As the proverbial clock marched towards midnight in 2020 Congress fought over how to deliver a second round of stimulus in the U.S. The end result was a watered-down version of the legislation passed earlier in the year in terms of cash payments to certain Americans, but the bill contained numerous provisions that, like most Congressional bills, had little to nothing to do with financial assistance for struggling Americans due to Covid-19.
The life insurance industry benefited from this Omnibus-bill-style law-making with a new rule allowing insurers to manufacture products with lower guaranteed accumulation rates. This, of course, arrives with a warm welcome from an industry on edge about ever declining interest rates. It also served as a marketing platform for some insurance marketers who exclaimed that the end of 2020 presented the greatest gift the life insurance industry ever received. Major media caught wind of the rule change and immediately took the story to the presses. In its all-too-common ready-fire-aim approach, this left us with a dozen or so stories quoting various insurance-related folks about a subject few of us really know much about.
So did Congress drop an end of the year present at the front door of the insurance industry? Or are some people speaking a bit out of turn when they rush to the public with claims that the happy days are here again regarding cash value life insurance?
7702 Rule Change: What Exactly Changed?
The Consolidated Appropriations Act of 2021 (HR 133), which President Trump signed into law in late December of 2020, allows insurers to manufacture life insurance policies with minimum guarantees rates that are lower than rates allowable under previous law. For the most part, this reduction takes the previous guaranteed rate of 4% and drops it to 2%.
The life insurance industry advocated for a rule change permitting reduced guaranteed rates due to current interest rate levels in the United States. The old minimum guaranteed rate established in the 80's came at a time when rates were significantly higher than today. The industry argued that it was unfair to build product guarantees on a model established in a time when rates were reaching into double-digit territory.
The important thing to note, however, is that this rule change merely opens the door for life insurers to create new products with lower guaranteed interest rates. It does not allow an insurer to now issue a currently available product with a lower guaranteed rate just because the rule changed. Nor does this rule change mean a life insurer can change the guaranteed accumulation rate on an in-force life insurance policy.
Impact on TEFRA/DEFRA and TAMRA Testing
The tax code revisions that established limitations on life insurance contracts back in the 1980s largely restrict the premium a policyholder can pay into a policy over a certain period of time given its death benefit. Conversely, this limit can also act as a minimum required death benefit one must have if planning to pay a specific amount of premium into a policy over a certain period of time.
The calculation for this restriction involves two critical components–the cost of providing the insurance and the guaranteed interest rate on the policy. Lowering the guaranteed interest rate “reduces” the restriction by allowing more premium per amount of death benefit–or less death benefit per a specific amount of premium.
Said another, more approachable and certainly more marketable way, the rule change allows people to put more money into a life insurance policy before create a Modified Endowment Contract. This…theoretically…creates a life insurance contract with less expense and a higher rate of return on premiums with respect to the cash value.
I say theoretically because while it certainly follows that lower guaranteed interest holding all other components constant will result in a higher allowable non-MEC premium (or lower non-MEC death benefit), we have no promise that life insurers will in fact hold all other components constant.
Keep in mind that life insurers wanted a decreased guaranteed rate to relieve the pressures they faced to meet contract obligations. The net result being they sought a rule change that increased the profitability of issuing life insurance contracts under current economic circumstances. Issuing new policies with lower death benefits than previously allowable has a net negative impact on the revenue generated by said policies. This fact leaves me dubious that the life insurance industry will embrace the rule change with policies designed to maximize the newly allowable non-MEC and CVAT or GPT compliant parameters.
I don't intend to suggest that the industry will attempt to bury these newly established boundaries in favor of enforcing old ones, I simply think that the net impact will come nowhere close to the relative change created by the minimum interest reduction.
For example, this rule change will likely cause close to a 100% increase in allowable non-MEC premium for a large segment of the population. I highly doubt this will create a 100% increase in the cash value of a whole life or universal life insurance policy issued with the new lower guaranteed interest. There are several levers insurers have regarding policy design that can impede or improve our attempts to maximize what the IRC permits regarding cash value life insurance. When the Tax Code stands in between an insurance company and profits, the life insurer has a tendency to ignore Tax Code allowances in favor of its own rules that favor profit building.
Case in point, the Tax Code places no restriction on the sum of paid-up additions paid to a whole life insurance contract–it only cares about the sum of premium entering the policy relative to its death benefit. Despite this, all life insurers I'm aware of who issue whole life insurance in the United States enforce rules limiting PUA payments to whole life contracts. I've run into more than one occasion where these limitations were far lower than the premium needed to violate the 7-Pay Test. Taking it a step further, I'll note how nearly impossible it is to violate the Cash Value Accumulation Test on a whole life policy with an intentionally large paid-up additions contribution.
Lower Guarantees Could Be Good or Bad
It's too early to tell what the net effect of lower guarantees will be on life insurance consumers. I already established that it should relieve pressure on life insurers because it lowers their commitment to new policy owners moving forward. What's unclear is how life insurers will use the money this move frees up.
In theory, mutual insurers will return the additional profits created by this rule change to participating policyholders–the majority of which are whole life policyholders. But this doesn't necessarily mean these policyholders will net higher cash value benefits versus older whole life policyholders with higher guarantees. Increasing the dividend and lower the guaranteed interest rate on a whole life policy may be little more than a semantics shell game.
Lower guaranteed rates could boost cap rates on indexed universal life insurance policies. Life insurers will need fewer assets in bonds to cover the guarantee, which increases the budget for options. There's nothing that forces life insurers to do this, however, so only time will tell if insurers use the freed-up resources to pursue a higher collar.
Ultimately, I think the net change will be minimal. The thing that drives the performance of a cash value life insurance policy is the overall return on assets. Better performing life insurance contracts will require either higher interest rates overall or life insurers who seek out and capitalize on alternative investments that make up for lost yield they face as older investments mature.
The one opportunity this rule change might bring back to the table is the availability of shorter pay guaranteed whole life products. Products like 7-pays may again be profitable for life insurers. This also put some security behind 10-pay whole life insurance, which has teetered on feasibility for a number of insurers since recent Fed activity to stem the tide of Covid's negative impact on the economy. So while we may not get vastly improved cash accumulating life insurance policies, we may pick up a few new products with shorter guaranteed premium payment periods due to this rule change.
Transition Will Likely Be Clunky
The rule change does pose some problems for certain profit models insurers in the universal life space implemented. This leaves those insurers in a position of either ignoring the rule change or entirely re-working various bonus models they created that depend on a certain level of COI-profit-taking.
The process for rolling out new insurance products is lengthy. While life insurers may have begun working on products that use the newly allowed minimum guarantee, they couldn't begin the actual filing process until the law officially changed. This now begins the process of filing new product approvals, which will almost certainly bog down state DOI's as they face an avalanche of new product approval applications.
Insurers will also need to make updates to internal systems to handle the new calculations for products issued with the new guaranteed rate. This isn't the first time the industry will undertake this task, but it will be the first time in the career of many home office employees now tasked with this job.