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«* RECORD, Volume 30, No. 2 Spring Meeting, San Antonio, TX June 14–15, 2004 Session 46 PD What’s New and Exciting in Insurance Product Taxation? ...»

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RECORD, Volume 30, No. 2

Spring Meeting, San Antonio, TX

June 14–15, 2004

Session 46 PD

What’s New and Exciting in Insurance Product Taxation?

Track: Product Development

Moderator: Brian G. King

John T. Adney†


Douglas N. Hertz

Summary: The U.S. life insurance industry has not escaped the attention of the

Treasury. Products sold by life insurers can be a source of additional tax revenue.

Hear industry and tax leaders discuss recent, ongoing and potential issues, including initiatives affecting various products and markets, Internal Revenue Code Sections 7702 and 7702A and 2001 CSO Mortality Table. Attendees learn the current and potential impact of tax issues on insurance products and are in a better position to address current issues and anticipate new ones.

MR. BRIAN G. KING: The first thing I'd like to mention is that the SOA is in the process of developing a new product taxation section. Everybody should have received an application form. The SOA Taxation Section isn't quite up and going at this point. One of the requirements is that we have 200 paid members in order for this to become a full-fledged section. If you do have an interest, it's important to get the application in as soon as you can. What we're trying to do with this section is to get a coordinated effort within the SOA to address tax issues. We're going to focus on insurance tax issues and product tax issues, as well as issues regarding qualified and nonqualified employee benefit plans. this organization will create networking and research opportunities. We're going to try and form a newsletter that will be published on a regular basis to update its members on current events and issues that are coming up, as well as doing sessions like these at SOA meetings. It would be worthwhile.


* Copyright © 2004, Society of Actuaries †Mr. Adney, not a member of the sponsoring organizations, is partner at Davis and Harman LLP in Washington, D.C.

Note: The chart(s) referred to in the text can be found at the end of the manuscript What’s New and Exciting in Insurance Product Taxation? 2 One thing that is going to make this a little unique is that we're going to open membership up to non-SOA members. Tax attorneys within companies and certainly those who practice in tax issues who have an interest in joining should feel free to do so. When you go back, you might want to let those people know about the tax section and see whether or not there's an interest there, as well.

One of the other tax-related issues that's going on now is a product tax seminar that's scheduled September 15—17 in Washington, D.C.. We're anticipating that we will have 200 members for the section, and one of the first efforts is going to be to sponsor a tax seminar. This is going to be the third year that the SOA is running a product tax seminar. Seminars were put together in 2000 and in '02 that were cosponsored by Aon Consulting and the SOA. The prior sessions tended to focus more on life insurance product tax. What we've decided to do this year is to expand the syllabus to include annuity tax issues, as well. We're trying to broaden the scope of the product tax seminar.

The structure this year is going to be a little different from what we've done in the past. We're going to offer what is called "boot camp," which is going to be a oneday intensive seminar, targeted more for those who probably don't deal with the tax issues on a day-to-day basis. We're going to run two concurrent seminars. One is going to focus on life insurance product tax and the Sections 7702 and 7702A requirements. The second is going to run alongside on the basics of annuity taxation. That will be on Wednesday, and that will be followed up on Thursday and Friday with some more advanced topics on some product tax issues.

The IRS has agreed to participate in this seminar, as well. Mark Smith, the branch chief, will be there. The organization's participation in the past has been wellreceived. It's going to be a good seminar.

What we're planning on providing to participants who attend the seminar is a book.

This is a book that is scheduled to be out in time for the seminar. The printing date is about a week or so before the seminar. The book is called Life Insurance and Modified Endowments Under Internal Revenue Code Section 7702 and 7702A. As far as I know, this is the first book of its kind to be developed dealing with life insurance product tax. For those who do get involved in product tax issues, trying to get your hands on available resources, guidance, legislative history and so on is not easy. What we put together here—the authors are Chris DesRochers, John T.

Adney, Doug Hertz and Brain King—is a comprehensive book covering from start to finish the requirements under Sections 7702 and 7702A. It gives the historical background that led to the development of these sections, the calculation rules, adjustment rules and so on.

We have three topics that we're going to cover in our session. I'm a vice president and consulting actuary with Aon Consulting. I'm going to spend some time going over the issues regarding product tax as it relates to the 2001 CSO. Doug Hertz, also a vice president with Aon, is going to follow up with a discussion on Sections What’s New and Exciting in Insurance Product Taxation? 3 7702 and 7702A issues. He'll talk about some of the recent rulings that have come out in the past year or so, as well as the revenue procedure that was issued last year that talks about taxation of distributions under Section 7702.

John Adney, a partner at Davis and Harman LLP in Washington, D.C., is going to follow that up with a discussion on some of the corporate-owned life insurance (COLI) and business-owned life insurance (BOLI) issues that are out there, as well as some of the recent guidance that's been issued that affects Section 412(i) plans.

What I'm going to talk about are the 2001 CSO issues as they relate to Section 807 reserves, as well as the issues that you're going to need to be aware of as they relate to our funding limitations under Section 7702 and to our modified endowment contract (MEC) limitations under Section 7702A.

Both the reserve calculations and the funding limitations under 7702 have associated mortality requirements that place a limitation on the level of mortality that we can use in those calculations. Our reserves are limited by way of what is called a "prevailing commissioners' standard table." That sets our mortality requirements for our Section 807 reserves. Similarly, our calculations under 7702 and 7702A have limitations on the mortality, as well. Those are limited by what is referred to as "reasonable mortality." We don't have a definition that explicitly tells us what "reasonable" means, but we do know that if we exceed the mortality in the prevailing table, we've crossed over that line. There's a connection between our mortality requirements under 7702 because that ties back to the Section 807 definition of the prevailing commissioners' standard table.

What is a prevailing table? Section 807 provides a definition for it. I broke it up into pieces, and we'll talk about those pieces individually. The prevailing table is the most recent commissioners' standard table prescribed by the NAIC. In December '03 the NAIC went through its approval process and adopted the model regulation for the 2001 CSO, so that standard has been met. The 2001 CSO is the most recent table prescribed by the NAIC.

The prevailing table also needs to be a table that's permitted for use in valuing reserves for that contract. The key word here is "permitted." The model regulation, as it's written, has both a permitted date and a required date. The permitted date is the date that companies can begin to use the 2001 CSO for purposes of reserves and nonforfeiture. There's also a sunset date, which is January 1, 2009, when all contracts sold in those states are required to use the table. What we're looking for is the states need to permit its use, so they need to go through their own state adoption process that would allow companies to use the table. We need 26 states to approve the table to allow for its use in order for the 2001 CSO table to be viewed as the prevailing table. This is a standard that would apply to newly issued contracts.

What’s New and Exciting in Insurance Product Taxation? 4 I believe we have reached the 26-state level, so I would expect that the 2001 CSO would be prevailing July 1, 2004. Most of the adoptions were retroactive back to the beginning of '04. A few of those had a prospective date of July 1, so even though I believe we've had 26, I think maybe 27 states approved it. Some of those approvals have a forward date associated with those. On July 1, 2004, the 2001 CSO should become the prevailing table. In the handouts that were printed, I had January 1, 2005, but I think it's going to be earlier than that.

As we move through the transition process to the new table, there are a couple of issues of which you need to be aware. This is the first time the industry has had to go through a transition process from one CSO table to the other. Back in 1984 when Section 807 was added to the Tax Code, the 1980 CSO was already the prevailing table so there was no need to transition for 807 purposes. Similarly, when the reasonable mortality requirements were implemented in '88, we had a ' short window where you could continue to issue products under the '58 CSO table, so the whole concept of transition in that regard was never a concern because essentially all products sold at that time were based on the '80 CSO. This is the first time we're going forward through a transition to a new table.

The good news for Section 807 is that the statute anticipated the transition to a new table. There was an expectation that over time the CSO tables would be updated. They had enough forethought to put transition rules directly into the tax law. From a transition perspective, things are somewhat clearer under Section 807 than they are under Section 7702. The transition rules under 807 essentially give us a three-year window that would start on the first of the calendar year following the 26th state adoption and continuing for the next three calendar years. We'll have a period now of three-and-a-half years, from July 1, 2004, to the end of '08, where companies have a choice of using either the old table or the new table. What I think you'll find is that as you move your products over from a 1980 CSO to a 2001 CSO, you'll move the reserve basis over to the new table as well.

What this creates is a one-year period, from '08 to '09, where the model regulation gives you the ability to sell products using a 1980 CSO mortality basis but puts you in a situation where your tax reserves need to be based upon the new mortality table. That last year may be problematic from a reserving perspective as you need to move those over to the new table.

There's also another rule in 807 that tells us which version of the 2001 CSO table we need to use for tax reserves. The 2001 CSO isn't a single table; it's a collection of tables. I believe there are upward of 84 different tables. You have an ultimate version, select and ultimate, a number of unisex versions, as well as smoker, nonsmoker and composite tables. There's a rule in 807 that says when we have more than one table to choose from, we choose the table that generally yields the lowest reserves. Part of the development of the 2001 CSO was to construct the tables in such a way that the ultimate version of the table would generally yield the What’s New and Exciting in Insurance Product Taxation? 5 lowest reserves. I think that's a good thing because it eliminates the need to have to implement select and ultimate tables into our reserve calculations.

The other choice for companies is whether to use the aggregate versus the smokerdistinct tables. Here you need to take a look at your in force and see what your distribution of smokers to nonsmokers is and how that compares to the underlying mortality in the tables. Then decide whether or not you want to use the smokerdistinct versus the aggregate table for reserves. Essentially you'll end up with a choice for smoker/nonsmoker or a composite and generally use the ultimate table.

This is an area where we should get some guidance from the IRS that will at least confirm what the Academy assumed in the development of its tables.

I'm going to move to over to the Section 7702 requirements. I mentioned earlier that we do have this requirement that says that we use reasonable mortality in developing our limitations under Sections 7702 and 7702A. Again, we don't have an explicit definition of what reasonable mortality is, but we do know that if we start to exceed the rates in the prevailing table, we've crossed that line. This is going to affect our guideline premium calculations, our net single premium calculations under the cash value accumulation test and our 7-pay premiums.

Again, we have similar issues that we have under Section 807. We have an issue as to when we're required to use the 2001 CSO in our tax law calculations. Again, which table should we use? We have a collection of tables, so which one is appropriate for these calculations? There's also another issue. The 2001 CSO has some unique characteristics that distinguish it from its predecessor tables. Not only is it select and ultimate, but it also has a terminal age now that runs out beyond age 100. This table goes out to age 121. This creates a little tension with the calculation rules under Section 7702, which are designed for a terminal age of age

100. The question becomes, if we do start to take advantage of the fact that the 2001 CSO runs out to age 121, what implications does that have under our 7702 requirements? How do we incorporate that? Can we incorporate that into our calculations? I'll get into that.

When is a 2001 CSO reasonable? Again, here we're talking about our transition rules. Section 807 was somewhat straightforward. That statute tells us what our transition period is and how we go through the transition from an old table to a new table. We don't have that in 7702. There isn't an explicit set of transition rules.

Section 7702 does refer back to Section 807 in terms of setting the prevailing table as the upper bound on reasonable mortality. Some feel that because it does that, it would encompass the transition rules under 807, as well.

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