Code Section 7702 and 7702A: What To Know about the Recent Changes

Introduction of Code Section 7702 and 7702A:

In the 1980’s (when both 7702 and 7702A were written) a 4-6% interest rate was a rather conservative one, given the environment.

At the moment, however, interest rates are much lower.

When you write a statute without a formulaic way to adjust for the rate, you can anticipate changes will be necessary.  Somehow, the minimum interest rate prescribed by these calculations (4-6%) hasn’t changed in over 30 years.

After over thirty years, Code Section 7702 and 7702A are finally in the spotlight after successful advocacy from organizations such as AALU.

So what exactly are Code section 7702 and 7702A?

Code section 7702 and 7702A are the code sections that deal with the statutory definition of life insurance.  It includes two separate tests, the cash value accumulation test (CVAT) and the guideline premium test (GPT).  Each policy must pass one of the tests in order to qualify and meet the definition of life insurance.  There are also limits set by the code on premiums paid into a policy and/or the amount of cash that can accumulate relative to the death benefit.

What Led to the changes to Code Section 7702 and 7702A:

While interest rates have been low for some time now, when COVID hit, and the federal government slashed interest rates to 0%, carriers were faced with extremely low interest rate investment options for maturing securities in their investment portfolios.  This led to additional pressure to reprice policies.  But the higher premiums needed to adequately fund policies in a low interest rate environment conflicted with the maximum premiums permitted under 7702, which was based on much higher interest rates.

This was causing a threat to the availability of affordable (and also profitable) insurance.

Changes to 7702 were included as part of the Consolidated Appropriations Act passed on December 27, 2020 and went into effect on January 1, 2021.

EBS Live Discussion – Recent Changes to Code Section 7702 and 7702A:

We sat down for a live discussion to talk through the changes and their impact on the insurance world.  Chris Rich, from EBS, and Michael Fontanini, from Lion Street were our experts.  The discussion was led by our moderator, also from EBS, Trevor Lattin.

Michael focused on the background of 7702 and 7702A as well as the details and high level impact the changes will have.  We’ll leave the calculations and formulas to Michael, but you can expect a walk-through of the two tests (CVAT and GPT), what led up to the changes, and the impact in general at a high level.

Policies need to be profitable, affordable, and pass the test.  This recent change will allow the formula to float (in everything but the single premium) given the interest rate environment in effect over time.

So what do the changes mean for the insurance world?

Ultimately, what the new 7702 formula means for whole life insurance is that it can be priced much more flexibly and still pass the tests to qualify as life insurance.  The change also means that the policy owner has the ability to pay more premium into the policy.

Michael said that carriers are going through pricing and competitive exercises (all of which can take time) but that he expects to see more carriers incorporate these changes into their policies as 2021 progresses.

He noted that the most important impact is that more premium can now be paid – for example, 50% more – into a policy without violating Section 7702.  That’s great news for clients – less death benefit per dollar of premium means improved performance.

Expect to see an improvement in COLI policies as well – the products used by corporations to informally fund SERPs, deferred compensation plans etc.  We heard from Chris Rich on the general impact of the changes on the corporate market.  He remarked on the significant reduction in net amount of risk because of the changes in 7702.  This is good for policyholders, but does potentially impact carriers with reduced revenue from mortality charges.  He agrees that we should expect to see repricing throughout 2021.  Producer compensation will likely be reduced as well.

At the same time, Chris said to expect to see some shifts in the BOLI space.  The decline in the face amount for a given amount of premium will have carriers trying to adjust crediting rates to offset the loss in insurance charges.  Of particular interest for producers is the fact that a fewer number of lives will be needed for a given transaction size.

On the other hand, what do we expect to see from the ICOLI market?  It’s quite a different market.

Chris Rich raised the question, “Why do insurance companies purchase ICOLI?”  Insurance companies are driven by an opportunity to expand asset allocations in their portfolio, and the insurance wrappers have tax and RBC advantages that allow insurance companies to access alternative investments that they otherwise could not.  The products used in these applications are almost always private placement policies.  The reduction in net amount at risk under new 7702 will have a modest impact on these policies because mortality charges are low upfront, or are even experience rated.