Iowa Actuaries Club

Taxing Topics

February 24, 2005

The 2001 CSO

• General Characteristics– 25 year select and ultimate– Ends at age 121, courtesy of Shigechio Izumi– M/F Composite; M/F NS; M/F SM available – Age 0 Select is the ultimate table

• In part, the new table was a response to a Treasury threat to create a table to replace the 1980 CSO for tax purposes

Comparison of Values

Ratios – 2001/1980 Table Values M F4% NSP 87% 89%6% NSP 82% 85%4% NLP 80% 83%4% 7PP 86% 88%Roughly, definitional limits decrease about13-20% for male values and 11-17% for

female.

Option 2: 4% NLP Ratios

Age 50 values

M F E@95 73% 70%

E@121 (100) 126% 127%This happens because the 2001 Tables

have a long streak of very high mortality at the end

Assumptions for IRR Example• Male insured age 40• 1980 CSO Male; 2001 CSO Male Ultimate

mortality • 105% 2001 CSO Select Male experience;

credited interest at 6.5% or 8%; 6% of premium expense

• Surrender at 65; tax rate 28% (plus 10% for MECs)

Pre-Tax Equivalent Rates 1980 CSO 2001 CSO difference 6.5% SPLGPL/CVC 6.35% 5.80% -.55%CVAT 6.48% 6.28% -.20% -.13% -.48% -.35% 6.5% 7-PayGPL/CVC 6.27% 5.81% -.46%CVAT 6.25% 6.03% -.22% .02% -.22% -.24%

Pre Tax Equivalent Rates 1980 CSO 2001 CSO difference 8% SPLGPL/CVC 8.53% 8.15% -.38%CVAT 8.39% 8.19% -.20% .14% -.04% -.18% 8% 7-PayGPL/CVC 8.33% 7.99% -.34%CVAT 8.14% 7.91% -.23% .19% .08% -.11%

Notice 2004-61

• Issued 10/12/2004; 2001 CSO became prevailing in mid 2004

• Notice 88-128 remains, but is modified– 1980 CSO safe harbor remains thru 2008– Reasonable mortality cannot exceed

contract guarantee– Contract must be issued in a state that

permits or requires 1980 CSO based values – Some concern the new restriction by

guarantees may be retroactive

New Safe Harbor

• 2001 Tables are deemed reasonable for §7702• Contracts issued after 2008, or before 2009 in

a state that permits or requires 2001 CSO values

• Mortality cannot exceed contract guarantee• Unisex blends allowed where state permits

them; must use for both males and females• Smoker/nonsmoker tables allowed where

state permits, provided used for nonsmokers as well as smokers

Issue Date Rules

What modifications cause a contract to be treated as a new contract?– Exchange creates a new contract with a new

issue date– A transaction is not deemed an exchange if

basic terms (DB, premium, guarantees) are unchanged

– A change pursuant to terms of the contract does not create a new contract if state allows use of the old table and the old form continues in force

Issue Date Rules (contd.)

• Addition or deletion of a rider, increase or decrease of death benefit (if not underwritten), and option switching are changes to which the above rules apply

• The underwriting provision is controversial: how much is too much? Do we want clarification?

Points not Covered

• No mention of multi-life contracts, substandard issues, or contracts lingering beyond the insured’s age 100

• Note 7702(e)(1)(B) deems the contract to mature between ages 95 and 100. What are the future benefits in a contract deemed to have matured in the past? Do CVAT contracts have a problem?

Rev Rul 2005-6: QAB Charges• Notice 88-128 allowed mortality charges

up to 1980 CSO level without regard to contract guarantees or actual charges

• Expense charges are more limited – reasonable if not materially different from amounts actually expected to be paid

7702 GPL Rules

• GPL is with respect to “future benefits”• Defined as death and endowment

benefits• Charges for QABs are treated as future

benefits• The above seems to have led some

people to conclude that all QAB charges are treated as mortality charges. Others restricted this to charges for term riders.

IRS Position

• PLRs waived mortality treatment of QAB charges as a reasonable error under 7702(f)(8)

• See PLR 200227036 or 200320020

• Rev Rul 2005-6 is the formal announcement of the IRS position.

The Logic

• For CVAT, QAB charges are “other charges” by statute (§7702(b)(2)(B))

• This carries over to 7-Pay calculations due to §7702A(c)(1)(B)

• IRS sees no reason to treat QAB charges differently for GPL/CVC contracts and held they are to be treated as expense charges.

• Effective date 2/7/2005

3 Alternatives to fix the error• If no contracts fail 7702, you can fix your

administration system to do it right• If failures have been created, the issuer can

apply for a closing agreement by 2/7/2006– Identify all contracts on the errant system; do

not identify resulting flunks or MECs– Identified contracts will not be treated as flunks

or MECs and existing accounting can be continued and applied to new or increased QABs to which the policyholder has a right as of 4/8/2005

The Cost

• There is a filing fee ($6,000) and a special charge based on the number of contracts on the errant system. ($1,500 for less than 20; $50,000 for more than 10,000)

• Note you can avoid the cost of fixing your system by doing this. This was the reason a group of companies pushed for IRS to offer this relief.

After 2/7/2006 …

• Closing agreements will have to identify MECs and flunks, and the contracts will have to be brought into compliance.

• The closing agreement must require the system be fixed

• It appears the fee will be the same as for a pre 2/7/2006 filing-based on number of contracts, not inside buildup

Rev Rul 2003-95

• Demonstrates operation of the force-out rules of 7702(f)(7)(B)-(E)

• In the real world, these rules have little application– It is all but impossible to get a force-out in

the first 5 years without making the contract a MEC

– It can be done in years 6-15, but the 7702(d) corridor applicable then will create little tax

So, Why Talk About It?

• In doing its examples, IRS used attained age layering to do reduction computations in the Guideline Premium Test

• Layering has unfortunate consequences, and clever actuaries have devised alternative calculation methods.

• If your company is using some other method, you might want to consider changing to attained age layering.