Executive Summary
The Consolidated Appropriations Act, 2021, which combines stimulus relief for the COVID-19 pandemic and appropriations for the federal fiscal year ending September 30, 2021, was signed into law on December 27, 2020 by President Trump. The Appropriations Act amended section 7702 of the tax code, which defines the term ‘life insurance contract’ for federal income tax purposes.
The amendment changes the interest rates in the actuarial tests used to determine whether a contract meets the statutory definition of a ‘life insurance contract’. While a low interest rate environment persists, the changes to §7702 will allow life insurance contracts to be funded with substantially larger sums without failing both actuarial tests required to meet the definition of a ‘life insurance contract’.
Background
The primary impetus for the change to §7702 was because of the financial challenges facing insurance carriers due to a protracted low interest rate environment. In particular, life insurance carriers who primarily sell whole life insurance were facing the prospect of guaranteeing 4% return under the cash value accumulation test (CVAT) while investing in fixed income securities with lower than 4% returns. Had the changes to section §7702 not occurred, whole life as a product group may have been pulled as uneconomical, thus jeopardizing the futures of many large, whole life carriers.
For consumers, a protracted low interest rate environment risks exhausting policy cash values before the contract matures, resulting in either a lapse or additional premiums.
Mechanics
The changes made to §7702 are relatively straight-forward. While market interest rates are low, the actuarial tests described in §7702 are permitted to use interest rates lower than 4% CVAT or 6% guideline premium limitation test (GPT).
For the CVAT, the 4% rate is replaced with a rate equal to the lesser of 4% or an ‘insurance interest rate.’ The insurance interest rate for a calendar year is the lesser of (1) the valuation interest rate prescribed by the National Association of Insurance Commissioners (NAIC) for life insurance with a guaranteed duration of more than 20 years, or (2) a 60-month average of the mid-term applicable federal rates (AFRs).
For the GPT, the 6% rate is replaced with a rate 3% higher than that used for the CVAT, thus preserving the two percentage point difference between the CVAT and GPTs rate in the prior law.
Since this change was enacted quickly, the law proscribes a transition rule for 2021 whereby the CVAT testing rate is the greater of 2% or the rate guaranteed under the contract, and the GPT testing rate is the greater of 4% or the rate guaranteed under the contract.
Key Takeaways
- Clients will be allowed to pay 1.4x – 2.0x the amount of premium based on the same death benefit.
- Accumulation efficiencies are minor when compensation is adjusted to mirror that of contracts under prior §7702 rules:
- While cash value accumulation efficiencies rise under the new rules, the primary driver of such efficiencies is decreased agent compensation. When compensation on new contracts subject to the new §7702 rules is adjusted to mirror that of contracts under the prior §7702 rules, the cash value accumulation efficiency only increases by 0.14%.
- Death benefit banding:
- Many carriers have preferential pricing for contracts that exceed a certain amount of death benefit (typically $1,000,000). Under the new §7702 rules, the same amount of premium on an accumulation contract will now require substantially less death benefit to qualify under the actuarial tests. Therefore, it is possible that clients could fall below the preferential pricing bands and be subject to higher costs.
- Implementation will be a challenge:
- Carriers will face challenges updating their illustration systems to the new rules, especially those who use legacy systems for testing purposes.
- Changes to existing contracts (such as reducing the death benefit) could subject those contracts to the new rules under §7702.
If you have any questions regarding the new rules set out in The Consolidated Appropriations Act, 2021, please contact our Advanced Planning team at advancedplanning@highland.com.