Section 7702 Changes and What It Means for the IBC

Photo by Felicia Buitenwerf on Unsplash

Background

Life insurance is an extremely old financial asset. Long before the United States of America — much less the Internal Revenue Service — was a thing, Lloyd’s of London was issuing life insurance.

Life insurance death benefit has always been viewed for what it is: replacement of lost income and/or assets upon the death of the insured. The idea of the “replacement of a loss” is distinct from other cash flows like income, capital gains, and (most) dividends. The important thing is that, generally speaking, death benefit (replacement of a loss) has virtually never been taxed (with the exception of estate taxes in some cases), whereas, of course, income, capital gains, and (most) dividends have been and are.

For the first time, the Deficit Reduction Act (DRA) of 1986 imposed a definition of life insurance for tax purposes. That definition is contained within Section 7702 of the IRS Code. Under Section 7702, if cash value in dividend-paying whole life insurance contract grows too quickly, relative to the death benefit, the policy becomes a Modified Endowment Contract or a MEC. Whereas in non-MEC life insurance contracts, policy loans, withdrawals, and dividend distributions while the cost basis is less the cash value, are non-taxable cash flows. In MECs, policy loans and other distributions after there’s a net gain in the policy are taxable cash flows and trigger a 10% penalty if taken before the owner is 59 1/2 years old.

[This isn’t tax-advice. But as my clients have heard me say, I can read.]

Section 7702 prescribes two tests to determine whether an insurance product is a MEC or not. They’re called the Cash Value Accumulation Test (or CVAT) and the Guideline Single Premium (or GSP) test. Of the two, according to the Society of Actuaries, the CVAT is the test used to check for MEC status particularly in dividend-paying whole life insurance (as opposed to, e.g., universal life).

The CVAT says that in order to remain a non-MEC, the cash value in a policy cannot be greater than the net single premium that would be required in that year to fully pay up the policy (i.e. pay for the death benefit on the policy without the requirement for future premiums).

Since CVAT involves present valuation (comparing values now to values later), interest is involved. The DRA specified the interest rate that companies had to use when accounting for the time value of money in these calculations. The original rate in 1984 was set to 4%.

This is the origin of the misleading marketing online from financial entertainers who used to, and may still, claim that policy owners get a “guaranteed growth rate” of 4% in their policies.

No.

This 4% number was a legislatively imposed discount factor that life insurance companies were required to use when comparing cash value growth to death benefits.

What Changed

Section 205 of the Consolidated Appropriations Act of 2021 is entitled MINIMUM RATE OF INTEREST FOR CERTAIN DETERMINATIONS RELATED TO LIFE INSURANCE CONTRACTS.

This relatively short section of a giant bill contain significant changes to the way death benefit in life insurance is priced.

Before, the discount rate companies were required to use to account for the time value of money was (1) fixed and (2) set equal to 4%.

Now, the discount rate companies are required to use to account for the time value of money is (1) variable and (2) is limited to a formulaic range of rates.

This article from the Society of Actuaries gives a great analysis of what exactly changed in Section 7702. Read that if you want to dive into the technical particulars (though ignore the bullet points about what this means for whole life toward the end. They’re confusing. Without specifying it, the bullet points assume a given amount of death benefit. So, yes, ‘cash values are higher’ is true, but more premium is paid for a given death benefit — see below for further explanation. Look, the author is an actuary — bless his heart).

For our purposes here, we’ll note that the current range of rates from which companies may select the discount factor they deploy in the actuarial construction of their products is 2% to 3.75%.

As mentioned above, this range can change in the future in so-called “Adjustment Years,” which, historically, come ever 8–10 years. Therefore, so long as the current law remains unchanged, the precise delineation of this range of possible rates could potentially shift as the source rates used to determine this range adjust.

Let’s be careful to distinguish, however, that just because this range of rates may fluctuate in the future, it is not the case that the rate selected for a given policy will change once the policy’s in force. If I buy a policy where the basis of values is 2% today, 2% will remain the basis of values for that contract for as long as it’s in force, regardless of how the range of rates changes in the future and regardless of what specific rate a company choose to build a particular policy in the future. In a sense, this must be the case, because if the basis of values changes, death benefit is repriced. This repricing can’t happen in in-force dividend-paying whole life insurance because dividend-paying whole life is a private asset, the terms of which cannot be changed by anyone once the policy the policy is in force, with a certain limited number of explicit exceptions, all of which are at the discretion of the policy owner.

What Companies are Doing

Since October 2021, companies have started to release new products (policies) for sale in order to adhere to the December 31, 2021 deadline prescribed by the Consolidated Appropriations Act. For short, from here out, I’ll refer to pre-CAA and post-CAA policies. Pre-CAA policies were constructed by actuaries with the 4% basis of values. Post-CAA policies are constructed with a basis of values between 2% and 3.75%.

Companies get to choose from within this range of values what specific basis they want to use for each specific contract. Some companies are using the same basis of values for all of their contracts. Others are offering contracts at one basis of values, e.g. 2%, and other contracts at a different basis, e.g. 3.75%.

What it Means for New Policies

Across the board, the lower basis of values will mean relatively more expensive death benefit per premium dollar.

Think of it in simpler terms. $10,000 today at 10% interest is worth $11,000 a year from now. In contrast, $10,000 today at 5% interest is work $10,500 a year from now. Death benefit pricing is nowhere near as simple as this, but you get the idea. A lower discount rate means future cash flows (death benefits) per premium dollar will be lower. Put differently, it takes more premium dollars in a post-CAA policy to buy the same death benefit as in a pre-CAA policy.

This is true across the board for all policies since the entire range of potential rates (2%-3.75%) is lower than the pre-CAA 4%.

But extrapolate further. All else equal, death benefit on a policy with a relative lower basis of values from within the range (e.g. closer or equal to 2%) will be more expensive than that on a policy with a relatively higher basis of values from within the allowable range (e.g. closer or equal to 3.75%).

This death benefit pricing dynamic has led some to conclude that cash value must be less in post-CAA policies than in pre-CAA policies.

This is definitely the case for guaranteed cash values, but not necessarily for non-guaranteed cash values.

In my own office’s audit of policies from two different 100+ year old, non-direct recognition mutual life insurance companies, non-guaranteed cash values seem to ever so marginally higher, and grow relative to premium payments or cost basis marginally quicker relative to that in pre-CAA policies.

Exactly why this is the case would be a great question for an actuary (I’m in the process of having those conversations).

But let me point out a few things.

First, much of the early cash value growth in dividend-paying whole life insurance is generated from PUA premium payment. PUA premium, by definition, buys paid up death benefit. Stated in reverse, the death benefit that PUA premium purchases is worth the quantity of the PUA premium at the time of the purchase. This is why policy owners see around a $1 of cash value growth per $1 of PUA premium in the first year of the contract (after the first year, due to compounding and dividends, this relationship is less obvious).

In a sense, the relationship between PUA premium and cash value generation is relatively immune from changes in the basis of values used to determine how much death benefit that premium of any sort buys. The PUA premium-cash value relationship is an outcome of the nature of present valuation, not the magnitude of a particular basis of values.

A further complicating fact is that there are two sides to a ledger: the guaranteed and the non-guaranteed side. The guaranteed side of the ledger assumes no dividends whereas the non-guaranteed side assumes dividends at the current (or less than the current) experience of the company.

Current experience didn’t change much from the week before a company changed to post-CAA policies to the week after. Consequently, for a given level of premium, guaranteed death benefits and cash values will be lower across the board relative to pre-CAA policies, non-guaranteed death benefits will be lower than pre-CAA policies (and the lower the basis of values, the lower the death benefits), while non-guaranteed cash values may be higher or lower (from what I’m seeing, they’re a bit higher).

What it means for Becoming Your Own Banker

In a word: nothing.

James and I did a podcast recently that will be released in early December 2021. We title it something to the effect of “Section 7702: Another Element of the Noise.”

Let’s get a few things straight.

Neither you nor I get to determine the basis of values used to price death benefit. The companies themselves only get to choose from a legislatively determined range. Remember, I’m a buyer just like you are.

Dividend-paying whole life insurance has always been and will continue to be the optimal place in which to build and from which to deploy capital. Period.

The Section 7702 change is consequential for folks who care purely about the death benefit that they can buy with their available premium dollars. Let’s be clear, if you care about amassing as much death benefit as possible given your limited financial resources, you should definitely buy a life insurance policy where the basis of values used to construct it is at the maximum end of the allowable range, i.e. 3.75% at present.

However, there is reason to suggest that this may be the opposite of what someone who wants to implement IBC might do.

To understand why this is the case we have to remember that purchasing life insurance is not a right. We apply, we ask permission, to buy life insurance. Underwriters are responsible for medical, financial, and suitability evaluation of applications to purchase life insurance.

It’s that third element of suitability that we care about here. Generally speaking, at the time of an application, an underwriter will only permit a certain maximum amount of death benefit to go in force across the presently requested death benefit and the death benefit that’s already in force on the life of the insured.

[Technically, this requires more nuance. We should say that there is a maximally suitable amount of death benefit across requested and currently in force death benefit for an insured, for the benefit of a certain party. In other words, the magnitude of insurable interest is always established in the context of a relationship between the proposed insured and the proposed beneficiary. For example, the amount of death benefit I have in force on my own life for the benefit of my private foundation does not reduce the allowable amount of death benefit I can request on my own life for the benefit of my spouse, if I had one.]

However, the point is that the amount of death benefit we can request on our own life for the benefit of a particular beneficiary is everywhere and always limited.

The amount of death benefit across all policies applied for and in force at a given time is limited either to our Human Life Value or our net worth, whichever is higher.

Underwriters view death benefit as the replacement of a loss, in particular, the loss of future income or the loss of net worth that, ostensibly, would go to support the lifestyle of the others after the death of the insured. In the case of Human Life Value, the amount of death benefit we can ask for is limited to an approximation of the present value of the insured’s future income. For instance, if I’m 30 years old (I’m not) and I earn $100,000 in gross annual income (I don’t), then companies will say that I can ask for 30 times my gross annual income in total death benefit across all policies in which I’m the insured, i.e. $3,000,000. If I’m 35, maybe they let me get 25 times my annual income in death benefit; if I’m 45, maybe they’ll let me get 20 times my income, and so on.

Because the present value of most people’s income is greater than their net worth, the death benefit applied for on most applications is just justified in Human Life Value terms (i.e. in terms of the present value of the insured’s future income).

Let me correct that. For the handful of agents who bother to justify the requested death benefit in an application, we often do so in terms of human life value, because this gives us a higher proposed death benefit ceiling than net worth would — and appropriately so.

Even in the event that net worth is used to justify the proposed underwritten death benefit as suitable, we can state the following with logical certainty:

In every individual’s lifetime there will come a point where the individual’s insurability maximizes.

On the one hand, in terms of Human Life Value, the present value of our future income will reach a maximum.

On the other hand, every individual’s net worth will reach a lifetime maximum.

Even more exact: the difference between human life value or net worth and the death benefit we currently have in force will maximize at some point in the life of an insured.

That is, there will come a time when the amount of death benefit that a person can ask for in an application will maximize.

Even in the event a proposed policy owner insures someone else, the death benefit for which we may apply to insure that other person will likewise maximize at some point.

In short, we can only apply for so much death benefit in our lifetimes.

So here’s the question: given the maximum amount of death benefit we can ask for, do we want to pay more or less premium for it?

From the perspective of conventional life insurance sales where all we care about is getting as much death benefit for as little premium as possible, the answer is less.

From the perspective of the IBC where what we primarily (though not exclusively) care about is cash value accumulation, the answer is more.

The more premium I pay, the more cash value I build, the more capital I have, the more opportunity I attract, the more financially autonomous and prosperous I am.

What Section 7702 really means for those who care about the IBC is that every single one of us can now pay more premium.

Generally speaking, that is a good thing.

“Well hold on a minute Ryan, first you said that the Section 7702 change means nothing from the perspective of IBC, and now it sounds like you’re saying it’s a good thing. What gives?”

Is there anything whatsoever about what I’ve told you that changes the fact that you need to become your own banker?

No.

Does anything I’ve said cause you to think that systematic capital accumulation in dividend-paying whole life insurance is a bad idea?

No.

Does a change in the regulated basis of values fundamentally alter the relationship between base premium, PUA premium, dividends, cash values, and death benefits?

No.

So you can see why I say above that the Section 7702 change means “nothing” for someone implementing the IBC.

In the event that cash value growth is either about the same or better in post-CAA policies than in pre-CAA policies, then given our discussion of maximum insurability, the 7702 change may be viewed as a positive development.

However, while I can imagine a scenario where, given an individual’s lifetime premium payments, that the cash value in pre-7702 contracts could exceed the cash value in post-7702 contracts, I can also imagine a scenario where a post-CAA system of policies could accept more premium and generate more cash value.

Furthermore, recall that the range of allowable rates will fluctuate in the future. It’s possible that the various bases of values across the policies in the system you build over your lifetime will be different. May God grant us the serenity to accept things we cannot change.

On the other hand, if you’re going to go purchase whole life insurance in late 2021 or 2022 (or later), you will have a choice between contracts designed at a 2% basis and those at 3.75% basis (I don’t see any companies choosing a number in the middle of the range).

Herein lies the real takeaway.

Throughout this entire article you’ve had this nagging thought at the back of your mind that goes something to the effect of, “Damn it, Ryan, just tell me which one I should get?” Or if you’re one of my agent readers, “…which one should I sell?”

The problem is that this question implies evaluation of other factors. The basis of values is not the only thing that matters.

Does the contract receive direct or non-direct recognition? Has the company paid a positive dividend for 100 consecutive years? Does the company offer the client an online portal for efficient policy management? What’s the company’s attitude toward IBC? Are policy loans allowed in the first year? Does the company have a track record of supporting the IBC and the Nelson Nash Institute? If I call the company, does an English-speaking human being answer the phone in a reasonable amount of time? Does the agent I want to work with answer my calls and respond to my emails? Does my agent write the best IBC blog on the planet (ha…)? How flexible is the company’s PUA rider? Does the company offer a PUA premium catch-up provision? Can I pay my PUA premium throughout the year when I want to? What are the PUA premium minimums? What’s the PUA rider expense charge? How much does the client care about death benefit? Is the client about to become fully insured? Are we already running into maximum insurability problems?

I could go on.

What happens in the context of things we don’t fully understand is that we look around to see what other people are talking about with respect to the given topic.

The section 7702 change is the first legislative change concerning dividend-paying whole life in over 30 years. People are going to be talking about it.

And you can bet your life that this will include online financial entertainers. I predict that agents will indulge their prospective clients’ desires for certainty amidst the confusion and lurch to provide “the one right answer.” This will lead to yet another manifestation of the one-size-fits-all thinking that pervades online marketing in the IBC footprint. “X% basis of values is ‘the best’ for IBC.” “Y% is the way to go for IBC!”

Similar to Federal Reserve monetary policy and tax-qualified plan regulations, frankly, I don’t really care what the federal government does to the basis of values. What I’ve learned in my analysis of pre-CAA and post-CAA policies is that death benefit is cheaper, non-guaranteed cash values may grow marginally faster, and that I wasted a lot of emotional energy worrying about it.

Look, I’m not perfect! I did my little audits and worried about whether this change was going to compromise the integrity of the asset. Like you, I wasn’t certain what exactly the implications would be.

It’s time like these where I really miss Nelson. He was a master at gently drawing your attention to the fact that you were far too concerned about the wrong thing.

“The question is who controls the banking function as it pertains to your needs.”

I hope this essay has clarified what changed with Section 7702 and what it means — and maybe more importantly, what it doesn’t mean — for those who know what the answer to that question should be.

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CEO, Griggs Capital Strategies. “Banks lend money that does not exist, and that is evil.” — R. Nelson Nash

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Ryan Griggs

Ryan Griggs

CEO, Griggs Capital Strategies. “Banks lend money that does not exist, and that is evil.” — R. Nelson Nash

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