Session 1: Life Insurance Product Tax Update: Life PBR and Related Topics  

Session Chair: Brian King 

Ernst & Young LLP  

Presenters: Sheryl Flum 

KPMG Brian King 

Ernst & Young LLP Alexis MacIvor 

IRS Office of Chief Council Mandana Parsazad 

American Council of Life Insurers (ACLI) Craig Springfield Davis & Harman LLP 

2016 Product Tax Seminar

Session 1: Life Insurance Product Update: Life PBR and Related Topics

Washington, DCSeptember 8, 2016

PresentersBrian KingErnst & Young LLP

Craig SpringfieldDavis & Harman LLP

Sheryl FlumKPMG

Mandana ParsazadAmerican Council of Life Insurers (ACLI)

Alexis MacIvorIRS Office of Chief Counsel

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SOCIETY OF ACTUARIES

Antitrust Notice for Meetings Active participation in the Society of Actuaries is an important aspect of membership. However, any Society activity that arguably could be perceived as a restraint of trade exposes the SOA and its members to antitrust risk. Accordingly, meeting participants should refrain from any discussion which may provide the basis for an inference that they agreed to take any action relating to prices, services, production, allocation of markets or any other matter having a market effect. These discussions should be avoided both at official SOA meetings and informal gatherings and activities. In addition, meeting participants should be sensitive to other matters that may raise particular antitrust concern: membership restrictions, codes of ethics or other forms of self-regulation, product standardization or certification. The following are guidelines that should be followed at all SOA meetings, informal gatherings and activities:

DON’T discuss your own, your firm’s, or others’ prices or fees for service, or anything that might affect prices or fees, such as costs, discounts, terms of sale, or profit margins.

DON’T stay at a meeting where any such price talk occurs.

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If you have specific questions, seek guidance from your own legal counsel or from the SOA’s Executive Director or legal counsel.

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Disclaimer

• These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting, tax or legal advice.

• The views and opinions expressed are solely those of the presenters and not those of Ernst & Young LLP, KPMG, the ACLI, Davis & Harman LLP or the Internal Revenue Service.

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Session Overview

• Part 1• The 2017 Commissioners’ Standard Ordinary (CSO)

Tables

• Part 2• Reasonable mortality requirements under Internal

Revenue Code (IRC) Section 7702(c)(3)(B)(i) • History of mortality table guidance from the IRS

• Part 3• The need for 2017 CSO-related guidance from the IRS

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Part 1: The 2017 CSO Tables

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The 2017 CSO TablesCharacteristics of the Tables

• The 2017 CSO Tables is a collection of tables (104 tables have been published by the Society of Actuaries) with the following variations:

• Age last birthday (ALB) and age nearest birthday (ANB) variations• Select and ultimate tables• Smoker distinct and composite (i.e., unismoker) tables • Preferred risk tables:

• Three risk classes for nonsmoker (super preferred, preferred and residual)• Two risk classes for smoker (preferred and residual)

• Gender-blended tables

• The structure of the 2017 CSO Tables is similar to the 2001 CSO Tables, which should make for a smooth transition for administration systems:

• Terminal age of 121• 25-year select period for nonsmokers (20-year select period for smokers)

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The Valuation ManualThe Process of Adopting New Mortality Tables

• New mortality tables will be adopted through the Valuation Manual (VM) by amendment without the traditional state adoption process:

• Amendments recognizing the 2017 CSO Tables were adopted by the National Association of Insurance Commissioners (NAIC) in 2015.

• VM-M:• Defines the 2017 CSO Tables for purposes of the Valuation Manual

• VM-02: Minimum Nonforfeiture Mortality and Interest:• Provides for mortality and interest requirements for computing minimum

nonforfeiture requirements for purposes of the Standard Nonforfeiture Law• VM-20: Requirements for Principle-Based Reserves (PBR) for Life

Products:• Provides mortality requirements for purposes of computing the net premium

reserve for life products

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The Valuation ManualVM-02: Minimum Nonforfeiture Mortality and Interest

• Mortality table standards are defined for three types of life insurance: • Ordinary life insurance policies:

• 2017 CSO Tables may be used on or after January 1, 2017, and shall be used for all policies on or after January 1, 2020.

• Choice of tables:• Plans with smoker-distinct rates can use composite or smoker-distinct mortality.• Plans without smoker-distinct rates must use composite mortality.

• Companies have a choice of using ultimate or select/ultimate forms.• Gender-blended tables are permitted where required under applicable law or utilize the

same premium rates/charges for males and females.• Preferred table structures are not permitted for purposes of nonforfeiture.

• Preneed and industrial life insurance policies:• Preneed: 1980 CSO Tables still apply• Industrial: 1961 Industrial Standard Tables still apply

• Interest rates:• A floor has been added to the nonforfeiture interest rate to prevent it from going

below the statutory minimum rate of 4% used for computing the IRC Section 7702 guideline level and net single premiums (and the IRC Section 7702A 7-pay premium).

• Assures that cash value accumulation test (CVAT) products can simultaneously satisfy both IRC Section 7702 and State Nonforfeiture Law requirements.

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The Valuation ManualVM-20: Requirements for PBR for Life Products

• The 2017 CSO Tables may be used on or after January 1, 2017, and shall be used for all policies on or after January 1, 2020:

• Selection of tables largely parallels VM-02, with the exception that the preferred table structure can be used subject to conditions

• A Guidance Note is included in VM-20, providing for transition rules to the new CSO table and recommending that the new CSO Table be:

• Adopted by July 1st of a given year• Permitted for use starting January 1st of the 2nd calendar year following adoption• Optional use until January 1st of 5th calendar year following adoption and mandatory

thereafter

• The Guidance Note conforms to IRC Section 807(d)(5)(B) transition period.• Provides consistent transition for statutory and tax reserving and alleviates any potential

transitional issues regarding the tables used for reasonable mortality purposes

Note that the adoption of the 2017 CSO Tables provides for an accelerated transition period relative to the Guidance Note in VM-20 as the NAIC did not follow its own recommendation.

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Impact of 2017 CSO TablesPercent Change in Ultimate Mortality Rates

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Impact of 2017 CSO TablesIRC Sections 7702 and 7702A Funding Limitations

• Guidelines, net single premiums (NSP) and 7-pay premiums (7PP) will generally decrease by 10% to 20% from comparable 2001 CSO levels.

• The magnitude of decrease is comparable to what was realized when the 2001 CSO Tables were adopted.

• Guideline single premiums (GSP) generally experience a larger decrease than guideline level premiums (GLP) and NSPs.

• Older issue ages (60+) will be affected less than younger issue ages, particularly for females.

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Impact of 2017 CSO TablesIRC Sections 7702 and 7702A Funding Limitations

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Impact of 2017 CSO TablesIRC Sections 7702 and 7702A Funding Limitations - Males

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Key assumptions:• Interest rates:

• GSP: 6%• GLP: 4%• NSP: 4%• 7PP: 4%

• No expenses• Mortality:

• ALB• Ultimate tables

• Endowment at 100• Annual curtate

calculations

2001 CSO to 80 CSO

2017 CSO to 80 CSO

2001 CSO to 80 CSO

2017 CSO to 80 CSO

2001 CSO to 80 CSO

2017 CSO to 80 CSO

GSP 81% 64% 83% 69% 76% 67%GLP 85% 70% 85% 73% 80% 71%NSP 87% 73% 88% 77% 83% 75%7PP 87% 73% 88% 77% 83% 75%

GSP 85% 67% 84% 73% 80% 67%GLP 85% 68% 83% 71% 80% 67%NSP 89% 76% 89% 80% 86% 76%7PP 89% 75% 88% 80% 85% 75%

GSP 88% 74% 89% 83% 87% 76%GLP 82% 64% 80% 72% 79% 66%NSP 92% 81% 92% 88% 91% 83%7PP 90% 78% 89% 83% 88% 79%

Age 25

Age 45

Age 65

Nonsmoker Smoker Composite

% Changes in Funding Limit Relative to 1980 CSO ValuesMales

Impact of 2017 CSO TablesIRC Sections 7702 and 7702A Funding Limitations - Females

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Key assumptions:• Interest rates:

• GSP: 6%• GLP: 4%• NSP: 4%• 7PP: 4%

• No expenses• Mortality:

• ALB• Ultimate tables

• Endowment at 100• Annual curtate

calculations

2001 CSO to 80 CSO

2017 CSO to 80 CSO

2001 CSO to 80 CSO

2017 CSO to 80 CSO

2001 CSO to 80 CSO

2017 CSO to 80 CSO

GSP 79% 61% 91% 74% 77% 66%GLP 84% 69% 93% 81% 82% 74%NSP 86% 72% 95% 84% 85% 77%7PP 85% 72% 94% 83% 84% 77%

GSP 85% 66% 97% 84% 84% 73%GLP 86% 69% 97% 85% 85% 75%NSP 89% 76% 98% 89% 89% 81%7PP 89% 75% 98% 89% 88% 81%

GSP 88% 75% 99% 93% 88% 83%GLP 83% 69% 97% 90% 83% 78%NSP 91% 82% 99% 95% 91% 88%7PP 90% 80% 99% 94% 90% 86%

Age 25

Age 45

Age 65

% Changes in Funding Limit Relative to 1980 CSO ValuesFemales

Nonsmoker Smoker Composite

Impact of 2017 CSO TablesIRC Section 7702 “Corridor” Requirements

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

25 35 45 55 65 75 85 95

Age

Minimum Death Benefit per $1,000 of Cash Value(Male Aggregate ALB Mortality - Endowment at 100)

GPT Factors CVAT-80CSO CV-2001CSO CVAT-2017CSO

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ObservationsImpact on Product Designs

• Universal life and variable universal life insurance contracts:• Increased pressure on being able to fully fund contracts or potentially keep contracts

in force to advanced ages:• Margins between current and guaranteed mortality rates are now further reduced.• Credited rates are currently at or the statutory minimum rates required by IRC Sections 7702 and 7702A.

• There may be a trend in developing products to qualify under the cash value accumulation test:

• Beware of the administrative challenges under the necessary premium test!• There will be an increase in underfunded contracts relying on IRC Section 7702(f)(6).• Will likely see a greater use of secondary guarantees (i.e., no-lapse guarantees), as it

may simply not be possible to pay premiums to keep contracts in force to their maturity date under differing funding scenarios and still satisfy IRC Section 7702’s guideline premium test.

• Whole life insurance: • Early-duration cash values will be reduced 5% to 10%, with reductions grading off

over time as cash values ultimately grade to the face amount.• Death benefits for dividend purchased additions will increase by 10% to 20%.

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Part 2: Reasonable mortality Requirements under IRC Section 7702(c)(3)(B)(i) and the history of mortality table guidance from the IRS

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Mortality Requirements Under IRC § 7702General Rule

• IRC § 7702(c)(3)(B)(i) requires the use of:… reasonable mortality charges which meet the requirements (if any) prescribed in regulations and which (except as provided in regulations) do not exceed the mortality charges specified in the prevailing commissioners’ standard tables (as defined in section 807(d)(5)) as of the time the contract is issued …

• IRC § 807(d)(5)(A) generally defines the prevailing commissioners’ standard table as:• The most recent commissioners’ standard tables prescribed by the

NAIC• Permitted to be used in computing reserves for that type of contract • Approved for use under the insurance laws of at least 26 states when

the contract was issued• IRC § 807(d)(5)(B) three-year transition rule

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Mortality Requirements under IRC § 7702§ 5011(c)(2) of TAMRA (the “TAMRA Interim Rule”)

• Absent regulations, the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) provides for an interim rule in § 5011(c)(2) which states:

… mortality charges which do not differ materially from the charges actually expected to be imposed by the company (taking into account any relevant characteristic of the insured of which the company is aware) shall be treated as meeting the requirements of clause (i) of section 7702(c)(3)(B) of the 1986 Code ….

• No regulations have been issued under IRC §7702(c)(3)(B)(i), so this rule remains in effect.

• The TAMRA Interim Rule is typically used for contracts covering a substandard risk insured, but the statute is not limited in its scope to such contracts.

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Mortality Requirements under IRC § 7702Notice 88-128 and Notice 2004-61

• Notice 88-128:• “… a mortality charge meets the requirements of section

7702(c)(3)(B)(i) if such mortality charge does not exceed 100 percent of the applicable mortality charge set forth in the 1980 CSO tables …”

• Limited rules for unisex tables and 1958 CSO• While the prevailing mortality table could be objectively

identified, there was uncertainty, and thus the need for safe harbor IRS guidance, with respect to the meaning of “reasonable mortality charges.”

• Notice 2004-61:• Initial guidance for transition to 2001 CSO• Replaced by Notice 2006-95

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Mortality Requirements under IRC § 7702 Notice 2006-95

• Notice 2006-95 “safe harbor” for 2001 CSO contracts:… mortality charge with respect to a life insurance contract will satisfy the requirements of § 7702(c)(3)(B)(i) so long as:

1) the mortality charge does not exceed 100 percent of the applicable mortality charge set forth in the 2001 CSO tables;

2) the mortality charge does not exceed the mortality charge specified in the contract at issuance; and

3) either: a) the contract is issued after December 31, 2008, or b) the contract is issued before January 1, 2009, in a state that permits or requires

the use of the 2001 CSO tables at the time the contract is issued.

• Consistency rules for unisex and smoker mortality• The notice includes material change rules for determining the issue date

of a contract that apply for purposes of the safe harbor

Note also that Revenue Procedure 2010-28 was issued to address contracts with maturity ages greater than age 100.

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Part 3: The 2017 CSO Tables and the need for guidance from the IRS

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IRS Guidance Relating to the 2017 CSO TablesExpected Guidance from the IRS

• The industry has asked the IRS for interim guidance in connection with the adoption of the 2017 CSO Tables:

• Use of 2017 CSO mortality tables as a safe harbor in a manner similar to the prior 1980 CSO and 2001 CSO safe harbors

• Requested modifications, however, of material change rules

• Desirability of permanent guidance later to address changes in prevailing tables:

• Shorter time frames for adoption process for new tables

• Timely guidance needed, given January 1, 2017 date for permitted use of 2017 CSO

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IRS Guidance Relating to the 2017 CSO TablesExpected Guidance from the IRS (cont.)

• If new IRS guidance generally follows Notice 2006-95, what clarifications and changes are warranted?

• Safe harbor form of guidance should continue• Material change rule?

• Notice 2006-95 clarified treatment of underwritten benefit increases and certain other transactions pursuant to a contract’s terms.

• But by focusing on whether a change is pursuant to a contract’s terms, the notice ignored the practices, often long-standing, of insurers in the administration of their contracts.

• These practices typically focus on meeting the changing needs of policyholders, not on increasing a contract’s investment orientation in anticipation of a change in mortality table.

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IRS Guidance Relating to the 2017 CSO TablesExpected Guidance from the IRS (cont.)

• Material change rule? (cont.)• What about smoking status changes, substandard rating changes,

adding qualified additional benefits and reducing benefits not pursuant to a contract’s terms but pursuant to general company practices?

• Many of these most common extra-contractual changes today have little effect on a contract’s investment orientation and may actually reduce investment orientation.

• Proposed elimination of “pursuant to the terms of the contract” standard:

• Continued requirement that the state in which the contract is issued does not require the use of the 2001 CSO tables

• Continued requirement that the contract continues on the same policy form or blank.

• Other clarifications, such as for the reinstatement rule.

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IRS Guidance Relating to the 2017 CSO TablesExpected Guidance from the IRS (cont.)

• Policy considerations for material change rules• Implications of new issuance treatment are troublesome, both because of

system considerations and because such treatment may not apply solely for purposes of ascertaining whether grandfather protection continues:

• The adjustment rule of IRC § 7702(f)(7)(A) is not limited to changes pursuant to a contract’s terms. When (and how) should a notice’s material change rule override the adjustment rule? Only when a contractual change occurs after a new prevailing table arises? Basis for this?

• In some instances, new issue treatment would increase a contract’s investment orientation, e.g., due to attained-age guideline premiums.

• If a contract is not new under “applicable law,” within the meaning of IRC § 7702(a), what does it mean to treat a contract as newly issued for purposes of a notice safe harbor?

• What if a new prevailing table reflects worsening mortality?• Should the arrival of a new prevailing mortality table be approached in the

same manner as situations where a new statutory or regulatory rule imposes new tax restrictions?

• Conforming changes to Revenue Procedure 2010-28

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Questions?

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