Will carriers begin filing products with lower guarantees?Recent commentary from A.M. Best examines the new 7702 tax rules. Excerpts are provided below. Access the full commentary here.
OLDWICK, N.J., March 29, 2021—New interest rate assumptions for U.S. life insurance companies in the recently enacted Consolidated Appropriations Act will allow higher premiums to be paid into life products and still meet the definition of life insurance, according to a new AM Best commentary.
Two tests are used to determine if a life insurance contract meets the definition of life insurance under Section 7702 of the IRS tax code for the favorable tax treatment of cash value build-up and death benefits. These tests pertaining to cash value accumulation and guideline premium/corridor rules that aim to ensure that life insurance contracts are used for protection rather than investments.
The Best’s Commentary, “U.S. Life Insurance Products to Change in Reaction to New 7702 Tax Rules,” notes that the new law sets an insurance interest rate, which will change when the reserve valuation interest rate changes and impact the testing. AM Best is of the view that the change in the interest rates used for the testing was long overdue, as these were set back in 1984 when rates were much higher. Although life insurers have had little time to react in the near term, the new law does give companies some time to prepare for when the insurance interest rate changes in the future.
Because of the new law, according to the commentary, companies are likely to start filing life insurance products with lower guarantees. Product pricing will change, particularly compensation, for universal life insurance. Most universal life commissions are paid using a target premium on which full commissions are paid, with a lower rate paid on premiums over the target premium. Target premiums may need to be adjusted due to the higher levels of premium that can be paid into the contract, while still maintaining the favorable tax status.
Excerpts From The Commentary:
At the end of 2020, the US Congress passed the Consolidated Appropriations Act, 2021, which contained changes to interest rate assumptions used to determine whether a life insurance contract meets the definition of life insurance under Section 7702 of the IRS tax code, for the favorable tax treatment of cash value build-up and death benefits. Two tests are used to determine if a life insurance contract meets the definition of life insurance for the tax-favored status. The first test is a cash value accumulation test, under which the cash value can be no greater than a net single premium determined using the guarantees in the contract. The interest rate used for the test is the greater of 4% or the guaranteed rate of the contract. This test is used primarily for whole life contracts as well as certain variable and universal life contracts, and is determined upon issue of the contract.
The second test is a guideline premium/corridor test. Under this test, either:
(a) the sum of premiums paid into the contract cannot exceed the guideline single premium calculated using a rate that is greater than 6% or the interest rate guaranteed by the contract, or
(b) the premiums paid into the contract cannot exceed the sum of a 7-pay guideline level premium at the greater of 4% or the interest rate guaranteed by the contract
The guideline single premium and the 7-pay guideline level represent the premiums that will mature for full death benefits. In addition to the guideline premium test, the relationship between the death benefit and the cash value must meet corridor requirements. The corridor starts at 250% and declines gradually to lower levels as the attained age rises. The guideline premium/corridor test is used primarily for universal life contracts. These provisions will ensure that life insurance contracts are used for protection rather than investments.
Lower Rate Allows For Higher Premiums
To test the tax status of life insurance contracts, the new law calls for the “insurance interest rate,” which will change when the reserve valuation interest rate changes. The insurance interest rate is the lower of the valuation interest rate used in determining reserves with a guarantee duration of more than 20 years and the “applicable federal interest rate,” which represents an average of mid-term rates over a 60-month period. This produces an insurance interest rate of 2%. The rate will apply to contracts issued in 2021.
The cash value accumulation test and the guideline level 7-pay test will be now be determined using the greater of 2% and the rate guaranteed in the contract, while the guideline single premium will be the rate that is the greater of 4% and the rate guaranteed in the contract. The use of lower rates results in higher premium levels that can be paid into life insurance contracts while still meeting the definition of life insurance for favorable tax benefits. As of year-end 2019, over 58% of individual life account values had guaranteed interest rates of 4% or higher, 24% of account values had guaranteed rates equal to or greater than 3% but lower than 4%, and 18% of account values, lower than 3%. We expect more companies to start filing life products with lower guarantees.
Product Pricing Will Change
The change in the interest rates used for the test was long overdue, as these were set back in 1984 when rates were much higher. Life insurers have had little time to react and will refile policy forms over time. However, the new law does give companies some time to prepare when the insurance interest rate changes—based on the valuation rate changes, which are known six months prior to the year applicable, the law defines an adjustment year as 18 months following a change in valuation rates, giving life insurers ample time to change product parameters.
Section 7702 was intended to discourage the use of life insurance contracts as an investment, but insurance contracts are sold as such for a subsegment of the affluent market. Once contracts are re-filed to recognize the changes to Section 7702, insurers will become somewhat more efficient in serving this market. Compensation will also be subject to change, particularly for universal life. Most universal life commissions are paid using a target premium on which full commissions are paid, with a lower rate paid on premiums over the target premium. Target premiums may need to be adjusted due to the higher levels of premium that can be paid into the contract, while still maintaining the favorable tax status.
To access the full copy of this commentary, please visit here.
About AM Best
AM Best is a global credit rating agency, news publisher and data analytics provider specializing in the insurance industry. Headquartered in the United States, the company does business in over 100 countries with regional offices in London, Amsterdam, Dubai, Hong Kong, Singapore and Mexico City. For more information, visit www.ambest.com.