2021 Update to Spotlight Issue 5 - 2011
IRC 7702 and IRC 7702A are some of the most important Internal Revenue Codes (IRCs) that impact the sales and design of life insurance policies in the U.S. Each IRC harkens back to the 1980s and have been periodically and sporadically updated over the years.
From a high-level perspective, each IRC determines a limit on premiums that can be paid into a life insurance contract and establishes a certain level of risk that must be maintained within the context of a life insurance contract.
IRC 7702 has two tests and a life insurance contract must pass one of the two tests. The test is selected at time of issuance and cannot be changed once the policy is issued. The Cash Value Accumulation Test (CVAT) establishes a corridor factor that is applied to the cash value to set a floor on the death benefit in a life insurance contract. The Guideline Premium Test (GPT) establishes the maximum amount of premiums that can be paid into a life insurance contract relative to the contract's benefits (base plan face amount and other qualified rider benefits). The GPT also uses a corridor factor, like the CVAT, although the corridor factors are lower than those used for the CVAT.
IRC 7702A has a premium test used to determine whether the contract is a Modified Endowment (MEC) or non-MEC. If the 7-Pay premium limit is breached, the contract is determined to be a MEC. A MEC is taxed on a less favorable last-in, first-out basis (LIFO), where earnings are assumed to be taken out first when a disbursement is made from a life insurance policy. A non-MEC retains a more favorable first-in, first-out tax treatment (FIFO), where cost basis is assumed to be taken out first. Return of basis is a non-taxable event.
From the beginning of IRC 7702 and 7702A, the interest rate assumptions used to develop the various premium limits have been fixed. For the Guideline Single Premium (GSP) test, the interest rate assumption is the greater of 6% or the interest rate guaranteed in the contract. The Guideline Annual Premium (GAP), CVAT and MEC premiums were based on the greater of 4% or the interest rate guaranteed in the contract.
As interest rates have continued their downward slide from the high-interest rates of the 1980s, the use of 6% (GSP) and 4% (CVAT/GAP/MEC) to develop IRC 7702 and 7702A have become out of touch with the level of interest rates in the market. Back in the 1980s, when IRC 7702 and 7702A were drafted, interest rates were significantly higher, and 6% or 4% were more in line with market interest rates of that decade.
The Consolidated Appropriations Act 2021 was passed at the end of 2020. This bill included long-awaited, though unanticipated, changes to the interest rate assumptions and their determination for IRC 7702 and 7702A calculations.
Starting in 2022, Interest rates will be determined using a formula approach. Interest rates for the following premium limits and CVAT corridors will be determined using the following approach:
The insurance interest rate from 7702(f)(11) is a market-based interest rate and equals the lesser of the Section 7702 life valuation interest rate and Section 7702 applicable federal interest rate. Both rates are based on averages of recent market interest rates. For example, the federal interest rate is based on an average of the federal mid-term rates over a 60-month period.
After 2021, IRC 7702 and 7702A interest rates will be redetermined only in "adjustment" years. An adjustment year is the year after a change in the applicable life valuation interest rate becomes effective. Any such change will give insurers up to 18 months to implement the change in IRC 7702 and 7702A interest rates.
2021 is a transition year where the IRC 7702 and 7702A interest rates are prescribed. The interest rate assumptions during the transition year for CVAT/GAP/MEC is 2% and GSP is 4%.
The above-mentioned changes are very important to the life insurance industry as they are likely to lead to lower interest rate assumptions for IRC 7702 and 7702A. Lower interest rate assumptions lead to more favorable limits (higher premium limits under the GAP/GSP/MEC and lower corridor factors under the CVAT). This will allow for more premium to be paid into a life insurance contract than under the original IRC 7702 and 7702A.
For years, premium paid into life insurance contracts have been constrained due to the high interest rate assumptions used in IRC 7702 and 7702A. Given that rates were explicitly stated in the original versions of IRC 7702 and 7702A (6% or 4%), has made life difficult for life insurance companies with respect to monitoring and managing premiums paid into life insurance policies. With this recent update to the interest rates used in IRC 7702 and 7702A, interest rates will be more responsive to market interest rates, similar to how life insurance valuation interest rates are determined. So, as time marches on, the interest rate assumptions used to determine IRC 7702 and 7702A will be in line with market interest rates. This will add to the dynamic that IRC 7702 and 7702A have been lacking since inception.
At Insurance Technologies, we have been working with our life insurance clientele to implement these changes. While the change in IRC 7702 and IRC 7702A interest rate determination was unanticipated, Insurance Technologies has been able to quickly respond to client request to implement the new rates into the ForeSight® Sales illustration solution.
William "Bill" Aquayo
SVP, Actuarial Services
FSA, MAAA, CFA, ChFC, CLU
The information provided within this article is intended to convey general information only and not to provide legal advice or interpretation. This article is not inclusive of the article topic and includes product marketing of Insurance Technologies.