Insurance: Is the income accumulating within a life insurance policy truly exempt?

For example, is the income earned within a Universal Life policy not subject to accrual taxation? If we based our answer on what we read in newspapers and in marketing brochures from insurers and firms, the answer is quite obvious.  Insurance is exempt from accrual taxation:

Globe and Mail on April 15, 2011: “One is purchasing a universal life or whole life policy and using the tax sheltering of investment income “to build significant wealth and accumulate it completely tax free and ultimately be able to leave that to kids or a charity, completely tax free at the end of the day.””

National Post: “A universal life policy allows tax-deferred growth,” says Jack Snedden, a certified financial planner and chartered life underwriter. “With the proper arrangements down the road, every dollar can be extracted tax-free.”

Industrial Alliance: “The surplus monies constitute the “savings” component of your contract and generate interest that accrues tax free. The interest generated and the interest bonus, which you are paid as of the fifth year, are reinvested in the investment options you have chosen. The insurance premiums are not tax-deductible, but income earned is tax-sheltered until the policy matures. If you withdraw funds during your lifetime, they are taxable to the extent the amount withdrawn exceeds the adjusted cost base.

As we say the jury is out and the verdict is in. Funds within a universal life insurance policy are not subject to accrual taxation under any forms. However how do you explain that I am telling you this may not be true?

What is the Investment Income Tax (IIT)?

It is not my intention here to review the history of the taxation of insurance. This has been done anyway in an amazing article written by Bill Strain in 1995 in the Canadian Tax Journal. This text should be obligatory reading for any professional dealing with life insurance:

Until 1968, life insurance was indeed tax exempt and this meant that no taxes existed at both the policyholder and insurer level on the income accruing within life insurance. This changed with the release of the Carter report in 1966 promoting tax equity. The recommendations found in this report generated a lot of opposition within the insurance industry. As a result, these recommendations were not put in place and instead new modifications were enacted to the ITA in 1969 and the Investment Income Tax was one of the changes that were adopted.

The Investment Income Tax is basically a 15% tax levied on the Canadian Investment Income of the insurance companies. The purpose of this tax was quite clear as stated on the Report on the White Paper on Tax Reform produced by the House of Commons:

“The current exemption from tax of investment income built up in life insurance policy reserves creates a bias in favor of insurance. The new tax will ensure that the investment income accumulating over the years in the policy reserves of life insurance companies bears a reasonable level of tax.”

 The insurance industry was clear and it would not accept any form of taxes that would be paid directly by the policyholder. Each time, a Finance Minister tried to do this he was defeated by the cries of “Death and Orphan Tax”. Instead it was agreed that taxation would only occur at the insurer level under the form of the 15% Investment Income Tax. It was up to the insurer to decide how to flow through this expense to the policyholder.

Wait a minute…Are you telling me…

 Are you telling me that when a policyholder surrenders his policy, he has to include the whole amount of the proceeds (assuming no ACB) in his income without the benefit of capital gains when he has already been taxed at 15%? Is this tax equity? This is unfair…

Eh! Don’t get mad at me. I did not write the law. But let me finish first.  There is a mechanism for a refund. So now you can breathe —- breathe—-.  Every time a policyholder surrenders a policy which creates a policy taxable gain this creates a deduction on the tax base used to calculate the IIT owed by the insurer. Therefore the question is quite simple. Who benefits from this deduction? The policyholder who has been paying this tax without knowing it or the insurer? The answer to this question will depend on the product bought.

 How is the Investment Income Tax paid and who is really paying for it?

 It truly depends on the type of policy you have. From this perspective, we could separate the years of insurance product development in two eras: 1) pre Universal Life and 2) post Universal Life. What differentiates these two eras is that in the post Universal Life, the investment element of the policy is unbundled from the insurance element.

a) In the pre Universal life era, you had two types of investment life policies. You had whole life participating and whole life non participating. For whole life participating, expenses are deducted from the participating accounts and in those expenses are included taxes such as IIT before performance and dividends are calculated. Therefore from this perspective we could state that par policies are indeed taxed on an accrual basis. The remaining question is whether the tax refund generated by par policies lapses is credited back to the participating account. It is impossible to know. Participating accounts are like a black box. You know what goes in and what comes out but what happens in between is the best kept secret in the industry; a wall of secrecy which I have tried to breach many times in my 25 years career but to no avail. Unless I kidnap an actuary and waterboard him or her, this shall remained unanswered.  However if there is a refund to the par funds, I could state that those who keep their policy inforce would benefit from the tax refunds of those who lapse their policies.

For non par policies, the only way for the insurer to recover its expenses is through the cost of insurance which is guaranteed and cannot change. Now if you have an old whole life non par policy based on a high rate of interest and lapse, since the COI is insufficient to cover the mortality experience of the block of business, we could state that the insurer is unable to flow through the IIT and therefore the funds of these policies are truly exempt from accrual taxation from the policyholder perspective. Please note that if the policy is lapse supported and the actuary has used the IIT refund created by lapses to discount the cost of insurance; not only is the policyholder not paying the IIT but he is also getting a credit for refunds that never took place.

b) Now let’s deal with this particular beast which is Universal Life. One of the great advantages promoted by insurers for this product is the unbundling of the investment from the insurance giving a lot more flexibility for the policyholder to manage his policy. But this is a double edge sword because with this unbundling comes also the unbundling of the expenses. This means the insurer who was making one bet through the Cost of Insurance can now edge that bet with other expenses. Truly this is to the advantage of the house and ensures a high level of probability that the house will win if the actuary is professional in his pricing. Luckily for the policyholders, many actuaries were far from being professional in the past and their pricing included a good dose of imagination. Since I can’t review all the Universal Life in the marketplace, I will focus my analysis on the two end of the pricing spectrum.

NN Challenger -The great Universal Life. When the actuary priced that one, I could state that he was smoking the good stuff… Ridiculously high long term interest rate and lapse rate made the COI of this policy a gift sent from heaven. However since now the investment is unbundled, there is also an expense applied to that investment called the Management Expense Ratio (MER). Part of the MER is used to pay the IIT and can represent .25% to .45%. However if you are invested in the guaranteed income account (usually 5 year account), there is a minimum interest rate guarantee that applies which is 4%. Usually you should be credited x% of the corresponding bond yield unless this is below the minimum. Since this percentage is currently below the minimum and has been for more than 10 years below the 4%, we can say that for the NN Challenger (and any other similar policies) no MER has been applied for the last 10 years. So yes these policies are truly exempt from accrual taxation on this basis as it is coming out of the pockets of the insurer.

Current UL:  the worst – policy holder invested in an Index fund – With index funds MER starting at 2.5% we could state that one thing is certain. There will always be ample room in the MER to flow through the IIT (.25% to .45%) to the policyholder. Therefore from this perspective, these Universal Life policies are taxed on an accrual basis on the income generated within the policy. Sorry; I know the truth hurts but it’s nonetheless the truth.

Policy Valuation

 Changes proposed by the Income Tax Act relating to the exempt test of life policies will change the Fair Market Value of insurance policies. They will become more valuable as many benefits offered by these policies will not be available in the marketplace. Also as we have seen, to know if your life policy is subject to accrual taxation, you have to understand the type of policies you have bought. The only way to do this is through an evaluation of your policy. This can be an actuarial evaluation done by an actuary or a market value evaluation done by an insurance specialist like me. The difference between these two valuations is that a market valuation assigns a positive or negative value to the contract provisions of a life policy from the point of view of a third party wanting to buy this policy while dealing at arm’s length.

Maritime Life a perfect case study on the IIT:

Towards the end of this great company, it embarked on a foolish odyssey of creating a Universal Life policy that would compete with an open investment such as mutual funds in order to secure its position and market share in the National Accounts which was under threat by companies such as Manulife. Maritime Life created the Life Accumulator and proceeded in shaving all of the cost of this UL down to the minimum such as reducing the base commission from 55% to 10%. Still this was not enough. The open investment was still better. This was normal after all. On the insurance investment you had to deduct a cost of insurance while the open investment had no such cost.

An actuary came up with the idea of directly refunding the IIT to the policyholder upon the surrender of the policy by grossing up the cash value by that amount in order to get closer to the values generated by an open investment. For the first time, the policyholder could see the amount of IIT he had paid on an illustration and this amount could be as high as 10% of the CSV. This was a marketing disaster. Here you had a Universal Life where Maritime Life was promoting the benefits of the tax exempt status of the UL in order to compete against an open investment while the illustration was showing the opposite with the IIT gross up amount representing the tax paid so far by the policy owner. Not too many advisors were willing to explain this to the policyholder. So the product launch and sales were a big disaster.

Still this product created an interesting question: If the insurer pays the IIT refund directly to the policy holder upon the surrender of his policy, should this IIT refund be included in the amount of the insurance proceeds therefore becoming taxable? The answer is obvious to me. How can a tax refund be taxable? This would be the worst double taxation… but under the ITA as we shall see later the answer is not as obvious.

Anecdote: Once a client asked me to explain to him in a few words the concept of life insurance. I answered: “it’s a conservative bet against your life.” The client became a bit angry with this definition upset that someone could bet against his life until I added “a bet that assumes you will live a long, healthy and prosperous life.” I was ready to emphasize my words with a Vulcan salute but this concept becoming less alien to him, he smiled: “I suppose there ain’t nothing wrong with this kind of bet.”


Well I will use Bill Strain’s conclusion as it still stands today:

“If the inside build-up of investment income in a permanent life insurance policy cannot be taxed on a fair and equitable basis at the policy holder level, the IIT will probably become a permanent fixture of Canada’s tax system. It seems extremely unlikely that the government will forgo tax on the investment income accumulating for the benefit of policy holders that is not currently taxable in the hands of either the policy holder or the company. However, the calculation of an appropriate base for the IIT may

become problematic if the method for determining the MTAR for corporate tax purposes is uncoupled from the method of calculating the base for IIT purposes. Perhaps the most troubling issue concerning the IIT has been the selection of an appropriate tax rate. The imposition of a flat 15 percent tax is

seen to be inequitable. Many individual policy holders would not be subject to a tax rate as high as 15 percent on their overall income. Others who are in higher tax brackets benefit from both a deferral of tax and complete exemption if the policy is held until death. However, the alternative of attempting to tax individual policy holders on the accumulating income is likely to create as many, if not more, inequities.”



  1. Jason Watt CD CLU RHU
    CFP and CLU Instructor

    Looks like we’re in for some mind-blowing stuff here, Richard. I linked to your Blog post from my various social media accounts. I am looking forward to what follows.

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