US Tax Changes Could Make Life Insurance More Popular
Changes to Section 7702 of the IRS tax code allow life insurance policyholders to squirrel away more cash at lower death benefits, effectively transforming policies into retirement vehicles in addition to, or instead of, protection.
- Terrence Dopp
- June 2021
- Change: The Consolidated Appropriations Act of 2021 lowered the interest rates that had been set in the 1980s to dissuade the use of life insurance policies as savings vehicles.
- Effect: In real-world terms, the federal government reduced the ratio of face value to premiums, allowing people to place more money in tax-advantaged life insurance accounts.
- Potential: On the negative side of the ledger, the shift could leave intermediaries feeling the pinch of lowered recurring premiums on future policies. On the positive end, people who once were hesitant to buy life insurance as an investment could change their minds, leading to a healthy increase in sales.
Life insurance and income taxes may not top many people's list of fascinating conversations.
But don't tell that to adviser Zac Majors, who's excited to sit with clients and discuss recent tax code changes that increase the amount of cash that can accumulate in a life insurance policy.
He's so psyched, in fact, he's “grinnin' like a possum eatin' a sweet 'tater,” the Texan said, using a southern colloquialism.
“It's not often that you put life insurance with tax code in the same sentence, and the word exciting accompanies it,” said Majors, chief executive officer of Centric Advisors LLC. “In this case it did.”
The shift was part of the 2021 Consolidated Appropriations Act passed late last year by Congress.
The Act specified new interest rate assumptions, which will allow higher premiums to be paid into life products and still meet the definition of life insurance, according to the Best's Commentary, U.S. Life Insurance Products to Change in Reaction to New 7702 Rules.
Historically, two tests determined whether a life insurance contract met the legal definition of “life insurance” under Section 7702 of the IRS tax code. These tests related to cash value accumulation and guideline premium/corridor rules, both designed to ensure the contracts were primarily about protection rather than investment. The underlying assumptions were designed in the 1980s.
“The old rate was as high as 6%, which was in line with guaranteed interest rates at the time this law was written in 1984,” said George Hansen, senior industry research analyst, AM Best. “As of 2019, nearly 40% of life individual policies have guaranteed interest rates of less than 4%, leaving nearly 60% with guaranteed rates of 4% or more.”
For contracts issued in 2021, the new rate for the guideline level test is the greater of 2% or the guaranteed interest rate in the contract. The new rate for the guideline single premium test and the cash value accumulation test is the greater of 4% or the contractual guaranteed rate.
The most positive effect will be that you get to put more money into a policy. A lot of people who are advisers and high income earners, they’re trying to put a good portion of their money into these types of vehicles, and sometimes they’re not as concerned with the death benefit.
Centric Advisors LLC
Accumulation, Not Protection
Vanilla, traditional death benefit protection may be the first product that pops into mind when thinking of life insurance. Although that coverage was the original intent of the industry, the range of products has shifted to include living benefits.
Last decade, consultants McKinsey &Co. found retirement planning was morphing into a lucrative business segment for carriers. One report stated retirement products generate 75% of operating profits. If insurance were “repositioned” as a way to help families attain financial goals despite premature death of a breadwinner, it would increase life insurance's appeal, the report said.
That gets to the heart of what Majors is hoping will happen as an outgrowth of the 7702 revisions, as consumers will be able to accumulate a greater amount of cash with a lower face value.
Majors said the change will be applied to new policies, and indexed universal life products will likely be the most impacted. Any future permanent life product with a cash accumulation component stands to be impacted, though it's still too early to tell exactly what those effects will be, he added.
“The most positive effect will be that you get to put more money into a policy,” he said. “A lot of people who are advisers and high income earners, they're trying to put a good portion of their money into these types of vehicles, and sometimes they're not as concerned with the death benefit.”
For Centric and other intermediaries, the reasoning is that giving consumers greater access to tax-advantaged savings is likely to mean increased interest in those types of products. While brokers and advisers may see some tightening in commissions due to lower face values, Majors said, he is optimistic that will be more than offset by higher volumes.
“Absent of changes to the commission structure, if you're cutting the insurance amount in half, then that means the commission follows,” said Stefan Dunajewski, chief life actuary with Zurich North America. “There will be an effort to balance that in a way, and it will be interesting to see how commission scales change as a result of this and whether intermediaries are willing to accept their fair share of the costs that this change in rate structure may bring about.”
The original intent of Section 7702 was to discourage the use of life insurance as an investment vehicle. Yet for the upper end of the market—people who max out other tax-advantaged accounts and are searching for a place to park more money—that's one of the purposes the policies have served for a long time.
The revised Section 7702 tax rates won’t create a new market for insurers. What they do allow companies to do is price existing offerings more effectively.
Taxing the Rich
To determine whether policies are deemed tax-free, the new law uses the “insurance interest rate,” which changes when the reserved valuation rate changes.
The 7702 changes take effect amid a broader U.S. political climate dominated by the COVID-19 pandemic and a racial reckoning. At the same time, some in Washington want to use tax policy as a means of addressing the growing wealth gap.
About 8% of U.S. adults are millionaires, according to Credit Suisse's Global Wealth Report 2020.
At the same time, President Joe Biden has called for raising to 39.6% both the top federal income tax rate and the capital gains tax for the highest earners, according to news reports. The top rate was lowered in 2017 by his predecessor, Donald Trump.
The U.S. Congress is a divided body, so those numbers could be modified up or down—or not at all—during the legislative process. Some say the discussion is a sign that there is an appetite to increase taxes for the first time in recent history.
“This 7702 change plays right into that,” Majors said.
Companies are likely to start filing life insurance products with lower guarantees due to the revision, and product pricing will change—particularly compensation—for universal life insurance, AM Best said in the report. Universal life commissions are mostly determined using a target premium on which the full amount is paid, with a lower rate for premiums over the target.
“Target premiums may need to be adjusted due to the higher levels of premium that can be paid into the contract, while still maintaining the favorable tax status,” the report said.
Speed of Change
The main surprise for the industry was how quickly the changes unfolded, and the implementation dates. The changes apply to all policies sold after Jan. 1, 2021.
Dunajewski said his company is very active in the high net worth market, where signs point to the changes having the biggest effect. The new regulations won't impact traditional, strictly protection life insurance policies. However, the company has been eyeing whether insurers, clients, intermediaries or a combination will pick up any resulting costs or loss of revenue as companies stand to lose out on excess cost of insurance beyond the policy amounts, Dunajewski said.
“You can really lower the face amount pretty drastically under the new calculation,” he said. “I don't think it really introduces any new requirements or fundamentally changes the industry or the products. But it's definitely a shift, and I think the challenge for the industry is being nimble enough to respond appropriately and quickly.”
He said Zurich is looking into all of the shift's potential effects, which may include pricing changes, refilings and changes to marketing.
Rosendale, of AM Best, said he doesn't see the revised Section 7702 tax rates creating a new market for insurers. What they do allow companies to do is price existing offerings more effectively. Hansen, also of AM Best, said the other test will come in the market when companies see the results of lower guarantees.
The long process of bringing new life insurance products to market—and the need for regulatory approval of rate changes—means any responses to the changes are likely in their infancy, and a clear picture isn't yet available.
“Insurers have definitely been challenged now for a while with the low interest rate environment, which continues to put a lot of pressure on investment margins and makes providing long-term benefits more expensive,” Dunajewski said. “What they might do is make certain types of products more attractive to customers and that could lead to more demand in these spaces.”
Majors had a similar sentiment.
“People are going to want to put more money into something that is tax-advantaged, and this gives them the ability to put more in than they ever have before,” he said. “Those people who were on the sidelines because there wasn't enough juice or because they couldn't put enough money in there, are going to start seeing insurance in a better light than they had before.”