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:
Option A: level death benefit
Face amount: level for the life of the policy. As the cash value grows, the space between the rising cash value and level death benefit become increasingly narrow. In other words, the “amount at risk” narrows.
Option B: increasing death benefit
Essentially, the policy owner is buying the same level amount of pure insurance above cash value for each year that Option B is in effect. This produces an ever-increasing cost for insurance as the policy holder ages, potentially eating away at all of the cash value and possibly causing the policy to lapse.
Note: Moving from Option B to Option A can have significant tax consequences. It is advisable for a policy holder to consult his or her tax specialist before making this decision.
Cash value accumulation test (CVAT)
Following are attributes of the cash value accumulation test:
- Requires that the death benefit be sufficient to prevent the cash value (generally the policy account value) from ever exceeding the net single premium required to fund the future benefits under the contract.
- Relates policy cash value to its death benefit.
- Uses net single premium (NSP) calculation.
- Annual effective interest of 4 percent, or, if greater, the rate or rates guaranteed on issuance of the contract
- “Reasonable” mortality charges
- Only expenses for qualified additional benefits (QABs) qualify
- NSP compared to policy cash value determines if CVAT requirements are met
- Cash surrender value (CSV) is determined with NO regard to any surrender charge, policy loan or reasonable termination dividends.
CVAT percentages are higher than those for the GPT at all ages prior to age 95.
The CVAT may allow higher funding in the first seven policy years under death benefit Option A as compared to funding limits on policies tested under GPT.
If, or when, the policy account value times the CVAT percentage multiple exceeds the regular Option A or B death benefit due to funding levels or performance, CVAT will generally result in a rapid increase in death benefit. One ramification of this extra death benefit is a “levelization” of the policy’s net amount at risk along the required minimum CVAT corridor and typically results in a maximization of possible Cost of Insurance charges.
Guideline premium test (GPT)
Following are attributes of the guideline premium test (GPT):
- Under the GPT, a Guideline Single Premium (GSP) and a Guideline Level Annual Premium (GLAP) are calculated at issue of the policy. Cumulative premium payments cannot exceed the greater of the GSP or the sum of the GLAPs. The client is refunded any premiums received that exceed guideline premium limits.
- A reduction in face amount as a result of a requested reduction or as a result of a change of death benefit option or a reduction or termination of certain additional benefit riders can result in reduced or even negative premium limits.
- In some cases this may require a forceout of previously paid premiums, either at the time of the change or in later years in order for the policy to maintain qualification as life insurance. Forceouts, which may have tax implications, will reduce the cash value available inside the policy to pay for future policy charges. Lower limits may restrict the amount of premiums the policy owner can pay into the policy in the future. Although an amount to maintain the policy on a yearby year basis is allowed by the Internal Revenue Code, such funding can become very expensive at older attained ages.
- The GPT also imposes a minimum required death benefit amount. This rule is referred to as a corridor test. An amount is calculated by comparing the policy’s death benefit to a percentage multiple of the cash value (generally the policy account value). The minimum percentage is determined by the Internal Revenue Code and varies by the insured’s attained age. The percentages provided under a particular policy must be greater or equal to those IRC percentages.
- It generally takes longer for the policy to reach the GPT corridor as compared to CVAT and lower required minimum death benefit amounts could result in higher cash surrender values, especially in the later years.
With either test, a “7-Pay” premium test must be satisfied or the policy would be categorized as a modified endowment contract (MEC), which has fewer tax advantages than non-MEC policies with respect to access to policy values using loans and/or withdrawals. If the plan is to use policy cash values for living needs, the policyowner will want to avoid MEC status.
Choosing the right policy design based on the policy-owners’ objectives requires diligence in reviewing a number of factors and policy options. Amongst the most important facts to consider is which definition of life insurance test to use. When selecting a definition of life insurance test, keep these key points in mind:
- Under CVAT, it is unlikely that premiums will be restricted for a policy with lower policy account values.
- It is suggested that you review illustrations under both the CVAT and GPT tests under various interest and/or investment return scenarios to explore which test is best suited for a client’s life insurance needs.
- The client should review with his or her financial professional various funding levels to determine the effect, if any, on the performance of the policy under both tests.
- If the policy allows for the selection of a definition of life Insurance, the selection must be done at issue and cannot be changed.
- Changes to the policy, such as reductions in face amount and/or change in the death benefit option, may cause future forceouts of premium with policies under the guideline premium test. This may result in the policy terminating well before life expectancy unless increasingly expensive premiums are paid to maintain the policy on a yearby year basis.
- Life insurers may reserve the right to require evidence of insurability or to limit certain premium payments that, when made, would increase the net amount at risk under the policy.
- There might be limitations on certain riders, policy provisions and/or endorsements based upon the definition of life insurance selected.
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