Internal funding of insurance sales

Internal funding refers to the process where a new insurance policy is funded by transferring funds from another existing in-force policy. Depending on the source of the transfer, this type of activity can create risks for the client, the advisor and the company.

All types of transfers can have risk; however, some types of internal funding arrangements pose higher risk, especially those that involve the following types of transfers from a permanent insurance policy:

  • policy loans
  • withdrawals from the policy fund of a universal life plan
  • surrenders of paid-up additions

These transactions can have adverse tax consequences that are difficult to project into the future, especially when such transfers are repeated over several years. In addition, it is difficult to project when the existing policy will be in a lapse position in the future as a result of such transfers. As a result, we no longer allow newly issued insurance policies to be funded from one of these three sources.

Here are some more details on the risks and challenges with these types of funding options:

Tax implications

These transactions can have adverse tax consequences, especially if they persist over several years. In general, a policy is not in a taxable gain position in the first 10 years or so. But over time an increasing percentage of the cash value will be taxable if surrendered or withdrawn. Eventually 100% of the CSV is taxable if surrendered or withdrawn. Withdrawals are taxable on a proportionate basis. For example, if in year 17 of the policy 50% of a cash value is taxable, and the client withdraws some money from the UL policy fund, then 50% of that withdrawal is also taxable. The same is also true for the surrender of paid-up additions.

Policy loans for amounts that are less than the adjusted cost basis (ACB) of a policy are not taxable. Over time though, the ACB of a policy reduces and eventually becomes zero. Therefore, eventually policy loans become fully taxable.

While Sun Life can provide an advisor or client with information about how much of a current withdrawal or policy loan is taxable, an in-force illustration can't project the future tax position of such transactions. This can make it difficult for clients to understand the future tax risk associated with these types of funding arrangements.

Jeopardizing In-force Status of Existing Insurance Business

Taking policy loans from an existing policy can also jeopardize the in-force status of such policies, especially if the loans are repeated over several years. As policy loans accumulate with interest over time, they may reach a point where they exceed the cash value and the policy will be in a lapse position unless the loan is paid back. Some products have adjustable cash values and if there are decreases in the future cash values, such policies may be in a lapse position much sooner than anticipated. Unfortunately, in-force illustrations can't project the impact of repeated policy loans. This can make it difficult for clients to understand the future lapse risk associated with using a policy loan funding strategy.

The same applies for taking repeated withdrawals from a universal life policy, especially if the policy has a yearly renewable term cost of insurance structure.

Surrendering Paid-up Additions

The surrender of paid-up additions (PUAs) can also have adverse tax consequences. In addition, it is important to recognize that the death benefit is reduced by a multiple of the amount of cash value of the PUAs withdrawn. For example, a withdrawal of $1,000 of cash value of PUA may reduce the death benefit by $3,000 to $7,000, depending on the age of the life insured.