IPTM8180 - Options: peppercorn options

A ‘peppercorn option’ is an option in the policy under which the policyholder can require the premiums to reduce to a nominal amount once the policy has run at least ten years, and is then able to make part surrenders of the policy, which is converted to whole of life.

Option in the policy

In testing at the outset whether a policy made on or after 1 April 1976 qualifies the effect of exercising any of the options in the policy must be considered. If the exercise of an option would result in a non-qualifying policy then the policy cannot be qualifying.

A policy containing a peppercorn option cannot be qualifying as explained below. It provides a good example of how the qualifying policy rules on options, substitutions and significant variations interact.

Substitution

The first option that the policyholder can exercise is to convert the policy to one with a peppercorn premium. This is a fundamental reconstruction, giving rise to a substitution of the policy with a whole of life policy. There would be regular, nominal premiums payable on the new policy and also a single premium paid at the outset relating to the transfer value of the old policy.

In testing whether the substitute policy would meet the conditions to be a qualifying policy it must be looked at as a stand-alone policy, disregarding the premium relating to the transfer value. Provided the minimum sum assured is maintained these conditions will be met, as the new policy would be a whole of life policy with regular premiums, albeit nominal. The new policy would then qualify under ICTA88/SCH15/PARA17(2)b)(i) because the old policy had run for at least ten years - see IPTM8130.

Significant variation

Once the policy has been substituted by the whole of life policy, the policyholder also has the option to make a part surrender of the policy at any time, and in particular within ten years of the substitution. This counts as a significant variation of the policy so it must be tested after the part surrender to see if it would qualify.

If the part surrender is made within ten years of the substitution, the relevant test is in ICTA88/SCH15/PARA17(2)(b) as described at IPTM8125. The varied policy would fail to qualify because it has an annual premium that is less than half the highest premium paid in its first 12 months, as that period includes the premium relating to the transfer value from the policy before the substitution.

It follows that the original policy cannot be treated as qualifying because the exercise of this option would result in a policy that would not qualify.