As of 09/30/2020
The Consolidated Appropriations Act, 2021 (the “Act”), which was enacted at the end of 2020 to fund the federal government, contained a change to the definition of life insurance contracts that will have a significant impact on the life insurance industry. More specifically, the Act changed the minimum statutory interest rate assumptions used in calculating the premium limits under sections 7702 and 7702A of the Internal Revenue Code from fixed rates to allow the rates used for new policies to change as often as once per year, along with a change to the rates for 2021.
Sections 7702 and 7702A
Section 7702 of the Internal Revenue Code (the “Code”) provides two tests that are used to determine whether a contract is treated as life insurance for income tax purposes.
- The Cash Value Accumulation Test (“CVAT”) requires that the cash value of a contract not exceed certain thresholds, which are determined relative to the face amount of the contract.
- The Guideline Premium Test (“GPT”) requires that premiums paid for the contract not exceed the limit determined under the statute.
Each of the tests under section 7702 utilize a defined interest rate assumption to calculate the target limits for cash value and premiums. The statutory rates were originally established at the time section 7702 was enacted, in 1984, and had not been changed since the inception of the law.
Section 7702A provides a test to determine whether a life insurance contract has too much investment orientation. This test, called the “7-pay” test, limits the amount of premiums that can be paid into a contract during the first 7 years after issue (this 7-year period may restart during the life of the contract under certain circumstances). If a policyholder pays premium in excess of the 7-pay limit, the contract will nonetheless retain its status as a life insurance contract if limits under 7702 are not exceeded. However, any distributions from the contract, including policy loans, will be treated first as distributions of income from the contract and taxable, and also potentially subject to a 10% additional tax.
New rates under sections 7702 and 7702A
The Act changed the minimum interest rates used in the calculations under 7702 that apply for contracts issued after December 31, 2020. For any contracts issued in 2021, the statutory rates are:
- 2% for CVAT and guideline level premium calculations; and
- 4% for guideline single premium calculations.
The Act did not explicitly amend section 7702A, but because the 7-pay test utilizes the same rate as the CVAT, the rate used for calculating the 7-pay premium will change from 4% to 2% under the new rules.
The new lower rates are effective for contracts issued on or after January 1, 2021. Contracts that were issued prior to 2021 are not impacted unless such a contract is exchanged for a new contract.
The Act also provides rules for determining changes to the statutory interest rates in years after 2021. These changes will generally be triggered by changes to the valuation interest rate for life insurance with guaranteed durations of more than 20 years, as that rate is defined in the NAIC Standard Valuation Law.
In general, the change to lower interest rates in the various calculations under sections 7702 and 7702A will result in increased funding limits for life insurance contracts. Premium limits calculated under the GPT and the 7-pay test will increase, in some cases substantially, over the limits calculated for similar contracts under the prior, higher interest rates. Similarly, using a lower interest rate to calculate the net single premium (“NSP”) for the CVAT will result in higher approved cash values relative to the face amount of a contract.
Insurers across the industry will have to determine whether to update existing life insurance products to conform the calculation of limits under sections 7702 and 7702 to utilize the new rates. Since calculations completed using the old rates will produce guideline, 7-pay and NSP limits that are more conservative than under the new rates, contracts issued based on the old rates will continue to comply with 7702 and 7702A going forward.
Lincoln is currently working to update our life insurance products, including product illustrations and administration, to take into account the new, lower interest rates in the calculations under sections 7702 and 7702A.
The following products launched with updated premium limits under sections 7702 and 7002A:
- February 2021: Lincoln VULONE (2021 ), SVULONE (2021), and MoneyGuard Market Advantage®
- May 2021: Lincoln WealthAccumulate® 2 IUL and Lincoln WealthPreserve® 2 IUL
- June 2021: Lincoln MoneyGuard® III (2021), Lincoln MoneyGuard® II (2020) – 06/14/21 and Lincoln MoneyGuard® II NY – 06/14/21
Until 7702 rates are updated on administration and illustration systems, Lincoln will enforce the 7702 limits as currently calculated. Requests for additional premiums above currently calculated limits will not be accommodated. Nonetheless, any products issued in 2021 but prior to the date that our products are fully updated will still comply with the requirements under sections 7702 and 7702A since calculations completed using the old rates are more conservative than under the new rates.
Additional Coronavirus legislation and relief is likely to be forthcoming from the 117th Congress later in 2021, so more to come.