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Demystifying the Net Cost of Pure Insurance(NCPI) 

By Herb Huck

The NCPI is a measure of the cost of insurance used for tax purposes. It is calculated by multiplying a prescribed mortality factor times the Net Amount at Risk, (NAAR). For post-82 policies the NCPI reduces the Adjusted Cost Basis, (ACB) of the policy for taxation years commencing after May 31, 1985. The ACB impacts potential gains on disposition and the amount that flows to the Capital Dividend Account, (CDA) of private corporations. The NCPI is defined in Regulation 308 of the Income Tax Act, (ITA) and is based on the 1969-75 mortality tables of the Canadian Institute of Actuaries. This tax measure for mortality costs should not be confused with the actual mortality cost charged by the insurer for a particular policy often referred to as the Cost of Insurance.

The question often asked by financial advisors is why the NCPI varies significantly between insurers for identical client situations if they are all required to use the same mortality table to do the calculation. There are two reasons why the NCPI may differ between carriers. The first is based on the mortality rates used, and the second is based on the method used by the insurer to derive the NAAR. Let’s look at how these two factors can result in significantly different NCPI amounts for similar policies issued by different carriers.

Mortality Rates
Each insurer must use the 1969-75 mortality tables prescribed by the ITA to come up with the rates of mortality used in the NCPI calculation. The 1969-75 table provides both select and ultimate mortality rates. Select mortality rates are those based on underwritten lives, which are generally in good health. The tables provide select mortality rates for issue ages from 15 up to 70. The tables provide you with the mortality rates for life insured’s based on their issue age, and projected out for 15 years (so select rates are available for a life insured age 70 at issue up to and including their 85th birthday). Ultimate mortality rates are provided on the prescribed tables for attained ages ranging from 30 to 105. These rates reflect the mortality expectations for the general population. They tend to be higher because both bad and good health risks are included in the rates.

The ITA prescribes the 1969-75 tables but does not direct the insurer on how to use the tables. As such, some insurers may use the select mortality rates while others may use the ultimate mortality rates. They are both included on the prescribed table. Secondly, those using select mortality rates need to adopt a procedure for issue ages over 70, which is where the table stops. Insurers could use the age 70 select rates and apply the projected mortality rates for subsequent issue ages up to age 85, (a 71 year old client could be modelled using the issue age 70 select rates projected one year out) For issue ages over 85 the insurer would than have to start using the ultimate rates. Alternatively, they could use the select rates for issue ages up to 70 and than use the ultimate rates for attained ages over 70.

As you can see, although the ITA prescribes a particular set of mortality tables to be used by all insurers, the actual rates used can vary from insurer to insurer. The differences can be significant. For example, the select mortality rate per $1,000 of NAAR for a 50-year-old male non-smoker is 1.61. The ultimate rate for attained age 50 for the same client is 3.03. On one million dollars of NAAR, that results in a difference of $1,420 in NCPI in the first year alone. That difference grows to $20,760 for a male non-smoker with an issue/attained age of 70.

NAAR
The second reason for the difference is that Regulation 308 of the ITA tells the insurer to apply the mortality factors in the 1969-75 mortality table to the NAAR. The NAAR is defined in the Regulation as follows;

(a)

the benefit on death in respect of the taxpayer’s interest at the end of the year,

Less

(b)

i) the accumulating fund, (AF)

     OR

ii) the cash surrender value, (CSV)

whichever the insurer chooses to follow on a consistent basis.

The (b) term in the above equation is what causes the differences. Some companies may use CSV while others will use the accumulating fund. This would cause a difference in the NCPI even if the two companies calculated the NCPI using the same mortality factors but choose different options for the (b) term to derive the NAAR. Complicating matters further is the fact that very few companies have similar CSV’s or AF for similar policies. CSV’s will vary because of surrender charge and bonus assumptions. AF will vary between insurers based on the underlying assumptions used to calculate the 1½ preliminary term reserve such as the premium payment period, lapses, interest, mortality, etc. The underlying assumptions used by different insurers vary considerably resulting in different accumulating funds.

The choice of using CSV or AF is often a strategic choice made by the insurer based on their market niche and other available planning techniques. For example, some companies may try to minimize the NCPI to keep the policy ACB as high as possible and thereby increase the after-tax policy values available for living benefits such as withdrawals and policy loans. Others may try to maximize NCPI to drive down the ACB and create larger CDA accounts for corporate clients. Since the ITA requires the insurer to use the method chosen consistently, there is no magic option for term (b) in Regulation 308 that will create advantages in all situations. But the choice between using the AF or the CSV for the b) term can create significant differences in the NAAR and therefore the NCPI used by different insurers.

Example
To best way to illustrate the potential differences that can arise is with an example. Let’s look at a case for a 50-year-old male non-smoker who purchases a one million-dollar face plus fund life policy. The policy will be funded over 10 years and is based on a level cost of insurance. At the end of the first year the CSV is $6,000 and the AF is $16,000. These products typically have low CSV’s in the early years, but the policy accumulating fund may be quite large, (to reflect the level COI reserve held by the insurer that recognizes the higher premiums paid in the earlier policy years that subsidize the lower premium costs in later years). The various components and options for deriving the NCPI are displayed below.  

  

Mortality Rate

 Select
 Ultimate

NAAR

 Based on CSV
 Based on AF

$1,010,000
$1,000,000

Possible NCPI values for year one:

Mortality /
NAAR

Select /
CSV

Select /
AF

Ultimate /
CSV

Ultimate /
AF

NCPI

 $1,626

  $1,610

  $3,060

 $3,030

The NCPI determined by this insurer could range from a low of $1,610 to a high of $3,060 based on these assumptions.  The range can be even larger if we look at other insurers that have different CSV and AF values for the same client situation.  

Summary
The industry submitted a paper to Finance on the Exemption test and had some initial dialogue with them in the late 90’s.  In that paper there were recommendations that would narrow the differences regarding the calculation of the accumulating fund and how to modify the NCPI for rated cases.  Even if those recommendations are adopted, the NCPI will likely continue to vary between insurers as a result of the choices between select and ultimate mortality rates, and the choice of CSV or the accumulating fund for determining the NAAR.  Unless the ITA is changed, you can continue to expect differences in the NCPI used by different insurers for similar type clients.  So financial advisors shouldn’t be surprised by the significant differences in the NCPI used by different carriers, in fact it would be quit a coincidence if the NCPI of any two carriers were in fact the same.

Herb Huck Director, Professional Advisory Services Roger Menard Insurance

How to engage the Professional Advisory Services Team:   To get the Professional Advisory Service team working for you, contact your Roger Menard Insurance Sales Representative. Your Sales Representative will provide you with information on the team’s services and help you engage their assistance if appropriate.

The findings, interpretations and opinions expressed in this published material are those of the author of the work only.

Author: car health