SOA 2011 Annual Meeting & Exhibit Oct. 16-19, 2011 Session 123 TS, Current Developments in Life Insurance Federal Income Tax Moderator: Christian J. DesRochers, FSA, MAAA Presenters: John T. Adney Christian J. DesRochers, FSA, MAAA Art Schneider J. Howard Stecker Primary Competency External Forces & Industry Knowledge
SESSION 123: CURRENT DEVELOPMENTS IN LIFE INSURANCE FEDERAL INCOME TAX Presenters: Christian DesRochers, E&Y LLP John Adney, Davis & Harman LLP Art Schneider, Aegon USA Howard Stecker, E&Y LLP Life Insurance Tax Issues Policyholder Tax Contingent Annuities Annuity-LTC Riders Partial Annuitization and Exchanges Definition of Cash Value Company Tax Actuarial Guidelines Variable Annuity Reserves IIR and Variable Annuity Hedging 2 1
Life Insurance Tax Issues, cont. Company Tax (continued) IIR and Bad Debts Implications of PBR Administration Legislative Proposals DRD Life Settlements COLI Implications of FATCA Deferred Tax: SSAP 101 3 Policyholder Tax: Contingent Annuities Living benefit guarantee wrapped around a mutual fund, rather than a variable annuity Tax issues: Treatment of the benefit payments under the IRC Effect on the mutual fund shareholder Insurance company tax treatment 4 2
Policyholder Tax: Contingent Annuities, cont. The IRS has issued a series of letter rulings, concluding: CA is an annuity under the Code Fees are investment in the contract under section 72 Benefits are taxable under an exclusion ratio, based on benefits and fees Coverage does not adversely affect the underlying investment account CA is not insurance for investment losses 5 Policyholder Tax: LTC-Annuity LTC-Annuity combination Access annuity cash value to provide LTC benefits Section 7702B Requires that LTC coverage is an insurance contract Provides for separate contract treatment Taxed as an A&H benefit (payments not taxed) Effect on annuity basis 6 3
Policyholder Tax: LTC-Annuity, cont. Permissible Designs Tail-risk design PLR 201105001 Coinsurance design PLR 200919011 Notice 2011-68 Reaffirmed IRS view of aspects of basis and 7.7% DAC Requested comments on immediate annuities, definition of insurance, and partial exchanges 7 Policyholder Tax: Partial Annuitization Small Business Jobs Act (9/27/2010) amended Section 72(a) to allow for partial annuitization of life insurance and non-qualified deferred annuities Payout must be for 10+ years or life contingent Effective 1/1/2011 Treatment under Section 72(a)(2) Annuitized portion is treated as a separate contract Pro-rata allocation of investment in the contract between annuitized and deferred portions Separate annuity starting date is determined See Feb. 2011 Taxing Times article 8 4
Policyholder Tax: Partial Exchanges Partial exchanges of nonqualified annuity contracts are addressed in Revenue Procedure 2011-38 Tax-free partial exchanges allowed since Conway Rev. Proc. 2008-42, concerned with abuse of LIFO rule, provided safe harbors After 2010 law, need to harmonize partial exchange rules with new partial annuitization rules New Rev. Proc. modified and superseded Rev. Proc. 2008-42 9 Policyholder Tax: Partial Exchanges, cont. Under Rev. Proc. 2011-38: Partial exchange respected as completely tax-free if no distribution from either contract within 180 days (previously 12 months; other prior safe harbors eliminated) Exception for partial annuitization If distribution within 180 days, treated as Section 1031 boot or Section 72(e) LIFO income (previously had disqualified exchange) Effective 10/24/2011; Rev. Proc. 2008-42 applies before then, with clarification 10 5
Policyholder Tax: Definition of Cash Value under Section 7702 What amounts are treated as cash surrender value under the CVAT and Section 7702(d) corridor? Return of premium benefits? Chronic and terminal illness benefits? Premium stabilization funds? Stable value provisions? 4 private letter rulings address the issue PLR 200521009 (waiver request) PLR 200528018 (waiver request) PLR 200745006 PLR 200901028 (waiver request) 11 Policyholder Tax: Definition of Cash Value, cont. Proposed Reg. Sec. 1.7702-2 Issued in Dec. 1991 Broad, comprehensive definition of cash surrender value: all contract benefits except as excluded by regulation (e.g., death benefits) Much of proposed regulation dealt with accelerated death benefits, subsequently addressed (mostly) in Sections 101(g) and 7702B Notice 93-37: regulation will not be effective earlier than the data of final regulations Controversy at 1993 hearing Proposal never finalized 12 6
Policyholder Tax: Definition of Cash Value, cont. Industry complaints Departure from state law 1984 legislative history - and vs. or question on loan values IRS has followed proposed regulation in private rulings, but also has recognized deficiencies Item on 2011-2012 Priority Guidance Plan Expectation that IRS will withdraw proposed regulation and re-issue revised regulation Effect of withdrawal/re-issuance? 13 Company Tax: Actuarial Guidelines Issued by NAIC Life Actuarial Task Force (or LATF, formerly LHATF) Not intended as statutory revisions, but as a guide to applying statute to a specific circumstance Guidelines differ: Temporary and periodically revised Change to a method in a prior guideline Adopt a new method for which there was no prior guidance Codify existing industry practice 14 7
Company Tax: Actuarial Guidelines AG 33 and TAM 200328006 AG 33, effective 12/31/1995, applied interpretation of CARVM to contracts with MGDBs, including contracts issued before that date IRS view in TAM: an actuarial guideline can be applied only to contracts issued after the guideline took effect Based on reading of Section 807(d) legislative history Because AG 33 was not in effect on issue date of pre-1996 contracts, it may not be used in determining their tax reserves 15 Company Tax: American Financial v. US Use of AG 33 for pre-1996 contract issues in litigation in Federal District Court in Ohio Government: New actuarial guidelines change CARVM Reserves using AG 33 before the effective date are not CARVM in effect on the date of issue Hence, no retroactive application Taxpayer: AG 33 is not a change to CARVM Court: AG 33 did not amend the SVL, nor did it change the definition of CARVM Case status 16 8
Company Tax: Variable Annuity Reserves -- Notice 2010-29 Standard Scenario Amount (SSA) under AG 43 is included in life insurance and total reserves SSA is the basis for Federally prescribed reserves For statutory cap, SSA is included in statutory reserves For tax reserves, AG 43 applies to contracts issued on or after December 31, 2009 For a contract issued before December 31, 2009, the method applicable to such contract when issued as prescribed under relevant actuarial guidance in effect before the adoption of AG 43 Excess of amount determined with regard to AG 43 over the amount determined without regard to AG 43 is subject a 10-year spread Notice 2010-29 is a limited safe harbor to allow the SSA as a tax reserve No inference for other issues 17 Company Tax: Variable Annuity Reserves, cont. Treatment of the CTE amount for statutory cap purposes not decided in Notice Federally prescribed reserve for issues before 12/31/2009 AG 39 reserves Based on accumulation of fees Issues on treatment under Section 816 Companies have adopted alternative Federally prescribed reserves for pre-12/31/2009 issues AG 43 applies for tax retroactively to all contracts issued on or after 1/1/1981 An AG applies retroactively only where it does not change a previous interpretation of CARVM AG 39 was intended as a temporary measure and does not apply after its sunset date 18 9
Company Tax: IIR and Variable Annuity Hedging Tax hedge accounting must clearly reflect income through reasonable matching of the timing of income, deductions, gains and losses in the hedging transaction and the item(s) hedged (Treas. Reg. Sec. 1.446-4) Hedging transactions include those entered into primarily to manage the risk of interest rate or price fluctuations with respect to ordinary obligations incurred or to be incurred in the course of a trade or business (Treas. Reg. Sec. 1.1221-2) Reserve deduction/hedging gain mismatch was a major industry issue in year-end 2008 Companies implemented methods of deferring hedge gains Development of a safe harbor methodology based on discussions between industry and IRS 2011-12 Priority Guidance Plan 19 Company Tax: IIR and Bad Debts Tax issues related to bad debts Accrual of interest and discount Availability of a principal write down Character of income: ordinary or capital IIR process has focused on REMIC regular interests accounted for under SSAP 43R, but may cover certain mortgage loans and other receivables that become bad debts 20 10
Company Tax: IIR and Bad Debts Industry goals for discussions with IRS Explicit acknowledgement that insurance companies can qualify for conclusive presumption of worthlessness (Treas. Reg. 1.166-2) Safe harbor that generally allows for book/tax conformity Transition rule that addresses prior years 21 Company Tax: PBR Issues-Tax Rules for Reserves Deduction Deductible life insurance reserves must be for future unaccrued claims Federally prescribed reserve assumptions are based on contract issue date Life insurance company expenses and policyholder dividends are deductible only on an accrual basis No deduction for deficiency reserves 22 11
Company Tax: Implications of PBR Notice 2008-18 identified tax issues related to PBR: Deduction for reserves in excess of expected value Use of company-specific expenses, lapse, and margin assumptions Annual adjustments to assumptions Gross premium method and inclusion of expenses in cash flow assumptions Difficulty in auditing 23 Company Tax: Implications of PBR, cont. Notice 2008-18 positive aspects: No desire for PBR to trigger disqualification as life insurance company No desire for PBR to change standards for qualification as life insurance contracts for policyholders Demonstrates flexibility on compliance with specified rules for interest rate and mortality tables 24 12
Company Tax: Implications of PBR, cont. PBR unresolved issues: Effective date for tax reserve method No phase-in period for change in method Treatment of stochastic excess Dynamic valuation interest rates Prevailing tables and Sections 7702 and 7702A Linkage of tax definition to prevailing tables NAIC process for table adoption 25 Legislation: Fiscal Year 2012 Administration Budget DRD and proration Separate Account DRD would be based on SA surplus to assets Adopt PC 15% haircut for Life General Accounts Life settlement reporting Reporting required for policies with death benefits of $500K or more Buyer must report price, issuer, contract number, buyer and seller TINs to IRS, insurance company and seller Insurer must report deaths to IRS, including payment, TIN of payee and estimated basis Applicable to new purchases COLI/BOLI Apply a pro-rata interest disallowance to all but 20% owners Applicable to new sales 26 13
FATCA: Implications for U.S. insurers FATCA imposes reporting requirements on foreign financial institutions with respect to U.S. accounts Application of FATCA requirements to insurance companies and products Policies subject to FATCA Excludes reinsurance and term products What definitions will be applied? Implications for domestic life insurers 27 Deferred Tax: SSAP 101 SSAP 101 would replace SSAP 10R for periods after 2011 Applies enhanced SSAP 5R principles to federal and foreign income tax contingencies Imposes further restrictions on admittance of DTAs against future taxable income, and potentially, against deferred tax liabilities Addresses regulators concerns about rapid deterioration of financial condition Requires further disclosures on use of reinsurance tax planning strategies 28 14