Premium spreading tests: main rules
In order to be a qualifying policy, endowment policies, whole of life policies and term assurance policies with a term of 10 years or more must satisfy two ‘premium spreading tests’ that ensure that the level of premiums payable is relatively smooth over the life of the policy. Both tests must be passed. They do not apply to term assurance policies with a term of less than ten years.
The references in each test to ‘any period of 12 months’ mean just that - application of the tests is not restricted to insurance years, tax years or calendar years.
Where premiums are waived because of a person’s disability they are treated as paid for the purpose of the premium spreading tests. Where an extra premium is charged because of an exceptional risk of death, it is disregarded when applying the premium spreading tests - see IPTM8075.
Where a discounted premium is paid instead of receiving commission or a cash-back, it is the actual discounted premium payable under the policy which must be used in the premium spreading tests.
The first test is that under the terms of the policy, the premium payable for any period of 12 months must not be more than twice that payable in any other period of 12 months. This is commonly referred to as the ‘twice-times rule’.
The twice-times rule means that, for instance, there is a limit on the escalation of premiums that is permitted under the terms of a qualifying policy. So, for example, a policy that initially provides for premiums of £100 per month, rising to £300 per month after 10 years, could not be a qualifying policy.
It is, though, possible for premiums to increase to more than twice the original premiums through the exercise of an option in the policy or a variation of the policy when there is more than ten years of the policy term to run. There is more on the effect of variations and options at IPTM8165 to IPTM8185. In effect, the twice-times rule only applies to premiums that are required to be paid by the policyholder under the contractual terms of the policy, that is, where the policyholder has no choice in the matter.
The other test that has to be satisfied is the ‘one-eighth rule’:
Step 1: For an endowment policy or a whole of life policy where premiums are only payable for a specified term calculate the total of premiums payable over that term. For a whole of life policy where premiums are payable for life, calculate the total premiums payable for the first ten years of the policy.
Step 2: Divide the total from step 1 by 8.
Step 3: Check that for any period of 12 months over the life of the policy premiums payable do not exceed the amount given from step 2.
For example, if a ten-year policy provides for annual premiums of £500 for the first 5 years and £1,000 for the last 5 years, total premiums payable are £7,500. Therefore, under the one-eighth rule, premium payments in any 12 month period must not exceed £937.50. But as there would be annual premiums payable of £1,000 later in the term of the policy, this test would be failed.
Further reference and feedback IPTM1013