In this post, I am going to discuss the recent tax law changes to Section 7702. My goal is to make you aware of the recent changes to the law and how these changes may potentially benefit the owners of Maximum Over-funded Life Insurance policies. I’m going to explain the changes, the reason behind the changes, the impact on life insurance in general and, more specifically, the impact on the Maximum Over-funded policies that we use for The Double Play.
What Changed?
The Consolidated Appropriations Act, was passed just before the end of 2020. The Act contained a change to the definition of life insurance contracts. The Act changed the minimum interest rate assumptions used in calculating the premium limits under sections 7702 and 7702A of the Internal Revenue Code. This rate had been set at 4% since 1984 when interest rates were much higher.
The Act changed this rate from 4% to 2% and also allows for the rates to be changed as often as once per year.
The Rules only impact policies issued after January 1st, 2021. Existing policies inforce will not be impacted.
Why Did It Change?
The Guaranteed rates used in determining life insurance premiums and funding limits had been fixed at 4% since 1984.[1] The Moody’s Corporate Bond Yield in 1984 was well over 10%. At that time, the Guaranteed rate must have looked like a very easy hurdle to overcome. You should understand that many years of double-digit growth on their reserves, while only guaranteeing 4%, meant that the life insurance companies had built up more than sufficient reserves to handle claims and surrenders.
Now imagine how life insurance company executives must be sweating today. They are guaranteeing 4% performance while the yield on the Moody’s Corporate Bond Yield has dropped well below 4%! The current rates are simply unsustainable. Insurance company reserves will be whittled away because the reserves will eventually become insufficient to meet claims and surrenders. I personally had been wondering how the industry can afford to pay 5 and 6 percent dividends while the new money they have been investing is earning less than 4%. It seemed unsustainable to me.
The industry must have been working overtime to lobby Congress to make changes to the law to prevent a potential financial collapse. In the next section, I’ll look at how the changes impact permanent life insurance.
Understanding The 7702 Interest Rates
To understand the impact of these rate changes on Permanent Life Insurance, it is important to have a good grasp of how permanent life insurance works.[2] Permanent Life Insurance is not like Car Insurance. The Life Insurance Company KNOWS it will have to pay a claim some day. The auto insurer only faces a risk that their policy owner will get into an accident.
To compensate for this certainty, the insurance company collects enough in premium for the policy owner to essentially save up the death benefit for the insured over the natural life expectancy of the insured. The blue line in the graph below shows the cash accumulation in a policy with a $1 Million dollar death benefit for a 45-Year old. The Orange line represents the $1 Million dollar death benefit. You can see that the cash value grows and eventually reaches the death benefit at around 113 years of age.
The main expense in a life insurance policy is the cost of covering the gap between the death benefit and the cash value. Notice the large gap between the death benefit and the cash value at Age 45 in the graph above. The risk of a 45 year old not making it to 46 is very low so the cost of insurance is very low even while the amount at risk is very high.
Later, as the cash value accumulates, the net amount at risk goes down while the cost of insurance goes up. The risk of a 79 Year old not making it to Age 80 is much higher than for a 45-Year old. Notice also that by Age 79 the cash value has grown to about $500,000. That means there is still another $500,000 at risk to the insurance company. So even as the cost of insurance is going up, the net amount at risk is going down. Because the rising cost of insurance is offset by the cash value narrowing the gap, the total cost is easily absorbed by the cash value.
Now if the gap was much wider, the cost of insurance may cannibalize the cash value. The following graph shows what would happen if the growth was less than what was used to determine the premium:
In this example, the cash value grows more slowly as illustrated by the darker blue line. You can see that the cash value growth is insufficient to keep up with the rising cost of insurance and the net amount at risk. The company has insufficient reserves to meet its liabilities. As interest rates dropped below 4%, this is the position that insurance companies found themselves in during the last few years.
If the gap was much narrower, it means that too much premium was collected. Think of the opportunity cost of potential clients that may not have purchased because the premiums were too high. The following graph shows what happens when insurance companies earn more than the rate used to determine the premium:
In this example, the cash value grows much more quickly, as illustrated by the dark blue line. There is more than enough cash value for the insurance company to meet its obligations. And until interest rates dropped below 4%, this is the position that the insurance companies had been in since 1984.
Insurance companies use the Statutorily-defined growth rates in Section 7702 to determine how much premium they need to collect. This rate NEEDS to be as high or higher than the rate of growth on the underlying assets into which the insurance company invests.
By lowering the interest rate from 4% to 2% and allowing for periodic changes in the rates, Congress has essentially saved the Insurance Industry. The low interest rate was causing companies to bleed reserves.[3]
Impact On The Life Insurance Industry
In my most recent blog post, Why Does IUL Have Such A Bad Rap?, I explained how the problem with Universal Life during the 1980s and 1990s was that policy owners underfunded the policies because they were counting on higher interest rates. When interest rates drop, the policies need more premium in order to compensate for the lower growth. The policy’s cash value must stay on the trajectory defined by the blue line in this graph:
The bottom line is that prices for Minimally-funded Life Insurance policies (Most policies!) is going to go up. The policies require more premium in order to compensate for the lower growth assumption.
What Does This Mean for Maximum Over-funded Policies?
Because the lower actuarial growth rate now requires more premium, maximum over-funded policies will be simply buying less death benefit for the same premium dollars. If we assume that there is some statutorily-defined minimum death benefit for every dollar of premium (or cash value), then the policies will be purchasing less death benefit for the same premium. This means that there really shouldn’t be any difference in funding after the rule change. The only thing that should be expected to change is the amount of death benefit protection. You should find that the death benefits are dramatically reduced.
One benefit for policy owners may be that they can simply put more dollars into a policy. For example, a typical rule of thumb is that the death benefit should not be more than 20 times the insured’s income. This would allow the beneficiary to purchase an annuity that would replace the insured’s salary. If the policy owner’s funding had been limited by this underwriting requirement, the new rules will allow for nearly twice as much premium to reach the same death benefit. This means that the policy owner will be able to stuff more cash into the policy.
I Told You So
I devoted a recent blog post to the issue of life insurance company guarantees.[4] I have long argued that life insurance company guarantees are meaningless from a consumer standpoint. The guaranteed rate is used for pricing and determining reserve requirements. The State Regulators use these rates to determine if they Insurance Companies are maintaining adequate reserves. The insurance company expects to earn far in excess of the Guaranteed Rate. Or at least they did until recently!
My position is that you should purchase a policy simply understanding what the insurance company is doing with the cash value. If the reserves are invested in the bond market, you should expect bond market type performance. Universal Life policies typically come with much lower guarantees than Whole Life. But despite the guarantees, you should expect that the dividend crediting rate on a Whole Life is very much the same as the interest crediting rate on a Universal Life.[5] The insurance company’s reserves are essentially invested in the same underlying assets.
An insurance company offering only Universal Life products with a 2% guarantee in today interest rate environment is going to be much healthier than a company offering only Whole Life with a 4% guarantee while interest rates remain below 4%. Their reserves will be depleted by the high cost of claims and surrenders. I have long stated that insurance companies do not have a secret stash of money from which they can pay the guaranteed rates. You are finding now that insurance companies want the rules changed now that rates have dropped.
Conclusion
Understand that the main reason for the 7702 to change was to save the life insurance industry. Interest rates below 4% meant that insurance company reserves were being depleted because they can’t afford to pay 4% when they are only earning 2.6%. Because the change increased the cost of death benefit protection, maximum over-funded policies will likely see significant death benefit reductions. The change should not impact the ratio of cash value to premium in new policies.
[1] Read THIS and THIS for more information on how the guaranteed rate is used in pricing and funding policies.
[2] Read Life Insurance 101 for a much more detailed look at the inner workings of a life insurance policy.
[3] You may notice that this is almost exactly the same problem that I discussed in my last Blog Post: Why Does IUL Have Such A Bad Rap? We’ll see how cocky all the Whole Life diehards are now that their product of choice had to be saved by Congress.
[4] Read Do Life Insurance Guarantees Really Matter?
[5] Dividend crediting rates and interest crediting rates are not apples-to-apples. Interest crediting on a UL is typically applied to the entire base of cash value whereas the dividend crediting on a whole life is only applied to the Guaranteed cash value. The same dollar amount could have two different rates. The rate on a Whole Life would be higher because the dividend is a higher percentage of the guaranteed base.
