G L O B A L S E R V I C E / I N D U S T R Y A U D I T / T A X / A D V I S O R Y / L I N E O F B U S I N E S S

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1 G L O B A L S E R V I C E / I N D U S T R Y Federal Income Tax Regulations Update A U D I T / T A X / A D V I S O R Y / L I N E O F B U S I N E S S Lisa A. Allbritten Tax Managing Director Insurance Tax Specialist Dallas, Texas November 19, 2009 ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. 2 1

2 Federal Income Tax Regulations Overview AG 43 PBR Separate Account DRD COLI Life Settlement Rulings Revisions to SSAP 10 3 G L O B A L S E R V I C E / I N D U S T R Y Tax Issues Associated with Actuarial Guideline 43-VACARVM A U D I T / T A X / A D V I S O R Y / L I N E O F B U S I N E S S 4 2

3 AG 43 Applies to variable deferred annuity contracts subject to CARVM with or without GMDB s or VAGLB s Applies to variable immediate annuity contracts with or without GMDB s or VAGLB s Group annuity contracts not subject to CARVM with guarantees similar to GMDB s or VAGLB s All other products with similar guarantees 5 AG 43 Replaces Guidelines 34 and 39 Approved by NAIC on September 24, 2008 Effective December 31, 2009 for contracts issued on or after January 1, 1981 The reserve is the Standard Scenario Amount (SSA) plus the excess of the Conditional Tail Expectation Amount (CETA) over the SSA. 6 3

4 Standard Scenario Amount Contract by contract calculation Reserve is the greater of cash surrender value or Basic adjusted reserve computed using Initial drop in asset values Projections of future account values (rates of return reduced by asset charges) Prescribed interest rates and mortality Prescribed policyholder behavior and election asssumptions 7 Conditional Tail Expectation Amount Stochastically generated projections based upon future economic scenarios Aggregate calculation (as opposed to seriatim) with reserve allocated to individual contracts Reserve is held at 70 CTE level (average of the worst 30 percent of outcomes) Uses individual and dynamic company assumptions for mortality, interest, and contractholder elections Takes hedging into account 8 4

5 Effects on Statutory Reserving Potential for 3 year grade in period with state approval 9 Tax Issues Associated with AG 43 Deductibility of reserve SSA CTEA Is the CTEA included in the statutory cap? Effective date and what contracts it is applied to 807(f) IRS issued Notice on January 14, 2008 following discussions with industry groups identifying these as issues 10 5

6 SSA Follows a methodology relatively consistent with current actuarial guidance and current tax methodologies Seriatim calculations Defined mortality and interest set at policy issuance Gross premium valuation may be an issue Notice acknowledges that the SSA is consistent with existing reserve methodologies 11 CTEA Utilizes individual company assumptions as to mortality and policyholder behavior Stochastic calculations do not have a defined interest rate, but are based upon multiple scenarios It is calculated in the aggregate and then allocated to individual contracts It is based upon the 30 percent of worst outcomes (but note that AG 33 is based upon greatest PV of all future benefits) It may be viewed as a solvency or deficiency reserve 12 6

7 Effective Date Effective for statutory on December 31, 2009 for contracts issued on or after January 1, 1981 IRS position is that tax reserves are computed using the method (actuarial guideline) in effect on the date the contract is issued Pending controversy over effective date of AG 34 Is AG 34 effective for tax purposes for contracts issued on or after December 31, 2009 or for all contracts issued in 2009? Will need to retain the valuation systems necessary to compute tax reserves under the old methods (f) Issues Provides for a ten year spread of changes in basis of computing tax reserves For contracts issued prior to the effective date (whatever that date is), the tax reserves will continue to be calculated under existing reserve rules, so no change in tax reserve, all other things being equal However, is 807(f) implicated if the total statutory reserve (SSA + CTEA excess) is less than the current tax deductible reserve or if the CTEA is not treated as a statutory reserve for purposes of the cap and the tax reserve becomes capped 14 7

8 Other Issues Auditibility of CTEA Guidance is included on the priority guidance business plan 15 G L O B A L S E R V I C E / I N D U S T R Y Tax Issues Associated with Proposed Life Principles Based Reserves A U D I T / T A X / A D V I S O R Y / L I N E O F B U S I N E S S 16 8

9 PBR Tax Implications Purpose: define the minimum valuation standard under a principles-based approach for individual life insurance policies. Would reserves under Proposed Life PBR constitute life insurance reserves under 816(b)? Prevailing State Assumed Interest Rate: - 807(d)(2)(B): tax reserve determined using greater of AFR or prevailing State Assumed Rate - Does single interest rate mean taxpayers can simply use AFR? - There is a disconnect between tax reserve calculation and Statutory reserves calculation under PBR - 807(d) tax reserves are capped by STAT reserves. Proposed PBR changes likely to decrease tax reserves and resulting deduction. 17 PBR Tax Implications Qualification of contracts as Life Insurance Contracts - Still possible to satisfy 7702(c)(3)(B): ) reasonable mortality charges in the commissioners standard mortality tables in 807(d)(5)? Contract-by-Contract vs. Aggregate Reserves Transition Rules: Application to In-Force Contracts - Does it apply to contracts issued after that date? In force on that t date? Tax Administration - Degree of discretion vested in taxpayers to determine the stochastic reserve could make audit difficult. 18 9

10 G L O B A L S E R V I C E / I N D U S T R Y Tax Issues Associated with Proposed Separate Account Dividends Received Deductions Changes A U D I T / T A X / A D V I S O R Y / L I N E O F B U S I N E S S 19 Separate Account DRD Effective Date: January 1, 2011 Change intended to ensure that the amount of the DRD that is claimed by life insurance companies bears a direct relationship to the companies actual economic interest in the separate accounts. The proposal will revise the proration formula. Currently for separate accounts, the company s share is determined by reducing required interest by fees charged by the insurance company for mortality and expense charges (amounts retained) and assuming that these charges have been retained solely from investment income. The characterization of expense charges as amounts retained from investment income can greatly affect the company s share and resulting DRD. Amounts retained by the company must now be treated as funded proportionately by items included in net investment income & items that are not in the required interest computation. Thus not all amounts retained would be included in expense charges that reduce required interest. Change will produce the company share in relation to the separate account that more accurately approximates the ratio of the mean of the surplus attributable to the account to the mean of the account s assets. The proposal will likely have the result of effectively eliminating or drastically limiting the SADRD for most insurance companies

11 G L O B A L S E R V I C E / I N D U S T R Y Tax Issues Associated with COLI A U D I T / T A X / A D V I S O R Y / L I N E O F B U S I N E S S 21 COLI Proposal: repeals the exception from the pro-rata rata interest expense disallowance rule for contracts covering employees, officers, directors, other than 20% owners of a business that is the owner or beneficiary of the contracts. Applies to contracts issued after date of enactment. Limits the ability to deduct interest expense allocable to tax-free inside buildup on life insurance contracts

12 G L O B A L S E R V I C E / I N D U S T R Y Tax Issues Associated with Life Settlement Rulings A U D I T / T A X / A D V I S O R Y / L I N E O F B U S I N E S S 23 Information Reporting for Sales of Life Insurance Contracts The proposal would require a person or entity who purchases an interest in an existing life insurance contract with a death benefit equal to or exceeding $1 million to report the purchase price, the buyer's and seller's taxpayer identification numbers (TINs), and the issuer and policy number to the IRS, to the insurance company that issued the policy, and to the seller. The proposal also would modify the transfer-for-value rule to ensure that exceptions to that rule would not apply to buyers of policies. Upon the payment of any policy benefits to the buyer, the insurance company would be required to report the gross benefit payment, the buyer's TIN, and the insurance company's estimate of the buyer's basis to the IRS and to the payee. The proposal would apply to sales or assignment of interests in life insurance policies and payments of death benefits for taxable years beginning after December 31,

13 Rev. Rul Issue: Amount and character of income recognized upon the sale of a life insurance contract to an unrelated 3 rd party. To determine gain on sale, taxpayer must reduce basis by that portion of the premium paid for the contract that was expended for the provision of insurance before the sale. Continuing insurance protection is part of the consideration for the contract. A portion of the premiums paid for annual insurance protection has been used at the time of the sale & must be subtracted from basis to arrive at adjusted basis at time of sale. A portion of the gain will be characterized as ordinary income due to the substitute for ordinary income doctrine. 25 Rev. Rul Issue: Tax consequences to the buyer of a life insurance contract for profit for which he has no insurable interest upon receiving the death benefits. Buyer recognizes a gain equal to the death benefits over the basis in the contract (equal to the amount paid plus any premiums paid since the sale to keep the contract from lapsing. Any gain will be ordinary in nature

14 G L O B A L S E R V I C E / I N D U S T R Y Tax Issues Associated with Proposed Revisions to SSAP 10 A U D I T / T A X / A D V I S O R Y / L I N E O F B U S I N E S S 27 SSAP 10 Proposed Changes: 1. 1-year reversal limit under paragraphs 10(a) & 10(b) would be expanded to: - 3-year limit % Surplus Limitation under 10(b) raised to 15% 3. Additional Disclosures Required 28 14

15 SSAP 10 Qualifications: Must be either: 1. RBC above trend-test test threshold (if subject to it), or 2. Above the maximum risk-based capital level where an action level could occur: a) 300% for P&C & Health b) 250% for Life Effective dates: 2009 annual, 2010 interim & annual reporting Tax Considerations for Actuaries 29 15