Policies entered into prior to June 21, 1988, and policies entered into on or after that date with low enough premiums to avoid being classified as MECs are generally treated the same as life insurance policies have been treated in the past. This means there will generally be no income tax applicable to withdrawals until the policyowner’s cost basis has been recovered (tax free). This is the cost-recovery rule or first-in-first-out (FIFO) treatment long associated with life insurance policy taxation. Distributions or withdrawals that are subject to tax are not subject to the additional 10 percent penalty unless the policy is reclassified as a MEC.
However, a grandfathered policy or a policy that originally passed the seven-pay test when it was issued can become a MEC if there is a material change in the policy. A material change, in itself, does not cause a policy to become a MEC. A material change only subjects the policy to the seven-pay test. It is reclassified as a MEC only if it fails the test. For example, a single-premium life insurance policy acquired before June 21, 1988 is not a MEC. However, if there is a material change in the policy, it is subjected to the seven-pay test, which it would probably fail. It would then be a MEC.
Similarly, an elective increase in the death benefit (requiring evidence of insurability) of a universal life policy that was acquired before June 21, 1988 would also subject the policy to testing. However, depending on the timing and level of premium payments and the cash value in the policy, the policy after the change, in many cases, would pass the test. The policy would continue to be treated under the normal rules for life insurance contracts.
Changes That Are Not Material
What constitutes a material change under the law? What is not a material change is somewhat clearer than what is a material change, so the changes that are specifically excluded from consideration as material changes are addressed first. The statute provides the following specific exceptions to the material change rules:
- cost-of-living increases in death benefits based on a broad-based index (such as the consumer price index) if the increase is funded ratably over the remaining life of the contract;
- increases in death benefits due to the premiums paid for the policy to support the first seven contract years’ level of benefits; and
- death benefit increases inherent in the policy design due to the crediting of interest or other earnings.
Exception (1) would be met by the standard cost-of-living rider where there is a level step-up of future annual premium charges for cost-of-living increases in death benefits. Exception (2) appears to exempt any increase in death benefits necessary to keep the required relationship between the death benefit and the policy guideline cash value or guideline premiums as specified in section 7702 from being classified as a material change. Exception (3) appears to exempt the increasing death benefits of an option II universal life policy or a variable life policy from being classified as a material change.
Also, certain changes will not be treated as material which, by inference, adds the following exceptions to the material change rules:
- increases in death benefits, without limit, on policies which, as of June 21, 1988, required at least seven level annual premium payments and under which the policyowner continues to make at least seven level annual premium payments; and
- increases in death benefits (or the purchase of an additional qualified benefit after June 21, 1988) if the policyowner had a unilateral right under the contract to obtain such increase or addition without evidence of insurability.
The first exception means that level premium whole life policies entered into before June 21, 1988, are permanently grandfathered from the material change rules as related to increases in death benefits (but other material changes, such as an exchange, would make them subject to seven-pay testing). Universal life or other flexible-premium policies are, presumably, not included since they do not require the payment of level premiums. The second exception appears to be a grace amount or safe harbor for death benefit increases that the policyowner had a contractual right to obtain without evidence of insurability such as might be provided by guaranteed insurability riders.
Material Change Defined
The statute says “the term ‘material change’ includes any increase in the death benefit under the contract or any increase in, or addition of, a qualified additional benefit under the contract.”
Material Increases in Death Benefits
Any increase in death benefits under a policy (excluding the exceptions mentioned above) will be treated as a material change if:
- before June 21, 1988, the policyowner did not have a unilateral right under the contract to obtain such increase or addition without providing evidence of insurability; or
- the policyowner has a unilateral right under the contract to obtain increases or additions without evidence of insurability but such increases exceed the death benefit under the contract in effect on October 20, 1988, by more than $150,000.
Basically, any increases in benefits that require evidence of insurability and even contractually-guaranteed increases that do not require evidence but that cumulatively exceed the amount in (2) will be treated as material changes. Shifting a universal life policy from death benefit option I to option II would be a material change since the election usually requires evidence of insurability.
On the other hand, increases without evidence of insurability may not be considered material. Examples of such could be safe contractual rights include increases pursuant to guaranteed insurability riders, guarantee issue offers, scheduled option II face amount increases, and section 7702 cash value corridor increases. Death benefit increases for grandfathered policies due to premium payments, reserve earnings, cash value corridor, and/or regular option II increases should not cause loss of grandfathering, even if over $150,000, because they are covered by the necessary premium exception to the material change rules.
Other Material Changes
The following other types of changes are also considered material:
- term life insurance conversions to permanent forms of coverage; and
- exchanges of one policy for another, whether or not tax free under Code section 1035.
It is uncertain whether changes in contract mortality charges or interest rate guarantees are material changes.
Seven-Pay Test as Applied to Material Changes
A material change in a contract’s benefits (or other terms) that was not reflected in any previous determination under the seven-pay test requires seven-pay testing. Apparently, a material change may take place anytime during the policy’s existence. When a material change occurs, the contract is treated as if it were a new contract entered into on the date when the change takes effect. The seven-pay test, as described above, is applied as of the date of the material change, not the issue date of the policy. In addition, the seven-pay test is adjusted by a rollover rule that takes account of the contract’s existing cash surrender value at the date of change.
The procedure is as follows:
- Determine the seven-pay premium (based on the insured’s then attained age) for each of the next seven contract years after the material change.
- Multiply (a) the cash surrender value as of the date of the material change (determined without regard to any increase in the cash surrender value that is attributable to the amount of premium that is not necessary) by (b) a specified fraction. The fraction is the ratio of:
the seven-pay premium for the future benefits under the contract after the change to;
the net single premium for such benefits computed using the same assumptions used in determining the seven-pay premium.
- Subtract the product of the multiplication in step (2) from the amount determined in step (1).
The remainder is the adjusted seven-pay premium used to test actual premiums paid in each of the next seven contract years.
The adjusted seven-pay premium so determined could be negative if the cash value is large enough. This should not automatically make the contract a MEC. However, payment of additional premiums in the next seven years might make the policy a MEC.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM