At Miller & Newberg, we make every effort to alert our clients to industry developments that are very important for insurance companies and fraternal benefit societies to know and act upon.
In the final days of 2020, Congress passed and President Trump signed into law a bill that the press characterized as a COVID-19 relief bill. But the bill, officially called the “Consolidated Appropriations Act, 2021” (the Act), at a whopping 5,593 pages, was much more extensive than the press indicated.
Starting on page 4,923 is a provision that the American Council of Life Insurers (ACLI) lobbied to have included and that will have far-reaching impacts on the life insurance industry. The provision directly lowered the interest rates to be used in guideline premium, 7-pay, and cash value accumulation test (CVAT) calculations effective immediately and provided for them to be indexed to the prevailing interest rate environment going forward. Indirectly, it also impacted the Standard Nonforfeiture Law for Life Insurance such that cash values on most traditional life products will need to change by January 1, 2022.
See the Q&A below for more details.
What did the Act directly change?
The Act revised section 7702 of the Internal Revenue Code.
Section 7702 prescribes a pair of tests – the guideline premium test and the CVAT – that specifies the relationships between premiums, cash values, and death benefits that must exist for a contract to receive the tax benefits of life insurance. Section 7702A adds an additional test – the 7-pay premium test – to further separate life insurance contracts into two separate tax treatments, as to whether or not they are modified endowment contracts.
The problem is that section 7702 had a pair of interest rates, 4% and 6%, that were hard-coded in the text. In today’s low interest rate environment, there was growing concern that life insurance carriers and fraternal benefit societies would no longer be able to profitably offer certain whole life products to the public under these provisions, and most carriers could no longer offer universal life plans that last to maturity under guaranteed assumptions when paying the guideline level premium, which is why the ACLI sprang into action.
The Act removed those hard-coded rates and changed them to a set of indexed rates. It also instituted a transition rule for 2021. The result is the following changes for 2021:
- In calculating guideline level premiums, 7-pay premiums, and CVAT calculations, the interest rate to use can be as low as the greater of the interest rate guaranteed in the contract or 2%, versus 4% previously.
- In calculating guideline single premiums, the interest rate to use can be as low as the greater of the interest rate guaranteed in the contract or 4%, versus 6% previously.
Starting in 2022, the interest rates to use for guideline level premiums, etc. are indexed to the lower of two rates:
- The maximum valuation interest rate for life insurance contracts with guarantee durations of 20 years or longer (currently 3%), or
- A sixty-month moving average of Federal mid-term rates as defined in Internal Revenue Code section 1274(d) (which has averaged 1.82% over the calendar years 2016 – 2020, and which is then rounded to the nearest whole percentage point, i.e. 2%).
Guideline single premiums will continue to use an interest rate that is 2% added to the rate to use for guideline level premiums.
What also changed because of the Act?
The Standard Nonforfeiture Law for Life Insurance references an interest rate from section 7702, thanks to a revision that was made in the NAIC Valuation Manual, minimum standard VM-02, effective January 1, 2021.
Under that law, the maximum interest rate that can be used in the calculation of traditional life product cash values is a rate equal to 125% of the maximum valuation interest rate, but no less than the interest rate specified in section 7702 for the CVAT. When the maximum valuation interest rate changes, as it did from 3.5% for 2020 to 3% for 2021, there is a one-year grace period before the change to the nonforfeiture rate is mandatory.
The maximum valuation interest rate for 2021 is 3%, and 125% of this rate is 3.75%. Before the Act, the CVAT interest rate was 4%, so it was allowable to build whole life cash value scales using an interest rate of 4% but no higher than 4.5% for 2021 issues, changing to 4% for 2022 issues.
Thanks to the Act’s change to the CVAT interest rate and its resulting impact upon the Standard Nonforfeiture Law, 2022 issues must use a nonforfeiture interest rate of at least 2% but no higher than 3.75%.
What are some implications for life insurance contract design?
For life insurance companies and fraternal benefit societies, if the cash values on your whole life products are currently based on an interest rate above 3.75%, you must raise the set of cash values on your whole life products by January 1, 2022. This is not optional, and absent any other changes to the products, it would make them less profitable.
However, you can – at your option – make the following design changes that would make the products more profitable:
- You can narrow the net amount at risk on your contracts that use the CVAT to comply with the tax law
- You can raise the premiums on your single premium whole life insurance contracts and still comply with the guideline premium test
- You can raise the premiums on your limited-pay whole life insurance contracts and still have them qualify as regular life insurance contracts, rather than as modified endowment contracts
You can also make design changes that would make your products more attractive to consumers who are looking for strong cash value accumulation. By raising the premiums more than you raise the cash values, you can create the margins needed to have a more generous dividend scale or provide attractive indexed interest crediting.
What does this mean for your company?
For life insurance companies and fraternal benefit societies, there is good news and bad news.
The bad news is that your “to do” list just got longer. By the end of 2021, any whole life products that currently use a nonforfeiture rate higher than 3.75%:
- Must have their cash value factors recalculated at an interest rate of 3.75% or lower
- Must be refiled for approval with the states or the Interstate Compact, even if the premiums are not changing, simply because their cash values are changing
- Should have their profitability checked, and have their premium rates increased if needed to restore profitability
The good news is that any profitability squeeze you were experiencing on your whole life products can now be eliminated on new business going forward with a few product design changes. And on your universal life products, you will be able to illustrate the possibility of the policy lasting to maturity under guaranteed assumptions. That is why the ACLI lobbied for this change.
Beyond that, more good news is the design change options you now have available to you to offer strong cash value accumulation to consumers. Many of your competitors will be taking advantage of these possibilities to make their products both more profitable and more attractive.
Your team at Miller & Newberg is available to assist you with all of this work. We are excited by the possibilities! Together, we can put together a game plan to make this change happen as smoothly as possible.
Is there any impact on term insurance?
As to term insurance, there is some ambiguity in the NAIC Valuation Manual as you look at the interaction between minimum standard VM-02 section 3.A and minimum standard VM-20 sections 3.B.4 and 3.C.2.b. Depending upon how you interpret these sections, the maximum nonforfeiture rate for term may be 4.75%, or it may be the same 3.75% rate that we mentioned above for whole life insurance. Given the ambiguity, we believe most companies will take the more conservative view: a 3.75% nonforfeiture rate definitely complies no matter how you interpret these sections.
The “to do” item here is that your term life products must undergo a nonforfeiture check to determine whether they create any cash values under the new nonforfeiture rate. If they do create cash values, their premium rates would need to be changed to prevent cash values, and that may also require a filing with the states or the Interstate Compact.