Internal Revenue Code 7702: Changes and Challenges

  Much has been written about the Consolidated Appropriations Act of 2021 and IRC section 7702, (§7702) where, effective January 1, 2021, minimum interest rates associated with the Cash Value Accumulation Test (CVAT) and the Guideline Premium Test (GPT) under the definition of life insurance have been lowered.  These adjustments created welcome changes for:  1) owners of insurance to put more money into cash accumulation plans of coverage without running afoul of definition of life insurance and Modified Endowment Contract (MEC) limits, and  2) carriers to get relief from onerous interest rate assumptions threatening the long term viability of Whole Life products, especially in short pay scenarios.

However, at the same time these changes create challenges — for carriers when implementing and balancing all stakeholder needs, and for producers who may quite possibly be staring at a future with significantly lower commissions on cash accumulation sales.

So what is being done on a carrier level and what impact will these changes have?

We asked two of our carrier partners to discuss the recent §7702 changes to get their take on what impact these may have on their companies and others.  We also included some of our own thoughts regarding producer impact as these changes are rolled out.

Our panelists are:

Josh Durand, Vice President, Life Insurance Business Leader - Lincoln Financial Group

Carol Meyer, AVP and Actuary - Principal Financial Group

How important are the changes to §7702 for the life insurance industry at large, and, if applicable, specifically for your company?

Josh:  The statutory rates underlying §7702 were originally established at the time §7702 was enacted, in 1984, and had not been updated since.  The changes to keep these interest rates more in line with the current environment were both appropriate and important for the life insurance industry.

Carol:  Also, the changes to §7702 benefit the customer, because they will better align tax limits with underlying policy guarantees.

Do you see any obstacles or difficulties in implementing the §7702 changes?

Carol:  We are in the process of evaluating implementation options.  The changes impact the entire product portfolio, so it will take some time to plan and execute any needed changes.

Josh:  The biggest issues with regards to implementation of these changes would be administrative systems that were not designed to allow for these interest rates to change.  This obstacle will require time to overcome, but is nothing we cannot handle.

Will the new interest rate rules of §7702 result in changes to your product portfolio?  If so, what kinds of changes?

Josh:  The changes to §7702 will have impacts on a product level but will not impact our portfolio at large and therefore Lincoln will continue to offer our broad set of products to the marketplace.

If you anticipate significant product changes do you expect a complete redesign of your products, or a more limited adjustment to the definition of life insurance and MEC calculations within the existing products?

Josh:  We do not anticipate any of our products being completely redesigned because of §7702, but we do anticipate many of them needing limited adjustments to align with the new regulation.  The limited adjustments that are anticipated mainly focus on a rebalancing of consumer value and agent compensation.

At least one company recently made revisions to their products prompted by the new rates in §7702.  The result was to create a significant decrease in target premium in some accumulation illustration scenarios.  What do you see as the potential impact to distribution partners as you attempt to balance product performance improvements with competitive compensation?

Carol:  Accumulation products funded at minimum death benefit levels will experience a reduction in required face amounts, resulting in changes to policy charges and compensation, absent other product changes.  Each company will review their product portfolio for their chosen balance of customer, producer and company perspectives.  Some companies may choose to adjust some or all of their product portfolio in response.

Josh:  Updating products for the changes to §7702 without adjusting other aspects of the product would reduce the face amount required to support a given premium level.  Cases that are max funded will therefore require a lower face amount which impacts the target premium and the compensation paid on a case.  Due to this impact, carriers across the industry will have to evaluate and make decisions on balancing consumer value and producer compensation.

Prior to the changes, §7702 used a fixed rate of 6% for the single pay guideline premium test, and 4% for CVAT and level pay GPT tests.  Will the new changes have an impact on companies choosing to use one test or the other for developing new products?

Josh:  The changing of the interest rates used in §7702 will not impact the use of one test vs. the other in product development but could open the possibility of using different policy designs for accumulation sales going forward.

Carol:  CVAT corridor factors will be reduced, and guideline and MEC premiums will increase relative to prior levels.  Companies should evaluate their products under available definition of life insurance options.

The market believes that the §7702 changes may have a significant impact on accumulation products sold at minimum death benefit levels.   Will the §7702 changes also impact death benefit focused products?

Carol:  Because death benefit focused products are not typically funded at maximum levels, it is likely that they will be minimally impacted.  In some cases, §7702 limits impact the ability to illustrate short pay scenarios.  This may be less likely under the new tax limits.

Josh:  The same changes that occur on accumulation designs will also occur on protection focused designs, but they will have much less of an impact due to protection designs not focusing on minimizing the face amount.  Because protection designed policies don't focus on minimizing the face amount, the reduction to the CVAT corridor factors will be the biggest impact of the §7702 changes to such policies.

We understand that the changes to §7702 require the minimum rate to float (indexed to the mid-term AFR) starting in 2022.   Do you anticipate selecting a fixed rate (at or higher than minimum rate) and applying that to all definition of life insurance calculations, or do you expect to make dynamic adjustments on a scheduled time period as rates change, or will you use some other approach?

Carol:  We are in the process of evaluating implementation options.  If a company would choose to use a fixed rate as described, they would need to ensure that the methodology met the requirements at policy issue and at any policy adjustment.

Josh:  Updates to the statutory rates underlying IRC 7702 can only occur in full percentage point increments and on an annual basis allowing carriers up to 18 months to implement.  Our assumption is that the changes will be relatively infrequent and given the long-time horizon allowed for product updates to occur, Lincoln anticipates making dynamic adjustments as needed.

Do you see any issues regarding policy administration/illustration systems?

Carol:  The interest rate has been static since §7702 was introduced.It will take time for companies to make modifications to both administrative and illustration systems to reflect the issue year based rates.

Do you anticipate any state regulatory (NAIC) involvement on product development or illustrations of accumulation focused products, due to changes to §7702?

Carol:  I am not aware of any involvement.  In coordination with the §7702 changes, the nonforfeiture rate for 2021 was reduced from 4.00% to 3.75% with a mandatory effective date of January 1, 2022.  The ACLI has expressed concerns with this timing and is proposing an extension to July 1, 2022.

Windsor wishes to thank Carol Meyer and Josh Durand for their gracious participation and insightful comments concerning the new changes to IRC Section 7702.  Below you will find additional resources for your information and review.  Thanks for joining us!

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Friday, 14 June 2024

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