Session 41, Tax Considerations for the Life Insurance Actuary. Moderator: Brian Prast, FSA, MAAA. Presenter: Graham Green Brian McBride, FSA, MAAA

Transcription

1 Session 41, Tax Considerations for the Life Insurance Actuary Moderator: Brian Prast, FSA, MAAA Presenter: Graham Green Brian McBride, FSA, MAAA Brian Prast, FSA, MAAA

2 2016 Valuation Actuary Symposium Brian McBride, FSA, MAAA Brian Prast, FSA, MAAA Graham R. Green, JD, LLM Tax Considerations for the Life Actuary August 29, 2016

3 Disclaimer This presentation is provided solely for the purpose of enhancing knowledge on tax matters. It does not provide tax advice to any taxpayer because it does not take into account any specific taxpayer s facts and circumstances. These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting advice. Presentations are intended for educational purposes only and do not replace independent professional judgment. Statements of fact and opinions expressed are those of the participants individually and, unless expressly stated to the contrary, are not the opinion or position of the Society of Actuaries, its cosponsors, or its committees. The Society of Actuaries does not endorse or approve, and assumes no responsibility for, the content, accuracy or completeness of the information presented. Attendees should note that sessions are audiorecorded and may be published in various media, including print, audio and video formats without further notice. The views expressed by the presenters are not necessarily those of Kansas City Life Insurance Company, MassMutual Financial Group, or of Sutherland, Asbill & Brennan LLP. 2

4 Agenda Tax policy and the regime for taxing life insurance companies Basic Tax Reserve Topics Additional Reserve Topics Principle-Based Reserves and 2017 CSO: Tax Reserve Issues IRS Examination Process Other Topics Tax Authorities and Resources Tax Reform Summary 3

5 Tax policy and the regime for taxing life insurance companies 4

6 Principles of Tax Policy Equity Horizontal Equity Vertical Equity Efficiency Administrability 5

7 Regime of Taxing Life Insurers Life Insurance Company Taxable Income (LICTI) subject to tax under 801 at corporate rates LICTI Life Insurance Gross Income minus Life Insurance Deductions Life Insurance Gross Income Premiums plus Decreases in reserves ( 803(a)(2)) Life Insurance Deductions Death benefits plus Increases in reserves ( 805(a)(2)) 6

8 Regime for Taxing Life Insurers Methods of Accounting Taxpayers generally General Rule 446(a): Start with book (e.g., GAAP) Tax Override 446(b): Clear reflection of income Insurers specifically 811(a) Start with book/statutory accounting consistent with NAIC Annual Statement Modify for tax purposes 7

9 Basic Tax Reserve Topics 8

10 Statutory vs. Tax Reserves Statutory Reserves Solvency Minimum Standards Movement towards Principle-Based Reserves (PBR) - AG43 reserves for Variable Annuities - VM-20 for Life Tax Reserves Start with statutory reserve assumptions Adjust as required by Internal Revenue Code (IRC) Final tax reserve is less than or equal to statutory reserve This inefficiency results in higher taxable income 9

11 Reserves Taken Into Account: IRC 807(c) IRC Category of reserves NAIC Annual Statement analogue (generally) 807(c)(1) Life insurance reserves ( 816(b) definition) 807(c)(2) Unearned premiums and unpaid losses 807(c)(3) 807(c)(4) Discounted amounts under ins./annuity contracts that do not currently involve life or A&H contingencies Dividend accumulations and other amounts held at interest under ins./annuity contracts Exhibit 5 + Exhibit. 6 NC/GR A&H Exhibit 6 canc. A&H + Exhibit 8.1 PVANYD Exhibit 7 Exhibit 7 807(c)(5) Advance premiums and premium deposit funds Exhibit 1 807(c)(6) Special contingency reserves under group insurance (retired lives or premium stabilization) Exhibit 5 or 6 NC/GR = non-cancellable or guaranteed renewable (under tax definitions; Treas. Reg (c) and (d)) PVANYD = present value of amounts not yet due (i.e., claim reserve) 10

12 Definition of Life Insurance Reserves 807(c)(1) refers to life insurance reserves as defined in 816(b) 816(b) defines life insurance reserves as amounts: Computed or estimated on the basis of recognized mortality or morbidity tables and assumed rates of interest Set aside to mature or liquidate, either by payment or reinsurance, future unaccrued claims arising from life insurance, annuity and noncancellable A&H insurance contracts Required by law 11

13 Tax Basis Life Insurance Reserve Definition (3-Prong Test) Tax reserve = the greater of the Federally Prescribed Reserve (FPR) and the Net Surrender Value (NSV), but no more than the Annual Statement Reserve (ASR) NSV is net of surrender charges but not net of market value adjustments Deficiency reserves are included in ASR cap but are not allowable tax reserves 3-prong comparison generally done at the contract level on an aggregate benefit basis 12

14 Differences Between the Federally Prescribed Reserve (FPR) and Annual Statement Reserve (ASR) Methodology Valuation interest rate Mortality/Morbidity tables Deferred & uncollected premiums are generally removed from FPR Removal of excess interest reserves from FPR Applies on contracts where an interest crediting rate above tax rate is guaranteed beyond the end of the tax year 13

15 FPR Computation Methodology 807(d) The tax reserve method applicable to that type of contract in effect on the date of the issuance of the contract as prescribed by the NAIC, which is: CRVM for a life insurance contract CARVM for an annuity contract 2-year full preliminary term method for noncancellable accident and health insurance contracts 1-year preliminary term for qualified long-term care, issued in 1998 or later Other prescribed method by the NAIC that covers such contract as of the date of issuance If such method does not exist, a method consistent with other applicable prescribed methods 14

16 FPR Computation Valuation Interest Rate 807(d) The greater of the applicable federal interest rate (AFIR) or the prevailing state assumed interest rate (PSAR), determined for the calendar year in which the contract is issued AFIR = average of federal mid-term rates over the 60 months ending the December prior to the issue year of the contract (first applied on 1988 issues) PSAR = highest reserve valuation interest rate permitted in at least 26 states at the start of the issue year 15

17 Tax and Stat Interest Rates : Whole Life Insurance 9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% AFIR PSAR 2.00% 1.00% 0.00% AFIR has had little impact in recent low interest rate environment 16

18 FPR Computation Mortality/Morbidity Tables Prevailing Commissioners' Standard Table - Most recent NAIC approved table permitted in 26 or more states for the contract type Where no Commissioners Standard Table exists, table shall be determined by Treasury regulations. Can use the old table for 3 years after a prevailing table change Example: 2001 CSO became prevailing in 2004 Optional for contracts issued in 2004, plus Required for contracts issued in 2008 (different from stat) IRC allows prevailing tables "adjusted as appropriate" to reflect the risks (such as substandard risks) incurred under the contract which are not otherwise taken into account If more than one table or option, must use the one which generally results in lowest reserves 17

19 FPR 807(d)(2)(C) Mortality Tables Year become prevailing Life Individual annuity Group annuity 1948 CSO 41 SA 37 SA CSO 58 (3-year setback) 1962 A 49 GA IA 71 GA CSO 58 (6-year setback) 1982 CSO 80 (smokercomposite) a 83 GAM 1986 CSO 80 (smoker-distinct; 1999 optional) Annuity GAR CSO IAR CSO Sources and abbreviations: Rev. Ruls and , NAIC Model Reg

20 Additional Reserve Topics 19

21 3-Prong Test Considerations: Supplemental Benefits 807(e)(3) lists supplemental benefits For supplemental benefits, FPR = stat reserve Qualified supplemental benefit treated as separate contract Separately identified premium Net surrender value under the contract for any other benefit not available to fund the supplemental benefit 20

22 3-Prong Test Considerations: NSV floor NSV floor comparison is generally applied on a contract by contract basis, aggregating all riders and benefits associated with each contract If qualified supplemental benefit (QSB) under 807(e)(3), treat benefit as separate contract Reserve after NSV floor, before statutory cap Default: Max (102, 100) = 102 QSB: Max (95, 100) + Max (7, 0) = 107 Life Insurance Contract With A Supplemental Benefit Base Supp Ben Aggregate FPR NSV Max (FPR, NSV) or

23 3-Prong Test Considerations: Statutory Cap Tax life insurance reserves capped by statutory reserves for the contract Statutory reserves defined as aggregate amount set forth in the Annual Statement with respect to tax reserves Amounts included in statutory cap Deficiency reserves confirmed by Notice CTE excess under AG43? Additional actuarial reserves/cash flow testing reserves? Life PBR deterministic and stochastic excesses?, 22

24 Change in Basis vs. Correction of Error 807(f) Adjustments for Changes in Reserve Basis Changes in basis require a 10-year spread of the change Corrections of errors are reflected currently Rev. Rul guidance Example 1: use of wrong mortality table in prior years Example 2: use of wrong interest rates Example 3: change from curtate to continuous reserves Example 4: missed range of contract cells in in-force file 23

25 807(f) Example of 10-year Spread Year of change = 2013, with the change entirely on an in-force block At year-end Old basis New basis Tax return Opening Schedule F Change in basis to spread = = 8 Amount per year = 8 10 = 0.8 Closing Deduction for year s increase in reserves Deduction for 807(f) spread of strengthening

26 Principle-Based Reserves and 2017 CSO: Tax Reserve Issues 25

27 Tax Reserves AG43 (IRS Notice ) Notice provides interim tax guidance on AG43 For statutory purposes, AG43 effective at YE 2009 for 1/1/1981 and later issues For tax purposes, AG43 applies to contracts issued on or after December 31, 2009 Life insurance reserves under 816(b) for determining whether an insurance company is a life insurance company Standard scenario is included Silent on CTE amount Federally prescribed reserve under 807(d)(2) Standard scenario is included CTE amount is specifically excluded Statutory cap under 807(d)(1) and 807(d)(6) Standard scenario is included Silent on CTE amount 26

28 Life PBR/VM-20: Background NAIC Valuation Manual (VM-20) prescribes minimum reserve valuation standards for individual life insurance policies What are some of the features of VM-20? Net premium reserve (NPR) serves as a floor Deterministic Reserve Formulaic Relies on company-specific information Stochastic Reserve Similar to CTE amount of AG43 Computed for a group of contracts based on many scenarios PBR made effective by the NAIC for 2017, with a 3-year transition period 27

29 Tax Reserve Issues Under VM-20 What pieces of the reserve (NPR, Deterministic, Stochastic) can be included in: Life insurance reserves under 816(b) for determining life insurance company status Federally Prescribed Reserves under 807(d)(2) Statutory cap under 807(d)(1) and 807(d)(6) What are the tax reserve implications of the statutory 3-year transition period? 28

30 How Will These Issues be Resolved? What guidance is available? Notice identifies key issues that could arise out of PBR Continued taxation of life insurers under Part 1 of Subchapter L Qualification of contracts as life insurance contracts Contract-by-contract v. aggregate reserving Prevailing assumed interest rate and prevailing mortality tables Notice on AG43 Priority Guidance Plan item Industry has requested guidance on product qualification and reserve transition, and plans to request guidance on other substantive reserve issues 29

31 2017 CSO: Tax Reserve Implications VM-20 will be effective 1/1/2017 VM-20 states 2017 CSO tables may be used on or after January 1, 2017, and shall be used for all policies on or after January 1, CSO is a series of tables Federally prescribed reserve (per 807(d)(2)) must be determined using the prevailing mortality table as of the date of issue of the contract 2017 CSO will become prevailing in 2017 Which tables are prevailing? 30

32 2017 CSO: Tax Reserve Implications 807(d)(5)(E) If more than one table, use the one which generally results in lowest reserves Has historically been interpreted by the life insurance industry as meaning a general application at the industry-wide level For the 2001 CSO, this interpretation has resulted in three sets of prevailing tables - the ultimate versions of: Unismoke - Composite 1 class Smoker distinct - Smoker/Nonsmoker 2 class Preferred structure 5 class Society of Actuaries Report on 2014 VBT/2017 CSO Impact Study looked at three plans whole life, 20 year level term and ULSG. Results showed: Reserves using the ultimate valuation tables were lower at most durations than reserves using the select & ultimate valuation tables. Overall level of reserves approximately the same on all three structures unismoke, smoker-distinct and preferred. 31

33 IRS Examination Process 32

34 IRS Audit Process Federal Tax Dispute Stages: Tax Return IRS Audit IRS Appellate Division Litigation The entire process starts with the tax return; every position, every tax planning idea, will ultimately be judged by its ability to hold up under audit The IRS Audit / Appeals / Litigation continuum for each year can be a long and expensive process Accurate documentation is a necessity; record retention of supporting materials is vital 33

35 Overview of a Typical IRS Audit - Exam IRS groups taxpayers based on asset size Large companies fall under the jurisdiction of the IRS Large Business and International Division (LB&I) Each years tax returns for companies that are subject to LB&I jurisdiction generally are subject to audit An on-site IRS examination team is assigned 34

36 Overview of a Typical IRS Audit - Exam Exam Kickoff meeting: Scope, agreed plan, timeline 6662 Disclosures Information Document Requests (IDRs) Timelines Enforcement Standard IDR - Reserve Questionnaire Numerical analysis and presentation by coverage type, issue year, interest rates, mortality and reserve method Application of statutory cap and net surrender value floor Calculation of federally prescribed reserves Notices of Proposed Adjustments - Forms

37 Overview of a Typical IRS Audit after IRS Exam Revenue Agent s Report (RAR) compilation of 5701s Taxpayer analysis of RAR and determination of issues to protest, if any Protest file written protest with Appeals Office IRS Rebuttal Appeals - All protested issues are discussed with an IRS Appeals Officer in an effort for each issue to be settled on the basis of the strength of the party s position (i.e. based on hazards of litigation). Upon completion of this phase, a Form 870-AD is issued. Litigation - For those protested issues not resolved with the IRS Appellate Division, and reserved on the Form 870-AD, a taxpayer may still pursue them further via Litigation in one of three forums (U.S. Tax court, U.S. Court of Federal Claims or Federal District Court) 36

38 Other Topics 37

39 Capitalized Policy Acquisition Costs ( Tax DAC ) 848 enacted in Revenue Reconciliation Act of 1990 Policy acquisition costs are deemed to be a specified percentage of net premiums in each category Annuity contracts % Group life insurance contracts % Other contracts % Individual life Individual/Group NC/GR A&H Tax DAC is amortized on a straight-line basis, generally over 120 months starting in second half of tax year 38

40 Tax DAC Example In 2013, Company receives premiums as shown below Premiums and capitalization: Contract Premiums Capitalization % Tax DAC Annuity 400,000, % 7,000,000 Group life 38,000, % 779,000 Individual life 133,000, % 10,241,000 Total 571,000,000 18,020,000 Amortization: Tax year Amortization Expense % 901, % per year 1,802,000 per year % 901,000 Total 100% 18,020,000 39

41 Proration and the Company s Share Most corporations are entitled to a deduction (DRD), which is usually equal to 70% of dividends received from domestic corporations Proration concept: because part of every dollar of life insurer s investment income is credited to policyholder reserves, which in turn are deductible, insurer should be required to reduce deductions to prevent a double benefit (compare 265) Applies separately to general account and separate accounts 40

42 Proration and the Company s Share Only life insurance company s share of DRD and tax-exempt interest is taken into account in determining taxable income Example: if policyholders share is 75%, company s share is 25%, so only 25% of tax-exempt income would effectively be tax-free Effectuated through deduction disallowance DRD allowed only for company s share of dividends Reserves reduced by policyholder s share of tax-exempt income 41

43 Proration and the Company s Share Company s share = company s share of net investment income divided by net investment income Company s share of net investment income = net investment income less policy interest Net investment income = 90% of gross investment income; 95% for separate accounts Policy interest = required interest at greater of PSAIR or AFIR Although the formula is complex, the concept is simple: How much of the company s net investment income is required to satisfy obligations to policyholders? 42

44 Proration and the Company s Share Industry understanding of current law has been consistent, and a one-time IRS controversy was resolved in 2014 Camp Discussion Draft proposes replacing existing regime with an approach based on the ratio of surplus to total assets Obama Administration FY 2016 Revenue Proposal is similar 43

45 Tax Authorities & Resources 44

46 Tax Authorities Internal Revenue Code 72, 101, 7702, 7702A, and Subchapter L ( ) Legislative History (Committee and Conference Reports) JCT Bluebook But beware of United States v. Woods (2013) Treasury Regulations Revenue Rulings Revenue Procedures Notices Private Letter Rulings Chief Counsel Advice (CCA), Field Service Advice (FSA), Technical Assistance Memo (TAM) Internal Revenue Manual (IRM) 45

47 IRS Priority Guidance Plan (PGP) Insurance Companies and Products Final regulations under 72 on the exchange of property for an annuity contract. Proposed regulations were published on October 18, 2006 Regulation under 72 and 7702 defining cash surrender value Guidance on annuity contracts with a long-term care insurance rider under 72 and 7702B Guidance under 807 and 816 regarding the determination of life insurance reserve for life insurance and annuity contracts using principles-based methodologies, including stochastic reserves based on conditional tail expectation Guidance under 833 Guidance on exchanges under 1035 of annuities for long-term care insurance contracts Guidance relating to captive insurance companies 46

48 Tax Resources DesRochers et. al., Life Insurance & Modified Endowments Under Internal Revenue Code Sections 7702 and 7702A Robbins & Bush, U.S. Tax Reserves for Life Insurers Burstein, Federal Income Taxation of Insurance Companies Black & Skipper, Life Insurance Tax Notes Today, Insurance Tax Review 47

49 Tax Reform 48

50 Tax Reform Background of Current Tax Reform Effort The Camp Draft (February 28, 2014) Summary of Key Insurance Provisions Ways & Means Blueprint (June 24, 2016) 49

51 Camp Draft Insurance Proposals 50

52 Ways & Means Blueprint Published June 24, 2016 Simpler, flatter, and fairer Simplify the IRC Eliminate the AMT for individuals and corporations Consolidate standard deduction and personal exemptions into a larger standard deduction Consolidate Child Tax Credit and Personal Exemption for children and dependents into a larger Child and Dependent Tax Credit Flatten rates Consolidate seven existing tax brackets for individuals into three brackets 12% / 25% / 33% Lower rates Lower highest individual income tax rate from 39.6% to 33% Expand standard deduction and personal exemptions to increase the number of non-filers Lower corporate tax rate to 20% 51

53 Summary 52

54 In Summary The Internal Revenue Code has very specific rules for taxing life insurance companies. Those rules, although straightforward in concept, are sometimes complex in practice and require the application of actuarial rules that sometimes differ from the statutory accounting rules that apply to the same block of business. The goals are equity (horizontal and vertical), efficiency, and administrability. 53

55 Questions & Answers 54