Note: This is part four of a series on tax and insurance.
In part one we talked about the general tax attributes of life insurance. In part two we looked at transactions resulting in a policy disposition, and how the proceeds and policy gain are determined. In part three we discussed the adjusted cost basis (ACB) of an insurance policy and how it’s determined.
In this article we discuss the net cost of pure insurance (NCPI), how it’s calculated and its impact on an insurance policy’s ACB and the collateral insurance deduction.
What is NCPI and how is it determined?
NCPI represents the pure annual cost of an insurance policy, used for certain tax purposes. To calculate it, the insurance company uses a formula in the regulations under the Income Tax Act. Essentially, NCPI for any given policy is the product of two factors:
- the annual mortality rate based on a specified mortality table, and
- the net amount at risk (NAAR) under the policy.
Since NCPI is based on a mortality factor, it generally increases as the insured ages.
For policies issued after 2016, both factors are subject to significant changes.
For pre-2017 policies, the prescribed mortality table is based on a Canadian Institute of Actuaries (CIA) 1969-75 mortality table. For policies issued after 2016, the more recent CIA 1986-92 mortality table is used, which also takes into account health ratings. Since the newer mortality table reflects improvements in life expectancy, the rates are lower than those applicable to policies issued before 2017.
A policy’s NAAR for any given year is generally equal to the policy’s death benefit less its fund value, as determined in the regulations. Due to changes in measuring the fund value for policies issued after 2016, this amount is generally higher than that of an earlier issued policy. This in turn results in a post-2016 policy’s NAAR being relatively lower.
Since, for a post-2016 policy, both the prescribed mortality charges and NAAR are generally lower, NCPI is also lower for these policies. However, the actual impact of these changes on NCPI for post-2016 policies varies based on policy design and cost of insurance charges.
NCPI’s effect on a policy’s ACB
As discussed in previous articles, an insurance policy’s ACB is relevant for two main tax purposes. First, if there is a policy disposition while the insured is alive, the excess of the proceeds over the policy’s ACB will be included in the policyholder’s income.
Second, where a corporation receives insurance proceeds upon the insured’s death, the excess of the death benefit over the policy’s ACB will normally be credited to the corporation’s capital dividend account (CDA). This is more tax-efficient, as capital dividends can be received tax-free by Canadian shareholders.
When determining a policy’s ACB, cumulative NCPI is deducted. Since NCPI generally increases every year, the policy’s ACB eventually declines and ultimately reduces to nil. In other words, the longer a policy is in force, the greater the chance of a taxable policy gain upon disposition. On the other hand, if the policy is retained, more of the death benefit received by a corporation will be credited to its CDA.
For many post-2016 policies, a lower NCPI benefits a policyholder who’s disposing of a policy (a higher ACB means lower policy gains). But the lower NCPI can be a negative for corporately owned policies on the insured’s death (a higher ACB means a lower credit to the CDA). Again, the NCPI charge for the same insurance amount varies depending on product design.
NCPI and collateral insurance deduction
Generally, life insurance premiums aren’t deductible from income. However, there’s an exception where the insurance policy is collaterally assigned to secure a loan used to earn income from a business or property, and other criteria are satisfied. The deduction is limited to the lesser of two amounts:
- the annual policy premium payable, or
- the policy’s NCPI for the year.
In its early years, a permanent insurance policy’s NCPI is typically much lower than premium payments, and therefore limits the deduction. But as noted, NCPI normally increases every year the policy remains in force, and could eventually exceed the premium. At that point the borrower can deduct the full annual premium.
Again, with the change in how a policy’s NCPI is determined for post-2016 policies, the collateral insurance deduction will generally be lower. However, since the mortality table applicable to post-2016 policies also factors in health ratings, it’s possible that, for substandard risks, the deduction could be higher relative to that for policies of comparable value issued earlier.
In the next article, we’ll explore in more detail the criteria that a policyholder must meet to qualify for the collateral insurance deduction.
Kevin Wark, LLB, CLU, TEP is managing partner, Integrated Estate Solutions, and tax consultant, Conference for Advanced Life Underwriting. He’s also the author of The Essential Canadian Guide to Estate Planning.