The New Year rang in a victory for the insurance industry via the introduction of long-needed changes to Internal Revenue Code 7702.
Now, if we can only figure out how to claim our prize.
On December 27, 2020, President Donald Trump signed the Consolidated Appropriations Act, 2021, which introduced the use of dynamic interest rates when performing life-insurance qualification tests in line with Internal Revenue Code 7702. Try repeating that without taking a breath.
In the eyes of regulators, there’s a problem with life insurance, particularly the permanent variety, with its cash-value component. Whether legislators or bureaucrats, these intricate minds think life insurance must simply be used for just that – to protect loved ones from a policyholder’s untimely death.
What’s more, they’re suspicious – it’s their nature – that life policies are being used as investment vehicles. Indeed, sometimes they are if it suits the customer’s estate plan. The problem is one of taxation: life products receive advantageous treatment in comparison to most traditional investment products.
Functionaries don’t want us taking unfair advantage of the system, if you can imagine us doing such things. They aren’t being spoilsports: they expect the life insurance industry, with its crucial role in securing family stability and business continuity, to keep its eye on the ball. I concede their point to an extent, because when profits rear their enticing heads, anyone can experience giddiness and lose sight of risk – and insurance is all about mitigating risks, after all.
Pity the poor men and women of insurance. Regulators introduce streams of instructions; sometimes they also mean well. Often, their ideas come straight from our industry. Business initiative in the legislative process is commonly viewed as nefarious, yet in the case of insurance, we get a gentle pass. We’ve nothing to gain from harming our clients; we profit from securing their legacies. Occasionally, then, the powers that be listen to us. Yet if we get what we want, we’re sometimes left scratching our heads on how to comply.
Our reg of today is IRC Section 7702, which defines the ingredients life insurance must have in order for them to be legally (that is, for tax purposes) defined as – wait, my mind and hands have gone numb from reading a legal memorandum and typing simultaneously – well, as life insurance contracts. The things I endure for you, readers.
Section 7702 makes pretty good sense, once you’ve sussed out its meaning. Life insurance contracts must conform to state law and pass actuarial tests. You get to choose from one of two barriers to hurdle, as customers will find in their insurance application forms. The wording is dire and I can’t bear more paraphrasing. Any customer who understands the concept at first glance should be rated a marvel; if not, agents explain, thereby deservedly earning their fees.
I’ll try to hand you the gist. Those anxious regulators set limits on the premiums one can pay in, and the cash value that may be accumulated in a policy – both factors in relation to the death benefit’s value. The actuarial athletics used to calculate these limits could rust out an iron man.
A crucial element of Section 7702 was the lower limits set for the interest rates used in those actuarials; for example, in setting the terms of a nonforfeiture clause. These minimum rates, still applicable in 2020, were set in 1984, when I sported black curly hair and could reliably observe my own toes. Interest rates were high then; exaggeratedly so in light of today’s historic lows.
The insurance industry had been struggling in the low-rate environment even before Covid-19 disruptions, when payouts rose and many customers couldn’t meet premiums. It’s a wonder more insurers didn’t go under; their own conservatism likely saved the day.
Let’s not allow legalese to deflate us. It’s like this: in a low-rate environment, insurance companies were straining to earn sufficient returns on their investments – the ones underpinning the liabilities carried to guarantee all those life policies. The basic interest rates set in the ‘80s were simply too high. IRC Section 7702, a bedrock of industry regulation, needed to change. Bedrock, friends, does not shift easily.
Yet it happened – surprise! – as an end-of-year wonder. The Consolidated Appropriations Act modifies IRC Section 7702 by establishing a dynamic interest rate template for use in calculating the statutory minimum rate. Simply put, the interest rate used in the actuarial calculations can fluctuate now, in line with market rate movements. Nothing could make more sense to me; I wonder how it ever was passed. It must have been the seasonal joy factor.
Here’s the tarnisher of our shiny new prize: insurers will need to quickly review all of their products and adjust them as necessary, to conform with the pleasant new regulations. Some products may need recertification by state regulatory officials; a trip to the dentist, I’m afraid. Aspects of client dealings, like policyholder administration, may need adjustment to meet the new requirements, too.
All needed changes can be easily accomplished with a strong legal advisory team and a reliable time machine. The changes brought in by CAA 2021 – signed, I remind you on December 27 – went live on January 1, 2021. There’s no ‘rosy’ when it comes to regulations.
Insurance insiders are expecting updates from the government, without much delay, they pray. Insurers shouldn’t wait for the regulators to speak: they must appeal with alacrity and force for guidance, I think. Some people – officials, mainly – can’t be rated as trustworthy if left solely to themselves. Still, a win is a win; take heart.