The Internal Revenue Service (IRS) Large Business and International (LB&I) division recently released an Industry Director’s Directive (IDD) that provides key guidance for life insurers.1 The IDD is the product of a two-year Industry Issue Resolution process that brought together representatives of the IRS and the life insurance industry to address the application of principle-based reserving (PBR) to life insurance reserves for tax purposes.2 The IDD protects a life insurer against audit adjustments to life insurance reserves for variable annuity and life insurance contracts if the insurer satisfies the IDD’s elective safe harbor. The IDD applies for all open tax years prior to 2018.
The IDD’s safe harbor is the missing piece of the puzzle regarding the way in which PBR will be taken into account for purposes of computing life insurance reserves for tax purposes for years prior to 2018. For tax years beginning after December 31, 2017, the changes to section 807(d) of the Internal Revenue Code3 promulgated in the Tax Cuts and Jobs Act4 (TCJA) will govern the computation of life insurance reserves for tax purposes.
Background
Tax Reserves
Section 807(d) sets forth rules for computing life insurance reserves for life insurance and annuity contracts. Prior to amendment by the TCJA, section 807(d) provided that the amount of the life insurance reserve for a contract was the greater of (1) the net surrender value of such contract, or (2) the amount of the reserve determined under section 807(d)(2) (Federally Prescribed Reserve). Under section 807(d)(2), the Federally Prescribed Reserve for any contract was determined using (1) the tax reserve method applicable to that type of contract, (2) the greater of the applicable federal interest rate or the prevailing state assumed interest rate, and (3) the prevailing commissioner’s standard tables for morbidity or mortality adjusted as appropriate to reflect the risks, such as substandard risks, incurred under the contract that are not otherwise taken into account. Both before and after the TCJA’s amendments, in no event may the life insurance reserve for any contract exceed the amount taken into account with respect to that contract as of that time in determining statutory reserves (Stat Cap).
Under section 807, the Commissioners’ Annuities Reserve Valuation Method (CARVM) prescribed by the National Association of Insurance Commissioners (NAIC) is the method used to compute life insurance reserves for annuity contracts and the Commissioners’ Reserve Valuation Method (CRVM) prescribed by the NAIC is the method used to compute life insurance reserves for life insurance contracts.5 For tax years prior to 2008, CARVM and CRVM were computed using the methods and assumptions applicable to the contract in effect as of the date the contract was issued. For taxable years beginning after December 31, 2017, CARVM and CRVM apply based on the method applicable to the contract in effect as of the date the reserve is determined.
Changes to Statutory Reserving
CARVM and CRVM are part of the Standard Valuation Law (SVL) developed by the NAIC and adopted by every state in some form. The SVL is interpreted by various model regulations and actuarial guidelines promulgated by the NAIC. The NAIC developed a Valuation Manual to consolidate into one document the minimum reserve requirements for insurance contracts.
Historically, the reserving methodologies promulgated by the NAIC involved fixed formulas with prescribed assumptions that were not based on a company’s experience (i.e., “deterministic” reserves). These formulaic reserves were the basis for the life insurance reserving rules in section 807(d).
In 2009, the NAIC promulgated an updated SVL and Valuation Manual that provide for the use of PBR. The new rules became effective January 1, 2017. In contrast to the computation of deterministic reserves, PBR methodologies include mortality and policyholder behavior assumptions based on a company’s experience. Moreover, multiple scenarios for various assumptions, such as changes to interest rates, are used to compute reserves for contracts on an aggregate basis (i.e., “stochastic” reserves). This process is intended to compute an insurer’s reserves more precisely. The move away from formulaic reserves for statutory accounting purposes raised questions about the application of PBR in a tax context.
Actuarial Guideline XLIII (AG 43) applies both deterministic computations and stochastic computations under PBR to compute reserves for variable annuity contracts as part of CARVM.6 AG 43 was effective December 31, 2009, for variable annuity contracts issued on or after January 1, 1981. AG 43 was incorporated into Part 21 of the NAIC Valuation Manual (VM-21), effective for variable annuity contracts issued on or after January 1, 2017. As part of its method, AG 43 provides for the computation of the Standard Scenario Amount, which is the deterministic reserve computed by applying the standard scenario method as described in AG 43 or VM-21, as applicable. Part 20 of the NAIC Valuation Manual (VM-20) applies both deterministic computations and stochastic computations under PBR to compute reserves for individual life insurance contracts as part of CRVM. VM-20 prescribes the minimum reserve valuation standards for individual life insurance contracts and was effective January 1, 2017.
Prior IRS Guidance
The IRS requested comments on the US federal income tax implications of the implementation of AG 43 and VM-20 in Notice 2008-18.7 The IRS issued interim guidance on some, but not all, of the US federal income tax issues associated with the implementation of AG 43 in Notice 2010-29.8 Under Notice 2010-29, for a variable annuity contract falling within the scope of AG 43 and issued on or after December 31, 2009, the Federally Prescribed Reserve is computed using the method prescribed in AG 43 for determining the Standard Scenario Amount. Additional stochastic computations of the Conditional Tail Expectation Amount under AG 43 could not be taken into account when computing the Federally Prescribed Reserve.
IDD Elective Safe Harbor
The IDD permits the election of a safe harbor method. The IDD distinguishes between variable annuity contracts issued on or after December 31, 2009, the effective date of AG 43, that are subject to either AG 43 or VM-21 (Eligible VA Contracts) and variable annuity contracts issued prior to December 31, 2009, that were subject to AG 39 (Eligible AG 39 VA Contracts).9 The IDD also applies to life insurance contracts issued on or after January 1, 2017, the effective date of VM-20 (Eligible Life Insurance Contracts).
Notwithstanding the IDD’s safe harbor method, under section 807(d) prior to its amendment by the TCJA, the life insurance reserve for a contract for taxable years beginning on or before December 31, 2017, remains the greater of the Federally Prescribed Reserve or the net surrender value of the contract. In addition, the life insurance reserve for a contract for tax purposes continues to be limited by the Stat Cap.
Eligible VA Contracts and Eligible AG 39 VA Contracts
The IDD provides that the Federally Prescribed Reserve for an Eligible VA Contract equals the sum of (1) the tax-adjusted Standard Scenario Amount determined under AG 43 or VM-21, and (2) 96% of the excess, if any, of the “Allocated Conditional Tail Expectation Amount”10 over the Standard Scenario Amount (not tax-adjusted).
Generally, a 10-year spread under section 807(f) is required to implement an adjustment resulting from the IDD’s safe harbor method.11 If a section 807(f) adjustment is required, the IDD provides an insurer with two options to apply the 10-year spread:
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Option 1: The adjustment applies as if the insurer implemented the IDD safe harbor method starting in 2016.12
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Option 2: The adjustment applies as if the insurer implemented the IDD safe harbor method starting in the insurer’s first open tax year, but the cumulative amount of such adjustments for prior years and for 2017 is taken into account on the insurer’s 2017 US federal income tax return.
A comparable methodology applies for Eligible AG 39 VA Contracts.
Eligible Life Insurance Contracts
The IDD provides that the Federally Prescribed Reserve for an Eligible Life Insurance Contract equals the sum of (1) the tax-adjusted “Net Premium Reserve”13 described in VM-20, and (2) 96% of the excess, if any, of the “Allocated Deterministic Reserve/Stochastic Reserve,”14 if any, over the Net Premium Reserve (not tax-adjusted).
If a life insurer implements the IDD for Eligible VA Contracts, it must also implement the IDD for Eligible Life Insurance Contracts.
IDD Procedures
The IDD directs auditors of electing insurers not to challenge life insurance reserves for 2017 computed in conformity with the IDD’s safe harbor method or the amount of any adjustment computed under the IDD and spread over subsequent tax years. The IDD also directs auditors to discontinue any current audit of the Federally Prescribed Reserve for earlier open tax years. Regular audit procedures apply to insurers that do not implement the IDD.
To elect the IDD safe harbor, an insurer must complete, sign and attach a certification statement to its 2017 US federal income tax return. Upon request, an insurer must provide the executed certification within 30 days to the insurer’s auditor. If a member of a consolidated group implements the IDD, all members of the same consolidated group must implement the IDD. For insurers that join in the filing of a consolidated return, auditors may request a separate certification from each insurer.
The IDD makes clear that, for electing insurers, the TCJA’s eight-year transition period for adjusting life insurance reserves takes into account 2017 year-end life insurance reserves as adjusted by the IDD’s safe harbor method. The IDD expressly states that it is not precedential and should not be construed as affecting the operation of any other provision of the Internal Revenue Code. No inferences should be drawn from the IDD that any deduction is allowed for asset adequacy reserves or deficiency reserves.
Conclusion
The IDD provides needed guidance to life insurers that implemented PBR prior to 2018 that will soon file US federal income tax returns for 2017 or may have earlier open tax years.
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1 “IRC Section 807: Large Business and International (LB&I) Directive Related to Principle Based Reserves for Variable Annuity Contracts (AG 43/VM-21) and Life Insurance Contracts (VM-20). LB&I-04-0818-015 (August 24, 2018).
2 For more background on the Industry Issue Resolution process, see Rev. Proc. 2016-19, 2016-13 IRB 497.
3 All section references are to the Internal Revenue Code of 1986.
4 PL 115-97.
5 Section 807(d)(3)(B).
6 Actuarial Guidelines are promulgated by the NAIC as interpretations of the SVL. The NAIC’s Valuation Manual is intended to consolidate into one document the minimum reserve requirements for insurance contracts.
7 2008-5 IRB 363.
8 2010-15 IRB 547.
9 AG 39 is an Actuarial Guideline that preceded the issuance of AG 43.
10 The “Allocated Conditional Tail Expectation Amount” means the amount of the Conditional Tail Expectation Amount (as described in AG 43 or VM-21, as applicable) allocated to an Eligible VA Contract (as described in AG 43 or VM-21, as applicable).
11 The IDD further addresses circumstances in which no adjustment is required.
12 Option 1 must be used if the insurer has a tax year that is not an open year after the earliest open year.
13 The “Net Premium Reserve” means the amount of the net premium reserve for an Eligible Life Insurance Contract as described in VM-20 (reduced by any amounts of deferred and uncollected net premiums).
14 The “Allocated Deterministic Reserve/Stochastic Reserve” means the amount of the deterministic reserve or stochastic reserve that is allocated to an Eligible Life Insurance Contract as described in VM-20.
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