What is the background and why was the change made?
Internal Revenue Code (IRC) Section 7702 provides requirements that must be met for an insurance contract to be treated as life insurance for federal tax purposes. The requirements impose limitations on the premiums paid into the contract and/or the amount of cash that can accumulate relative to the death benefit. These limits use actuarial calculations for determining the present value of future death benefits using the greater of 6% or the guaranteed interest rate for guideline single premium and the greater of 4% or the guaranteed interest rate for guideline level and MEC (7 pay) calculations.
7702 was implemented in 1984 and 7702A in 1988. The minimum interest rates (the 4% and 6% above) mandated in the calculations have not changed in those 30+ years. In 1988, the Federal Funds average yield was around 7.5%, and the guaranteed interest rates offered on life insurance products were aligned with the minimum interest assumptions required by 7702 and 7702A. Even through the 90s, guideline premiums and MEC premiums worked well with guaranteed illustrations as interest rates were high enough that those premium levels generally provided a guaranteed premium that endowed a policy on a guaranteed basis. Today the Federal Funds rate is hovering around the .25% mark on average. (Please see our May POINTS “Interest Rate Interplay” for more information.) So, while these mandated minimum interest rates in IRC Section 7702 have stayed the same, market interest rates have significantly declined, and companies are challenged to generate a return on assets above the high bar set by the tax code.
The Consolidated Appropriations Act, 2021 has made a substantial change to the interest rates in IRC Section 7702. For 2021, the minimum rates now both move down 2% and use 4% for guideline single premium calculations and 2% for guideline level and MEC calculations. The minimum rates will be dynamic after 2021. What this means is for a specific death benefit, the guideline and MEC premiums will be higher than they are today. Moving forward, the 7702 and 7702A interest rates will be better aligned with those seen in the market and the guaranteed interest rates of products.
What does this mean for insurance products?
Companies will need to change the 7702 and 7702A premiums for all products that they currently market. Transition rules are not yet clear, and in the absence of more clarity, carriers will likely interpret how quickly it needs to be implemented differently. The regulation went into effect 1/1/2021, and companies need time to get the changes implemented across their product portfolios.
Term products: There is no impact on term products as term premiums are guaranteed and well below the 7702 and 7702A premium levels.
Whole life products: Short pay premium case designs will work across more pay periods since the MEC premiums are increasing.
Universal, Indexed, Variable products: The impact on these products is difficult to predict. Accumulation products may require repricing depending on the underlying design of the product. The design considerations are explored a bit more in the “How does this impact an insurance company?” section. As companies incorporate the new 7702 and 7702A rates in their products, LifeTrends will examine our accumulation benchmarks and determine what, if anything, needs to be adjusted. In particular, how CVAT and death benefit options are used in case design could change. Protection oriented products should not be impacted.
How does this impact the insured/policyowner?
For inforce policies, there should be no impact unless the policyowner converts or 1035 exchanges to a product that has implemented the new 7702 and 7702A rates.
Assuming companies do not reprice their products, minimum non-MEC death benefit accumulation illustrations will have reduced death benefits (which implies lower charges) and slightly better IRRs. Once new rates have been implemented, insurance professionals designing cases for new accumulation sales can also expect to have an expanded range of “n-pays” available that satisfy 7702 and 7702A requirements.
How does this impact an insurance company?
System implications for companies:
Guideline premiums and MEC premiums are imbedded in illustrations and administrative systems. They are also shown on the policy contract. Depending on how the calculations are done in those systems, this could be a large project to reflect the new interest rate in the calculation and to use a dynamic rate moving forward.
How integrated the guideline and MEC premiums are in product design can vary from company to company. Here are some design issues that companies may need to consider:
- If target premiums are set at guideline or MEC levels, target premiums may need to be adjusted.
- If percent of premium loads on excess premium above targets are tied to guideline and/or MEC premiums, the percent of premium loads may need to be adjusted.
- With non-MEC minimum death benefit solves producing lower initial death benefits, per thousand charges may need to be adjusted in products geared towards that case design.
- If any pricing changes do need to be made, the company may have to file those changes.
These types of product design considerations and changes will likely determine how quickly a company implements the new interest rates. Our best guess is term and non-accumulation variable, indexed and universal life products will implement the changes more rapidly. Whole life and other accumulation-oriented products will likely require more internal analysis for companies to weigh the pros and cons and determine if pricing changes are needed.
LifeTrends will track what products have implemented the new 7702 and 7702A rates for our partners on the News page.