The Income Tax Act contains rules that govern how much growth can accumulate within a life insurance policy, along with the tax implications associated with accessing the value within the policy.
The last time that there were major changes to the Income Tax Act provisions relating to life insurance was in 1982. Since then, mortality costs have dropped and there have been many changes to life insurance products. The new rules take these changes into account.
• changes to the definition of an exempt policy
• changes to the calculation of the Accumulating Fund (AF) of a policy
• updated mortality tables for calculating the Net Cost of Pure Insurance (NCPI)
• changes to the formula for the Adjusted Cost Basis (ACB) of a life insurance policy.
• price increase for Level Cost of Insurance (LCOI)
Exempt Testing and the Accumulating Fund
Every life insurance policy is compared to a hypothetical, benchmark policy called the exempt test policy (ETP), with the comparison against the actual policy occurring at each policy anniversary. As long as the savings component of the actual policy stays within the savings element of the ETP, the policy will remain exempt.
The savings element of the ETP and the actual policy is measured by the Accumulating Fund (AF) in each policy. The new rules continue to have the AF of the actual policy as the higher of the cash value of the policy, or an actuarially calculated reserve but the new reserve method is called the Net Premium Reserve (NPR) and is based on the premium or cost of insurance pattern. Instead of using pricing or cash value assumptions, the interest and mortality assumptions will be the same as those used to value the AF of the ETP.
Surrender charges will no longer be taken into account when comparing against the cash value. This significantly impacts the AF of UL policies, particularly so for Level Cost of Insurance (LCOI) UL policies.
Calculating the Net Cost of Pure Insurance
The Net Cost of Pure Insurance (NCPI) provides a measure of the annual cost associated with the mortality risk for a life insured in a particular year for tax purposes. It generally increases each year in conjunction with the mortality factors and is calculated by multiplying a mortality factor by the net amount at risk under the coverage. A number of factors used in this calculation will be changing. On January 1, 2017, the mortality tables used will be updated to reflect the improvement in Canadian mortality.
The legislation also introduced a new method of calculating the net amount at risk for the purposes of calculating the NCPI. Currently, insurers look at the death benefit, minus the AF or the cash surrender value of the policy (depending on the method previously used by the insurance company). It will now be determined as the difference between the death benefit and an actuarial calculation referred to as the Net Premium Reserve (NPR). This change results in a lower net amount of risk for NCPI than before.
After the changes take effect, the mortality factors used will also consider substandard ratings when calculating the NCPI.
The revised calculations will generally result in a lower NCPI amount than under the current rules. The NCPI of a life insurance policy is an important factor in determining the deductibility of life insurance premiums for tax purposes in certain situations. Section 20(1)(e.2) of the Income Tax Act allows for the lesser of the premium or the NCPI amount for the year to be deducted when the life insurance policy has been collaterally assigned as security for a loan, provided certain conditions are met. Life insurance strategies involving leveraging may experience a decrease in the deductible amount available to the client for income tax purposes.
Adjusted Cost Basis of a Life Insurance Policy
The Adjusted Cost Basis (ACB) of a policy is used in calculating the taxable policy gain that arises from certain transactions. The changes to the NCPI factors as described above will also have a significant impact on the ACB. A lower NCPI results in a higher ACB for a longer period time. This means that it will take longer for ACB to grind down to zero.
The formula for calculating the ACB of a life insurance policy is complex, but can be generalized by referring to the sum of the premiums paid less the total NCPI. The formula also contains several other variables that are being revised in a number of ways. For example, the current formula does not take into account additional amounts paid for substandard ratings. The updated formula will alter this.
For personally-owned policies, the higher ACB may lessen the taxable gain associated with certain transactions as described above. For corporate-owned polices where the corporation is the beneficiary of the death benefit, the changes to the ACB will impact the amount of credits to the Capital Dividend Account (CDA). In general, the new tax rules will allow less of the death benefit to flow into the CDA, thereby reducing the amount of the tax-free dividends that can be paid to the surviving shareholders.
Price increases for Level Cost of Insurance
New taxation rules for life insurance policies will result in price increases for level cost of insurance (LCOI) because of the insurers’ investment income tax.
The investment income tax (IIT) that insurance companies must pay will rise in 2017. Generally, insurers absorb this tax and include it in the product price paid by the client. It is not a tax that is directly payable by the policyholder but it effectively reduces the rate of internal growth in the policy and requires an appropriate premium adjustment to fixed premium, fixed value policies. It is usually reflected in the administrative costs with a universal life policy.
Until now, the IIT applied only to the net cash value of an individual life insurance policy. Starting January 1, 2017, the tax will apply to the entire accumulation fund of the individual life insurance policy.
The price of Level Cost of Insurance will rise due to the extended application of the tax on insurers’ investment income. The projected increase is from 5% to 20%. In addition, insurers will use this repricing opportunity as a chance to raise LCOI rates even further to offset the impact of low interest rates.
Grandfathering of life insurance policies issued prior to January 1, 2017
Loss of grandfathering will occur when:
Certain exceptions have also been included in the legislation, for example:
• Changing from smoker to non-smoker status
• Medical underwriting to reduce a rating
• Reinstatements of a policy
• Addition of a non-life insurance rider to a policy, like a disability waiver
• Transfers of ownership
The new rules in 2017 will impact the amount of money that can accumulate within an exempt life insurance policy on a tax-preferred basis. The most significant impact will be to Level Cost of Insurance in Universal Life, bringing these policies more in line with other product types.
All types of permanent life insurance will continue to offer significant advantages over alternative, taxable investments, even with the changes taking place in 2017.