Exempt test for life policies revised

The proposed changes aim to ensure that the exempt test rules reflect current mortality tables and product design developments. (The existing rules date back to 1982.)

“Thirty years later, we find that those rules are a little bit out of date,” says Ron Sanderson, director of policyholder taxation and pensions at the Canadian Life and Health Insurance Association Inc. in Toronto. “The economic environment has changed, the social environment has changed and products have changed an awful lot.”

Some insurance products and features popular today did not exist when the exempt test rules were introduced. As a result, clarity has been lacking in their application. Clients with universal life (UL) policies, for instance, have been able to enjoy a higher level of tax-deferred accumulation room under the exempt test because of that product’s flexibility.

“Universal life has benefited from the fact that the act didn’t really contemplate the full range of options that those products provide,” says Steve Krupicz, assistant vice president, actuarial and underwriting consultants, retail markets, with Toronto-based Manulife Financial Corp. “And that allowed clients to accumulate a very significant amount of extra money inside their policies.”

Clients who purchase UL policies under the new rules will see their accumulation room scaled back to roughly the same level as for other types of life insurance policies.

“The rules are intended to create equity between permanent-type products,” says Kevin Wark, president of the Conference for Advanced Life Underwriting, “in terms of how much can be accumulated on a tax-deferred basis.”

Clients with other types of policies also will have less tax-exempt room, although the impact will be less pronounced compared with UL. During the first 10 to 12 years of a policy, the new rules will provide most policyholders with roughly the same amount of accumulation room as they currently have. Later in the life of the policy, however, the amount of room will decrease substantially from its current level.

“Where the reduction is predominantly occurring is for policies that are 20, 25 or 30 years old,” says Krupicz. Because it’s more common for policyholders to overfund their policies during the early years rather than doing so for 20 or 25 years, he adds, this reduction is not expected to affect many clients.

The new rules also crack down on policies that allow clients to pay up their policies fully over an extremely short period – in some cases, in just one or two payments. These policies are not common, but have appeal for some clients. Under the new rules, a policy will no longer be tax-exempt if the policyholder funds it too quickly.

The taxation of prescribed annuities issued after 2016 also will change as a result of increasing lifespans. For tax purposes, the payments from a prescribed annuity are divided into two components: return of capital and interest. As the government adopts new assumptions for life expectancy, the capital component of an annuity payment will be spread over a greater number of years; as a result, a greater proportion of each annuity payment will be classified as taxable interest.

Life policies and annuities already issued will be grandfathered under the existing exempt test rules. However, clients who make certain changes to their policies after 2016 could find themselves subject to the new rules. For example, if a client converts a term life insurance policy to a permanent policy in 2017, the policy will become subject to the new rules.

Wark urges you to review the rules and help your clients decide whether it’s worthwhile to buy a new policy or make changes to an existing one: “Anyone who has insurance, or is contemplating insurance within the next two years, should sit down with their advisor and determine what the implications of the new rules are.”

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