LIFE INSURANCE POLICIES INTENDED mostly for protection have long enjoyed rules that exempt them from taxes on their investments. But the federal government has announced those rules will change, becoming more restrictive and further limiting tax-free growth in those policies. That decision reflects growing rates of longevity and historically low interest rates.

The new rules, first proposed in the federal budget this year, are some way off. And that hiatus may create opportunities for insurance advisors and clients looking for ways to shelter investment income using whole and universal life policies.

“There is a selling opportunity for advisors,” says Bob Allebone, manager of insurance and estate planning, advanced financial planning, with Investors Group Inc. in Winnipeg, “and, [as well], for clients to acquire life insurance before the [new] rules come into effect.”

However, it is doubtful that the proposed changes will be implemented within the timeline announced in the budget. Ron Sanderson, director, policyholder taxation and pensions, with the Canadian Life and Health Insurance Association Inc. in Toronto, cautions: “Since detailed proposed rules — let alone, final rules – aren’t public, current government proposals do not appear to provide adequate implementation time.”

The federal budget proposes changes in the test for exemption, which distinguishes between insurance policies that provide pure protection vs those that have a savings component. This test has not been revised since being implemented 30 years ago.

In an exempt policy, the income earned on the savings component is not subject to annual taxation on the growth of the cash value in the policy. A life insurance policy is classified as an exempt policy when the savings accumulating in the policy do not exceed the savings in a theoretical “benchmark” policy. This benchmark policy is generally defined as a policy in which two criteria are met: the death benefit is payable upon the earlier of either death or the policyholder reaching age 85 (the endowment time); and the policy’s premiums are payable for 20 years after the issuance of the policy (the pay period).

The actual savings in the benchmark policy are established using a complex formula, which includes variables such as “prescribed” mortality and interest rates as well as the cash surrender value of the policy.

The feds are proposing five key changes to the test for exemption:

1. The interest rate used to measure the savings in both an actual and the benchmark policy will be lowered to 3.5% from 4%.

2. The Canadian Institute of Actuaries’ 1986-92 mortality tables will replace the tables created in 1958 to account for current mortality rates.

3. The endowment time for the benchmark policy will be increased to 90 years from 85 years to account for increased life expectancy.

4. The pay period of the benchmark policy will be reduced to eight years from 20 years, in keeping with current industry practices.

5. Complex new methodology will be implemented to measure savings in both an actual policy and the benchmark policy.

@page_break@ The result? “Over the long term, people will be able to shelter less money from taxes in a policy,” says Terry Vive, chairman of the policy owner tax task force for the Conference for Advanced Life Underwriting in Toronto.

Allebone suggests that the changes will promote greater consistency among policies issued by different insurance companies – some of which, he says, “have not been playing by the intended rules” by using creative structuring strategies to build up long term cash values.

For instance, Allebone says, some companies have been “building in very high surrender charges in certain policies in the early years of a policy; then, in later years, the charges are brought down to increase the cash value in the policy.” The effect is to allow greater savings to be sheltered from taxes over the long term. This strategy has been used in “single premium” and “quick pay” whole life and universal life policies, in particular, and will be curbed when the new proposals are implemented. In the future, says Allebone, “People would not be able to pay up a policy in a shorter period of time.”

Vive, for his part, argues that the use of “single deposit” premiums is inappropriate and an abuse of the spirit of the guidelines.

Proposals to revise the test for exemption will affect the majority of whole life and universal life insurance policies. According to Vive: “Less than 1% of policies are not exempt.”

Sanderson advises: “The budget announcement did not address many of the details of the exempt test. While [the federal Department of Finance] has been consulting with [insurance sector] representatives in an effort to define those details better, no final proposals have been communicated.”

The insurance sector has insisted on adequate lead time to revise product design, software, advisor education programs, and administration and tax compliance systems to accommodate the impending changes.

© 2012 Investment Executive. All rights reserved.