LIFE INSURANCE RESERVES ON FLEXIBLE PREMIUM UNIVERSAL LIFE INSURANCE POLICIES CANNOT BE REVALUED UNDER SECTION 818(c).

UIL Number(s) 0818.03-00

Date: March 31, 1987

Control No. CC:C:2:9 - TR-32-11658-86

District Director: * * *

Company = * * *

Unless otherwise indicated, all references to the life insurance provisions of the Internal Revenue Code are to the provisions in effect prior to enactment of the Tax Reform Act of 1984.

ISSUE

Whether the life insurance reserves which Company calculated and held with respect to certain flexible premium universal life insurance policies qualify for revaluation under section 818(c) of the Internal Revenue Code.

FACTS

Company is a life insurance company within the definition of section 801(a) of the Code and files its returns on a calendar-year basis. During the taxable years 1982 and 1983, Company issued a series of flexible-premium life insurance products, commonly referred to as "universal life insurance policies" (UL policies). Each of the UL policies issued during the years involved was denominated a nonparticipating life insurance policy under the applicable state law and was subject to the general state law requirements as regards valuation and nonforfeiture treatment. Furthermore, each of the UL policies qualified as life insurance contracts under the temporary guidelines provided by section 101(f) of the Code for purposes of the exclusion of death proceeds from gross income.

As is characteristic of universal life insurance products, the UL policies issued by Company permitted the policyholder to vary, independently of each other, the amount or timing of one or more premium payments, and to change the policies' death benefit with a minimum of difficulty. Under the policies there were slight variations in the death benefit pattern; however, as a general rule, the policies provided for a death benefit equal to the greater of (1) the insured's Initial Specified Amount (referred to as an "Option I" death benefit); or (2) the policy's cash value plus a minimum risk amount, defined in the policy form either as an absolute dollar amount or as a specified percentage of the cash value (an "Option II" death benefit). The death benefit options offered under the policies differed as to the pattern of benefits and their effect on the insurer's net amount at risk. Option I provided a level death benefit for which, depending on the change in the policy's cash value, there was an inverse effect on the insurer's net amount at risk. Thus, if the cash value increased over time, the net amount at risk decreased by the same amount, and vice versa. Conversely, Option II provided a varying death benefit which at any time equalled the sum of a stated level net amount at risk and the then cash value. Thus, if the cash value increased over time, the total death benefit increased exactly with the cash value increase. Whichever death benefit option was selected, the policyholder could change the death benefit pattern under the policy at any time subject to certain contractual restrictions, either by adjusting upward or downward the policy's specified amount or by selecting a different death benefit option.

As indicated, the UL policies issued by Company provided considerable flexibility as regards the timing and amount of premium payments. Nevertheless, as a business practice, Company normally determined a planned or target premium for each policyholder at the time a policy was issued, which was used by Company as the basis for preparing regular billing notices. The amount of the policyholder's planned premium was variously computed, in some cases reflecting the level annual premium which would mature the policy for the initial specified death benefit assuming the permanently guaranteed rates of interest and mortality provided in the policies, and in other instances reflecting either the level annual premium which would mature the policy at the initial specified death benefit assuming the rates of interest or mortality charges currently being credited or the maximum commissionable premium. Within limits outlined in the policies, however, the policyholder could pay more or less than the planned premium without Company's approval. Also, failure of the policyholder to pay the planned premium then due would not cause the UL policy to lapse, except to the extent that the policyholder's account balance was insufficient to continue to fund the operation of the policy.

In determining the cash value and the reserves of the UL policies, Company utilized a retrospective method under which the cash value and reserves with respect to a policy were equivalent to the policyholder's available account balance. The account value was recalculated each month in accordance with the premium payments made, expenses related thereto, the cost of insurance charge, and interest credits. Under the basic formula used in this calculation, the policy account value (and hence the cash value or reserve) with respect to a UL policy on any monthly anniversary date was equal to an amount determined as follows:

(a) the cash value or reserve on the preceding monthly anniversary; plus

(b) one month's interest on (a); plus

(c) 92.5% of the gross premiums received in the preceding month; minus

(d) the cost of insurance charge; minus

(e) one month's interest on (d).

Additionally, in the case of two UL policies which incorporated "back- end loads", or surrender charges, as part of the policy provisions, the cash value and reserve of the policy was further reduced by the surrender charge that would be imposed in the event the policyholder surrendered the contract.

For purposes of the above formula, the UL policies provided that the interest rate used in determining a policyholder's account value would consist of a guaranteed rate of interest plus additional ("excess") interest which Company would determine from time to time. The guaranteed rate of interest was .36478% per month, which was equivalent to a rate of 4 1/2% per annum. Under the policies, however, Company had the discretion of using a current interest rate for purposes of calculating a policyholder's account value which was higher than the guaranteed rate. In each of the years involved, the amounts reflecting interest which Company actually credited in determining policyholder account values under the UL policies were at rates in excess of the permanently guaranteed rate.

The cost of insurance was determined on a monthly basis and, with the exception of one of the UL policies (for which the additional expense charges in (b) and (c) did not apply), was calculated as follows:

(a) the cost of insurance (as described below) plus the cost of additional benefits provided by rider, plus

(b) a charge equal to 40% of the cost of insurance for the Initial Specified Amount, which applied only to the first 12 policy months, plus

(c) a charge equal to 40% of the cost of insurance for any increase in the specified amount. This charge applied only to the 12 policy months following the monthly anniversary day on which an increase in the specified amount became effective.

The cost of insurance charges applied in determining a policyholder's account value were a function of the monthly cost of insurance rate, which was based on the sex, attained age, and rating class of the person insured, and the policy's net amount at risk. The UL policies provided that the monthly cost of insurance rate could not exceed permanently guaranteed rates set forth in a "Table of Guaranteed Maximum Insurance Rates per $1,000". The rates specified in this table were based on the Commissioners 1958 Standard Ordinary Mortality Table. Under the policies, however, Company could apply cost of insurance rates which were less than the tabular rates provided that these lower rates were used for all individuals in the same rating class. In each of the taxable years involved, the amounts which Company actually deducted as mortality charges in determining policyholder account values were based on cost of insurance rates which were less than the permanently guaranteed rates set forth in the table.

Under the applicable state law, Company was required to calculate and hold, as a minimum amount of statutory reserves, a reserve at least equal in amount to a reserve calculated on the Commissioners Reserve Valuation Method in respect of the death benefit provided under the policy. In 1982 and 1983, Company reported in Exhibit 8 of its Annual Statement the aggregate reserves for the UL policies as calculated above. These reserves were reported in Company's Annual Statements as being computed on the basis of the 1958 CSO Table at 4 1/2% interest, using the Commissioners Reserve Valuation Method.

In filing its tax returns for the years 1982 and 1983, Company made an election under section 818(c) of the Code to revalue the reserves calculated and held with respect to the UL policies to a net level premium basis.

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

(B) increased by $5 per $1,000 of term insurance in 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, a preliminary term reserve method cushions the administrative 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, however, 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 for the reserve each year, the combination of these 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 computed under a preliminary term method are equal to the present value of the 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 an adjustment 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 revaluation election as follows:

ELECTION FOR 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. lst Sess., 1959-2 C.B. 736, 766-767; and S. Rept. No. 291, 86th Cong. 1st Sess., 1959-2 C.B. 770, 823-824.

Therefore, the revaluation election provided by section 818(c) of the Code allows a life insurance company which uses a preliminary term reserve method for computing reserves for State law purposes (because this method increases the company's statutory surplus and allows it to write a larger volume of new business) to adjust its reserves for purposes of computing its Federal income tax liability to a net level premium basis (because this method generally results in a larger policyholders' share exclusion of investment yield 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, fixed premiums are payable periodically over the entire premium paying period of the contract and fixed 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. The net valuation premium, which is used for calculating the insurer's statutory reserve liabilities, represents a hypothetical amount computed on the basis of prescribed mortality and interest assumptions to provide for all benefits under the policy. Once the mortality and interest rates have been determined and 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 an intervening change in reserve basis.

In contrast to the fixed assumptions which underlie the valuation of traditional ordinary whole life insurance policies, the life insurance industry has developed in recent years a spectrum of new products generally referred to as universal life insurance policies, which permit policyholders to obtain high yields on the investment element of their policies as well as the potential for low cost coverage depending on changes in the mortality and interest rates 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 fixed 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 amounts credited as interest or charged against the "policy value" account as mortality charges may be bounded by contract guarantees or restrictions. Within those limits, however, the insurer has broad discretion in setting the actual periodic interest and mortality rates to be applied in determining policy values. This flexibility as regards the interest and mortality rates used in determining policy values effectively permits the insurance company to adjust the cost structure of a universal life-type policy at any time after issuance of the policy based on changes in the insurer's expectations regarding interest rates, future mortality, or in response to competitive pressures.

In addition, flexible premium universal life policies permit the policyholder to vary the amount or timing of the premiums or to adjust the amount of the death benefit, as the policyholder's needs change. Flexible premium policies may be purchased with a lump sum premium (e.g., as a replacement for a conventional policy), with level premiums, a limited number of premiums, or with a large initial premium followed by smaller renewal premiums. Similarly, flexible premium policies permit the policyholder to change the death benefit from time to time within contract limits, subject only to the requirement of providing satisfactory evidence of insurability for benefit increases.

These elements of flexibility and discretion and the role of the policy value account in determining the amounts charged and credited represent basic differences between universal life-type policies and traditional ordinary whole life insurance policies. Traditional products may provide some degree of flexibility as to the level of benefits or use of policy values. For example, under a whole life policy, the policyholder is provided various options in the application of nonforfeiture values, including policy loans, the dividend options of participating policies, and the purchase of paid- up insurance. See Black and Skipper, Life Insurance, 80 (11th ed. 1986). However, the options offered by traditional contracts are limited in scope and present choices among a number of alternatives that are fixed and guaranteed by the terms of the contract. No flexibility or discretion is included in the operation of the basic insurance policy nor can the fixed amounts that the contract specifies typically be altered.

By contrast, the distinguishing feature of universal life insurance is the existence of an indeterminate policy value account from which specified periodic charges are deducted and to which specified interest is credited at rates not determinable at issue. This basic difference has been acknowledged in the Universal Life Insurance Model Regulation recently adopted by the National Association of Insurance Commissioners (NAIC) as well as in the studies of the universal life-type contracts prepared by the accounting and actuarial professions. 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.

Similarly, the Financial Accounting Standards Board (FASB) has concluded in a recently issued exposure draft of a proposed statement of financial accounting standards for long-duration insurance contracts that "there are significant differences between universal life-type contracts and traditional long-duration insurance contracts" and that a retrospective deposit method of accounting based on the policy value account more accurately measures the insurer's liability under a UL policy than a conventional reserve formulation.

The account balance is an amount that, absent future action by the policyholder, will continue to fund the contract until exhausted or reduced to a contract minimum. The insurer has a present obligation, arising from past transactions, to continue to maintain the contract and provide mortality protection as long as an account balance exists. Future events and transactions will change the amount of the enterprise's obligation, as policyholders make additional premium deposits and realize contract benefits. The present obligation, however, is fixed by the amount that has accrued to the policyholder.

See Proposed Statement of Financial Accounting Standards: Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Insurance Contracts and for Realized Gains and Losses from its Sale of Investments, No. 036 Financial Accounting Series, 13 (December 23, 1986).

Since the reserves for a universal life policy are based on an indeterminate "policy account" value, the issue is whether these reserves can be properly characterized as reserves computed on a recognized preliminary term basis within the meaning of section 1.818- 4(a) of the regulations.

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 computed under a preliminary term method are equal to the present value of the net level valuation premiums. See Ernst and Ernst. GAAP Stock Life Companies, 603-04 (1974).

Implicit in the definition of a preliminary term reserve method is that, like with 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 is equal to the present value of the net level valuation premiums. The net valuation premiums used in these calculations are computed actuarially using fixed assumptions as regards the level of death benefit, interest, and mortality rates, which will enable the insurance company to provide for the benefits under the policy.

By contrast, the reserves calculated and held with respect to a universal life-type policy are based on a policy account value which varies according to the policyholder's premium payments, to changes in the level of death benefit, and to the insurance company's discretionary declarations of interest and mortality rates. The distinguishing characteristic 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 rates not determinable at issue. In view of the elements of discretion and flexibility provided under a universal life-type policy, the net premium additions to the reserve for all policy durations are not determinable at issue. The use of a retrospective policy value account mechanism to derive the reserves for a universal life policy recognizes this basic difference, since the fund value does not require any assumptions as to future experience.

Notwithstanding the above, Company argues that the reserves which it calculated and held with respect to the UL policies should be regarded as reserves computed on a recognized preliminary term basis within the meaning of section 1.818-4(a) of the regulations. In Company's view, the formula set forth in the UL policies to calculate a policyholder's available account balance is equivalent to a retrospective version of the reserve accumulation for a traditional ordinary whole life policy. Also, Company argues that the resulting reserves should be regarded as preliminary term reserves because they were lesser in amount than the reserves which would have been determined for the policies using a net level premium method. Company suggests that the NAIC Universal Life Method Regulation should be considered the applicable standard for a net level premium method for universal life insurance reserves. In support of this position, Company furnished a reserve calculation with respect to a sample of its UL policies which purports to show that the reserves under its method were less than the reserves calculated under the NAIC Model Regulation.

Company's reliance on the NAIC Universal Life Model Regulation in support of the position that the reserves which it calculated and held with respect to the UL policies were preliminary term reserves appears misplaced. As a practical matter, the NAIC Model Regulation was not enacted until December, 1983, and is still being reviewed by the great majority of state insurance departments, with future changes likely. See Black and Skipper, Life Insurance, 179, 364 (1986). Therefore, even if the NAIC Model Regulation could be accepted as the applicable standard for universal life insurance reserves on a net level premium basis, it did not exist as a practical alternative method for calculating universal life reserves for the taxable years involved. Rather, the uniform practice of life insurance companies issuing flexible premium universal life policies in 1982 or 1983 was to calculate policy reserves and, in some cases, the cash surrender values on the basis of the policy account value. See NAIC Update, Record, Society of Actuaries, Vol. 10, No. 2, 960 (1984). This industry practice is significant, especially in view of the legislative purpose underlying the section 818(c) revaluation election of minimizing disparities of tax treatment between companies using different reserve methods.

Furthermore, we do not believe that the differential between the amount of the reserves which Company calculated and held with respect to the UL policies and the hypothetical reserves determined under the NAIC Model Regulation necessarily indicates that Company's reserves were computed on a preliminary term basis. In general, the Model Regulation requires an assumption that future premiums will be paid at a whole life level and contains an adjustment mechanism when the premiums actually paid do not meet the assumed premium. Under the Model Regulation, it is possible to disassociate the reserve valuation of a universal life policy from the account value mechanism. This was believed necessary because as universal life-type policies evolved, the policy values incorporated elements which were not based on the actuarial manner in which reserves generally accumulate (e.g., "back- end loads", interest rate guarantees based on outside investment indexes, fixed expense allowances, etc.). The reasoning underlying the Model Regulation was that the policy account value mechanism in a universal life policy could be considered the cost structure of the policy and not the valuation structure. See NAIC Update, supra, 960- 962; see also Black and Skipper, Life Insurance, 362-364 (1986). As a practical matter, however, and despite its apparent complexity, the Model Regulation will not result in reserves which are materially different from reserves based on the policy value account provided the fund accounting mechanism incorporates interest and mortality guarantees equivalent to the reserve valuation rates.

Although read literally the Model Regulation has sections that seem exceedingly complex, for those plans which are designed under the classical model (i.e. with interest and mortality rate guarantees equivalent to the reserve valuation rates) the reserve can be reduced to a simple formula involving only a one-step adjustment to the account value. No projection and discounting is necessary. For those plans which deviate from the classical model only by way of one-year prospective guarantees, a single two-step adjustment will suffice. The valuation method was designed such that those who wanted to try more esoteric forms (of fund accounting) would not be prohibited from doing so, yet for 90% of the plans out there the calculation would be very simple. . . . [I]f the plan is designed under the classical model, then the reserve is . . . a simple adjustment to the fund value.

Statement of Mr. Shane P. Chalke, NAIC Advisory Committee, NAIC Update, supra 966 (1984). Therefore, the differential between reserves calculated on Company's policy value method and universal life reserves based on the Model Regulation is not indicative that Company used a preliminary term reserve method. Rather, this difference may reflect surrender charges, prospective rate guarantees, or the effect of adjustments required when the premiums actually paid are less than a whole life level.

CONCLUSION

The life insurance reserves calculated by Company with respect to the UL policies are not reserves computed on a recognized preliminary term basis. Therefore, the reserves established during the taxable years 1982 and 1983 do not qualify for revaluation under section 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.