October 2016

TAX DEVELOPMENTS

IRS Guidance Concerning Use of 2017 CSO Tables under Section 7702

On October 19, the IRS released Notice 2016-63, which provides guidance regarding the applicable mortality tables that are permissible in connection with the “reasonable mortality charge” requirement of IRC § 7702(c)(3)(B)(i).

As background, the actuarial qualification for life insurance under IRC § 7702 mandates the use of reasonable mortality charges. As described in the Notice, the rates are deemed to be reasonable provided that they do not exceed the most recent commissioners’ standard tables prescribed by the NAIC that are permitted to be used in computing reserves for that type of contract under the insurance laws of at least 26 states when the contract was issued.

Effective 1/1/2017, the 2017 Commissioners’ Standard Ordinary mortality and morbidity tables (2017 CSO) will become the prevailing commissioners’ standard tables. Similar to when the 2001 CSO tables succeeded the 1980 CSO tables, the IRS has provided guidance regarding which tables are permissible based on the issue date of a life insurance contract.

  • Issue Dates Through 2008 — 1980 CSO
  • Issue Dates 2005-2019 — 2001 CSO (Note that contracts issued between 1/1/2009 and 12/31/2016 must use this table)
  • Issue Dates 2017 and After — 2017 CSO (Tables will be mandatory as of 1/1/2020)

Noteworthy New Guidance Regarding the Determination of an Issue Date

This Notice provides new guidance stating that if the only change to an existing contract is a reduction or deletion of benefits provided under the contract, such a change will not affect the determination of the issue date of a contract for purposes of the reasonable mortality charge safe harbor. Below is an excerpt providing the rationale for this position:

This modification is consistent with the treatment of a decrease in benefits for purposes of § 7702A. The legislative history of § 7702A states that a decrease in future benefits under a contract is not considered a material change, which would result in the contract being treated as a new contract subject to new testing as of the date of the material change. H.R. Rep. No. 100-1104, at 101 (1988) (Conf. Rep.), 1988-3 C.B. 591; cf. § 7702(f)(7) (reduction in future benefits is an event requiring appropriate adjustments of determinations under § 7702).

This guidance is quite distinct from previous guidance in Notice 2006-95, which included “an increase or decrease in death benefit (whether or not the change is underwritten)” in the list of items that must be done pursuant to the terms of the contract. In a Private Letter Ruling released in July 2012, the IRS ruled that face amount reductions that were not explicitly addressed in the contracts would trigger a new Issue Date for purposes of this rule.

It now appears that policyholders may request face amount reductions regardless of whether such a right is explicitly addressed in the terms of the contract.

 

ACCOUNTING DEVELOPMENTS

FASB Proposed Accounting Standards Update – Targeted Improvements to the Accounting for Long-Duration Contracts

On September 29, FASB released a Proposed Accounting Standards Update (ASU) for Topic 944: Targeted Improvements to the Accounting for Long-Duration Contracts. This project has been underway for several years. The proposed updates apply to issuers of long-duration insurance contracts; not policyholders. We have previously confirmed that this is the applicable accounting regime for non-participating BOLI/COLI contracts.

Key elements of the Proposed ASU include:

  1. Improve the timeliness of recognizing changes in the liability for future policy benefits by requiring that updated assumptions be used to measure the liability for future policy benefits (that is, that assumptions be “unlocked”) and modify the rate used to discount future cash flows. Financial statement users raised concerns about the use of out-of-date or “locked-in” assumptions to calculate the liability for traditional, limited-payment, and participating insurance contracts, as is currently required in generally accepted accounting principles (GAAP).
  2. Simplify and improve the accounting for certain options or guarantees embedded in variable contracts (“market risk benefits”). Financial statement users commented that market risk benefits should be measured on a consistent basis because they share similar risks and economics. Additionally, users and preparers expressed concern with the existing financial reporting disincentive to economically hedge capital market risk exposures arising from market risk benefits currently measured under an insurance accrual model, because the hedging instruments (that is, derivative instruments) are measured at fair value, resulting in earnings volatility not reflective of the economics.
  3. Simplify the amortization of deferred acquisition costs (DAC). The Board received feedback from users and preparers about several issues with the current DAC amortization methods. The currently required estimated gross profit amortization method is complex, requiring numerous inputs and assumptions, and periodic adjustments are challenging to calculate and interpret.
  4. Improve the effectiveness of the required disclosures. Financial statement users provided feedback that current disclosures provide limited decision-useful information. Users expressed an interest in obtaining more information about the exposures of an insurance entity and the drivers of the entity’s results. Users also expressed an interest in better understanding the assumptions used in the measurement of long-duration contract liabilities and changes in those assumptions.

The proposed amendments would apply to in-force contracts. Changes to the liability for future policyholder benefits would be applied retrospectively as of the beginning of the earliest period presented. If that were deemed impracticable, the proposed amendments would be applied to in-force contracts on the basis of their existing carrying amounts at the transition date.

Comments are due December 15, 2016.

 

JUDICIAL DEVELOPMENTS

Florida Supreme Court Upholds STOLI Subsequent to Expiration of Contestability Period

On September 22, the Supreme Court of Florida issued an opinion that upheld the validity of STOLI policies in Florida subsequent to the expiration of the contestability period. Procedurally, the Eleventh Circuit had certified two questions to the Supreme Court of Florida:

  1. Can a party challenge an insurance policy as being void ab initio for lack of the insurable interest required by Fla. Stat. § 627.404 if that challenge is made after expiration of the two-year contestability period mandated by Fla. Stat. § 627.455?
  2. Assuming that a party can do so, does Fla. Stat. § 627.404 require that an individual with the required insurable interest also procure the insurance policy in good faith?

The Supreme Court of Florida, in analyzing the STOLI policies at issue, noted that the insurable interest statute looks to see whether there is an insurable interest at the time it is made and that “The insurable interest need not exist after the inception date of coverage under the contract.” The court determined that all the STOLI policies at issue did in fact satisfy the insurable interest requirement as of the time they were made. The court found that it is irrelevant if the policy is created as a result of a STOLI scheme. The court went on to say that these policies where then subject to the 2-year incontestability statute.

In the end the court changed the certified questions to the following, which it answered in the negative:

Can a party challenge the validity of a life insurance policy after the two-year contestability period established by section 627.455 because of its creation through a STOLI scheme?

 

OTHER DEVELOPMENTS

Society of Actuaries (SOA) Releases New Mortality Projection Scales for Pension Plans

On October 20, the SOA released new mortality projection scales reflecting the most recent mortality improvement data. The new scales have rates of increase in life expectancies that are slower than the prior projections. According to a publication from Pricewaterhouse Coopers, employers using mortality assumptions from the SOA study are likely to have benefit obligations reduce by 1–3%.