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Segregated Funds

Segregated Funds are an insurance contract with similarities to mutual funds. They can also offer enhanced guarantees, including creditor protection.

What Are Segregated Funds?

As an insurance contract, segregated funds are an obligation of an insurance company and form part of its assets. Insurance companies “segregate” the portfolios that these contracts are based on, separating these assets from their general assets. The contracts have a minimum value, the price at which they were issued.

Characteristics and Features of Segregated Funds

Differences From Other Funds

It is important to realize that insurance segregated funds might look and act like a mutual fund, but that it is actually something quite different. A mutual fund is a trust, or sometimes a company, which owns title to the actual securities in the funds. The unitholders own the trust that in turn owns the assets. An insurance segregated fund is an insurance contract or a “variable rate annuity.” Legally, the insurance company issues the contract the same way it would an annuity or life insurance policy under the relevant insurance legislation. The buyer, or “policy holder,” has contracted for a payment that is based on the underlying prices of the portfolio that supports the contract but does not have a direct claim or ownership on the securities that form the portfolio. Although insurance companies “segregate” the assets to support these contracts, the holder of the contract does not own these assets.

Features and Valuation

The insurance contract nature of segregated funds makes for an interesting feature that insurance companies often use in their marketing. The contract can be issued with an initial “book value” that the company can agree to pay no matter the actual value of the portfolio supporting the contract. If the market value of the portfolio falls below the book value, the company agrees to pay no less than the book value, known as the “minimum value guarantee” or the “higher of book or market.” Initially, this guarantee feature has some value. Since marketable securities increase over longer periods, it becomes less important over time.

Tax Treatment

Another wrinkle of segregated funds is their tax status. Since they are insurance contracts, they are taxed as such. Sometimes segregated funds are used as investment options for “universal” or “whole life” life insurance that provides a savings option as well as insurance. Life companies market the tax shelter aspects of these contracts, which allow compounding of investment income untaxed while inside the insurance contract.

Legal Status

Another sales aspect of segregated funds is their characteristics under bankruptcy legislation in some jurisdictions. In Canada, for example, an insurance contract is not available to creditors in a bankruptcy. This means an RRSP that uses segregated funds would be protected from creditors in a bankruptcy while an RRSP that invested in mutual funds would be exposed.

Understanding Segregated Funds

In summary, although insurance segregated funds look and function like mutual funds, they are actually insurance contracts based on the valuation of a portfolio of marketable securities. As always, investors are wise to consider all the aspects of insurance contracts in their legal jurisdiction prior to investment.

4 years ago

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