LIFE INSURANCE RESERVES UNDER UNIVERSAL LIFE POLICY ARE NOT RESERVES COMPUTED ON A RECOGNIZED PRELIMINARY TERM BASIS.

UIL Number(s) 0818.03-00

                                             Date: December 22, 1986

ISSUE

Whether the life insurance reserves established during the taxable year 1983 under the Company's Current Value Whole Life policy qualify for revaluation under section 818(c) of the Internal Revenue Codes.

FACTS

Company is a life insurance company subject to tax under section 802 of the Code. During 1983, Company introduced a new life insurance product known as a Current Value Whole Life policy ("the policy"). The Company has made an election under section 818(c) of the Code to revalue the life insurance reserves held with respect to the policy to a net level premium basis.

The policy is denominated a participating whole life insurance policy under which level policy premiums are allocated between a risk premium and an accumulation premium. The proceeds of the policy are payable upon the death of the insured or surrender of the policy. Upon written request, instead of a lump sum payment, Company will apply the net proceeds in accordance with one of the following optional methods of settlement: an annuity certain, a life annuity with certain period, a deposit at interest or installment payments until the proceeds are exhausted.

On the death of the insured, the death proceeds will equal:

The sum insured (or the cash value, if greater)

+ Any additional insurance on the insured's life provided by an additional benefit agreement;

+ Any paid-up additional insurance bought with dividends;

+ Any dividend accumulations;

+ Any dividend credited at death;

+ Any premium paid for coverage beyond the policy month in which death occurs;

- Any indebtedness on the policy;

- Any premium due for coverage to the end of the policy month in which death occurs.

The policy provides a surrender value equal to:

The guaranteed cash value of the policy (or the cash value, if greater)

+ The cash value of any paid-up additional insurance bought with dividends;

+ Any dividend accumulations;

- Any indebtedness on the policy.

The guaranteed cash value of the policy is based on the Commissioner 1958 Standard Ordinary Mortality Table using an assumed interest rate of 4-1/2% per year. The cash value of the policy (without loans or withdrawals) is computed in the following manner:

(1) The insurance risk amount is calculated for any policy year as the sum insured less the accumulation account at the end of that policy year.

(2) The risk premium for the policy year is calculated as the product of the insurance risk amount and the current risk rate for the attained age of the insured at the beginning of the policy year. The current risk rate is set annually by the Company and may be smaller but not larger than the risk rates guaranteed in the policy.

(3) The accumulation premium of the policy year is the excess of the total annual premium payable for the policy (including all attached agreements) over the sum of the risk premium and the annual premium payable for any attached agreements.

(4) The accumulation premium is then added to the accumulation account balance at the end of the preceding policy year. This amount becomes the accumulation account balance at the beginning of the policy year.

(5) The accumulation account balance at the end of the policy year is determined by accumulating the accumulation account balance at the beginning of the policy year at the current interest rate. The current interest rate is set annually by the Company, but cannot be less than 4 1/2 percent.

(6) The cash value at the end of a policy year is then equal to the accumulation account at that time less a surrender charge, if applicable. The surrender charge applies only if surrender takes place within the first 20 policy years.

The policy will terminate if the premium due is not paid before the end of the grace period. In such case the surrender value will be used to provide either extended term insurance, reduced paid-up insurance or a single sum payment of the surrender value. The policy provides that the policyholder may make deposits to a premium deposit fund, which shall bear interest of at least 3% per year. Company will pay from this fund any premium due which remains unpaid on the last day of a stated grace period. If Company cannot pay the premium from a premium deposit fund, the excess of the cash value over the guaranteed cash value, if any, will automatically be used to pay the premium due. If the entire premium due cannot be paid by either of the above methods, the premium may be paid by a policy loan. The policy provides for policy loans up to the maximum loan value. The maximum loan value is equal to the guaranteed cash value of the policy. The policy loan interest is calculated at a rate of 8% per annum and becomes due and payable each year on the policy anniversary.

The policyholder may at any time surrender the policy for its surrender value. A surrender charge is deducted from the accumulation account balance to give the actual cash value available for surrender purposes. The initial surrender charge is shown in the table of projected policy values contained in the policy. This charge remains level for the first 6 policy years. It then is reduced by 4% of the initial charge for each of the next 5 policy years and by 8% of the initial charge for each additional policy year. There is no charge made for surrenders after the twentieth policy year. Whenever the actual cash value of the policy exceeds its guaranteed cash value, the policyholder may withdraw such excess without affecting the sum insured.

In Exhibit 8 of its annual statement, Company identified the reserve basis used to determine reserves under the policy as one of the preliminary term methods described under the Standard Valuation Law ("1958 CSO 4-1/2% CRVM"). Because of the high surrender charges imposed under the policy, however, the reserves held with respect to the policy in 1983 were equivalent to the minimum reserves required under state law for ordinary whole life insurance policies. In subsequent periods, in addition to the minimum required reserves, Company will reflect additional reserve liabilities under the policy as excess cash surrender values over the required reserves, on item G- 3 of Exhibit 8 on its annual statement.

APPLICABLE LAW

Section 818(c) of the Code provides, in part, that for purposes of Part I of subchapter L (other than section 801), at the election of the taxpayer the amount taken into account as life insurance reserves with respect to contracts for which such reserves are computed on a preliminary term basis may be determined on either of the following bases:

(1) EXACT REVALUATION -- As if the reserves for all such contracts had been computed on a net level premium basis (using the same mortality assumptions and interest rates for both the preliminary term basis and the net level premium basis).

(2) APPROXIMATE REVALUATION -- The amount computed without regard to this subsection --

(A) increased by $19 per $1,000 of insurance in force (other than term insurance) under such contracts, less 1.9 percent of reserves under such contracts, and force under such contracts which at the time of issuance cover a period of more than 15 years, less 0.5 percent of reserves under such contracts.

Section 1.818-4(a) of the Income Tax Regulations provides, in part, that the reserves a life insurance company may elect to revalue are those computed on one of the recognized preliminary term bases.

RATIONALE

In general, the preliminary term reserve method cushions the administration costs associated with the issuance of a life insurance policy by using a first year net valuation premium that is smaller than the first year net valuation premium calculated under the net level premium method. Under the net level premium method, the valuation net premium that is added to the reserve remains level over the premium paying period of the policy. See Menge, Preliminary Term Valuation, The Record; American Institute of Actuaries, 182 Volume XXV (1936). As a practical matter, the life insurance company's expenses associated with the policy, such as agent's commissions, costs of medical examinations, approving applications, etc., are mainly incurred during the first policy year. These first-year expenses usually exceed the expense loading of the gross premium and, in fact, may be greater than the amount of the first-year gross premium. Since the net level premium method assumes that level net valuation premiums are available each year, the combination of first-year policy expenses and the net level premium method effectively forces the life insurance company to draw from its surplus funds to provide for the excess of expenses over loading during the first policy year. This surplus strain normally creates no difficulty for well-established companies with ample surplus funds, because in any year the deficiency of loadings relative to expenses on new policies is offset by the excess of loadings over expenses on renewal business. However, small companies with limited surplus funds could find their financial position impaired, or their ability to generate new business severely restricted, due to the funding assumptions imposed by the net level premium method.

To afford companies with limited surplus funds relief from this first-year surplus strain, state valuation laws generally permit the use of preliminary term reserve methods which give recognition to the decreasing incidence of expense and provide a larger loading in the first policy year than in the renewal years. As distinguished from the net level premium method where net valuation additions to the reserves are level, a preliminary term reserve must be built from a first year valuation premium which is less than the renewal valuation premiums. See Jordan, Society of Actuaries' Textbook on Life Contingencies, 283- 284 (2nd ed. 1967). Stated another way, a preliminary term method provides for a borrowing of some portion of the net level valuation premium in the first policy year to partially offset the excess of expenses over level loadings in this period. The borrowed portion of the net level valuation premium is restored to the reserves in later policy periods, when there is an excess of loadings over expenses. Taken together, however, the present value of the first-year and renewal net valuation premiums under a preliminary term method are actuarially equivalent to the present value of net level valuation premiums.

While reserves calculated under a preliminary term method are eventually graded up to equal reserves under the net level premium method, the preliminary term method results in reserves that will be lower, both initially and throughout the grading period, than reserves computed on a net level premium basis. Because of the central role played by life insurance reserves in the taxation of life insurance companies, Congress believed a mechanism was necessary to equate the reserves of companies using different reserve methods in order to avoid the disparity of treatment which would otherwise result between companies with greater and lesser amounts of surplus.

The committee reports on the Life Insurance Income Tax Act of 1959, the legislation enacting section 818(c), explained the purpose of the provision as follows:

ELECTION OR LIFE INSURANCE RESERVES COMPUTED ON PRELIMINARY TERM BASIS. -- Some life insurance companies compute their life insurance reserves on what is called a preliminary term basis. The effect of this is to take the full agents' commissions (which are larger in the initial period of a life insurance contract) out of amounts which would otherwise be added to reserves during the first year of a contract and to add correspondingly larger amounts to reserves in later years. The effect of this is to work a hardship on insurance companies using the preliminary term reserves as compared with those which use ordinary reserves, since the policy and other contract liability deduction depends on the size of the reserves. Moreover, additions to the reserves, deductible under phase 2, also would in some cases be smaller. To avoid this result, life insurance companies which had computed their reserves on a preliminary term basis are permitted to recompute their reserves on a net level premium basis. This can be done either by an exact revaluation of the reserves to a net level premium basis or by approximating this result under a formula set forth in the bill. H.R. Rept. No. 34, 86th Cong. 1st Sess., 1959-2 C.B. 736, 748. See also, S. Rept. No. 291, 86th Cong. 1st Sess., (1959-2 C.B. 770, 792; H.R. Rept. No. 34, 86th Cong. 1st Sess., 1959-2 C.B. 736, 766-767; and S. Rept. No. 291, 86th Cong. 1st Sess., 1959-2 C.B. 770, 823-824.

Accordingly, section 818(c) of the Code permits a life insurance company which computes its reserves on the preliminary term basis for annual statement purposes (because such method produces a larger statutory surplus) to revalue such reserves to a net level basis for tax purposes (because such method results in a larger exclusion of investment income and first year reserve deduction).

When section 818(c) of the Code was enacted in 1959, ordinary whole life insurance policies provided fixed guaranteed interest rates and stated levels of mortality charges. Under the traditional ordinary whole life insurance policy, a fixed amount of premiums are payable periodically over the entire premium paying period of the contract and a fixed amount of benefits (the face amount of the policy) are payable on the death of the insured. Similarly, the reserves of an ordinary whole life policy are calculated on the basis of net valuation premiums which are determinable at issue. Once a reserve method has been established (e.g. the net level premium method or a preliminary term reserve method), the net valuation premium additions to the reserve for the duration of the policy are known absent a change in reserve basis.

In contrast to the fixed assumptions inherent in traditional ordinary whole life insurance policies, the life insurance industry has introduced a variety of new products generally referred to as universal life insurance which permit policyholders to obtain high yields on the investment element of their policies and/or reduced premium costs depending on changes in mortality and interest assumptions declared by the insurance company. In general, under a universal life insurance policy, premiums paid by the policyholder (less certain expense charges, if any) are credited to a "policy value" account from which are deducted specified periodic charges for life insurance coverage (the "mortality charges") and to which specified periodic interest is credited at rates which are not determined at issue. The policy value account, which may be different from the policy's net cash surrender value, provides the base upon which the interest credits are calculated and also serves as the amount subtracted from the policy's face value to determine the net amount at risk for calculation of the mortality charge. The interest credited to the policy value is generally based on a guaranteed minimum rate plus additional ("excess") interest declared by the insurance company. Since both the periodic interest rate and the periodic mortality charge may be adjusted by the insurance company at any time after the issuance of the policy based on changes in the company's expectations regarding interest rates, mortality, or in response to competitive pressures, the policy value of a universal life policy cannot be determined at issue. This is so even though the policy form, as in the case of Company's Current Value Whole Life policy, may provide for specified premiums and a stated face amount of insurance.

In view of the indeterminate policy value of a fixed premium universal life policy, the issue is whether the reserves held with respect to such a policy are reserves computed on a recognized preliminary term basis within the meaning of section 1.818-4(a) of the regulations.

Company takes the position that notwithstanding the provisions of the Current Value Whole Life policy allowing excess interest and mortality cost reductions to be taken into account in determining policy values, the policy reserves are computed on a recognized preliminary term method. In Company's view, fluctuations in the specified periodic interest rate and mortality charges which are taken into account in determining a policyholder's accumulation account balance merely relate to the policy's nonforfeiture values and do not affect the basic policy reserve. Therefore, Company contends that the reserves held with respect to the Current Value Whole Life policy may be viewed as consisting of a basic policy reserve, which was computed under a recognized preliminary term method, and an additional reserve liability for net cash surrender values in excess of the policy reserve.

Company's position that the reserves held with respect to the Current Value Whole Life policy may, in effect, be bifurcated into a basic policy reserve and a reserve for excess cash surrender values is not supported by the prescribed reserve method for universal life insurance recently adopted by the National Association of Insurance Commissioners (NAIC). This method is set forth in a Universal Life Insurance Model Regulation which has been enacted into law by several states and, for taxable years after 1983, is the prescribed tax reserve method for computing reserves for a universal life contract. See sections 807(d)(2)(A) and 807(d)(3)(A)(i) of the Code, as added by the Tax Reform Act of 1984; see also H.R. Rept. No. 98-432, pt. 2, 98th Cong., 2d. Sess., 1415 (1984).

Under the NAIC prescribed method it is acknowledged that the actuarial structure of a universal life contract is unlike that of traditional ordinary whole life insurance. Section 3 of the Universal Life Insurance Model Regulation states:

Unlike the unitary nature of traditional whole life insurance, a distinguishing feature of universal life insurance is the existence of an indeterminate policy value from which specified periodic charges are deducted and to which specified periodic interest is credited at a rate not determined at issue. This indeterminate policy value with separately identified charges and credits may or may not have a premium pattern predetermined by the insurer at issue.

Since the death benefit, premium pattern, interest rate, and mortality cost assumptions of a universal life contract are not fixed at issue, the NAIC concluded that specific rules were required to establish uniform standards of valuation and nonforfeiture treatment of such products.

For purposes of the present issue, it is significant that the Universal Life Insurance Model Regulation provides that excess interest and/or mortality cost reductions credited in determining policy values under a universal life contract must be reflected as part of the policy reserve, rather than merely as an addition to nonforfeiture values. Under section 5 of the Model Regulation, excess interest and mortality cost reductions are taken into account in determining the future guaranteed benefits under the contract. From an actuarial standpoint, excess interest or mortality cost reductions may be viewed as similar to an increase in benefits because these amounts may be applied to reduce future premiums or may cause the contract to endow before its stated maturity date. Accordingly, the Model Regulation recognizes that by crediting excess interest or reducing mortality charges the insurance company has in fact provided the policyholder with an additional guaranteed benefit which must be reflected in the policy reserves.

To the extent that excess interest and mortality cost reductions allowed in determining policy values are reflected in the reserves of a universal life policy, the resulting reserves do not bear a conventional relationship to reserves computed on a recognized preliminary term basis. Neither the Code nor the regulations set forth a definition of a preliminary term method. It is generally understood, however, that a preliminary term reserve method represents a modified system of calculating reserves involving (1) a first-year net valuation premium that is reduced in order to provide a special first- year expense allowance in addition to the normal level loading, and (2) renewal net level valuation premiums that are increased to amortize the special first-year expense allowance. It is also understood that, taken together, the present value of the first-year and renewal net valuation premiums under a preliminary term method are equal to the present value of the sum of net level valuation premiums.

Implicit in the definition of a preliminary term method is that, like the net level premium method, the net valuation premium additions to the reserve for all policy durations are determinable at issue of the policy. That is, the present value of the first-year net valuation premium and renewal net valuation premiums calculated under a preliminary term method are equal to the present value of net level valuation premiums. By contrast, the reserves of a universal life policy are sensitive to changes in the life insurance company's declarations regarding interest rates and mortality charges. In any period in which the insurance company credits excess interest or reduces mortality charges in determining the policy value of a universal life contract, there is a corresponding increase in the policy reserves. The distinguishing feature of universal life insurance is the existence of an indeterminate policy value from which specified periodic charges are deducted and to which specified interest is credited at rates not determinable at issue. Given the ability of the insurance company to alter the underlying interest and mortality assumptions, the net valuation premium additions to the reserve for a universal life insurance contract for all policy durations are not determinable at issue of the policy. Accordingly, the reserves held by the Company with respect to the Current Value Whole Life policy cannot be computed on a recognized preliminary term basis as required by section 1.818-4(a) of the regulations.

CONCLUSION

The life insurance reserves held by Company with respect to the Current Value Whole Life policy are not reserves computed on a recognized preliminary term basis. Therefore, the reserves established during the taxable year 1983 under the policy do not qualify for revaluation under 818(c) of the Code to a net level premium basis.

A copy of this technical advice memorandum is to be given to the taxpayer. Section 6110(j)(3) of the Code provides that it may not be used or cited as precedent.