Spotlight Issue 2 – 2011

The economic downturn of the past few years has adversely impacted a large number of individuals and businesses alike. In addition to high unemployment and foreclosure rates, this prolonged slump has affected our outlook of the future. More than 50% of North Americans feel that they will be delaying retirement due to money lost in the financial markets. This is but one example of the devastating impact that the prolonged downturn has had on the collective psyche. Consumers and businesses are skeptical and have scaled back expenditures either out of necessity or apprehension.

In times such as these, it is quite common for there to be a flight to quality and certainty. In the life insurance industry, this has translated to a revival of whole life insurance, both participating and non-participating.

Even though sales of whole life have decreased from a high of 90% (1976) down to 25% (2010), sales of whole life have been on the upswing for a few years. Also, at its high in 1976, other forms of life insurance such as Universal Life and Fixed Indexed Life Insurance did not exist. These newer forms of life insurance (plus term insurance) still account for the majority of life insurance sales.

Participating whole life insurance policies are, in their simplest form, comprised of a whole life insurance policy with a dividend option. Dividends are determined by the insurance company and represent a distribution of profits to the policyholders. Most dividend paying policies have been sold in the past by mutual insurance companies, though such plans can also be sold by stock insurance companies.

What makes the participating (par) whole life insurance policy attractive is the combination of a whole life guarantee plus the dividend potential and the flexibility of how dividends can be applied to the policy. Many common dividend options include the ability to purchase paid up additions to the existing insurance policy, using dividends to offset premium payments, receiving dividends in cash, leaving the dividends to earn interest, as well as using the dividends to purchase rider coverage, or pay down a policy loan.

Another advantage is that the performance of par whole life is not directly tied to the performance of the financial markets, and that can be comforting to the growing number of risk-averse individuals who are skittish of financial market volatility and seek more stable performing vehicles.

Companies issuing par whole life have been very creative in developing dividend options and policy riders that augment the flexibility and viability of a par whole life policy. Even though premiums for participating whole life policies are higher than a similar non-participating whole life policy, the dividend stream can offset the extra cost and even provide a lower cost policy in many cases.

Usage and Flexibility

Dividend options afford the agent and policy owner flexibility in designing a policy that meets the needs of the owner and/or insured at various life stages. Most companies allow the policy owner the ability to change dividend options during the life of the policy to meet such needs.

For example, assume that a young individual purchases a par whole life policy. In the policy’s early durations, dividends can be used to purchase paid up additions, thereby increasing the death benefits and cash values available under the policy. There are additional increases that can be realized as many companies also pay dividends on the paid up additions.

Later on in life, such as when children are in college, the policy owner can change the dividend option to start receiving the dividends in cash to pay for expenses or similarly switch the dividend option to offset the premium payment due on the policy. In general, as the policy ages, dividend payments increase. It is not uncommon for dividend payments, at later policy durations, to be in excess of the premium payment due.

At retirement, the dividend option can be set to have dividends paid in cash. Also, the policy owner can start taking distributions from the policy in the forms of withdrawals to supplement retirement income. While these distributions can have the effect of continually lowering the aggregate death benefit, there may not be as much need for as much death benefit as originally purchased if many of life’s obligations (such as raising a family) no longer apply during the retirement years. Of course, there may be a need to keep at least a certain amount of insurance for a spouse beneficiary.

For policies that have retained a non-Modified Endowment Contract (non-MEC) status, retirement income strategies usually involve taking distributions in the form of partial withdrawals until the policy’s cost basis is hit, then switching the distributions over to loans afterwards.

Non-MEC policies are taxed using a FIFO approach (return of basis first, then earnings), and adverse tax consequences can be avoided at these later stages of the policy by switching over to distributions in the form of loans to avoid touching any of the gain. Once again, dividends can be put in play here by using them to pay down the loan, for example, or loan interest. This can help a policy from becoming over-loaned and the tax consequences associated with a lapsed policy.

For estate planning purposes, if there is still a significant amount of life insurance left post-retirement, the life insurance policy can then be placed into an irrevocable life insurance trust. At death of the insured, the life insurance proceeds can be used to pay down estate liabilities, expenses, and taxes.

Finally, distributions from par policies can also be a viable liquidity strategy in tough economic times such as these. Par whole life policies can be tapped into, and usually without any adverse tax consequences. This may be a better strategy than tapping into a retirement plan or 401(k) which have adverse tax consequences of their own.

Company Dividend History

While there are several life insurance companies selling par whole life products, it is important to research the company and the policy offered before jumping in and buying a par whole life product. The usual research items apply here, such as company ratings from the major rating agencies (e.g. A.M. Best’s, S&P), but there is another item to consider—a company’s dividend payment history. There are companies that have been selling par whole life (and other participating products) for many years that are more than willing to tout their track record of paying dividends at or near illustrated levels, as well as the length of time that the company has been paying dividends on its participating products. As with any purchase, it is important to evaluate the non-guaranteed portion of a participating whole life insurance contract (i.e. current scale dividends) to avoid purchasing policies with illustrated dividends that seem overly aggressive.

Older par whole life plans have benefited from returns generated on extant older issue bonds, as well as companies continuing to tighten their belts with respect to expenses, and continuing decreases in mortality. Newer issued par whole life plans face challenges due to lower investment returns that have been a part of the financial markets for several years now. Some companies have made some use of equities in the par fund in order to stimulate aggregate return but this strategy is not without risk, especially in today’s volatile equity markets.

Taxation Issues

As mentioned, there are many dividend options available to the par whole life owner. This flexibility allows the agent and policy owner to tailor the policy to best meet the needs of the owner and/or insured.

Dividends that are received as cash, left to earn interest, used to pay down a policy loan (or policy loan interest) or held at interest and then used to purchase paid up additions, are all considered to be a return of basis to the insured. Similarly, any paid up additions that are surrendered for cash are also treated as a return of the policy owner’s basis. In general, there are no taxable consequences until the policy’s basis is exceeded and earnings are tapped into.

The above holds true for policies that are non-Modified Endowments (non-MECs). Section 7702A of the Internal Revenue Code created a class of policies known as Modified Endowments (MECs). A policy that becomes a MEC by failing the 7-Pay Premium test switches tax treatment from First-in-First-out (FIFO) to Last-in-First-out (LIFO). In short, FIFO treats distributions as a return of a policy owner’s basis first (therefore non-taxable) , then followed by policy earnings. LIFO policies are the other way around – any distributions are assumed to access earnings first (and therefore subject to tax at ordinary income rates plus, in some instances, an additional 10% penalty), then a return of basis.

Most policies are issued with the intent of having and retaining a non-MEC status. Companies have gone to great lengths to update their administrative, point-of-sale and inforce ledger systems to meet the requirements of both 7702A and 7702.

This includes implementing the Necessary Premium Test under 7702A, which tracks increases in aggregate death benefits and the necessary premium to fund the lowest death benefits of a contract. Once the test detects an “unnecessary premium”, the policy is deemed to have undergone a material change, which leads to a restarting of the 7-Pay Test period as well as a recalculated 7-Pay Premium.

With respect to 7702, several companies have opted to use the Cash Value Accumulation Test (CVAT) in developing their par whole life policies. This test avoids the premium limitations set in the Guideline Premium Test (GPT). However, the CVAT corridor factors are significantly larger than those found in the GPT which can cause the death benefit to grow steeply as the policy’s cash value increases.

Another potential tax item to be aware of is the Recapture Ceiling as defined under IRC 7702. Even if a policy is a non-MEC, there may be consequences if a policy owner takes a distribution of cash within the first 15 years of the contract. In summary, a contract can be a non-MEC but still taxed on a LIFO basis (earnings first, then return of basis) if the recapture ceiling is hit.

Companies have, as mentioned, gone to great lengths to not only be in compliance with the various facets of 7702 and 7702A, but have also tried to implement procedures to help policy owners from making policy level decisions that could lead to a policy losing its non-MEC status or, worse, being in violation of IRC 7702, which could lead to a loss of its classification as a life insurance policy.

Summary

The volatile economic times of the past few years have left many people feeling uncertain and apprehensive about the future. In the life insurance industry, this sentiment has fostered a revival in the sales of whole life insurance, both participating and non-participating.

The par whole life policy provides the guarantees of a non-par whole life policy, but also includes the potential of annual dividend payments. Dividends provide a large degree of flexibility in a policy as the dividend can be used in a number of different ways. While dividends are not usually guaranteed, there are many companies that have excellent and long track records of paying dividends. The par whole life policy can also be tailored to the various life stages; in the early years when assets are being accumulated, middle years when assets are being consolidated, and later years when assets are being consumed.

Par whole life can be tailored to comply with both IRC 7702 and 7702A, thereby preserving the tax advantages inherent in life insurance, such as an income tax free death benefit to one’s beneficiary, FIFO treatment of distributions and tax free buildup of cash value.

William “Bill” Aquayo
SVP, Actuarial Research
FSA, MAAA, CFA, ChFC, CLU
Insurance Technologies