As life insurance products evolved, particularly in the early 1980s, with the advent of universal life (UL) insurance characterized by flexible premiums, other client considerations came to the forefront.
Should permanent life insurance products be designed to emphasize pure death benefit protection or pure accumulation? Death-benefit-focused products have more “levelized” costs, i.e., a shallower expense curve, with higher charges in early years and lower charges in later years, whereas the opposite is true for those focused on accumulation, which have a deeper curve with lower costs early in the policy duration and higher costs at the later stages.
Because some of the new UL products at that time veered toward investment vehicles — with cash surrender values — and away from traditional definitions of life insurance, the federal government stepped in with the Deficit Reduction Act of 1984 (DEFRA).
DEFRA established the qualifications that UL policies must meet in order to maintain their advantaged tax status under the Internal Revenue Code (IRC). To fulfill the IRC definition of life insurance, the life insurance contract must provide for a sufficient “amount at risk” — the pure death benefit protection that a beneficiary would receive upon the death of the insured. In other words, the face value minus the built-up cash value.
Essentially, a policy must meet one of the two tests that are used to define life insurance — the cash value accumulation test (CVAT) or the guideline premium test (GPT).
These tests are used to assure there is a minimum amount of death benefit protection relative to the policy’s cash value in order to maintain the benefits of life insurance as defined in IRC Section 7702.
Note: Life insurance qualification test elections are required when a client’s application for coverage is completed, and may not be changed after policies are issued. If an election is not specified, the default is generally to GPT.
Each test regulates the death benefit relative to the policy account value, also known as the cash value, although the relationship varies by test. If the policy account value is too high relative to the death benefit, the death benefit generally will be increased automatically under the terms of the policy to ensure compliance with Section 7702.
The choice of test should be made on a casebycase basis with the policyholder giving consideration to how he or she might want to make premium and death benefit changes in the future.
For situations where the planned premium is closer to the maximum premium amounts that can be paid as compared to minimum premium amounts, particularly on younger insureds, the choice can have a significant impact on policy values.
Illustrations assuming various funding scenarios with anticipated and unanticipated policy changes such as reductions in face amount, changes in the death benefit option and various interest rate and/or investment return assumptions under each test should be reviewed before the choice is made.
Note: There might be limitations on certain riders, policy provisions and/or endorsements based upon the definition of life insurance selected.
The death benefit options
A and B, and a change from B to A with a UL contract in order to maximize accumulation: