Federal Definition of Life Insurance

Life insurance is a private contract between an individual, called an insured, and a life insurance company. Normally, the insured is also the policy owner, but this is not true in every case. The insurer provides an amount of money to the insured's beneficiaries upon the insured's death. However, because some life insurance contracts include a savings component, the federal government has made changes over the years as to what constitutes a life insurance contract. To be considered as a life insurance contract, the policy must pass several tests.

Cash Value Accumulation Test

The cash value accumulation test specified by the Internal Revenue Service demands that, for a life insurance contract to be considered a life insurance policy, the cash surrender value (cash value) of the life insurance policy can never be more than the net single premium required to pay all future benefits outlined in the contract. If the policy ever fails this test, the policy is no longer considered a life insurance policy.

Guideline Single Premium/7-Pay/Corridor Test

Alternatively, the life insurance policy can opt for a guideline single premium test in lieu of the cash value accumulation test. Under this test, the aggregate, or total, premiums cannot be more than either the "guideline single premium" or the sum of the "guideline level premiums" as outlined in the life insurance policy. The guideline single premium is the lump sum premium that would be able to fund the future benefits of the contract while the guideline level premium is the level premium amount that would keep the policy in force until the insured's age 95. The death benefit must also never be less than a certain percentage (based on the age of the insured) of the cash value. The difference between the cash value and the death benefit is the "corridor." These tests must be passed in any given seven-year period of the policy, or the contract will become a modified endowment contract and lose the tax advantages afforded to life insurance.

Material Contract Changes

Any material contract changes that would result in a substantial change in benefits (an increase of benefits, but not a decrease), must be treated as a new contract. This generally includes an increase in the death benefit or some other substantial benefit outlined in Section 7702 of the Internal Revenue Code.

Considerations

When purchasing a life insurance contract, it's important to understand what you are purchasing and how you fund the contract. Sometimes, it may be beneficial to purchase a modified endowment contract. These single-premium life insurance policies are used extensively in estate planning. However, a life insurance policy that needs its tax-advantaged status will have to adhere to the federal definition for a life insurance contract.

Warnings

Failure to comply with the definitions of a life insurance contract will result in your life insurance policy becoming a modified endowment contract, or MEC. Many insurance companies take a proactive stance on this and warn policy owners that their policy will become a MEC. However, you should also pay attention to the amount of premium that you are paying under flexible premium contracts (universal life insurance) where violating the seven-pay or cash value accumulation test can be easily done.

References

• "Life & Health Insurance, License Exam Manual, 6th Edition"; Dearborn Financial; 2004
• BFA Family Wealth Planners: Definition of Life Insurance