Session 41 PD, Introduction to Product Tax. Moderator: Brian G. King, FSA, MAAA

Session 41 PD, Introduction to Product Tax Moderator: Brian G. King, FSA, MAAA Presenters: Philip Ferrari, ASA, MAAA Brian G. King, FSA, MAAA Craig R. Springfield, JD

Introduction to Product Tax Session 41 2015 SOA Annual Meeting Austin, TX October 12, 2015

Presenters Brian King, FSA Ernst & Young LLP Craig Springfield, Partner Davis & Harman LLP Philip Ferrari, ASA Ernst & Young, LLP 2

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Disclaimer 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 or Davis & Harman LLP 4

Overview General tax treatment of proceeds paid from a life insurance contract Death benefits, including accelerated death benefits Distributions of cash value Life insurance qualification requirements under the Internal Revenue Code (IRC) IRC 7702 IRC 7702A IRC 101(g) and 7702B Additional requirements for variable contracts Consequences and remediation of non-compliance

Life Insurance Policyholder Tax Treatment The Internal Revenue Code provides for certain favorable tax treatment applicable to payments made from a life insurance contract, including: Death benefits Earnings on cash value Withdrawals or distributions of cash value

Tax Treatment of Death Benefits In General IRC 101(a)(1) provides that death benefits paid to the beneficiary generally are tax free Some exceptions apply: Transfer for value rules (e.g., life settlements) Need of an insurable interest at issue Employer-owned life insurance must satisfy IRC 101(j) 7

Tax Treatment of Death Benefits Accelerated Death Benefits under IRC 101(g) and 7702B Benefits can be paid prior to actual death, and in certain instances, receive death benefit tax treatment Terminal illness accelerated death benefits (ADBs) under IRC 101(g) Physician certification of illness or physician condition expected to result expected in 24 months or less Generally treated as a tax-free death benefit Chronic illness ADBs - IRC 101(g) riders and IRC 7702B qualified long-term care insurance (QLTCI) ADBs generally tax-free as accident & health insurance benefits (for QLTCI) or as death benefits (for IRC 101(g) riders) Per diem limitation for non-reimbursement benefits $330/day ($120,450/year) for 2015 Adjustments for higher incurred costs and reimbursements 8

Taxation of Cash Value Life Insurance Earnings and Distributions IRC 72(e) provides that interest/earnings credited to a life insurance policy s cash value (the inside buildup ) are not includible in the taxable income until distributed For partial withdrawals, IRC 72(e) defines income for a life insurance contract as the excess of (a) over (b): (a) the cash value of the contract, over (b) the investment in the contract In general, pre-death distributions of cash value are taxed on a return of investment first or first-in-first-out (FIFO) basis, including: Withdrawals / partial surrenders Full surrenders Policyholder dividends (unless retained to pay premiums) 9

Statutory Requirements IRC 101(f) & 7702 In order for policyholder and beneficiaries to receive the intended tax treatment, a life insurance contract must satisfy certain legal requirements and actuarial tests: IRC 101(f) Prescribes rules that must be met by flexible premium contracts issued before 1/1/85 in order to receive favorable tax treatment IRC 7702 Establishes a permanent definition of life insurance contract that applies for all federal tax purposes Applies to all life insurance contracts issued 1/1/85 and later, not just flexible premium contracts 10

Statutory Definition of a Life Insurance Contract IRC 7702 To qualify as a life insurance contract for federal tax purposes, a contract must: Be life insurance under applicable law Meet satisfy one of two actuarial tests: Cash value accumulation test (CVAT) Guideline premium and cash value corridor test (GPT) Note: The actuarial tests limit the investment orientation of a life insurance contract by regulating the relationship of the premium, death benefit and cash value. 11

IRC 7702A Defining a Modified Endowment Contract Additional qualification requirements apply to contracts issued or entered into after June 20, 1988 IRC 7702A defines a class of life insurance contracts called modified endowment contracts or MECs A MEC is a qualifying life insurance contract that fails to satisfy a premium based test (the 7-pay test ) designed to measure the premium funding rate of a life insurance contract Consequences of becoming a MEC Applies annuity tax treatment ( last-in-first-out or LIFO rules) to predeath distributions of cash value Applies to additional deemed distributions that are not otherwise taxable for non- MECs, including policy loans, assignments and pledges MECs are also subject to a possible 10% penalty tax under IRC 72(v) for distributions that occur before the owner is 59½, with exceptions 12

Summary of Policyholder Taxation (Generally) Life Insurance Contract General Tax Treatment of a Life Insurance Contract MEC Status Non MEC MEC Death Benefits Treatment Tax Treatment of "Earnings" on Cash Value Tax Free Deferred until Distributed" Applicability of 10% Penalty Tax N/A Yes Distributions of Cash Value Partial Surrenders and Withdrawals FIFO LIFO Distributed Dividends FIFO LIFO Loans, Assignments and Pledges N/A LIFO 13

Qualifying as Life Insurance under the Internal Revenue Code The Actuarial Tests of IRC 7702

Requirements for Qualification IRC 101(f) and 7702 As noted earlier, to qualify as a life insurance contract for federal tax purposes, a contract must satisfy one of two actuarial tests: Guideline premium and cash value corridor test (GPT) Generally applies to flexible premium contracts likes universal life, variable universal life, etc. Cash value accumulation test (CVAT) Generally applies to whole life insurance contracts Can also apply to flexible premium contracts as well 15

The Actuarial Tests of IRC 7702 The Cash Value Accumulation Test To meet the requirements of the CVAT, the contract must be structured so that, at all points in time, the cash surrender value can never (under any possible scenario) exceed the net single premium for future benefits Key elements of the CVAT Cash surrender value IRC 7702 defines cash surrender value as the contract s cash value determined without regard to any surrender charge, policy loan, or reasonable termination dividends. Net single premium The CVAT uses a single premium as a measure of the maximum permissible cash value in a qualifying life insurance contract Future benefits Limitations are imposed on the future benefits assumed more to come 16

CVAT Limitation: Net Single Premium $1,000 Death Benefit $1,000 Net Amount at Risk $400 Single Premium Policy Value 17 45 50 55 60 65 70 75 80 85 90 95 100 Age Assumptions: 2001 Commissioners Standard Ordinary (CSO) Male Aggregate, Age Nearest Birthday, 4%, Male Age 45 P

The Actuarial Tests of IRC 7702 The Guideline Premium Test The guideline premium test is a dual-element test: Gross premiums paid under the contract do not exceed the guideline premium limitation Statutory cash value corridor requirement is satisfied (IRC 7702(d)) Guideline premium limitation equals the greater of: The guideline single premium (GSP) Sum of the guideline level premiums (GLPs) to date 18

Guideline Premium Limitation per $1,000 of Insurance Assumptions: 2001 CSO Male Aggregate, 4% GLP, 6% GSP, Age 45, Endowment at Age 100 350 GSP Sum GLP 300 Amount of Premium 250 200 150 100 50 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Duration in Years 19

Minimum Death Benefit per $1,000 of Cash Value (Male Aggregate Mortality Endowment at 100) 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 25 35 45 55 65 75 85 95 Age GPT Factors CVAT - 2001 CSO 20

The Guideline Premium Test Premiums Paid Premiums paid is defined to be the premiums paid under the contract less: Distributions that are not taxed under IRC 72(e) Excess premiums described under IRC 7702(f)(7)(B) and (E) Amounts returned (with interest) within 60 days of the end of a contract year that must be returned to remain in compliance Note: Premiums paid may differ from investment in the contract under IRC 72(e). 21

Determining the Actuarial Limits under IRC 7702: Guideline & Net Single Premiums

Defining Guideline & Net Single Premiums Model or Test Plan Concept Actuarial premiums serve as the basis for defining the maximum permissible funding limitation under IRC 7702, and are based on actuarial principles involving present value calculations Contract benefits and guarantees for interest, mortality and expenses generally serve as the starting point for defining the actuarial assumptions used Future benefits and charges taken into account Minimum statutory and contractual interest, mortality and expense assumptions Follow contract structure Actuarial safeguards were built in to limit manipulation of plan designs Section 7702 may impose additional restrictions on (1) the timing and magnitude of contractual benefits and (2) the actuarial assumptions used to calculate guideline and net single premiums Note: The restrictions imposed by IRC 7702 vary based on contract issue dates, particularly for contracts issued before and after October 21, 1988 23

Defining Guideline & Net Single Premiums Limitation on Future Benefits Benefits assumed in the calculation of guideline and net single premiums are limited (the Computational Rules ) Generally death benefits are assumed not to increase Exception for the GLP Assumed maturity date must be between attained ages 95 and 100, regardless of whether the contract has an earlier or later maturity Death benefits are assumed to the deemed maturity date Endowment benefit cannot exceed the least death benefit payable Qualified additional benefits (QABs): Charges for additional benefits can be taken into account in the calculation, but only for QABs: Guaranteed insurability Accidental death or disability benefits Family term coverage Disability waiver benefit 24

Defining Guideline & Net Single Premiums Limitation on Actuarial Assumptions Interest Rates Interest rates are the greater of the statutory rates or the rate or rates guaranteed upon issuance of a contract. Statutory rates: NSP: 4% GSP: 6% GLP: 4% Short-term guarantees Mortality IRC 101(f): Mortality charges guaranteed under the contract IRC 7702 requirements vary based on issue dates: - Entered into before October 21, 1988 Mortality charges specified in the contract - Entered into after October 20, 1988 Reasonable mortality charges Notice 2006-95 safe harbors Expense (and other) charges Parallels exist between mortality and expense charge requirements: - Contracts entered into before October 21, 1988 Expense charges specified in the contract - Contracts entered into after October 20, 1988 Reasonable charges reasonably expected to be actually paid Cannot use expenses under the CVAT, except in the case of qualified additional benefits (QABs). 25

The Actuarial Test under IRC 7702A The 7-Pay Test

The Actuarial Test of IRC 7702A The 7-Pay Test The 7-pay test is used to measure the funding rate of a life insurance contract First year after issue: A contract will fail the 7-pay test if the accumulated amount paid under the contract, at any time during that contract year, exceeds the 7-pay premium Second through seventh contract years: Accumulated amounts paid under the contract are compared to the sum of the 7-pay premiums through the start of that contract year 27

IRC 7702A s 7-pay Test Additional Considerations Amounts paid Generally follows the IRC 7702 definition of premiums paid Actuarial assumptions for calculating the 7-pay premium The 7-pay premium is a net premium that does not include expenses in the calculation Largely follows rules applicable to the CVAT $75 allowance in section 7702A(c)(4) for contracts with a death benefit of $10,000 or less Computational rules applicable to the 7-pay premiums IRC 7702A incorporates the IRC 7702(e)(1) computational rules with one exception: IRC 7702A(c)(1)(B), which requires that the death benefit provided for in the first contract year be assumed to be provided until the maturity date of the contract without regard to any scheduled reduction after the first seven contract years 28

Policy Adjustments Under IRC 7702 and 7702A

Policy Adjustments Adjustment Rules under IRC 7702 & 7702A Policy changes require adjustments to the actuarial limitations imposed by IRC 7702 and 7702A Adjustment events under IRC 7702 are accounted for differently based on the actuarial test for qualification (CVAT or GPT) IRC 7702A provides for two different rules for policy changes Material changes result in the contract being treated as newly entered into, subjecting the contract to a new 7-pay test Reduction in benefits may result in the retroactive application of the existing 7-pay test reflecting the reduced benefits 30

Adjustments under IRC 7702 Guideline Premium Test The guideline premium test applies over the life of a contract, starting with policy issuance and continuing to policy termination, either by death or surrender As policy changes occur, adjustments are needed to the GSP and GLP to allow for: Additional funding when benefits are added or increased Restrictions on funding that is no longer necessary to support benefits that are no longer present Adjustment to the existing GSP and GLP are based on the attained age of the insured at the time of the change and reflecting the change in benefits Commonly referred to as the attained-age adjustment methodology Not all policy changes require adjustments to GSP and GLP Changes requiring adjustments are typically those requested by the policyholder 31

Adjustments under IRC 7702 Cash Value Accumulation Test The CVAT requires that all benefit changes be taken into account under adjustment rules Adjustments under the CVAT are based on the future benefits at the time of the change Unlike GPT, does not reflect the level of benefits before the change CVAT limit is equal to the NSP for future benefits computed using the IRC 7702 restrictions on assumed future benefits and actuarial assumptions and the insured s age Contract treated as newly issued The CVAT has been described as self-adjusting 32

Adjustments under IRC 7702A Reductions in Benefits If benefits under the contract are reduced during the first seven contract years, then IRC 7702A is applied as if the contract had originally been issued at the reduced benefit level The new reduced limitation is applied to the cumulative amount paid under the contract for each of the first seven years (this can cause the contract to become a MEC retroactively). Special rule for survivorship contracts 33

Adjustments under IRC 7702A Material Changes The material change rule applies throughout the life of a contract. It does not cease applying after a contract passes through a 7-pay testing period without becoming a MEC. Material Change includes any increase in the death benefit or any increase in/or addition of a QAB, or changes to contract terms Exceptions to material change treatment: Any increase in benefits that is attributable to the payment of a necessary premium and interest / earnings thereon (more to come) To the extent provided in regulations, any COLA increase (with conditions): No regulations to date (i.e., provision is inoperative) 34

Adjustments under IRC 7702A Material Changes (continued) Upon the occurrence of a material change, the contract is treated as newly entered into The contract will be tested from that point forward over the ensuing seven years under a new 7-pay test 7-pay premium under the new 7-pay test is based on the future benefits then provided and the insured s then attained age, adjusted to take into account the contract s existing cash surrender value This adjustment is referred to as the rollover rule 35

Adjustments under IRC 7702A The Necessary Premium Test As noted, an increase in future benefits may not result in a material change if the increase is attributable to the payment of necessary premiums and interest / earnings thereon Necessary premium is the premium required under the contract guarantees to fund the lowest future benefit during the initial seven contract years (or for seven years following a material change) Manner for implementing differs between GPT and CVAT contracts Based on OBRA 1989 legislative history, insurers generally may defer recognition of a benefit increase as a material change if no unnecessary premium has been paid If deferred, a material change must be recognized at the time unnecessary premium is paid into the contract 36

Accelerated death benefits under IRC 101(g) and 7702B

Accelerated Death Benefits Qualification Rules IRC 101(g) and 7702B - Chronically ill individual: An individual who has been certified within the prior 12 months by a licensed health care practitioner as either Requiring substantial assistance for at least 90 days with at least 2 of 6 activities of daily living (eating, bathing, dressing, transferring, continence, and toileting) due to loss of functional capacity, or Requiring substantial supervision to protect the individual to threats to health and safety due to severe cognitive impairment 38

Accelerated Death Benefits Qualification Rules Other requirements for IRC 101(g) riders Costs incurred by the payee for qualified long-term care services and Medicare coordination requirements Per diem exception Consumer protection rules Business use policies Other requirements under IRC 7702B riders Insurance coverage only of qualified LTC services and Medicare coordination Per diem exception Guaranteed renewable Cash value and investment orientation restrictions Return of premium exception Consumer protection rules Special rules for LTC riders 39

Qualification Requirements for Variable Contracts

Variable Contract Requirements In General IRC 817(d) defines the term variable contract to mean a contract that provides for the allocation of all or part of the amounts received under the contract to an account that, pursuant to state law or regulations, is segregated from the general asset accounts of the company In the case of a life insurance contract, the amount of the death benefit (or the period of coverage) must be adjusted on the basis of the investment return and the market value of the segregated asset account. 41

Variable Contract Requirements IRC 817(h) Diversification Each segregated asset account that a variable contract is invested in must be adequately diversified according to specific rules No more than 55% of the value of the total assets of the account is represented by any one investment; No more than 70% by any two investments; No more than 80% by any three investments, and No more than 90% by any four investments Generally applies to each sub-account or investment option Test needs to be satisfied at end of each quarter w/ 30-day cure window 42

Variable Contract Requirements Investor Control For federal income tax purposes, a life insurance company normally is treated as the owner of the separate account assets it holds in support of variable life insurance contracts it issues A policyholder, rather than the insurance company, is treated as the owner of the separate account assets if he or she has sufficient incidents of ownership in them Three related indicators of control: Actual control over asset acquisition, disposition, management Use of publicly available pools of assets Use of de facto publicly available pools of assets The general intent is to not allow a policyholder to use life insurance as a way to obtain tax benefits (e.g., deferral of tax on inside build-up) from investments that are otherwise available to a policyholder absent the life insurance contract 43

Consequences and Remediation of Non-compliance

Consequences of Non-compliance In General Insurance companies are required to administer life contracts within the life insurance qualification requirements imposed by the IRC Maintaining qualification with the IRC 7702 requirements Properly identifying a contract s status as a MEC or non-mec Variable contract administration Maintaining a properly diversified segregated asset account Insuring policyholders do not have sufficient control over the management/selection of assets Sometimes errors occur causing contract noncompliance with one or more of these requirements The consequences for non-compliance will vary based on the type of noncompliance 45

Life Insurance Non-compliance An IRC 7702 Failed Contract The contract is not life insurance for tax purposes A failed life insurance contract creates a tax liability for policyholders The inside-build up is taxable annually to the policyholder Only the net amount at risk would generally be tax free to the beneficiary The insurance company has information reporting and withholding obligations with regard to the income for a failed contract Also implications for how the contract would be accounted for under the insurance company s tax return Insurance companies generally will not knowingly administer a failed life insurance contract The IRS has a correction program to remediate failed life insurance contracts in Revenue Procedures 2008-40. Conditions for use include: Failure must be inadvertent Errors must be corrected Policies must be brought into compliance with IRC 7702 A toll charge must be paid to the IRS Auto-waiver may be available under Revenue Procedure 2008-42 46

Life Insurance Non-compliance An IRC 7702A Inadvertent MEC An inadvertent MEC is still a qualifying life insurance contract for tax purposes Creates a policyholder tax liability to the extent distributions were not properly tax reported under rules applicable to a MEC Similarly, the insurance company is also exposed to information reporting and withholding errors Like Revenue Procedure 2008-40, the IRS also has a correction program to remediate inadvertent MECs in Revenue Procedure 2008-39. Conditions for use include: MEC status must be inadvertent Errors must be corrected Policies must be brought into compliance with the 7-pay test A toll charge must be paid to the IRS 47

Life Insurance Non-compliance Diversification Failure Failure to satisfy IRC 817(h) diversification requirements results in the following: Policyholder is currently taxable on earnings under entire contract (not just non-diversified account) Similar to a failed life insurance contract Insurance company is exposed to withholding and reporting requirements The IRS has a correction programs to remediate diversification failures in Revenue Procedures 2008-41. Conditions for use include: Failure must be inadvertent Failure must be corrected within reasonable time A toll charge must be paid to the IRS 48

Life Insurance Non-compliance Investor Control Failure under investor control doctrine Policyholder is considered the owner of the assets Generally taxed under investment rules applicable to the underlying assets No standard IRS correction program to remediate violations of the investor control doctrine 49

Concluding Thoughts

Thank You