ACB Explained & CDA Created by Insurance Death Benefit

In order to efficiently transfer wealth to the next generation with taxes minimized, a company often purchases life insurance for its shareholders with the following objectives:

Shareholders to live long.
After the shareholders have passed, the insurance payout minus the ACB (adjusted cost base) goes to the company’s CDA (capital dividend account).
The new shareholders happily get money from the CDA account, free from tax.

Therefore, the lower the ACB is, the higher the amount transfers to the company’s CDA, resulting in greater satisfaction for new shareholders.

Now, let’s explore how the ACB of a policy is calculated. It is important to note that in the life insurance industry, the ACB calculation differs from the traditional concept of ACB as described in Glossary of Tax Planning Terms.

To grasp the concept of ACB more effectively, I created an Excel spreadsheet and plotted a graph illustrating the ACB trend based on the example of a company purchasing a whole life insurance policy for its shareholders.

Here are the assumptions for the illustration:

The insured person is currently 40 years old.
The total premium is $200,000, paid over 20 years at $10,000 per year, starting from the current year.
Premium payments cease at the age of 60.
The concept of Net Cost of Pure Insurance (NCPI), representing the insurance company’s cost, is important here.
- In this case, the NCPI starts at its lowest point of $100 as the insurer is at his youngest and healthiest age, and the NCPI increases by 20% annually.
The formula for calculating the ACB of a policy is: Total premium paid – NCPI = ACB.
- In other words, subtracting the NCPI for each year from the total premium paid yields the ACB for that year.

Analyzing the data reveals that:

If an individual starts paying premiums at the age of 40, by the time they reach their 80s, the ACB of the policy will be close to zero.
This means that if they live until the day when the ACB reaches zero, the CDA will be maximized, resulting in the greatest satisfaction for new shareholders.