Session C: Necessary Premium Testing. Session Chair: Craig Springfield Davis & Harman LLP

Transcription

1 Session C: Necessary Premium Testing Session Chair: Craig Springfield Davis & Harman LLP Presenters: Ann Delaney John Hancock Life Insurance Company Brian King Ernst & Young LLP Craig Springfield Davis & Harman LLP

2 2016 Product Tax Seminar Necessary Premium Test under IRC Section 7702A(c)(3) Washington, DC September 9, 2016

3 Disclaimers These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting or tax advice. The views and opinions expressed are solely those of the presenters and not those of Ernst & Young LLP, Davis & Harman LLP, or John Hancock Life Insurance Company. 2

4 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. DON T make public announcements or statements about your own or your firm s prices or fees, or those of competitors, at any SOA meeting or activity. DON T talk about what other entities or their members or employees plan to do in particular geographic or product markets or with particular customers. DON T speak or act on behalf of the SOA or any of its committees unless specifically authorized to do so. DO alert SOA staff or legal counsel about any concerns regarding proposed statements to be made by the association on behalf of a committee or section. DO consult with your own legal counsel or the SOA before raising any matter or making any statement that you think may involve competitively sensitive information. DO be alert to improper activities, and don t participate if you think something is improper. If you have specific questions, seek guidance from your own legal counsel or from the SOA s Executive Director or legal counsel. 3

5 Instructors Craig Springfield Davis & Harman LLP Brian King Ernst & Young LLP Ann Delaney John Hancock Life Insurance Company

6 Overview What is the Necessary Premium Test (NPT)? Application of the NPT Guideline premium test contracts Cash value accumulation test contracts Analysis of the effect of deferring a material change 5

7 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. DON T make public announcements or statements about your own or your firm s prices or fees, or those of competitors, at any SOA meeting or activity. DON T talk about what other entities or their members or employees plan to do in particular geographic or product markets or with particular customers. DON T speak or act on behalf of the SOA or any of its committees unless specifically authorized to do so. DO alert SOA staff or legal counsel about any concerns regarding proposed statements to be made by the association on behalf of a committee or section. DO consult with your own legal counsel or the SOA before raising any matter or making any statement that you think may involve competitively sensitive information. DO be alert to improper activities, and don t participate if you think something is improper. If you have specific questions, seek guidance from your own legal counsel or from the SOA s Executive Director or legal counsel. 6 6

8 What is the Necessary Premium Test? 7

9 Accounting for Changes in Terms and Benefits IRC 7702A vs. IRC 7702 Policy changes under Internal Revenue Code (IRC) 7702A Two adjustment rules under IRC 7702A IRC 7702A(c)(2) - Reductions in benefits that occur within a 7-pay test period A special reduction in benefits rule applies to survivorship products (i.e., second-to-die) IRC 7702A(c)(3) - Material changes Different approach than under the adjustment rule of IRC 7702(f)(7)(A) 8

10 Material Changes Under IRC 7702A Consequences of a material change The contract is treated, for purposes of IRC 7702A, as a newly entered into 1 contract Triggers a new 7-pay test period So-called rollover rule of IRC 7702A(c)(3)(A)(ii) accounts for existing cash value 1 Newly entered into treatment does not mean that mortality charge grandfathering is lost. 9

11 Material Changes Under IRC 7702A (cont.) General definition of a material change A material change occurs when there is a material change in the benefits under (or in other terms of) the contract which was not reflected in any previous determination under IRC 7702A. Death benefit increases and additions of/increases in qualified additional benefits (QABs) are included (but not benefit reductions). The material change rule applies throughout the life of the contract; it does not cease after 7-pay period. Material changes serve the dual purpose of (a) subjecting benefit increases to the funding limits of IRC 7702A, but also of (b) allowing adequate funding of those increases. 10

12 Exceptions to Material Change Treatment Why do we need an exception to material change treatment? Necessary premium test (NPT) exception Under IRC 7702A(c)(3)(B)(i), a material change does not include: any increase which is attributable to the payment of premiums necessary to fund the lowest level of the death benefit and qualified additional benefits payable in the 1st 7 contract years (determined after taking into account death benefit increases described in subparagraph (A) or (B) of section 7702(e)(2)) or to crediting of interest or other earnings (including policyholder dividends) in respect of such premiums 11

13 NPT Concept of a Necessary Premium Under the NPT, a material change is not triggered by benefit increases attributable to premiums necessary to fund the lowest level of benefits in the first 7 years and in the 7-year period following a material change. Funding permitted for lowest level of benefits How should attributable and necessary be interpreted? NPT designed to allow paid-up additions (PUAs) and corridor increases without triggering material change, but may be broader based on legislative history 12

14 NPT Concept of a Necessary Premium (cont.) Necessary premiums Legislative history provides that material change treatment of a benefit increase may be deferred if no unnecessary premium has been paid. Guideline premium test (GPT) contracts Applies concept of a necessary guideline premium limitation (i.e., based on lowest benefits) May differ from IRC 7702 guideline premium limitation to the extent the lowest level of benefits assumed for NPT purposes differs from the future benefits assumed in the guideline premium limitation Cash value accumulation test (CVAT) contracts Permits funding of deemed cash surrender value (DCSV) (or actual cash value, if lower) up to the net single premium (NSP) for the lowest benefits 13

15 Alternative Testing Methodologies Authorized by OBRA 1989 Omnibus Reconciliation Act (OBRA) Legislative History (Senate Report) [A] death benefit increase may be considered as attributable to the payment of premiums necessary to fund the lowest death benefit payable in the first 7 contract years or the crediting of interest or other earnings with respect to such premiums if each premium paid prior to the death benefit increase is necessary to fund the lowest death benefit payable in the first 7 contract years. Any death benefit increase that is not considered a material change under the preceding sentence, however, is to be considered a material change as of the date that a premium is paid that is not necessary to fund the lowest death benefit payable in the first 7 contract years. [Emphasis added.] 14

16 Alternative Testing Methodologies Authorized by OBRA (cont.) Conveys some degree of choice for timing of material change treatment of benefit increases An insurer arguably may defer material changes for certain types of changes until an unnecessary premium is paid but not defer material changes for other types of changes Must make a distinction between: A material change that starts a new 7-pay period A deferred material change, meaning an event that would be a material change but for application of the NPT 15

17 Necessary Premium Testing Guideline Contracts 16

18 Necessary Premium Testing - Guideline Contracts Necessary premium for a GPT contract equals the excess of the guideline premium limit (GPL) for the lowest benefits over premiums paid May differ from the IRC 7702 limitation due to benefits, such as short-term QABs, that increase the GPL but not the NPT-GPL Reliance on the IRC 7702 guideline premium limit as a proxy for necessary premium limit? It may be necessary to administer all IRC 7702 adjustments events as material changes to align the GPL with the GPL-NPT, which limits the usefulness of the NPT. Reductions in benefits? Effect of recognized material changes? 17

19 Necessary Premium Testing Example 1 - GPT Example 1 - GPT - Immediate Recognition of the Material Change Duration Death Benefit Necessary Premium Limitation (NPL) Necessary GLP Necessary GSP 7-Pay Premium Limitation Sum of Necessary GLP NPL Death Benefit 7-Pay Prem 7-Pay Limit Death Benefit 1 100, ,000 10,740 1,002 1,002 10, ,000 3,323 3, , ,000 10,740 1,002 2,004 10, ,000 3,323 6, , ,000 10,740 1,002 3,005 10, ,000 3,323 9, , ,000 10,740 1,002 4,007 10, ,000 3,323 13, , ,000 10,740 1,002 5,009 10, ,000 3,323 16,615 Face Amount Increase from $100,000 to $150,000 - Immediate Recognition as a Material Change CV = $10, , ,000 17,593 1,628 6,637 17, ,000 4,327 4, , ,000 17,593 1,628 8,266 17, ,000 4,327 8, , ,000 17,593 1,628 9,894 17, ,000 4,327 12, , ,000 17,593 1,628 11,523 17, ,000 4,327 17, , ,000 17,593 1,628 13,151 17, ,000 4,327 21, , ,000 17,593 1,628 14,779 17, ,000 4,327 25, , ,000 17,593 1,628 16,408 17, ,000 4,327 30, , ,000 17,593 1,628 18,036 18, , ,000 17,593 1,628 19,665 19, , ,000 17,593 1,628 21,293 21, , ,000 17,593 1,628 22,921 22, , ,000 17,593 1,628 24,550 24, , ,000 17,593 1,628 26,178 26, , ,000 17,593 1,628 27,807 27,

20 Necessary Premium Testing Example 2 - GPT Example 2 - GPT - Deferred Recognition of the Material Change with UNP Duration Death Benefit Necessary Premium Limitation (NPL) Necessary GLP Necessary GSP 7-Pay Premium Limitation Sum of Necessary GLP NPL Death Benefit 7-Pay Prem 7-Pay Limit Death Benefit 1 100, ,000 10,740 1,002 1,002 10, ,000 3,323 3, , ,000 10,740 1,002 2,004 10, ,000 3,323 6, , ,000 10,740 1,002 3,005 10, ,000 3,323 9, , ,000 10,740 1,002 4,007 10, ,000 3,323 13, , ,000 10,740 1,002 5,009 10, ,000 3,323 16,615 Face Amount Increase from $100,000 to $150,000 - Defer Recognition as a Material Change until an Unncessary Premium is Paid 6 150, ,000 10,740 1,002 6,011 10, ,000 3,323 19, , ,000 10,740 1,002 7,013 10, ,000 3,323 23, , ,000 10,740 1,002 8,014 10, , ,000 10,740 1,002 9,016 10, , ,000 10,740 1,002 10,018 10, , ,000 10,740 1,002 11,020 11, , ,000 10,740 1,002 12,022 12, , ,000 10,740 1,002 13,023 13, , ,000 10,740 1,002 14,025 14, , ,000 10,740 1,002 15,027 15, Payment of an Unnecessary Premium - Forces recognition of a Material Change CV = $20, , ,000 21,693 2,006 17,033 21, ,000 5,101 5, , ,000 21,693 2,006 19,038 21, ,000 5,101 10, , ,000 21,693 2,006 21,044 21, ,000 5,101 15, , ,000 21,693 2,006 23,049 23, ,000 5,101 20, , ,000 21,693 2,006 25,055 25, ,000 5,101 25, , ,000 21,693 2,006 27,061 27, ,000 5,101 30, , ,000 21,693 2,006 29,066 29, ,000 5,101 35,706 19

21 Necessary Premium Testing CVAT Contracts 20

22 Necessary Premium Testing - CVAT Contracts For a CVAT contract, the TAMRA Conference Report (at ) indicates that a premium is necessary so long as the net portion of that premium does not exceed the difference between: 1) the attained age NSP for the lowest death benefit (and presumably lowest QABs) during the 7-pay period; and 2) the lesser of: (a) the policy's deemed cash surrender value or (b) the actual cash surrender value 21

23 Necessary Premium Testing - CVAT Contracts (cont.) Deemed cash surrender value (i.e., DCSV) Generally, the value that would arise if all premiums grew at interest based on the greater of 4% and the guaranteed policy rate, and certain mortality and expenses had been charged PLR reflection in the DCSV of reasonable expenses that satisfy the reasonable mortality charge rule Expenses that are reasonable and reasonably expected to be actually paid 22

24 Necessary Premium Testing - CVAT Contracts (cont.) The attained-age NSP as used in the formula must be based on the lowest level of future benefits in the 7-pay period. Excludes those benefit increases for which material change treatment has been deferred pursuant to the NPT Lowest benefits are identified by reference to the current or most recent 7-pay period NSP calculation otherwise reflects CVAT rules Some unanswered questions: Expense assumptions to reflect in the DCSV How the DCSV is determined after a material change Effect, if any, of reductions in benefits upon a contract s DCSV 23

25 Necessary Premium Testing Example 1 - CVAT Example 1 - CVAT - Immediate Recognition of the Material Change Necessary Premium Limitation (NPL) 7-Pay Premium Limitation Duration Death Benefit Death Benefit NSP DCSV NPL Death Benefit 7-Pay Prem 7-Pay Limit 1 100, ,000 20, , ,000 3,323 3, , ,000 21,396 2,030 19, ,000 3,323 6, , ,000 22,152 3,106 19, ,000 3,323 9, , ,000 22,935 4,225 18, ,000 3,323 13, , ,000 23,742 5,389 18, ,000 3,323 16,615 Face Amount Increase from $100,000 to $150,000 - Immediate Recognition as a Material Change CV = $8, , ,000 36,864 6,600 30, ,000 4,649 4, , ,000 38,154 7,859 30, ,000 4,649 9, , ,000 39,482 9,168 30, ,000 4,649 13, , ,000 40,847 10,530 30, ,000 4,649 18, , ,000 42,250 11,946 30, ,000 4,649 23, , ,000 43,686 13,419 30, ,000 4,649 27, , ,000 45,155 14,951 30, ,000 4,649 32, , ,000 46,662 16,544 30, , ,000 48,205 18,200 30, , ,000 49,800 19,923 29, , ,000 51,445 21,715 29, , ,000 53,139 23,579 29, , ,000 54,878 25,517 29, , ,000 56,656 27,533 29,

26 Necessary Premium Testing Example 2 - CVAT Example 2 - CVAT - Deferred Recognition of the Material Change with UNP Necessary Premium Limitation (NPL) 7-Pay Premium Limitation Duration Death Benefit Death Benefit NSP DCSV NPL Death Benefit 7-Pay Prem 7-Pay Limit 1 100, ,000 20,664 1,658 19, ,000 3,323 3, , ,000 21,396 3,382 18, ,000 3,323 6, , ,000 22,152 5,176 16, ,000 3,323 9, , ,000 22,935 7,041 15, ,000 3,323 13, , ,000 23,742 8,981 14, ,000 3,323 16,615 Face Amount Increase from $100,000 to $150,000 - Defer Recognition as a Material Change until an Unncessary Premium is Paid 6 150, ,000 24,576 10,998 13, ,000 3,323 19, , ,000 25,436 13,096 12, ,000 3,323 23, , ,000 26,321 15,278 11, , ,000 27,232 17,547 9, , ,000 28,166 19,907 8, , ,000 29,124 22,361 6, , ,000 30,103 24,913 5, , ,000 31,108 27,568 3, , ,000 32,137 30,329 1, , ,000 33,200 33, Payment of an Unnecessary Premium - Forces recognition of a Material Change CV = $40, , ,000 51,445 36,186 15, ,000 1,857 1, , ,000 53,139 39,292 13, ,000 1,857 3, , ,000 54,878 42,521 12, ,000 1,857 5, , ,000 56,656 45,880 10, ,000 1,857 7, , ,000 58,471 49,373 9, ,000 1,857 9, , ,000 60,317 53,006 7, ,000 1,857 11, , ,000 62,187 56,785 5, ,000 1,857 12,996 25

27 To Defer or Not to Defer? That is the Question. 26

28 To Defer or Not to Defer, That is the Question Contract design may be the key driver, since some designs (such as universal life ( UL ) CVAT and whole life with premium paying additions) may effectively require active NPT monitoring. For whole life with a premium paying addition, payment of a premium for the addition can cause a later fixed premium to exceed the NPT limit. For UL CVAT, the flexibility to pay premiums that drive up the death benefit under a corridor mechanism usually allows for receipt of unnecessary premium. Administrative complexity of monitoring a separate GPL or DCSV. Consideration of how particular transactions will be treated. If some increases (e.g., corridor-based increases) are deferred, then the NPT is being relied upon to an extent. While corridor increases often are not adjustment events under IRC 7702, they will always result in material changes under IRC 7702A unless the NPT applies to prevent material change treatment. 27

29 To Defer or Not to Defer, That is the Question (cont.) Deferring material changes avoids subjecting a contract to a new 7-pay period. However, where material changes are deferred, the NPT limit will constrain funding to that permissible for the lowest benefits existing prior to the change. Immediate material change recognition triggers a new 7-pay period, but the new 7-pay test permits funding of the current (as of the date of the material change) and prior benefit increases. 28

30 To Defer or Not to Defer, That is the Question Further Observations Dual limitations on funding if you are trying to avoid being a MEC 7-pay test controls the timing and magnitude of premium payments in the short term. Deferring recognition of a material change can impose greater short term funding limitations. The necessary premium test imposes a long term aggregate funding limitation on the overall magnitude of premium payments. 29

31 To Defer or Not to Defer, That is the Question Further Observations (cont.) While policyholder administrative system considerations often drive whether material changes are deferred or immediately recognized, does it matter for the policyholder? No simple answer, but in many cases, it will not matter. Low and moderately funded contracts usually would not be MECs under either approach. Likewise, heavily (and quickly) funded contracts usually would be MECs under either approach. Differences could arise for contracts with in-between funding or funding close to, but less than, the 7-pay limit. Even then, the effects on contract investment orientation appear to be small. 30

32 Case Studies 31

33 IRC 7702A s Necessary Premium Test Case Studies Case Study 1 UL contract tested under the guideline premium test (GPT) Use of IRC 7702 GPL as a surrogate for the NPT limit What if the necessary GPL differs, such as due to the presence of a short-term QAB? What if there have been prior material changes or a reduction in benefits? Case Study 2 Ordinary whole life insurance tested under the CVAT Use of the tabular cash value as a surrogate DCSV in determining the NPT limit Again, what if there have been prior material changes? These first two case studies present the fewest challenges. 32

34 IRC 7702A s Necessary Premium Test Case Studies (cont.) Case Study 3 UL contract tested under the CVAT Consider a contract under which an annual premium equal to the 7-pay premium is paid in each of the first 8+ years Death benefit increases will likely arise due to CVAT corridor mechanism At some point (probably in year 8 in this example), unnecessary premium will be paid, triggering a material change Rollover rule application and possibility of MEC treatment from unnecessary premium Policyholder consent to MEC status 33

35 IRC 7702A s Necessary Premium Test Case Studies (cont.) Case Study 3 (cont.) Strategies for NPT testing Establish an NPT monitoring system to actively assess whether unnecessary premium has been received Alternatively, trigger a material change if any premium is received after the point in time when the contract s death benefit first becomes based on the CVAT corridor mechanism Does the OBRA legislative history contemplate this approach? 34

36 IRC 7702A s Necessary Premium Test Case Studies (cont.) Case Study 4 Whole life insurance contract with benefit additions after issuance that are funded by premiums Benefit increases are occurring; also, premiums are being paid to fund those benefit increases (as opposed to funding only the contract s lowest benefits) To defer or not to defer material changes on such facts? If deferred, the premiums for the additions will increase the DCSV without a corresponding increase in the lowest benefits underlying the calculation of the NSP used to determine the NPT limit. As a result, the contractual premium will eventually exceed the NPT limit, triggering a material change (and possibly MEC status) at some future date. Consent to MEC treatment importance and timing challenges These contracts likely become MECs at some future date; they are difficult to fix if non-mec treatment is desired 35

37 Questions? 36