marginal rate, interest is taxed at nearly 44%, eligible dividends are taxed
at around 24% and capital gains at close to 22%. That’s why dividends and capital gains are favoured
as a source of income by taxpayers in the upper income brackets.

Stock Market Indices

An index is a statistical measure of the state of the stock market, based on the performance of
certain stocks. There are numerous stock market indices in Canada. The Toronto Stock Exchange
(TSX), the country’s largest, lists 20 indices ranging from the bellwether S&P/TSX Composite
Index and the S&P/TSX 60 Index to lesser known indices such as S&P/TSX Capped Utilities
Index and S&P/TSX Small Cap Index. The S&P/TSX Composite Index is considered to be the
“mirror of the Canadian stock market” and includes over 200 of the largest companies in Canada
while the S&P/TSX 60 Index includes the 60 largest companies in Canada and is akin to the Dow
Jones Industrial Average in the US, in terms of its importance and status in Canada.


After reading this section, you should be able to:
• Define the major types of securities trading in capital markets: derivatives, options,
futures contracts, rights and warrants.

Derivatives are financial instruments that allow market participants to more easily trade
and/ or manage the asset upon which these instruments are based. They are used
extensively by institutional investors, mutual fund managers and speculators. Derivatives
are not asset classes unto themselves. Their values are derived solely from an underlying
interest, which may be a commodity such as wheat or a financial product such as a bond,
stock, foreign currency or an index.
While a stock or bond has a value that can be related to an income flow or an asset base, most of
the value of a derivative stems from the security upon which the derivative is based. A company



can issue derivatives to investors as a method of raising capital or individual investors can
issue them to other parties.
This section covers company-issued derivatives such as rights and warrants and exchange-
traded equity options, and index options. Futures and forwards are also considered in this
chapter as they also derive their value from an underlying security or commodity, such as
corn, hog bellies (bacon), indexes and currencies.

A right is the term applied to the privilege granted to existing shareholders to acquire
additional shares directly from the issuing company. To raise capital through the issuance
of additional common shares, a company may offer each shareholder the right to buy shares
in direct proportion to the number of shares already owned. For example, the offer may be
based on the right to buy one additional new share for each ten shares held. The
subscription or offering price for the new shares is set lower than the current market price
to entice investors to purchase the new shares. Rights are typically short-term in nature
with a lifespan of between four and six weeks.
Rights are issued to the shareholder in the same way as dividends are paid. The company’s books of
record are closed on a certain date, known as the record date, and all common shareholders
appearing in the record on that date receive rights – typically one right for each share held.
The rights are transferable, and certificates for the proper number of rights are mailed to
each shareholder.

The most common definition of a warrant refers to the certificate that allows the holder to buy
shares in the company directly from the company at a set price for a set period of time. Warrants
are often attached to new debt and preferred share issues to make these issues more attractive
to buyers. Warrants give the new issue buyers the potential to participate in capital gains on the
underlying common share’s market price, thereby functioning as a sweetener (or equity kicker).
They are usually detachable either immediately or after a certain holding period and then trade
separately. A warrant’s lifespan is longer than that of a right and normally extends from one to
several years from date of issue. One of the main attractions of warrants is their leverage
potential. Warrants are usually priced much lower than the underlying stock and the warrant tends
to move in the same direction and to the same degree as changes in the price of the stock.

An option is a contract or agreement between a buyer and seller based on a particular asset or
security called the underlying security. The buyer pays a premium or fee to obtain certain rights
from the seller who receives this amount and in turn, takes on an obligation. The contract has a
limited lifespan or time to expiry. The date on which the contract expires is known as the expiry
date and the price or level at which the rights granted to the buyer can be exercised is called
the strike or exercise price. The contract is based on a particular number of shares or units of
the underlying security. In the case of an equity option listed on an exchange, the underlying
contract size is always 100 shares. Options are usually bought or sold through an exchange
facility and, as such, exchange-traded options have a secondary market.



There are two types of options – calls and puts. A call option grants its holder (or buyer) the
right to buy the underlying security at the strike or exercise price at any time until expiration.
The seller (or writer) of the call has the obligation to sell or deliver the underlying security at
the strike price until the expiry date.
An investor purchasing a call option contract believes that the price of the underlying security
will rise in value. The investor could, of course, purchase the underlying security itself, using
either a cash or margin account. But buying a call option typically offers the greatest potential
return. The decision will depend on the strength of the investor’s belief that the price will
rise. The seller of the call option, on the contrary, believes that the price of the underlying
security will remain the same or decline in value.

A put option grants the holder or buyer the right to sell the underlying security at the strike
price until the expiry date while the seller or writer of a put has the obligation to buy or take
delivery of the underlying security until the expiry date. The holder of the put option believes
that the price of the underlying security will decline. The seller of the put option, on the
contrary, believes that the price of the underlying share will remain the same or rise in price.


Table 5.3 provides an easy way to remember the rights and obligations associated with
option positions.


Holder or Buyer Seller or Writer

Pays Premium Receives Premium

An underlying interest at a fixed price for a specified time period

Pays Premium Receives Premium


An underlying interest at a fixed price for a specified time period.

Futures and Forwards

Both futures and forwards contracts are derivative instruments used extensively as a risk
management tool by portfolio managers, corporations and manufacturers as well as individual
investors and other hedgers. Speculators wishing to profit from market behaviour also use
futures. Like options, both futures and forwards allow the investor to use a great deal of leverage.
Often very little margin is required from the investor to initiate a trade in these instruments and
although this leverage can be advantageous, it can lead to tremendous risk. Any person trading in



futures and forwards markets should be fully aware of the total risk involved with any trade
and should have the financial resources available to cover worst-case losses.
Futures contracts are legally binding commitments to deliver or take delivery of a specified
quantity and quality of a commodity at a specified future time period and at a price agreed
upon when the contract is initiated. These products trade by open outcry in the trading pit
of a commodity or futures exchange. The delivery time period can be a four to six week
window in the case of a commodity such as corn or wheat or one day for an index contract.
A futures contract does not entail an immediate transfer of ownership of the underlying security.
The contract is set at today’s market prices but is for delivery or consummation sometime in the
future. In actuality, most contracts are closed out in the marketplace prior to this delivery date so
physical deliveries are rare and occur only in about 2% of all futures contracts.
In addition to agricultural products such as wheat, canola, corn, coffee, cocoa, hogs and
cattle, metals (e.g., gold, copper and silver), lumber and plywood, certain foreign currencies
and heating oil also trade on futures markets. Some financial instruments, including several
types of interest rate products and stock indexes, also trade as futures contracts.
Forwards are the over-the-counter equivalent of futures contracts. A forward allows the holder to
make or take delivery of the underlying commodity or financial instrument at some time in the future
at a price that has been negotiated based on today’s market values. Unlike a future, a forward is a
contract between two individuals rather than a contract negotiated on an exchange floor. Forward
contracts have advantages over futures contracts because the details can be tailored
to meet the exact needs of the parties. Forwards, however, can suffer from illiquidity because
there may not be another party willing to accept such a specific contract. Another risk with
forwards is default risk. Futures are cleared through a clearing corporation that guarantees the
performance of the contract. Forwards are backed only by the credit-worthiness of the two parties.


After reading this section, you should be able to:
• Describe how a mutual fund works.

Introduction to Mutual Funds

Over the years, a diverse range of managed fund products has emerged to meet the many different
investment objectives of the investing public. The majority of products are individual mutual
funds that are typically part of larger fund families in which a central company manages several
different funds, each with distinct investment objectives. Theses funds are distributed either
directly by the company’s own sales force or through stockbrokers and independent mutual fund
salespeople. Other fund groups are managed and sold in-house (called proprietary funds) by trust
companies, banks, life insurance companies and credit unions.
A fund’s prime investment goals are stated in the fund’s prospectus and generally cover the degree of
safety or risk that is acceptable, whether income or capital gain is the prime objective and the



main types of securities in the fund’s investment portfolio. Individuals who sell mutual
funds must have a good understanding of the type and amount of risk associated with
each type of fund.
An investment fund is a company or trust engaged in managing investments for other people. By
selling shares or units to many investors, the fund raises capital which is then invested according
to the fund’s investment policies and objectives. The fund makes money from the dividends and
interest it receives on the securities it holds and from capital gains obtained through trading its
investment portfolio. A mutual fund may be organized as either a trust or a corporation.
The mutual funds industry in Canada has experienced tremendous growth since 1980. In
1980, mutual fund net assets totalled only $3.6 billion in Canada. By 2000, mutual fund
net assets grew to more than $418 billion. By the end of 2009, mutual fund net assets
totalled approximately $595 billion (source: Bloomberg).


Mutual funds offer many advantages for the investing public. Besides offering varying
degrees of safety, income and growth, their chief advantages are:

Low Cost Professional Management

The fund manager, an investment specialist, manages the fund’s investment portfolio on a
continuing basis. Most investors purchase mutual funds because they do not have the
time, knowledge or expertise to monitor their portfolio of securities. It is an inexpensive
way for the small investor to access professional management of their investments.
The fund manager’s job is to analyze the financial markets and select securities that best match
a fund’s investment objectives. The fund manager also plays the important role of continuously
monitoring fund performance in order to fine-tune the fund’s asset mix as market conditions
change. Professional management is especially important when it comes to specialized asset
categories, such as overseas regional funds, sector funds or small-cap funds. These specific
types of funds are called specialty funds.

A typical large fund might have a portfolio consisting of 60 to 100 or more securities in 15
to 20 industries. For the individual investor, acquiring such a large portfolio of stocks is
probably not feasible. Because individual accounts are pooled, sponsors of managed
products enjoy economies of scale that can be shared with mutual fund shareholders or
unitholders. In addition, managed funds have access to a wider range of securities and can
trade more economically than an individual investor. Consequently, fund ownership
provides a low cost way for small investors to acquire a diversified portfolio.

Variety of Types of Funds/Transferability

Many different types of funds, from fixed income funds to aggressive equity funds, are
available which enables investors to meet a wide range of objectives.
Most fund families also permit investors to transfer between two or more funds that are
managed by the same sponsor at small or no additional fees. Transfers are also usually
permitted between different purchase plans under the same fund.



Variety of Purchase and Redemption Plans

There are many purchase plans, ranging from one-time, lump-sum purchases to regular
purchases in small amounts under periodic accumulation plans (pre-authorized contribution
plans or PACs). One of the main advantages of mutual funds is the small amount of money
required to invest. With as little as $100, an investor can begin to purchase units in a fund and
make regular contributions through a PAC. Investors who want to redeem their funds also
have a wide variety of plans to choose from.

Mutual fund shareholders have a continuing right to redeem shares for cash at net asset
value. Payments upon redemption must be made within three business days, in keeping
with security industry settlement requirements.

Ease of Estate Planning

A mutual fund share or unit represents a broadly diversified portfolio that continues to be
professionally managed during the probate period until estate assets are distributed. In
contrast, other types of securities may not be readily traded during the probate period even
if market conditions undergo dramatic changes.

Loan Collateral
Fund shares are usually accepted as security for a bank loan.

Margin Eligibility
Fund shares are acceptable for margin purposes and, as such, allow aggressive fund buyers
access to the benefits and risks of leverage in their financial planning.

Various Special Options

Mutual funds consist of not only an underlying portfolio of securities, but also a package of
customer services. Most mutual funds offer the opportunity to compound an investment
through the reinvestment of dividends.
Other benefits associated with managed products include record-keeping features that save
time for clients and their advisors when complying with income-tax reporting and other
accounting requirements. For example, mutual fund companies that administer registered
plans had procedures that monitored an account and flagged it for action if an individual
investor exceeded the 30% limit on foreign content. The February 2005 federal budget
eliminated the 30% foreign property rule, to allow broader international diversification
opportunities for retirement investments.
In sum, mutual funds offer a wide range of flexible money management services.


For most people, a weakness in investing in a mutual fund is the perceived steepness of their sales and
management costs. Historically, most mutual funds charged a 9% front-end load or sales commission
in addition to a management fee. In comparison, brokers typically charge around a 3% commission on
single stock purchases. Competition in the market has subsequently reduced both load and
management fees and investors are now offered a wider choice of investment



options. Many providers (especially the large chartered banks) offer hundreds of funds for
sale on a “no load” basis.

Unsuitable as a Short-Term Investment

Most funds emphasize long-term investment and, consequently, are unsuitable for investors who
are seeking short-term performance. Since sales charges are often deducted from a plan holder’s
contributions, purchasing funds on a short-term basis is not generally beneficial. An investor
would want to recoup the sales charges, at the very least, on each trading transaction. This
disadvantage does not apply to money market funds which are designed with liquidity in mind.

Unsuitable as an Emergency Reserve

With the exception of money market funds, fund holdings are generally not recommended
as an emergency cash reserve, particularly during declining or cyclically low markets when
a loss of capital could result from an emergency redemption or sale.

Professional Investment Management Is Not Infallible

Like equities, mutual fund shares or units can decline in falling markets where unit values are
subject to market swings (systematic risk). Volatility in the market is extremely difficult to
predict or time and is not controllable by the fund manager.

Tax Complications
Buying and selling by the fund manager creates a series of taxable events that may not suit
an individual unitholder’s time horizon. For example, although the manager might consider it
in the best interests of the fund to take a profit on a security holding, an individual unitholder
might have been better off if the manager had held on to the position and deferred the capital
gains liability.

The Structure of a Mutual Fund


Mutual fund companies may be set up as federal or provincial corporations. Provided that
they meet certain conditions set out in the Income Tax Act, investment fund corporations
are eligible for a special taxation rate. Under the Act, the corporation’s holdings must
consist mainly of a diversified portfolio of securities and its income must be derived
primarily from the interest and dividends paid out by these securities and any capital gains
realized from the sale of these securities for a profit. Investors in mutual fund corporations
receive shares in the fund instead of units that are sold to investors in mutual fund trusts.

The directors of a mutual fund corporation and the trustees of a mutual fund trust hold the
ultimate responsibility for the activities of the fund by ensuring that the investments are in
keeping with the fund’s investment objectives. To assist in this task, the directors or
trustees of the fund may contract the business of running the fund to an independent fund
manager, a distributor and a custodial organization. While the fund itself issues and
redeems its own securities, it may enter into detailed contracts (with independent
managers, distributors and custodians) that identify the services each will provide and the
fees and other charges to which each is entitled.




The fund manager provides day-to-day supervision of the fund’s investment portfolio. In trading
the fund’s securities, the manager must observe a number of guidelines specified in the fund’s
own charter and prospectus as well as constraints imposed by provincial securities commissions.
Other responsibilities of a fund’s manager include calculation of the fund’s net asset value or
price per unit or share, preparation of the fund’s prospectus and reports and supervision of
shareholder or unitholder record-keeping. The fund manager must also provide the custodian
with documentation for the release of cash or securities. The fund manager receives a
management fee for these services. This fee is paid annually and is calculated as a percentage
of the net asset value of the managed fund.

Mutual funds are sold in many ways: by advisors employed by securities firms, by a sales
force employed by some organizations that control both management and distribution (e.g.,
Investors Group), by independent direct sales organizations and by “in-house” distributors.
The latter include employees of trust companies, banks and credit unions who have duties
other than selling.

When a mutual fund is set up, an independent financial organization, usually a trust
company, is appointed as the fund’s custodian. The custodian collects money received from
the fund’s buyers and from portfolio income and arranges for cash distributions through
dividend payments, portfolio purchases and share redemptions.
Sometimes, the custodian also serves as the fund’s registrar and transfer agent and is
responsible for maintaining ownership records.

Pricing of Mutual Funds Units or Shares

Mutual fund shares or units are purchased directly from the fund (often through a distributor)
and are sold back to the fund when the investor redeems his or her units. Given that they
cannot be purchased from or sold to anyone other than the fund, mutual funds are said to be
in a continuous state of primary distribution. Securities sold in the primary market are
usually sold through an information document known as a prospectus and mutual funds are
no exception to this rule.
The price an investor pays for a share or unit is known as its offering price. In the financial
press the offering price is expressed as the net asset value or NAV. The redemption or selling
price is the price the investor receives when he or she sells the shares or units back to the fund.
When an investor purchases or sells a mutual fund share or unit, the price paid or received will
equal or be very close to the value of the net assets held. It is usually expressed on a per share or
unit basis called net asset value per share (NAVPS). This price is based on the NAVPS at the close
of business on the day that the order was placed. The NAVPS is the theoretical amount a fund’s
shareholders would receive for each share if the fund were to sell its entire portfolio of investments
at market value, collect all of its receivables and pay all of its liabilities.



If a mutual fund does not charge a commission when a share or unit is purchased, an
investor would pay the fund’s current NAVPS. NAVPS is calculated as:
Total Assets -Total Liabilities
Total Number of Shares or Units Outstanding

For example, ABC fund has $13 million in assets, $1 million in liabilities and one million
units outstanding. The offering price (the price paid by an investor for one unit) would be
calculated as:
NAVPS = $13, 000, 000 -$1, 000, 000 = $12 per unit
1, 000, 000

This would also be the redemption price if no sales charges or fees were levied at redemption.

Mutual Funds Fees

Mutual funds can be categorized according to the type of sales commission or load. If
loads are charged when the investor purchases shares or units, they are called front-end
loads; if fees are charged at redemption, they are called back-end loads. Most load funds
let the investor choose between front-end or back-end charges.

Some funds charge a front-end load which is payable to the distributor at the time of
purchase. It is usually expressed as a percentage of the purchase price or NAVPS. The
percentage typically decreases as the purchase amount increases.
Investors should be aware that the front-end load effectively increases the purchase price of
the units and, consequently, reduces the actual amount invested. For example, a $1,000
investment in a mutual fund with a 4% front-end load means that $40 (4% × $1,000) goes to
the distributor while the remaining $960 is actually invested.
Regulations require that front-end loads must be disclosed in the prospectus both as a percentage
of the purchase amount and as a percentage of the net amount invested. In the example above,
the prospectus would state that the front-end load charge would be 4% of the amount purchased
(($40 ÷ $1,000) × 100) and 4.17% (($40 ÷ $960) × 100) of the amount invested.
To determine a fund’s offering or purchase price when it has a front-end load charge, you
must first determine the NAVPS and then make an adjustment for the load charge. Using an
NAVPS of $12 and a front-end load of 4%, the offering or purchase price is calculated as:
Offering or Purchase Price = NAVPS
100% -Sales Charge

Offering or Purchase Price = $12 = $12 = $ 12 = $12.50
100% - 4% 1.00 -0.04 0.96

Note that the sales charge of 4% of the offering price is the equivalent of 4.17% of the net
asset value (or net amount invested):
4% of $12.50 = $0.50
= 4.17%



Many mutual funds, primarily those offered by direct distribution companies and banks, are
sold to the public as no-loads with little or no direct selling charges. Although there are no
direct selling charges, some discount brokers may levy modest “administration fees” to
process the purchase and/or redemption of no-load funds. These funds, like other funds,
charge management or other administrative fees.
There was a great deal of controversy when no-load funds were introduced. Many felt that
funds had to make money somewhere. As such, the no-load funds were said to have higher
management fees. Prospective purchasers of no-load mutual funds should read the
prospectus carefully as this may or may not be true. Higher management fees may allow
some no-load funds to compensate salespeople through ongoing trailer or service fees, which
are described in more detail below.


A growing number of funds do not apply sales charges on the original purchase, except
for perhaps a nominal initial administrative fee, but instead, levy a fee at redemption.
This type of fee is known as a back-end load, redemption charge or deferred sales charge
(DSC). The fee may be based on the original contribution to the fund or on the net asset
value at the time of redemption.
In most cases, deferred sales charges decrease with the length of time that the fund is held. For
example, an investor could be subject to the following schedule of deferred sales charges:

Year Funds Are Redeemed Deferred Sales Charge

Within the fi rst year 6%
In the second year 5%
In the third year 4%
In the fourth year 3%
In the fi fth year 2%
In the sixth year 1%
After the sixth year 0%

For example, an investor purchases units in a mutual fund at an NAVPS of $10. If the
investor decides to sell the units in the fourth year when the NAVPS is $15, the fund will
charge a 3% DSC.
If the back-end load (i.e., DSC) is based on the original purchase amount, the investor
would receive $14.70 a unit, calculated as:
Selling/Redemption Price = Current NAVPS – DSC
= Current NAVPS – (NAVPS at purchase x DSC percentage)
= $15 – ($10 x 3%)
= $15 – $0.30
= $14.70



If instead, the back-end load is based on the NAVPS at the time of redemption, the
investor would receive $14.55, calculated as:
Selling/Redemption Price = $15 – ($15 x 3%)
= $15 – $0.45
= $14.55

Another kind of fee is the trailer fee, sometimes called a service fee. This is a fee that a
mutual fund manager may pay to the distributor that sold the fund. This fee is paid to the
advisor each year as long as the client holds the fund. Service fees are usually paid from
the fund manager’s management fee.

A small number of funds charge a set-up fee in addition to a front-end load or back-end load.
A variation of the redemption fee is the early redemption fee. Some funds, even no-load
funds, note in the prospectus that funds redeemed within 90 days of purchase may be
subject to an early redemption fee such as 2%. These fees are charged to discourage short-
term trading and to recover administrative and transaction costs.

Switching fees may apply when an investor exchanges units of one fund for another fund in
the same family or fund company. Some mutual fund companies allow unlimited free switches
between funds while others permit a certain number of free switches per calendar year.

Management fees vary widely depending on the type of fund, with fees ranging from less than 1% on
money market and index funds to as much as 3% on equity funds. In general, fees will vary depending
on the level of service required to manage the fund. For example, management fees associated with
money market funds are low, in the range of 0.50% to 1%. The management of equity funds (with the
exception of index funds) requires ongoing research and, therefore, higher management fees that
range from 2% to 3%. Index funds, however, try to mirror the market with occasional re-balancing.
Since this strategy is largely a passive buy and hold strategy, management fees are usually lower. In
all cases, management fees are outlined in the prospectus.

Management fees are generally expressed as a straight percentage of the net assets under
management. For example, they could be “an annual fee of not more than 2% of the average
daily net asset value computed and payable monthly on the last day of each month”. This
method of compensation has been criticized because it rewards fund managers on the level of
assets managed and not on the performance of the fund. Of course, a fund that consistently
underperforms will find that its assets will fall as investors redeem their holdings.
The management fee compensates the fund manager but it does not cover all the expenses of
a fund. Other operating expenses like interest charges, audit and legal fees, safekeeping and
custodial fees and the costs of providing information to shareholders or unitholders are charged
directly to the fund. The management expense ratio (MER) represents the total of management
fees and other expenses charged to a fund; it is expressed as a percentage of the fund’s average



net asset value for the year. Trading or brokerage costs are excluded from the MER
calculation because they are included in the cost of purchasing or selling portfolio assets.
MER is calculated as:

Aggregate Fees and Expenses Payable During the Year ´100

Average Net Asset Value for the Year

All expenses are deducted directly from the fund and are not charged to the investor. As such,
fund expenses decrease the ultimate returns to the investors. For example, if a fund reports
a compound annual return of 7.5% and an MER of 2.5%, it has a gross return of
roughly 10%. This means that the MER, expressed as a percentage of returns, is 25%
of the return [(2.5% ÷ 10%) × 100].
Published rates of return are calculated after the management expense ratio has been
deducted and the NAVPS of investment funds is calculated after the management fee has
been deducted. Funds are required by law to disclose in the fund prospectus both the
management fee and the management expense ratio for the last five fiscal years.


After reading this section, you should be able to:

• Identify non-insurance investment products where redemptions would have

tax implications.
After acquiring shares in a mutual fund, an investor may decide to dispose of his or her
shares or units. The mechanics of disposing fund units are fairly straightforward. The client
must notify the fund or the fund’s distributor and request redemption of all or part of his or
her units or shares. At the end of the valuation day, the net asset value is calculated and a
cheque is sent to the investor.

Calculation of the Redemption or Selling Price

Mutual funds redeem their shares on request at a price that is equal to the fund’s NAVPS. If
there are no back-end load charges, the investor receives the NAVPS. If there are back-end
load charges or deferred sales charges, the investor receives the NAVPS less the DSC.

Tax Consequences
Mutual funds can generate taxable income in two ways:

• Through the distribution of interest income, dividends and capital gains realized by
the fund.
• Through any capital gains realized when the fund units/shares are eventually sold.



When mutual funds are held outside a registered plan (such as an RRSP or RRIF), the
unitholder of a mutual fund is sent T3 and T5 forms. Each form lists all income that has been
paid out during the year including dividends that have been reinvested. Both forms show the
types of income distributed including foreign income and Canadian interest, dividends and
capital gains. Each type of income is taxed at the fundholder’s personal rate in the year that
the income was received.
For example, an investor purchases an equity mutual fund for $10 per share and in each of the
next five years, receives $1 in annual distributions composed of $0.50 in dividends and $0.50
in distributed capital gains. Each year, the investor would receive a T5 from the fund company
indicating that he or she must report an additional $1 in income. The T5 could indicate
offsetting dividend tax credits (from dividends earned from taxable Canadian corporations).
It is sometimes difficult for mutual fund investors to understand why they have to declare capital
gains when they have not sold any of their units. There is, however, a simple explanation. The
fund manager buys and sells stocks throughout the year for the mutual fund. If the fund manager
sells a stock for more than its purchase price, a capital gain results. It is this capital gain that is
passed on to the mutual fund holder. Unfortunately, a capital loss that arises when a stock is
sold for less than its purchase price cannot be passed on to the mutual fund holder. These losses,
however, are held in the fund and may be used to offset capital gains in subsequent years.


When a fund holder redeems the shares or units of the fund, the transaction is considered a
disposition for tax purposes and may give rise to either a capital gain or a capital loss. Only
50% of net capital gains (total capital gains less total capital losses) are added to the
investor’s income for tax purposes.
Suppose in the above example that the mutual fund shareholder sold his or her shares in the fifth
year at an NAVPS of $16. Having bought them at NAVPS of $10, the investor would have to
report an additional $3.00 in income (per share) for the year (50% × $6 capital gain). This capital
gain would not be shown on the fund’s T5, as this was not a transaction initiated by the fund.


A potential problem may arise when an investor chooses to automatically reinvest fund income in
additional non-registered fund units. The complication arises when the fund is sold and capital
gains must be calculated on the difference between the original purchase price and the sale price.
The adjusted cost base of the investor’s fund holdings will include the original units purchased
plus those units purchased over time through periodic reinvestment of fund income. This mix
of original and subsequent units can make it difficult to calculate the adjusted cost base of
the investment in the fund. Many investment funds provide this information on quarterly or
annual statements. If these statements are not kept, it could be very time consuming to
attempt to reconstruct the adjusted cost base of the investment. In addition, if careful records
have not been kept, the investor could be taxed twice on the same income.
For example, consider the case where an investor buys $10,000 of fund units. Over time, annual
income accrues and tax is paid on it, but the investor chooses to reinvest the income in additional
fund units. After a number of years, the total value of the portfolio rises to $18,000 and the
investor decides to sell the fund. A careless investor might assume that a capital gain of $8,000
has been earned. This would be incorrect as the $8,000 increase is actually made up of two



factors: the reinvestment of income (on which the investor has already paid taxes) and a
capital gain. The portion of the increase due to reinvestment must be added to the original
investment of $10,000 to come up with the correct adjusted cost base for calculating the
capital gain. If, for example, the investor had received a total of $3,500 in reinvested
dividends over the course of the holding period, the adjusted cost base would be $13,500 (the
original $10,000 plus the $3,500 in dividends that have already been taxed). The capital gain
is then $4,500 ($18,000 - $13,500), not $8,000.


During each year, a mutual fund will realize capital gains and losses when it sells securities
held in the fund. Capital gains are distributed to the fund investors just as interest and
dividends are distributed. If this distribution of capital gains is done only at year-end, it can
pose a problem for investors who purchase a fund at this time.
Consider an investor who purchased a non-registered equity mutual fund on December 1 at an
NAVPS of $30. This fund had a very good year and earned capital gains of $6 per share.
These capital gains are distributed to the investors at the end of December. As is the case with
all distributions, this causes the NAVPS to fall by the amount of the distribution, to $24. At
first glance, one might think that the investor is just as well off, as the new NAVPS plus the $6
distribution equals the original NAVPS of $30. Unfortunately, the $6 distribution is taxable in
the hands of the new investor, even though the $6 was earned over the course of the full year.
For this reason, some advisors caution investors against buying a mutual fund just prior to the
year-end without first checking with the fund sponsor to determine if a capital gains
distribution is pending.



After reading this section, you should be able to:
• Describe risk and volatility as they relate to mutual funds.
• Compare and contrast the investment instruments, risk, and volatility of various types of
funds, including: money market funds, mortgage funds, bond funds, dividend funds,
equity funds, international and global funds, specialty funds, real estate funds, balanced
funds, asset allocation funds, index funds, and fund of funds.

Self-Regulatory Organizations (SROs)

Canadian funds fall under the jurisdiction of the securities acts of each province. Securities
administrators control the activities of these funds and their managers and distributors,
through a number of National and Provincial Policy Statements that deal specifically with
mutual funds, and by provincial securities legislation applicable to all issuers and
participants in securities markets.



The Mutual Fund Dealers Association (MFDA) is the mutual fund industry’s SRO for the
distribution side of the mutual fund industry. It does not regulate the funds themselves. That
responsibility remains with the securities commissions; however, the MFDA regulates how
the funds are sold. The MFDA is also not responsible for regulating the activities of mutual
fund dealers who are already members of another SRO. For example, IIROC members who
sell mutual fund products will continue to be regulated by IIROC.
The MFDA has essentially the same powers as other SROs. That includes the ability to
admit members, to audit and to enforce rules through a disciplinary process that can
result in fines, suspension or loss of registration.


Since fund investors buy the fund’s treasury shares rather than previously issued and
outstanding stock, the treasury shares must be registered for sale in each jurisdiction. With
certain exceptions, they must file a prospectus or simplified prospectus (described below)
each year that must be acceptable to the provincial securities administrator.
Because mutual fund investors typically purchase newly issued or treasury shares of mutual
funds, the fund is considered to be in a continuous state of primary distribution. As a result,
each purchaser must receive a prospectus.


In order to adhere to the disclosure requirements of a prospectus and allow the
industry to function smoothly, a simplified prospectus system is in place.
The simplified prospectus system consists of:
• a simplified prospectus
• the annual information forms
• the annual audited financial statements or interim unaudited financial statements
• other information required by the province or territory where the fund is distributed,
such as material change reports and information circulars
A mutual fund prospectus is usually shorter and simpler than a typical prospectus for a new
issue of common shares. Under the simplified prospectus system, the issuer must abide by
the same laws and deadlines that apply under the full prospectus system. As well, the buyer
is entitled to the same rights and privileges.
Investors purchasing a mutual fund for the first time must be provided with the simplified
prospectus, the latest financial statements and any other information required to be provided by
the province. The securities acts of most provinces require that a prospectus be mailed or
delivered to all purchasers of securities. This mailing or delivery must be made to the purchaser
not later than midnight on the second business day after the purchase. The annual information
form does not need to be included but should be available to the investor if requested.




Much of the disclosure required in the Annual Information Form (AIF) is similar to that
provided in the simplified prospectus. The AIF contains, in addition to the above,
information concerning:
• significant holdings in other issuers
• the tax status of the issuer
• directors, officers and trustees of the fund and their indebtedness and remuneration
• associated persons, the principal holders of securities, the interest of management and
others in material transactions
• the particulars of any material contracts entered into by the issuer


As part of the simplified prospectus system, each fund must provide its investors with financial
statements. Annual audited financial statements must be made available to the securities
commission(s) where the fund is registered on or before the deadline set by the commission(s).
Unaudited financial statements as at the end of six months after the fund’s year-end must
also be submitted to the securities commissions, usually within sixty days after the reporting
date. These statements must also be distributed to new investors.
The following financial statements must be provided:
• The Balance Sheet (Statement of Financial Position/Statement of Net Assets)
• The Income Statement
• Statement of Investment Portfolio
• Statement of Changes in Net Assets
• Statement of Portfolio Transactions

Types of Mutual Funds

Mutual funds offer different risks and rewards to investors and advisors have an
obligation to match appropriate funds with the needs of their clients.
Risk is often discussed in terms of volatility. The more volatile the security or mutual fund,
the greater is the risk. Mutual funds reduce risk through diversification but not all risk can be
diversified away. The following sections discuss those risks that cannot be diversified away,
management fees, and the types of returns an investor expects to receive and the
associated tax implications of these returns.
It was believed that if portfolios were diversified internationally, further risk reduction
would result. While this is marginally true, it is now realized that global markets interact.
For example, when North American markets decline, Asian markets also tend to decline.
Moreover, investing internationally adds a new risk dimension by exposing investors to
foreign exchange risk or currency risk.



All individual risks can be diversified away by creating portfolios. These types of risks are
called diversifiable or non-systematic risks. All those risks that are beyond the control of
the fund manager are called non-diversifiable risks or systematic risks.
There are three basic varieties or asset classes of funds: equity funds, fixed income funds and
money market funds. All other funds in the market are simply variations on these three
themes. For example, equity funds that invest in companies with market capitalization under
a certain amount, say $300 million, are called “small cap” funds and equity funds that invest
outside Canada may be called global equity funds or international equity funds. Equity funds
that invest in companies in the same sector or geographical region are called specialty funds.
All of the aforementioned funds are a type of equity fund. A “fund of funds” is a relatively
recent entrant in the mutual funds marketplace. Essentially, a fund of funds is a fund that
invests in units of underlying mutual funds. They are usually sold “off the shelf” meaning
that the fund of funds has already been created; the investor does not have the ability to
choose the funds that belong in the fund of funds.


The primary objective of this type of fund is to produce some income while maintaining
liquidity through investments in short-term money market instruments such as Treasury bills,
commercial paper and short-term government bonds. These funds offer almost no opportunity
for capital gain as they strive to keep the net asset value fixed at a set level (e.g., $10) by
distributing monthly income to unitholders in cash or new units. The relatively low risk of the
underlying securities and the fixed NAVPS make this category of fund appropriate for
investors who want high liquidity and low risk.
While risk is low, money market funds, as is true of all mutual funds, are not guaranteed. While
fund managers try to maintain a stable NAVPS, rapid increases in interest rates could reduce the
value of the shares or funds. Money market funds are, therefore, subject to interest rate risk.
Distributions received from non-registered money market funds are treated as interest
income. Interest received is 100% taxable. Investors include this interest in their income and
pay taxes on the entire amount received.


Mortgage Funds
The objective of these funds is to generate income and provide a high level of safety. It is
possible to have capital gains if the fund trades the mortgages but, for the most part, interest
income is generated. Mortgage funds typically invest in first mortgages on Canadian
residential properties. Some funds also invest in commercial properties.
Unit and share values are affected by shifts in interest rates (interest rate risk) in the same way
that bond prices are affected by changes in interest rates. Nevertheless, because mortgage terms
are usually shorter than bond terms (e.g., one to five years) and because mortgage payments are
made monthly while bond income is received semi-annually, the volatility of mortgage funds is
lower than that of most bond funds. This lower volatility or risk means that mortgage funds are
considered less risky than bond funds. There is also the possibility of default risk but this is
diversified away. Mortgage funds usually hold several thousand individual mortgages.
As with money market funds, distributions are typically in the form of interest income and
are 100% taxable.



Bond Funds
Bond funds are designed to generate a steady stream of income in combination with the safety of
principal. Bond funds invest primarily in good quality, high-yielding government and corporate
debt securities. Their degree of volatility is related to the degree of interest rate fluctuation;
however, fund managers will attempt to change the term to maturity or duration of the portfolio
and the mix of low- and high-coupon bonds to compensate for changes in interest rates.
Interest rate volatility is the main risk associated with this type of fund. If the fund
invests in corporate bonds, it will also be exposed to default risk. For example, a North
American car manufacturer’s shaky financial prognosis has caused major concerns
regarding the “safety” of billions of dollars in bonds that it has outstanding.
The primary source of returns from non-registered bond funds is interest income. The mutual
fund investor may also receive a capital gain if the fund sells some of its bonds at a profit.


The main investment objectives of these funds are to provide a balanced mixture of safety,
income and capital appreciation. These objectives are sought through a portfolio of fixed
income securities for stability and income and a broadly diversified group of common stock
holdings for diversification, dividend income and growth potential. The balance between
defensive and aggressive security holdings is rarely 50-50. Instead, managers of balanced
funds adjust the percentage of each part of the total portfolio in accordance with current
market conditions and future expectations. In most cases, the prospectus specifies the fund’s
minimum and maximum weighting for each asset class. For example, a balanced fund may
specify a weighting of 60% equity and 40% fixed income.
Asset allocation funds have objectives similar to balanced funds but they differ from
balanced funds in that they typically do not have to hold a specified minimum percentage
of the fund in any class of investment. The portfolio manager has greater freedom to shift
the portfolio weighting among equity, money market and fixed income securities as the
economy moves through the different stages of the business cycle.
An investor in balanced and asset allocation funds would be subject to market and interest
rate risk depending on the split between fixed income and equity securities. The investor
may receive a combination of interest, dividends and capital gains.

Equity funds represent the largest group of mutual funds, based on total assets. The main
investment objective of this type of fund is long-term capital growth. The fund manager
invests primarily in the common shares of publicly traded companies. Short-term notes or
other fixed income securities may be purchased from time to time in limited amounts for
liquidity and, occasionally, income. The bulk of assets, however, are in common shares in
the pursuit of capital gains. Because common share prices are typically more volatile than
other types of securities, prices of equity funds tend to fluctuate more widely than the funds
previously mentioned and are, therefore, considered riskier.
Some equity funds invest in a variety of markets outside of Canada including the United States,
Europe and Asia. These funds invest in markets perceived to offer the greatest opportunity for
growth on a global basis. Investments outside of Canada are also subject to foreign exchange risk
– a non-controllable risk.



As with common stocks, equity funds range greatly in degree of risk and growth potential. These
funds are all subject to market risk. Some equity funds are broadly diversified holdings of blue
chip income-yielding common shares and would, therefore, be classified at the conservative end
of the equity fund scale. Other common stock funds adopt a more aggressive investment stance,
by investing, for example, in young growing companies with an objective of achieving above-
average capital growth. Other equity funds are of a more speculative nature – aggressively
seeking capital gains at the sacrifice of safety and income by investing in certain sectors of the
market (e.g. precious metals funds) or certain geographical locations (e.g. Asian funds).
The tax implications are the same as for any fund that holds equity securities. The
distributions will be in the form of capital gains and dividends, and are taxed accordingly.

This type of equity fund seeks capital gains and is willing to forgo broad market exposure in
the hope of achieving above-average returns. The portfolio manager concentrates holdings in a
group of companies in one industry (e.g., biotechnology/health sciences), geographic location
(e.g., Far East), or segment of the capital market (e.g., precious metals). While still offering
some diversification, specialty funds are more vulnerable to swings in the sector where most of
their shares are held and/or in currency values if they are holding foreign securities. Many
specialty funds tend to be more speculative than most types of equity funds. One type of
specialty fund is a real estate fund that invests in income-producing real property to achieve
long-term growth through capital appreciation and reinvestment of income. Such funds are less
liquid and may require investors to give advance notice of redemption. Their valuation is based
on appraisals of properties held in the portfolio and is done infrequently (monthly or quarterly).

Stock indexes and averages are important statistical tools that enable portfolio
managers and investors to measure their portfolio’s performance against commonly
used yardsticks or benchmarks within the stock market. They help gauge the overall
directional move in that market.
A stock market index is a time series of numbers that represent a combination of various
stocks’ prices that can be used to calculate a percentage change of this series over any period
of time. The chosen stocks are considered as representative of the market as a whole. If the
index rises in value, the market it represents is considered to have risen in value.
The index fund manager’s mandate is to match the performance of the market as
represented by a specific index. He or she needs to make sure that the portfolio reflects the
index it is supposed to mirror. For this reason, management fees associated with index
funds are usually lower than those of other equity funds. The purpose of the fund is to track
a specific market index such as the S&P/TSX 60.
Of late, exchange traded funds (ETFs) have gained in popularity. The Toronto Stock Exchange
(TSX) describes exchange traded funds as “a special type of financial trust that allows an investor
to buy an entire basket of stocks through a single security that tracks and matches the returns of a
stock market index. ETFs are considered to be a special type of index mutual fund, but they are
listed on an exchange and trade like a stock.” ETFs have relatively low operating and transaction
costs and, therefore, are offered at very competitive MERs. However, since they trade like a
stock, commissions must be paid upon purchase and sale.



These funds provide tax-advantaged income with some possibility of capital growth. Dividend
funds invest in preferred shares as well as high-quality common shares that have a history of
consistently paying dividends. Income from these funds is in the form of dividends which have a
tax advantage through the dividend tax credit. There is also the potential for capital gains.
The price changes that lead to capital gains or losses on dividend funds are driven by both
changes in interest rates (interest rate risk) and general market trends (market risk). Price
changes in the preferred share component of the fund are driven by interest rate changes
while general upward or downward movements in the stock market most heavily affect the
common share component.
Recall that preferred shares rank ahead of common shares but below bondholders in the
event of bankruptcy or insolvency. Consequently, dividend funds are considered riskier than
bond funds but less risky than regular equity funds. Dividends received from a taxable
Canadian corporation get preferential treatment by way of the dividend tax credit
mechanism while dividends received from foreign corporations do not.

Comparing Risk and Return of Different Types of Mutual Funds

As explained above, different types of mutual funds are subject to different degrees of risk and
return. Figure 5.8 illustrates the risk-return trade-off between the different types of mutual funds.


Specialty Funds

Equity Funds

Dividend Funds

Balanced Funds

Bond Funds

Mortgage Funds

Money Market Funds


Another factor that complicates comparisons between funds is that there is often no
attempt to consider the relative risk of funds of the same type. One equity fund may be
conservatively managed while another fund might be willing to invest in much riskier
stocks in an attempt to achieve higher returns.



Any assessment of fund performance should consider the volatility of a fund’s returns.
There are a number of different measures of volatility, but each attempts to quantify the
extent to which returns will fluctuate. From an investor’s standpoint, funds that exhibit
significant volatility in returns will be riskier than those with less volatility.


Chapter 5B

Segregated Funds



Segregated Funds


Key Features
Owners and Annuitants
Maturity Guarantees and Death Benefits
• How Maturity Guarantees Work
• Age Restrictions
• Reset Dates
• Death Benefits
Creditor Protection
Segregated Funds and Bankruptcy Law
Segregated Funds and Family Law
Bypassing Probate
Convergence with Mutual Funds
• A Growing Segment
• Need for Common Rules


• Reviews Conducted by CLHIA
• Solvency Monitored by OSFI
• Assuris’s Compensation Fund
• Unique Needs of Segregated Funds
• Buying and Selling Segregated Funds
Fees and Expenses
• The Cost of the Guarantees
• Sales Charges
Tax Considerations
• Effect of Allocations on Segregated Fund Net Asset Values
• Tax Treatment of Maturity Guarantee
• Tax Treatment of Death Benefits
• Interest Deductibility on Borrowing
• Tax Reporting on the T3 Slip
• Segregated Funds and RESPs
• Regulatory Requirements for Issuers
• Key Disclosure Documents
• Other Information Sources
• Advertisements and Marketing
• Innovations Related to Segregated Funds




Segregated funds have unique features that enable them to meet special client needs
such as maturity guarantee, death benefits and creditor protection. Unlike other types of
investment funds, segregated funds are insurance contracts and, therefore, mostly
exempt from the requirements of provincial securities laws.
In this chapter, you will learn about the key investment and insurance attributes of
segregated funds.


After reading this section, you should be able to:
• Define and explain the term IVIC.

• Explain the following terms as they apply to IVICs: Contract holder, Annuitant,
Beneficiary, Contract Date, and Maturity Date.
An IVIC is an “individual variable insurance contract” entered into between a contract holder and
a life insurance company. Maturity and death benefit guarantees are provided to contract holders
and beneficiaries under an IVIC. Purchasers of an IVIC hold an insurance contract that gives
them certain specified benefits based on the value of one or more specified segregated funds (or
groups of assets). A “segregated fund” is a pool of assets owned by the life insurance company
and held by the company separate and apart from other similar pools and its general assets. An
IVIC gives a purchaser the right to choose among various segregated funds.
Individual variable insurance contracts are often mentioned in the same breath as mutual funds
and other types of managed investment products. There are, in fact, many similarities. Segregated
fund contracts and other types of widely held investment funds all offer professional investment
management, diversification, ability to invest in small amounts, regular client statements and
other services including the opportunity to receive investment advice. These investment products
combine investments and related services into an integrated package. With segregated fund
contracts, investments and certain aspects of insurance contracts are combined.
Segregated funds have unique features that enable them to meet special client needs such as
maturity guarantee, death benefits and creditor protection. Unlike other types of investment
funds, segregated funds are insurance contracts regulated by provincial insurance authorities
and, therefore, mostly exempt from the requirements of provincial securities laws. Contract
holders who buy a segregated fund do not actually own the fund’s underlying assets. Instead,
their rights are based solely on the provisions of the contract itself.



Because it is a contract, the rights and benefits associated with holding a segregated fund are
more complex than the rights and benefits associated with holding a security. Essentially, a
segregated fund contract covers the following three parties:
1. The Contract holder: This is the person who purchases the contract (also known
as the policyowner).
2. The annuitant: This is the person on whose life the insurance benefits are based.
3. The beneficiary: This is the person who will receive the benefits payable under the contract
in the event of the death of the annuitant. A contract may have more than one beneficiary.
The maturity date of a segregated fund contract is an important date. It is normally set 10
years from the contract date and, by law, it cannot be less than 10 years. The maturity date is
a critical component of the contract because the maturity guarantee comes into effect on that
date, and no sooner. So, if an investor decides to redeem a segregated fund contract, say 8
years from the contract date, the investor would be paid the market value of the segregated
fund holdings, whatever the market value may be on the date of redemption. The maturity
guarantee would not get triggered until the maturity date.


When the contract is held in a registered plan, such as an RRSP, the Contract holder and the
annuitant must be the same person. When the contract is held outside a registered plan, the
Contract holder or owner of the contract does not have to be the person whose life is insured
under the contract; however, in most situations, the Contract holder and the annuitant is the
same person.
There are restrictions on whose life a Contract holder can base a contract. The general rule is
that the Contract holder, at the time that the contract is signed, must have an “insurable
interest” in the life of the annuitant. Otherwise, the proposed annuitant must consent in
writing to have his or her life insured.
In cases where the Contract holder and the person whose life is being insured are different
persons, the Contract holder may die before the annuitant. If that happens, the contract may
be transferred to a successor Contract holder. If no successor has been designated by the
original Contract holder, the contract becomes part of the Contract holder’s estate.


The segregated fund contract’s beneficiary is the person(s) or organization(s) entitled to

receive any maturity or death benefits payable under the contract. The designation of
beneficiaries can be either revocable or irrevocable. A revocable designation offers the
advantage of greater flexibility because the Contract holder has the freedom to alter or revoke
the beneficiary’s appointment. In the case of an irrevocable designation, changes to the rights
of a beneficiary are subject to the beneficiary’s consent.



A beneficiary should be designated at the time that the Contract holder completes the
application to establish a contract. A copy of the designation should be retained by the
Contract holder and reviewed annually to determine whether any changes are required.
The designation of an irrevocable beneficiary can be made in the segregated fund contract
itself or by a declaration filed with the insurer. It cannot be made in the Contract holder’s
will; if a beneficiary is named in a will, the beneficiary is considered revocable, even if the
will provision intends to appoint the beneficiary irrevocably.
A beneficiary designation made in a will is no longer valid if the will is revoked. Also, a will’s
provisions will be superseded if another designation is made after the date that the will was
signed. On the other hand, a beneficiary designation in a will replaces an earlier designation.
What follows applies to traditional life insurance policies and also to segregated fund
contracts/ IVICs.
It is important to consider the long-term implications of designating a beneficiary
irrevocably. Although it may work nicely in a situation that is well-defined and has a high
degree of certainty, things can and do change over time and a great situation could turn
adverse. For example, assume that Paula and Corey are happily married for the last eight
years, with two children under 6 years of age. Corey is a physician with a thriving practice
and purchases a $5,000,000 insurance policy on his own life and appoints Paula as an
irrevocable beneficiary. Ten years later, the two have problems in their marriage and go
through a bitter divorce. A year after the divorce, Corey marries Wanda and wants to change
the beneficiary designation on his $5,000,000 policy. Unfortunately, he cannot do so without
Paula’s consent and that is unlikely to be forthcoming given the acrimonious nature of their
breakup. If Corey had named Paula as beneficiary (but not irrevocably), then it would have
been a relatively simple matter of changing the beneficiary designation to Wanda.
Irrevocable beneficiary designations are most useful when the insured needs protection from
creditors and the intended beneficiary is not a spouse, child, grandchild or parent. For example,
Calvin is a successful fashion designer, age 35 and single. He has significant business debts but
wants to provide for an aging uncle, Tom, who looked after him in his childhood. He purchases a
$1,000,000 whole life insurance policy on his own life and names Tom as irrevocable
beneficiary. Eight years later, Calvin’s fashion business hits a wall and creditors come knocking.
They seek the $60,000 in cash value built up in the life insurance policy but cannot do so as
Calvin has named Tom as an irrevocable beneficiary. If, instead, Calvin had named Tom as a
revocable beneficiary, this protection would not have been available and Calvin’s creditors could
have seized the $60,000 cash value of the policy in payment of his business debts.
Beneficiary designations in favour of a spouse, child, grandchild or parent of the life
insured result in protection from creditors as soon as the beneficiary is named (similar to
the protection provided when an irrevocable beneficiary is designated). Creditor protection
will be covered in further detail later in this chapter.




After reading this section, you should be able to:
• Explain the age restrictions related to various investments.
• Analyze a variety of client-specific scenarios to determine the impact on the client of
the distinguishing features of segregated funds, including maturity guarantee, death
benefit and reset options.
Segregated funds alter one of the conventional principles of portfolio selection, namely the notion
that the older the client, the less exposure he or she should have to riskier long-term assets.
With the availability of maturity guarantees of up to 100%, along with death benefits, the
risks associated with capital markets become less of an investment constraint. Segregated
funds enable clients to invest in higher-growth asset classes, while offering assurance that the
principal amount of their contributions is protected, either fully or partially.
One of the fundamental contractual rights associated with segregated funds is the guarantee that
the beneficiary will receive at least a partial return of the funds invested in accordance with the
provisions of the contract. Provincial legislation requires that the guarantee be at least 75% after a
10-year holding period. Some sponsors of segregated funds top up the maturity guarantees to
100%. These guarantees – whether full or partial – appeal to people who want specific assurances
about the return of the principal amount invested and a limit on their potential capital loss.
For example, Sergei Yukovich deposited $150,000 in a segregated fund policy and named his
son, Vaslav, as beneficiary. The policy offers a 75% guarantee on death or maturity with a
minimum 10-year holding period. Five years later, Sergei dies in a skiing accident while
holidaying in Switzerland.
If we assume that the investments within the segregated fund policy are worth $200,000 at
Sergei’s death, Vaslav would receive $200,000. If, however, the investments have dropped in
value and are worth $140,000 at Sergei’s death, then Vaslav would receive $140,000 (which
is still greater than the 75% guaranteed amount of $112,500). Now, if we assume that the
investments have suffered a significant decline in value in the intervening five years and are
worth $100,000 at Sergei’s death, then Vaslav would receive the guaranteed amount of
$112,500, i.e., 75% of $150,000, the amount Sergei originally deposited.
If the policy had come with a 100% guarantee on death or maturity, then in the second
instance (i.e., where investments are worth $140,000 at death) and the third instance (i.e.,
where investments are worth $100,000 at death), Vaslav would have received the guaranteed
amount of $150,000.
A Contract holder may make withdrawals from a segregated fund contract during any time that
the annuitant is alive. Guarantees do not apply to amounts that are withdrawn or redeemed from a
segregated fund contract prior to the maturity date. The value of the guarantees would be reduced
by withdrawals and, as such, systems that track the ongoing value of the guarantees must be put
into place. Typically, when periodic deposits have been made, withdrawals will come from



the oldest units first. A partial withdrawal of units purchased on a particular date reduces
the guaranteed amount for the remaining units that were purchased at the same time.
Upon withdrawals from a segregated fund contract, the guarantees can be adjusted on a
dollar-for-dollar basis or on a proportional basis. Let’s look at an example.
An investor has deposited $25,000 in a segregated fund policy which purchased 2,500 units
at $10 each and comes with a 100% guarantee at death or maturity. Now two years later, the
investor wishes to withdraw $5,000 from the contract and the value of each unit has risen to $13.
So the investor would have to give up 384.615 units to get the $5,000 ($5,000 ÷ $13 per unit).
If the policy contract uses a dollar-for-dollar basis (also known as linear basis) for
adjusting the amount of the guarantee, then the guaranteed amount would be adjusted to
$20,000 ($25,000 initial deposit - $5,000 withdrawn).
If, however, the policy contract uses a proportional basis, then the adjusted guaranteed amount
would be different. The investor has sold 384.615 units and, therefore, 2115.385 units are left
(2,500 – 384.615). On a proportional basis, the adjusted guaranteed amount would be
$21,153.85 (initial deposit $25,000 × 2115.385 units remaining ÷ 2,500 units originally
purchased). As you can see, the investor in this situation benefits if the guarantee is adjusted
on a proportional basis. That, however, is not always the case.
Contract holders usually have the right to switch between various funds offered by the insurer;
however, the number of switches may be limited. For instance, some companies allow a certain
number of free switches per calendar year. A charge is levied for all switches made beyond
this amount. These transfers may affect the initial value and date of a policy and the
maturity guarantees may be reset at varying levels or with different maturities.
The death benefits associated with segregated funds meet the needs of clients who want
exposure to long-term asset classes and insurance that protects their beneficiaries if the client
dies. If the annuitant passes away, holdings in a segregated fund will bypass the fees and
delays of probate proceedings. For business owners and self-employed professionals,
segregated funds can also serve to shield their savings from creditors or lawsuits.
Because of the insurance benefits they offer, segregated funds are a more costly form of
managed investment as compared to an uninsured mutual fund. In recommending a
segregated fund to a client, the advisor should weigh the benefits and distinct features of
segregated funds against their added costs.

How Maturity Guarantees Work

Maturity guarantees, particularly those that offer full protection after 10 years, alter the
normal risk-reward relationship. With a maturity guarantee in place, a client can participate
in rising markets without setting a limit on potential returns. At the same time, subject to the
10-year holding period, he or she is assured that invested capital, i.e., principal amount, is
protected from loss.
Maturity guarantees must cover a term of at least 10 years. Almost all individual segregated
fund policies sold in Canada carry a 10-year term, although longer terms are permissible.



When a Contract holder makes deposits over the course of several years, it can complicate the
calculation of guarantees and maturity values. There are basically three types of guarantees:

• A deposit-based guarantee: When deposits under the segregated fund contract are
made at different times, such as regular monthly deposits, each deposit may have its
own guarantee amount and maturity date.
• A policy-based guarantee: This type of guarantee helps make record-keeping simpler.
It groups all deposits made within a 12-month period and gives them the same maturity
date. Insurers may also choose to group all deposits within a calendar year. For policy-
based guarantees, the first maturity date is generally 10 years after the contract was first
signed (not the month of the first deposit).
• The most generous type of policy-based guarantee bases all maturity guarantees on the
date that the policy was first issued. With this type of guarantee, there may be
restrictions on the size of subsequent deposits to prevent clients from making minimal
deposits at account-opening and much larger deposits several years later. Doing so
would effectively shorten the holding period required for the maturity guarantee and
increase the potential risk to the insurer.
Depending on the insurance company, maturity guarantees may be based on either the entire
portfolio of funds held by a client or on each fund. Where possible, a fund by fund guarantee is
generally considered better for the client because holding a fund that invests in a single asset
class, such as a Canadian equity fund, is inherently more risky than holding a balanced
portfolio diversified among domestic and foreign equities and fixed-income securities.
In historical terms, the risk of losing money in the North American stock markets over a
minimum 10-year holding period has been virtually non-existent. For example, in any 10-year
historical period, the S&P/TSX Composite total-return index has not had a negative return. The
rarity of negative 10-year returns has led many advisors and experts to conclude that the costs of
full (i.e., 100%) maturity guarantees exert an unwarranted drag on a client’s investment returns.
But the potential value of maturity guarantees should not to be dismissed outright. As the
performance of the Japanese market suggests, even the largest and most developed markets
are vulnerable to losses over a 10-year (or longer) period. The Nikkei (Japan’s most widely
watched index of stock market activity) peaked in December 1989 at 38,915 and was only at
9,709 in late March 2011, 21 years later.
To offer greater capital protection, many insurers have topped up the minimum statutory 75%
guarantee to a full 100%. The guarantee provisions are set out in the funds’ information folder.
A more recent trend is the introduction of segregated fund families that give clients a choice
between maturity guarantees of either 100% or 75%. This enables clients to choose not only the
underlying investments and money manager, but also the degree of protection that they prefer.
The 100% guaranteed funds have higher management expense ratios than the 75% guaranteed
funds and reflect the higher risks associated with offering full maturity guarantee after 10 years.
Some companies offer a 100% maturity guarantee on only a few of their funds.



Age Restrictions
Several insurance companies that offer 10-year maturity guarantees that exceed the statutory
requirement of 75% impose restrictions on who qualifies for the enhanced guarantee.
Depending on the age of the client and his or her requirements for death benefits, such
restrictions can be a crucial consideration in selecting a provider of segregated funds.
In most cases, the restrictions are based on age. A client who has reached a certain age might
be excluded outright from buying a company’s segregated funds. One insurance company, for
example requires that the individual on whose life the death benefits are based must be 80
years old or younger at the time that the policy is issued. Alternatively, the purchaser could
be subject to a reduced level of protection under the policy once he or she reaches a certain
age. For the industry as a whole, provincial insurance legislation does not specify a
maximum age limitation. For non-registered contracts, therefore, companies may set
maximum age limitations, such as age 90. Registered segregated fund contracts are subject to
the traditional rule, i.e., RRSP deposits/ assets must be withdrawn or converted into an
annuity or RRIF by the end of the year in which the Contract holder turns age 71.

Reset Dates
Although segregated fund contracts must have at least a 10-year term, they may be renewable
once the term expires. Whether they can be renewed or reset may depend on the annuitant’s age.
If renewed, the maturity guarantee on a 10-year contract would “reset” for another 10 years.
Many insurers issuing segregated funds have expanded the reset concept to include
greater flexibility in the form of more frequent reset dates. In some cases, holders of
segregated fund contracts may lock in the accrued value before the original 10-year
period has expired and, in doing so, extend the maturity date by 10 years.
Depending on the insurance company, the reset provisions may be initiated by the
policyowner or be an automatic feature of the policy. When resets are optional, there are
generally limitations on the number of resets per year. Resets provide additional flexibility
in investment strategy and financial planning.
The frequency of reset dates will vary according to the insurance company and are specified in
the information folder. Reset dates can range anywhere from daily to once a year.
The daily reset feature (generally set up on an automatic basis) benefits clients in either rising or
falling markets. In a rising market, when the net asset value of fund units is increasing, daily
resets enable Contract holders to continually lock-in accumulated gains. In a falling market
net asset values are declining, Contract holders are also protected because the guarantee is based
on the previous high. Daily resets are generally offered for contracts with maturity dates greater
than 10 years and are not available during the final 10 years of a contract. For instance, an
investor who is expecting to retire in 16 years could invest in a segregated fund contract with a
daily reset feature that would lock in market gains for the first 6 years of the contract.



Table 5B.1 provides a simplified example of how the daily reset feature works when the
market value of a fund’s assets is either rising or falling:


Accumulated Guaranteed Impact

Date value maturity value of reset
Jan. 2 $ 10,000 $ 10,000 None
Jan. 3 $ 9,900 $ 10,000 Protects against $100 market loss
Jan. 4 $ 10,125 $ 10,125 Locks in $125 market gain

Death Benefits
The basic principle behind the death benefits offered by a segregated fund is that the
beneficiary or estate is guaranteed to receive payouts equal to at least 75% of the original
premiums invested, excluding sales commissions and certain other fees. The basic amount of
the death benefit is equal to the difference, if any, between the market value of the fund
holdings and at least 75% of the original amount(s) invested.
Table 5B.2 illustrates the death benefits when the market value of the units held in the
segregated fund is below, the same as, or higher than the original purchase price. To simplify
the illustration, it is assumed that the fund has been held long enough that any deferred sales
charges are no longer applicable.


Guaranteed amount Market value at death Death benefit

$ 10,000 $ 8,000 $ 2,000
$ 10,000 $ 9,000 $ 1,000
$ 10,000 $ 10,000 None
$ 10,000 $ 11,000 None

As the table shows, death benefits are paid only when the market value of the fund holdings
is below the guaranteed amount. For example, when the market value at death is $9,000, the
beneficiary will receive a death benefit payment of $1,000. Therefore, including the $9,000
market value of the fund holdings, the total payment to the beneficiary is $10,000.
Death benefits can provide a great deal of reassurance to clients who want to participate in
the potential for higher returns offered by equities and long-term fixed-income funds but, at
the same time, are concerned about preserving the value of their investment for their heirs.
The death benefit enables these clients to pursue a long-term investment strategy while being
protected against sustaining a loss if death occurs during a losing period for the fund.



For example, without the protection afforded by segregated funds, the death of the annuitant
would trigger a deemed disposition at a loss if the market value at the time of death was below the
original amounts deposited. Assuming a 100% death benefit, holdings in the form of a segregated
fund are generally protected from any shortfall between the market value of the units held and the
original price of the units acquired. In this respect, segregated funds can be compared with other
guaranteed investments such as index-linked GICs or fund-linked notes.
Because of death benefits and flexibility regarding beneficiaries, segregated funds may
be very useful in estate planning.
However, death benefits commonly have other types of conditions or exclusions that may reduce
payouts to the beneficiary. The most common exclusion is based on age. Once the insured person
reaches a certain age, the beneficiary may have to accept a reduced percentage of benefits.
For example, one company’s guaranteed death benefits are based on a graduated scale
according to age. Annuitants who are younger than 77 years at the time of the deposit
qualify for 100% death benefits. The benefit declines to 95% at age 77, 90% at age 78, 85%
at age 79, and 80% for annuitants who are 80 or older.
When deposits have been made over a period of time and benefits vary according to the
client’s age, the death benefit is calculated according to a formula that factors in the amount
of deposits and the client’s age when they were made. Another restriction is based on a
combination of age and the length of time that the contract has been held.
Insurers also have the flexibility to offer death benefits in excess of 100% of the premiums
paid. For example, one insurance company offers a distinctive type of escalating death
benefit as part of its segregated fund package. This feature provides a death benefit equal to
at least the principal deposit plus an additional 4% simple interest per year.


After reading this section, you should be able to:
• Analyze a variety of client-specific scenarios to determine the impact on the client
of the distinguishing features of segregated funds, including creditor protection.
Segregated funds generally offer protection from creditors that is not available through
other forms of managed investment products such as mutual funds. Creditor protection is
available because segregated funds are tied to insurance contracts. As such, ownership of
the fund’s assets resides with the insurance company rather than the Contract holder. As a
matter of public policy, insurance proceeds generally fall outside of bankruptcy legislation.
Creditor protection can be a valuable feature for clients whose personal and/or business
circumstances could make them vulnerable to court-ordered seizure of assets to recover
debt. Owners/entrepreneurs, professionals or other clients who have concerns about their
personal liability are among those who might welcome the creditor protection offered by
a segregated fund.



Assume, for example, that a self-employed professional, Samuel Gold, died and left a non-
registered investment portfolio of $300,000 and business-related debts of $150,000. If the
portfolio consisted of mutual funds, creditors would have a claim on half of the portfolio,
leaving only $150,000 for the surviving family members. Furthermore, the estate would be
subject in most provinces to probate fees based on the size of the estate. In provinces such as
Ontario and British Columbia, the probate fees would be more than $2,000.
If the portfolio consisted of segregated funds and Samuel had appointed his wife, Sarah, as
beneficiary, the full $300,000 would be payable directly to Sarah, the named beneficiary.
Creditors could claim nothing and Sarah would receive the proceeds promptly without
having to deduct a portion for probate fees.
Creditor-proofing does not apply under all circumstances. In order for the assets held in
the contract to be eligible for creditor protection, a beneficiary (other than the insured or
his/her personal representative) must be named.
Several provisions in the Uniform Life Insurance Act provide creditor protection to the
insured and beneficiary of life insurance contracts, and that extends to those who hold
segregated fund contracts.
1. “An insured may in a contract, or by a declaration other than a declaration that is part of a
will, filed with the insurer at its head or principal office in Canada during the lifetime of
the person whose life is insured, designate a beneficiary irrevocably, and in that event the
insured, while the beneficiary is living, may not alter or revoke the designation without
the consent of the beneficiary and the insurance money is not subject to the control of the
insured or of the insured’s creditors and does not form part of the insured’s estate.”

2. “Where a beneficiary is designated, the insurance money, from the time of the
happening of the event upon which the insurance money becomes payable, is not part of
the estate of the insured and is not subject to the claims of the creditors of the insured.”
3. “While a designation in favour of a spouse, child, grandchild or parent of a person
whose life is insured is in effect, the rights and interests of the insured in the insurance
money and in the contract are exempt from execution or seizure.”
Provisions 1 and 3 above offer the greatest extent of creditor protection as it (i.e., creditor
protection) begins to apply as soon as the designation is in effect whereas the protection
from creditors offered in 2 (where a beneficiary is designated) generally comes into play
only upon the death of the life insured. In the example of Samuel and Sarah mentioned
earlier, Samuel did the right thing by naming Sarah as the beneficiary of his segregated
funds portfolio because that protects the portfolio from Samuel’s creditors once Sarah is
named as beneficiary (Sarah being Samuel’s spouse and getting protection under 3).




Under federal bankruptcy law, segregated funds are normally exempt from being included in
property to be divided among creditors. The federal Bankruptcy and Insolvency Act
specifically excludes from bankruptcy proceedings any property that is deemed exempt from
seizure under provincial law. For example, a bankruptcy trustee cannot change a beneficiary
designation to make the proceeds of the contract payable to the Contract holder’s creditors.
However, the creditor-proofing features of segregated funds are subject to a number of
limitations. The purchase of the segregated fund must be made in good faith and not with
the intent of evading legal obligations such as those arising from bankruptcy.
Claims for creditor protection may be subject to a successful court challenge by the bankruptcy
trustee if the purchase of a segregated fund is made in order to wilfully or fraudulently evade
a Contract holder’s debt obligations. Other types of challenges involving statutes other
than bankruptcy legislation are available in the event of fraud.
Under the federal Bankruptcy and Insolvency Act, the proceeds of a segregated fund may
be subject to seizure if it can be proven that the purchase was made within a prescribed
period before the bankruptcy. This will be the case even if the beneficiary is a family
member or if the beneficiary has been designated irrevocably. Generally, the proceeds of a
contract will not be protected from seizure if it was purchased within one year of the date
of bankruptcy. But if the client was legally insolvent at the time that the contract was
purchased, the segregated fund purchases could be challenged as far as five years back.
Because segregated funds allow new contributions to be made over time, a portion of the
segregated fund holdings might be protected, while new contributions or reinvestment of
fund distributions could be subject to seizure. The extent of the protected portion would
depend on whether the Contract holder’s status changed during the life of the policy.


A person’s matrimonial obligations may also have an impact on an investment in a

segregated fund. Although insurance contracts do not normally form part of an estate, they
are nonetheless subject to family-law provisions designed to provide for the welfare of
family members or other dependants.
Because there is a cash surrender value belonging to a segregated fund contract – the
policy is redeemable for cash at any given time – it is considered matrimonial property. In
the common-law provinces, the cash surrender value is part of the total assets to be divided
between the two divorcing spouses.




After reading this section, you should be able to:
• Analyze a variety of client-specific scenarios to determine the impact on the client of
the distinguishing features of segregated funds, including exemption from probate.
Segregated funds can help clients avoid the burden of costly probate fees that would
otherwise be levied against assets held in investment/mutual funds. The ability to bypass the
probate process can result in considerable cost savings and is one of the key estate planning
advantages of segregated funds.
These savings arise because the proceeds of a segregated fund pass directly into the hands
of the beneficiary.
One advantage of bypassing probate is the ease of transfer of funds to the beneficiary. Proceeds of
a segregated fund are payable immediately. There is no waiting period for probate to be
completed and payment would not be delayed over any dispute regarding settlement of the estate.
Saving on probate fees is not the sole financial advantage of bypassing probate. By passing
assets directly to the beneficiary via a segregated fund, the beneficiary also saves on fees
payable to executors, lawyers and accountants.


After reading this section, you should be able to:

• Describe the advantages/disadvantages of various life insurance investment

vehicles as compared to non-insurance investment vehicles.

A Growing Segment
Segregated funds have gained wider recognition in recent years and are a growing segment of
the investment fund industry in Canada. At the end of 2009, according to the Canadian Life and
Health Insurance Association (CLHIA) – a national industry trade group representing nearly all
issuers of segregated funds – an estimated $174 billion in segregated fund assets were held on
behalf of Canadian policyholders and annuitants and premiums from segregated funds of $28.2
billion represented 35.6% of total premium income of $79.1 billion.
This represents a huge leap from the end of 1995 when the industry held segregated fund
assets of $30.3 billion. Segregated funds were created in 1961 when insurance companies
used them to manage money for pension plans. During the mid-1960s, provincial regulatory
authorities began to allow insurance companies to issue segregated funds to individuals.



Along with welcoming new entrants, the late 1990s saw a period of innovation for the
segregated fund industry. New features, such as reset provisions that allowed Contract
holders to lock in capital gains and roll forward their 10-year maturity dates, increased the
ability of segregated funds to fit into a wide range of investment strategies.
On the product side, the number of segregated fund asset categories available for investment
has grown rapidly. Along with the traditional core categories, there now are segregated funds
that invest in riskier and more specialized areas such as small-cap equities and geographic
regions such as Asia. More recently, there has been an emerging trend towards offering
packaged portfolios of funds.

Need for Common Rules

The competitive environment for insured investment funds has been fundamentally altered
by industry developments that occurred in the late 1990s. Innovative products created by
both the insurance and mutual fund industries along with new marketing alliances between
the two have created a convergence between segregated funds and mutual funds.
It has become increasingly common for segregated funds to include brand-name mutual funds
as their underlying assets. In addition, recent years have seen the introduction of mutual funds
with capital-protection features that mimic the maturity guarantees offered by segregated funds.
On the distribution side, there is a continuing trend towards dual licensing of advisors that
allows them to sell insurance products and securities.
The convergence of products, distribution and marketing has encouraged the view among
regulators that coordinated efforts are needed to protect the interests of the investing public.
Progress towards harmonization occurred in May 1999 when the Canadian Securities
Administrators (CSA) and the Canadian Council of Insurance Regulators (CCIR) released a
joint study that compared the features of various segregated funds and mutual funds.
Recognizing that segregated funds and mutual funds have common features and serve many
similar needs, the insurance and securities regulators expressed the common goal of creating
a level playing field for the two products.
Table 5B.3 highlights some of the key similarities and differences between segregated funds
and mutual funds while Table 5B.4 lists the advantages and disadvantages of segregated
funds vis-a-vis managed investments.





Features Segregated Funds Mutual Funds

Legal status Insurance contract. Security.

Who owns assets Insurance company. Fund itself, which is a separate legal
of fund entity.

Nature of fund units Units have no legal status, and serve Units are legal property which carry
only to determine value of Benefits voting rights and rights to receive
payable. distributions.

Who regulates Provincial insurance regulators. Provincial securities regulators.

their sale

Who issues them Mainly insurance companies, some Mutual fund companies.
fraternal organizations and mutual
fund companies (in partnership with
insurance companies).

Main disclosure Information folder. Prospectus.


How often valued Usually daily, and at least monthly. Usually daily, and at least weekly.

Redemption rights Right to redeem is based on Redeemed upon request.

contract terms.

Required financial Audited annual financial statements. Audited annual financial statements
statements and semi-annual statements that do
not require an audit.

Sellers’ Licensed life insurance agents. Registered brokers or dealers.

qualifications BC, Saskatchewan and PEI also
require successful completion of an
investment funds course approved
by the provincial Insurance Council.

Government None None


Distribution Income and capital gains are Income and capital gains are
of income allocated to notional units distributed from existing units,
periodically, at least once a year. As causing net asset value to fall
a result, the net asset value of these by amount of distribution. If
units rises. distributions are reinvested, the
number of units held increases.





Features Segregated Funds Mutual Funds

Death benefit Yes; guarantee that at the death of No such guarantee.
the annuitant, beneficiary will receive
at least a partial return (minimum
75%) of the funds invested.

Maturity guarantee Yes; guarantee that upon maturity No such guarantee generally available;
(generally a minimum ten-year however, a breed of mutual funds
holding period), Contract holder will called “protected funds” allows
receive a partial (75%) or full (100%) investors to benefit from potential
return of the funds invested, growth in the securities market while
regardless of the market value of the guaranteeing repayment of the
underlying investments at the time. principal amount invested

Protection from Creditor protection is available to No creditor protection available

creditors Contract holders because segregated
funds are tied to insurance contracts.
Valuable feature especially for self-
employed professionals and
business owners who want to shield
assets from creditors

Bypassing probate At death of the annuitant, proceeds No such bypass available

from a segregated fund pass
directly to named beneficiary and
do not have to go through the
expense and delay of probate.

Protection in event Assuris, a self-financing industry Mutual funds are separate entities from
of insolvency of organization, provides up to $60,000 the sponsor fi rm. The funds own their
issuer or 85% of the guaranteed amount, own assets, which are held separately by
whichever is higher, in compensation a third-party custodian. If sold by an
against any shortfalls in policy investment dealer, protection against loss
Benefits resulting from the insolvency of due to financial failure of the dealer is
a member fi rm (restricted to death available through the Canadian Investor
Benefits and maturity guarantees). Protection Fund (CIPF).
An Investor Protection Corporation
has been put into place by MFDA to
provide protection if a mutual fund
dealer becomes bankrupt.

Fees Significantly higher MERs levied Relatively lower MERs on mutual funds
on segregated funds to pay for the
guarantees and insurance component

Range of While the range of investments in Tremendous variety of investment

investments segregated funds has expanded in opportunities offered to an investor
available recent years, it still does not come in mutual funds.
close to the options available for
managed fund products




After reading this section, you should be able to:
• Explain the role of Assuris in investment products offered by insurance companies.
• Describe the regulatory requirements for issuers of IVICs, including the role of
CLHIA IVIC Guidelines.
Most issuers of segregated funds are insurance companies, nearly all of which are federally
registered. To be an eligible issuer of segregated funds, a company or other organization must
be authorized by law to carry on the business of life insurance and be licensed by provincial
insurance regulators to sell contracts in the jurisdictions in which it wishes to sell funds. Along
with federally chartered insurance firms, other eligible issuers include fraternal organizations
that are qualified to sell life insurance and provincially chartered insurance companies.
Laws and regulations governing segregated funds are very similar in all provincial and
territorial jurisdictions across Canada. For the most part, segregated fund contracts are
subject to provincial legislation that governs all types of life insurance contracts of which
segregated funds are only one type. Each province and territory has accepted the CLHIA
guidelines as the primary regulatory requirements. Ontario, for example, has adopted the
CLHIA guidelines as regulations under the province’s Insurance Act.
Other provinces and territories generally apply the CLHIA guidelines as industry standards.
There are, however, some differences between jurisdictions. Quebec and Ontario, among
others, have special rules that govern the sale of segregated fund contracts.
Provincial regulators in the four Western provinces have delegated some licensing and
enforcement roles to provincial insurance councils. These councils consist of representatives
from various industry groups.
Federal insurance regulators do not regulate the sale of segregated funds. External
money managers of these funds are subject to provincial securities legislation if they are
registered as portfolio managers.

Reviews Conducted by CLHIA

Approval by provincial insurance regulators is required before a segregated fund can be
offered to the public. In carrying out their role, the regulators rely heavily on CLHIA.
Although CLHIA has no formal legal status as a self-regulatory organization, it plays a
critical role in supervising its members.
Applications to issue segregated funds must first be filed with CLHIA. The application
package consists of a completed application form, the proposed contract, information
folder, summary fact statement and financial statements.
After CLHIA completes an extensive review and gives its written approval, the application
and accompanying documents are forwarded to the regulators in the provincial or territorial



jurisdictions in which the applicant intends to sell the segregated funds. In most
instances, provincial regulators rely on the review conducted by CLHIA and do not
conduct their own additional review.

Solvency Monitored by OSFI

A federal regulatory body, the Office of the Superintendent of Financial Institutions
(OSFI), is responsible for ensuring that federally regulated insurance companies are
adequately capitalized under the requirements of the federal Insurance Companies Act.
Segregated fund contracts are subject to OSFI guidelines on guarantee provisions. These
rules are set out in OSFI’s guidelines for equity-linked insurance and annuity contracts with
guaranteed benefits.
OSFI’s key requirements for segregated fund contracts include:
1. The amount of the maturity guarantee payable at the end of the term of the policy cannot
exceed 100% of the gross premiums paid by the Contract holder. (This rule also applies
to contracts that carry reset features that allow the Contract holder to lock in gains and
set a new 10-year term to maturity.)
2. The initial term of the segregated fund contract cannot be less than 10 years.
3. There can be no guarantee of any amounts payable on redemption of the contract
before death or the contract maturity date.
When assets are not properly accounted for or liabilities are not paid, OSFI may take temporary
control of an insurance company, including its segregated funds, and manage the company’s
affairs. Under the federal Insurance Companies Act, the appointed actuary of the insurance
company must review, and monitor liabilities created by the issuance of segregated fund
In 2001, OSFI instituted more stringent (i.e., higher) capital reserve requirements on insurance
companies so as to ensure that they could cover generous segregated fund guarantees being
offered. OSFI was concerned in this regard mainly because of the sharp decline in the securities
and capital markets after the “dot.com” bubble burst. This move by OSFI resulted in issuers
raising MERs on segregated funds and easing off on 100% guarantees. Sales fell, some issuers
decided to no longer offer segregated fund contracts and there was consolidation in the segregated
funds sector. In short, a regulatory change resulted in major market developments.

Assuris’s Compensation Fund

Generally, because the funds are segregated from the insurance company’s general assets, they
provide sufficient protection to Contract holders against corporate insolvency. But there is
an additional layer of protection in the form of an industry-financed organization,
Assuris (previously known as CompCorp).
Assuris is the insurance industry’s self-financing provider of protection against loss of policy
benefits in the event of the insolvency of a member company. Insurers licensed to write life
insurance business in Canada are required to be members of Assuris and to pay its levies.

It is financed by assessments levied on its members and is incorporated federally as a non-

profit organization. There are around 100 Assuris members.



Assuris’s membership includes nearly all entities that sponsor segregated funds in Canada
including all life insurance companies that are licensed to sell life insurance or health
insurance to the public. However, fraternal benefit societies are not members of Assuris.
Since 1990, when it first began providing coverage of segregated fund guarantees, it has
never had to make restitution to segregated fund Contract holders. For example, when
Confederation Life Insurance Company was ordered liquidated in 1994, the company’s
segregated fund contracts were transferred to other insurance companies that agreed to
assume Confederation’s obligations to Contract holders.
In the event of an insurer’s default, Assuris will top up any shortfall in the amount payable on
policies issued by its members. While the presence of Assuris provides an additional measure of
safety of capital to Contract holders, in practice this contingency fund has never been put to use.
The Assuris guarantee covers only the death benefits and maturity guarantees applicable to a
segregated fund contract. The assets of the funds themselves are not eligible for Assuris protection
because they are segregated from the general assets of the insurance company. As such, segregated
fund holders enjoy a built-in form of protection against an insurance company’s insolvency.

Assuris guarantees that the policyholder will retain up to $60,000 or 85% of the promised
guaranteed amounts, whichever is higher. For example, if a segregated fund policy has a
maturity guarantee of $80,000, then upon insolvency Assuris would cover as a policy benefit
$68,000, i.e., 85% of $80,000.
If a segregated fund policy provides a Guaranteed Minimum Withdrawal Benefit
(GMWB) option, i.e., an income benefit, Assuris protection is available as follows:

• In the savings phase, Assuris guarantees up to $60,000 or 85% of the promised

guaranteed withdrawal balance, whichever is higher.
• In the payout phase, Assuris guarantees up to $2,000 per month or 85% of the
promised guaranteed income benefit, whichever is higher.
GMWBs are discussed later in the chapter.
Also see Chapter 11, Professional Standards, for more information on Assuris.


While there are many similarities, segregated funds and mutual funds differ significantly in
terms of their legal structure.
Most open-ended mutual funds are structured as trusts and the remainder as corporations. In
addition to having to comply with securities legislation, the structure of a mutual fund is
either outlined in the declaration of trust at the time that the fund is established or governed
by the rules for business corporations. In both cases, the structure is one of ownership. In
contrast, segregated funds are contracts of life insurance, known as individual variable
insurance contracts (IVICs), between a Contract holder and an insurance company.
Unitholders do not own segregated fund assets and are non-participating policyholders. However,
the insurance company holds these assets apart from or “segregated” from the firm’s other assets.



Despite their legal structure, segregated funds are treated as trusts held on behalf of investors. If an
insurance company fails financially and has insufficient assets to fulfill its guarantees, the
assets of segregated fund holders would be dedicated solely to them and could not be
claimed by other policyholders or creditors. Since a segregated fund contract does not
represent ownership, segregated funds do not require the approval of investors to change
their management, investment objectives, or auditor or to decrease the frequency of
calculation of net asset values. For open-end mutual funds, such material changes would
require a vote by unitholders. Except in Quebec, segregated fund Contract holders are also
not entitled to attend company general meetings or to vote.
Because of their legal structure, segregated funds do not issue actual units or shares to
investors since this would imply ownership. Instead, an investor is assigned notional units of
the contract, a concept that helps measure a Contract holder’s participation and benefits in a
fund. This concept of notional units also makes it possible to compare the investment
performance of segregated funds with that of mutual funds.


After reading this section, you should be able to:
• Explain the investment limitations of an IVIC.
Traditionally, the administration of segregated funds has been the responsibility of companies
that offer the funds. In general, these fund sponsors, who were once mostly life insurance