In an era of higher interest rates in the late 1990s, two predecessor companies of Industrial Alliance Insurance and Financial Services Inc. and Manulife Financial Corp. issued life insurance policies that allowed holders to invest in side accounts that guaranteed rates of up to five per cent and four per cent, respectively.
These side accounts did not contain an explicit limit on the size of investment, which means in today’s low-rate environment they are potentially lucrative for their holders and a significant liability for the companies that wrote them.
At least three limited partnerships purchased such policies several years ago in Saskatchewan, one of only four Canadian provinces that permit the purchase of insurance policies from their original holders. These investors are in court in Saskatoon to force the insurers to accept their money.
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If the court decides in favour of the investors, two major Canadian insurance companies could incur significant costs and even face “liquidation” in a worst-case scenario, according to one expert witness.
The universal life policies in question were written in 1997 by Aetna Life Insurance Co. (subsequently acquired by Maritime Life Assurance Co., which, in turn, was acquired by Manulife in 2004) and 1999 by National Life Assurance Co. of Canada (acquired by Industrial Alliance in 2005).
Universal life policies provide the twin advantages of a death benefit and a means to earn investment income on a tax-exempt basis within the policy, thereby building a cash value that can be accessed prior to death, though Canada Revenue Agency imposes a limit on the policy value to maintain this tax-exempt status.
As the investment options available to customers expanded to include equity market-related index returns, the volatility of the policy values increased. This sometimes required insurers to return funds to customers to stay within CRA limits, only to turn around and request the annual premium payment shortly thereafter.
The side account was introduced as a solution to this customer annoyance, according to company representatives in their affidavits. Rather than sending cheques back and forth, the side account acted as a receptacle for the insurer to deposit excess funds beyond the CRA limit and for policyholders to prepay future premiums.
Most side accounts offered more limited investment options — frequently, for example, just a daily interest account — than those offered in the main policy account.
However, older policies issued by a few insurers offered very attractive investment options in the side account, including a renewable 10-year guaranteed investment account with a fixed, unalterable rate significantly above current market rates.
That option caught the attention of Michael Hawkins, a self-described businessman, farmer and actuary with more than 24 years of experience in the life insurance industry, and an officer of the general partner of Ituna Investment LP and Mosten Investment LP, the plaintiffs in the case before the court.
In 2007, he began to look for policies, underwritten by credit-worthy insurers, that offered attractive guaranteed interest rates, no ability for the insurers to reduce them, and no caps on the size of permitted investment.
In 2009 and 2010, according to his affidavit, Hawkins and his partners found what they were looking for and Ituna and Mosten purchased the IA and Manulife policies.
Focusing their efforts on the more lucrative IA policy, they gradually invested more than $4 million (net of withdrawals) over three years, at close to five per cent (including bonus interest), before IA shut them down in early 2016 after an internal audit of the policy.
They were less successful with Manulife, which accepted only $10,000 into the side account in 2015 before returning their funds in 2016. After unsuccessful attempts to negotiate an “acceptable” level of investment in the policies with the insurers, Ituna and Mosten filed court applications last December to compel the insurers to accept their investments.
But company executives argue in affidavits that the side account cannot be used to hold funds that aren’t reasonably required for future life insurance premium payments, pointing to contract language that refers to balances as “premiums on deposit.”
Furthermore, they note, it was never industry practice for the side account to be used for large investments, pointing out that commissions were not paid to brokers on balances in the side account.
The investors counter that prior to purchasing a policy of the same type in 2009, Ituna requested and received a schedule from IA illustrating a hypothetical $1-million investment in the side account.
The insurers’ counsel has also called on Nicholas Le Pan, a former head of the Office of the Superintendent of Financial Institutions. In written testimony, he noted that if insurers were forced by the court’s decision to accept large deposits into the side account, they would contravene the Insurance Companies Act, which prohibits deposit taking.
However, according to its own testimony, Industrial Alliance did not have procedures in place to guard against deposit taking nor detect Ituna’s large investment.
Further, while the company’s automated system tracked and reported that the $4-million peak level represented almost 15,000 years’ worth of future premium payments on the underlying policy, its first move to deal with the issue when detected in 2015 was not to return the large deposit, but to place additional deposits by Ituna into a short-term, lower-rate option. All funds were eventually returned in September 2016 through IA’s counsel.
The third defence argument, provided by an independent actuary, Oliver Wyman, asks the court to consider the system-wide impact of the court’s decision.
If investors are permitted to place unlimited amounts earning five per cent, the insurers would, in a worst-case scenario, face unlimited and un-hedgable liabilities, be unable to attract capital, and may even have to cease operations, which would obviously negatively impact other policyholders, insurers and society at large.
Hawkins addressed that possibility in an affidavit, arguing that it wouldn’t make sense for them to invest unlimited amounts because, “It would be contrary to Ituna’s interests for Industrial Alliance to become insolvent or otherwise unable to pay its obligations …”
The cases raise interesting legal issues, especially in light of recent Supreme Court of Canada decisions in unrelated income tax cases.
In Canada (Attorney-General) v. Fairmont Hotels and Jean Coutu Group (PJC) Inc. v. Canada (Attorney-General), both issued in 2016, the court severely limited the application of “rectification” (termed “reformation” in the U.S.), an equitable remedy whereby a court orders a change in a written document to reflect what it ought to have said in the first place.
Making the implied limit on the size of investment in the side account actually explicit would be an application of the rectification remedy in this case. But that may be an even more remote possibility here.
“Normally the court leans to the insured if there is any ambiguity in the policy,” noted a Toronto-based lawyer not connected with the case who asked to remain anonymous, since the insurer has access to experts to assist in drafting the policy and complete control over its contents.
A third insurer, BMO Life Assurance Co., is the subject of a case in Estevan, Sask., brought by the same investor group. Its policy carries only a three per cent guaranteed rate. However, given the similarity in underlying issues, BMO Life has decided to join IA and ManuLife in seeking a common hearing of the three cases before the Saskatoon court.
The Canadian Life and Health Insurance Association has also weighed in, seeking intervenor status (recently granted) to bolster the arguments of its members, and to clarify the deposit-taking legal issue for the industry.
A judge on Nov. 20 ruled that the three cases will remain separate, but, given similarities in legal issues, they will all be heard during the same five-day trial period in April 2018 by a common judge in Saskatoon.
Meanwhile, the plaintiffs may have found a new source of potential profits. They recently brought a second action against BMO Life and Manulife, contending the insurers have been applying the tax-exempt test for these contracts on the incorrect date, resulting in the policies being fully taxable. They argue that this should give them the right to invest large amounts in the main account as well.
Not surprisingly, the investment options provide even more attractive terms than those in the side account for these policies.
Industrial Alliance and BMO both declined comment citing the legal proceedings underway. Manulife declined detailed comments for the same reason, but reiterated its primary defence that it could not accept interpretations or uses of its products that are contrary to their intents and purposes.