Changes to the IRS are affecting life insurance

14th July 2021

Changes to IRS Section 7702 are creating opportunities for insurance companies to offer insurance policies that are more attractive. This has created a flurry of repricing, product implementation, and illustration development work to make these changes to their portfolios.

Life insurance has historically offered favorable tax treatment in the United States, and the industry has protected the provisions in IRC Section 7702 and Section 7702A from change since the previous Section revisions in 1984 with DEFRA and in 1988 with TAMRA.  The life insurance companies have feared that any change may make these less attractive from a tax standpoint. Over time, these tax laws became outdated, because interest rates declined significantly from rates in the 1980’s.

All of this has changed. Late in December of 2020, Congress passed the Consolidated Appropriations Act, which lowered the 7702 interest rates. As a background, Section 7702 was enacted as part of the Deficit Reduction Act of 1984 (DEFRA) to restrict the amount of funds that can be paid as premium in a life insurance. It must bear a relationship to the death benefit measured by meeting one of two tests: the Cash Value Accumulation Test (CVAT) or the Guideline Premium Test (GPT).  These tests involve projections using interest rates specified in IRC Section 7702.

The Cash Value Accumulation Test (CVAT) limits the premium to the amount creating cash values no greater than the net single premium (NSP) using 4%. The difficulty with using 4% is that the resulting premiums are inadequate to fund the policy in today’s economic environment.

Similarly, the Guideline Premium Test (GPT) requires that the premiums are limited to the maximum of the net single premium using 6% or the cumulative sum of the “guideline annual premium,” which is a premium solved for that endows the premium using 4%. Once again, these limits solve for premiums that are inadequate to fund the policy in today’s economic environment.

The Consolidated Appropriations Act lowered the interest rates. For the CVAT, the interest rate was lowered to 2% in 2021, and for the GPT, the interest rates were lowed to 4% and 2%. These rates are dynamic, and subject to potential future changes without changing Section 7702.

The following chart summarizes the interest rates before and after the change to the tax code:

Test Premium IRC Code Section Original 7702 / 7702A Interest Rate for Calculations Consolidated Appropriations Act (CAA) Changes to Interest
CVAT – Net Single Premium (NSP) 7702(b)(2)(A) Greater of 4% or the rate or rates guaranteed on issuance of the contract Greater of Applicable Accumulation Test Minimum Rate (currently 2%) or the rate or rates guaranteed on issuance of the contract
Guideline Level Premium (GLP) 7702 (c) (4) Same as Net Single Premium Same as Net Single Premium
Guideline Single Premium (GSP) 7702 (c) (3)(B)(iii) Greater of 6% or the rate or rates guaranteed on issuance of the contract Greater of Applicable Accumulation Test Minimum Rate (currently 4%) or the rate or rates guaranteed on issuance of the contract
Seven Pay Premium (7-Pay) 7702A (c) (1) (B) Same as Net Single Premium Same as Net Single Premium

The reason that these interest rates are so important is that the premiums needed to endow the policy at age 100[1] are greater at these new lower rates than the interest rates prior to CAA. Higher premiums for a policy provide higher cash values for the same death benefit, which means that more funds are subject to favorable tax treatment.

The actuaries at Davies Insurance Services are preparing to help insurance clients with this impact. These changes will require modifications to administrative systems, which will require significant amounts of testing. The illustration systems will require changes, and these, too will need testing. Finally, many of the currently sold life insurance products will require repricing.  This will take a team effort, and the actuaries look forward to the pricing, product development, and system testing.

For more information actuarial services, please contact Stefanie Porta, Consulting Actuary on stefanie.porta@davies-group.com

 

[1] Age 100 or age from the requirements of Rev. Proc. 2010-28 using “Age 100 Safe Harbor Testing Methodologies.”

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