The insurance industry will continue to feel the effects of various developments that took place in the past year. Low interest rates will impact insurers, in-force policies and new product pricing. Revised reserving rules on no-lapse policies may cause insurers to abandon the no-lapse market altogether. In addition, some court cases dealt with the issue of phantom income from a lapsed life insurance policy and a private letter ruling clarified what happens when an insurance policy is sold from one trust to another. Here’s an overview of this year’s significant events.
Sustained Low Interest Rates
The Federal Reserve has announced plans to keep short-term interest rates very low through 2015. What’s the impact of low interest rates on insurers, in-force policies and new product pricing?
Policyholders and insureds can expect continued downward pressure on insurers’ general portfolio accounts that consist primarily of long-term bonds. This will result in insurers continuing to reduce their universal life (UL) crediting rates and whole life dividend interest rates. Lower portfolio yields may also translate into lower cap rates on indexed UL policies and increase the price for new no-lapse or secondary guarantee universal life (SGUL) policies (which are also facing pending changes to reserving rules, discussed later).
Bond interest rates have been declining for more than three decades. The current dilemma for insurers is that new money bond rates are probably at least 125 basis points below their overall general portfolio account yields. This creates yield compression on the insurer’s profits.
For UL products, existing policyholders must anticipate that future crediting rate reductions will require additional premiums and/or reduce the policy death benefit. New purchasers must be prepared for an initial period of annual crediting rate reductions. Bottom line: Fund the policy conservatively to offset the anticipated initial reductions in the policy crediting rate. Even if rates spike in 2015, policyholders won’t see an immediate uptick in crediting rates on existing policies, and they may be incentivized to swap the policy for a new UL policy that can immediately offer a higher initial crediting rate.
No-lapse guarantee UL policyholders are somewhat insulated from the downward trend in interest rates. Since no-lapse premiums are guaranteed, and these policies have anemic cash value, which limits their exchange potential, the biggest consumer risk is in the insurer’s long-term financial strength. When current insurer portfolio yields are below the insurer’s guaranteed pricing assumptions made when the policy was issued, the insurer will be required to post higher reserves to this business line, which adversely impacts its overall earnings and surplus. New policies will be more expensive, or the insurer may even decide to suspend issuing new no-lapse policies.
For indexed UL policies, if an insurer’s general account portfolio yield continues to decline, but its cost to purchase a call option spread on the relevant equity index remains the same, the insurer would likely need to reduce the cap rate for the equity index account. If the general account yield declines and the insurer’s cost of the call option spread also drops, the insurer may be able to retain its current cap rate. Remember, on these policies, the carrier retains the right to change the overall interest crediting rate, which includes the cap rate and other levers.
Higher Reserves on No-lapse Policies
The National Association of Insurance Commissioners (NAIC) plans to introduce revised reserving rules for insurers, effective Jan. 1, 2013, on no-lapse or SGUL products. The NAIC believes the latest round of revisions to so-called AG 38 reserving will effectively preclude insurers from using multiple shadow accounts to reduce the formula for minimum statutory reserves on SGUL products.
In-force vs. new policies. The NAIC revisions will differentiate between current (in-force) SGUL policies and new SGUL policies:
Current in-force policies (July 1, 2005 through Dec. 31, 2012). For in-force SGUL policies, insurers will be required to perform a reserve calculation based on more conservative cost of insurance assumptions, to confirm to state regulators that existing reserves are sufficient to offset future insurer liabilities to policyholders. If not sufficient, the affected insurer will be required to set aside additional reserves for these SGUL policies. Each insurer will be impacted differently. (Because the insurer can’t change the premiums on an existing SGUL policy, the insurer—not the policyholder—will be responsible for funding any increased reserve amount required on an existing SGUL policy).
Affected insurers have been hoping to limit the look-back period (that is, the retroactive effective date) for these new reserving rules. Some insurers have urged the NAIC to adopt a 2007 effective look-back date or, perhaps, 2005. One state regulator suggested a 2003 look-back date.
New policies (Jan. 1, 2013 and later). The revised AG 38 reserving requirements for all SGUL policies issued after Jan. 1, 2013 will result in moderate-to-large premium increases imposed by all insurers issuing new SGUL policies. Term contracts and UL products without meaningful secondary death benefit guarantees shouldn’t be affected.
Impact. The revised rules will impact insurers and policyholders:
Insurers. Some insurers may decide to abandon the SGUL marketplace altogether or, at least, suspend writing new SGUL business until they can design new SGUL products that incorporate markedly higher reserves. Prompted by consumer demand for SGUL products, insurers will enter and exit the SGUL marketplace.
Already, some insurers with a longstanding presence in the SGUL marketplace have offered up alternative UL products with a “life expectancy” guarantee, which offers policyholders lower premiums in exchange for lower reserve requirements for insurers, because the guarantee period is shorter (that is, not for life). However, the insured ultimately bears the potential risk of future premium inadequacy in a life expectancy guarantee product if he should outlive the selected guarantee period and there’s then insufficient cash value to sustain the policy for the balance of the insured’s life.
Policyholders. SGUL policyholders should be relatively insulated from mandatory higher reserves. The greatest risk to policyholders is that to the insurer’s overall financial strength. Posting higher reserves on in-force business will impact an insurer’s earnings and surplus. The most prudent approach for policyholders and fiduciaries is to diversify SGUL coverage across a number of top-rated insurers.
In two cases, Brown v. Commissioner1 and Feder v. Comm’r,2 the courts ruled that the lapse of a life insurance policy created phantom income. As the court noted in Brown:
Under Code Sec. 72(e)(6), a taxpayer’s net investment in the insurance contract is the sum of all premiums that the policyholder paid minus any amounts he received before he surrendered the policy upon its cancellation by the insurance company or by his own choice.
A simple way to calculate whether there’s any gain in a policy is to total all the premiums that were paid either in cash or by loan. (The payment or accrual of loan interest isn’t part of basis.) Total the cash surrender value at the time of the lapse, disregarding any loans. Add to that the sum of all dividends that were received, but weren’t reflected in the policy’s surrender value. If the sum of the cash surrender value and dividends received are greater than the premiums paid, the policy has a gain that becomes taxable either on surrender or policy lapse.
Example: X owned a policy on his life. The sum of the premiums paid or loaned was $250,000. The total cash value plus any dividends separately received was $300,000. Because of the amount of the loans and accrued interest, the policy lapsed. X has a taxable gain of $50,000, even though X received nothing when the policy lapsed.
Sale from One Trust to Another
A grantor who sets up an irrevocable life insurance trust (ILIT) may want to move the policy by selling it to another ILIT with provisions more to the grantor’s liking. For this strategy to be effective, the practitioner must address three important issues:
• Is the new trust a grantor trust?
• Does the sale of the policy to the new trust create a transfer-for-value income tax issue?
• Are the death proceeds includible in the grantor’s estate under either Internal Revenue Code Sec-
tion 2042 or IRC Sections 2033, 2036 or 2038?
In Private Letter Ruling 201235006 (Aug. 31, 2012), the IRS ruled in favor of the taxpayers on the above issues.
1. Grantor trust. Whether the new trust is a grantor trust directly bears on whether there’s a transfer for value. In ruling on the issue, the IRS said that the trust was a grantor trust, because of a provision in the trust to allow the grantor to reacquire trust property in a non-fiduciary capacity by substituting other property of an equivalent value under IRC Section 675(4). Further, the IRS added that: “ . . . it is a grantor trust in its entirety with respect to Taxpayer notwithstanding the withdrawal rights held by the beneficiaries that would otherwise make them owners under § 678(a).”
2. Transfer for value. If there’s a transfer for value, there will be income tax on the death benefit in excess of premiums paid. The PLR cites IRC Section 101(a)(2)(B), which lists transfers that would be exempt, including a transfer (for income tax purposes) to the insured. Citing Revenue Ruling 2007-13, 2007-11 C.B. 684, which addressed transfers from both grantor and non-grantor trusts to a different grantor trust, the IRS ruled that since the new trust is a grantor trust for income tax purposes, and the grantor is the insured, there’s no transfer for value.
3. Inclusion of policy proceeds in grantor’s estate. Citing Rev. Rul. 2011-28, 2011-48 C.B. 830 and Rev. Rul. 2008-22, 2008-16 C.B. 796, the IRS ruled there was no estate inclusion of the life insurance policy. Rev. Rul. 2011-28 specifically addressed the grantor’s right to substitute for a life insurance policy in a non-fiduciary capacity under IRC Section 2042, while Rev. Rul. 2008-22 addressed the general issue of substituting property under IRC Sections 2036 and 2038.
An important point to note: The sales price was determined using a formula in IRC Section 25.2512-6(a) and, therefore, met the equal value criteria for substitution.3
Long-term Care Rider on Policy
One of the new things to come along in the long-term care (LTC) insurance field is a rider to a life insurance or annuity policy that provides for LTC payments if the insured meets the qualification criteria. The advantage of the rider is that it can’t be canceled—the cost can’t change. The continuing rate increases in traditional LTC policies have added to the attractiveness of having the LTC rider on a life insurance or annuity policy. The other advantage is that if the rider isn’t used and the insured dies, the death benefit payable is greater than the premiums paid. Regular LTC policies don’t have that feature.
In PLR 201213016 (March 30, 2012), the IRS cited IRC Section 7702B(b) in determining that the rider was insurance. The PLR stated that, under IRC Section 104(a)(3), the rider was treated as a separate qualified LTC contract, and benefits paid would be excludible from gross income.
1. Brown v. Commissioner, 110 A.F.T.R.2d, 2012-5265.
2. Feder v. Comm’r, T.C. Memo. 2012-10.
3. See also Richard Harris, “Substituting a Life Insurance Policy in an Irrevocable Trust,” Trusts & Estates (April 2012) at p. 54.