Updated September 7, 2023, at 11:31 AM
Of course, the first part of the title is the famous first line to one of the greatest stories ever written, A Tale of Two Cities by Charles Dickens. That opening line fittingly describes the landscape of our industry right now on two noteworthy levels.
The life insurance industry has gone through the best of times and the worst of times during the COVID-19 pandemic. Life insurance applications are up significantly due to COVID, but underwriting and processing these apps have been slower and more challenging than ever.
Many families face significant financial struggles due to layoffs and reduced income during COVID, making it more difficult for them to pay the premiums on life insurance policies.
Often, when budgets get tight, life insurance premiums are the first budget cuts made. But, also arising from the pandemic, we’ve seen two exciting and advantageous regulation updates that’ll ultimately benefit our industry in significant ways.
A Tale of Two Changes
That’s the second analogy that fits Dickens’s classic opening line. The life insurance industry right now is going through a “tale of two changes.” These two changes will affect our industry for years, decades, and even generations to come. These two changes revolve around permanent life insurance, and they involve Actuarial Guideline 49-A (AG 49-A) and Section 7702 of the Internal Revenue Code. These alterations are happening simultaneously, making this a truly revolutionary moment in our industry.
While most of the changes brought about by these two regulation updates are very good (the best of times), some changes can be construed as negatives for those in our industry (the worst of times). First, let’s dive into a short history of both regulations.
AG-49 Transforms into AG 49-A
Before there was AG 49-A, there was Actuarial Guideline 49 (AG-49). It was developed in 2015 by the National Association of Insurance Commissioners (NAIC) to provide some rules and regulations toward how life insurance carriers illustrated their index accounts’ performance in their indexed universal life plans. Some carriers showed potentially unrealistic assumed rates of return on their illustrations, which many felt were misleading to the public.
So, the NAIC developed this new guideline to try to level the playing field. As we all know, insurance companies are very innovative and creative when it comes to staying competitive. And before we knew it, many started including bonuses and multipliers in the IUL products, which effectively circumvented the AG-49 regulations. With these bonuses and multipliers, the illustrated rates could again inflate, potentially misleading the consumer. The playing field was, again, unlevel.
In late 2020, the NAIC developed and implemented AG 49-A, a revision to this original AG-49. Now, AG 49-A requires all IUL products—even those with bonuses, multipliers, or other enhancements—to be illustrated appropriately and consistently under new standardized guidelines. In a nutshell, this new revision regulated the extent to which IUL carriers could manipulate their illustrated returns based on these enhancements, bonuses, and multipliers.
The enhancements could still be illustrated, but there were specific limits on enhancing upside potential and downplaying downside risk. It provides a more realistic and conservative defined return for the consumer, which is a good thing. The downside to this new regulation was that it cost insurance carriers a lot of time, effort, and money in revising their products to fit the new guidelines.
How Section 7702 Came to Be
The story behind the changes in Section 7702 is fascinating, and these changes have a potentially meaningful impact on permanent life insurance in the future. Section 7702 is the Internal Revenue Code section that defines what the US government considers a legitimate life insurance contract and the taxation of that contract. Staying within the guidelines of Section 7702 is a crucial element to having access to several significant tax advantages that are inherent in a life insurance policy.
Regarding the cash value in a life insurance policy, staying within the Section 7702 guidelines can provide access to the cash value inside a life insurance plan with significant tax advantages. In many cases, the cash can even be accessed income-tax-free. The problem was that Section 7702 created a conundrum for whole life contracts. When the guidelines were set for a “guaranteed interest rate” under 7702 (in the mid-1980s), interest rates were generally pretty low, and the IRS didn’t foresee rates dropping much further, if at all.
So, the IRS set a static rate of 4% to the mandated minimum interest rate a whole life policy had to guarantee. Well, interest rates did fluctuate, and yes, they did drop from those mid-1980s levels. We all know how low interest rates have been recently and how long they’ve been incredibly low.
Whole life carriers were suffering from providing good, reliable products as they had to guarantee a 4% rate of return when it was next to impossible to generate that type of return anywhere in the market. This created a severe lack of flexibility in whole life products that had to adhere to these 7702 guidelines.
Life Insurance Changes Due to Section 7702
Enter 2020 and the COVID-19 pandemic (and the economic tumult that ensued). It became evident that interest rates were going to remain low for the foreseeable future. Near the end of 2020, Congress put together a relief bill, essentially to help the American public with problems created by the pandemic. Many elements of this spending bill were added (and some would say sneakily added) at the eleventh hour, and the bill passed through Congress at the end of 2020, with very little fanfare.
One part of this spending bill included changes to Section 7702. The primary difference was that the guaranteed minimum interest rate could now be fluid and no longer set at a static, unchanging 4%. It made sense to make the change. It’s just peculiar to many in the industry why the change was so covertly hidden in the bill at the last minute. Nevertheless, it was, and now guaranteed rates are lower and more flexible. The details behind what this change will bring are complex, but I’ll attempt to summarize it in a “best of times, worst of times” fashion:
This change will bring about much more flexibility in whole life contracts and all permanent contracts. Because of the lower mandated guarantees now required, there’s much more flexibility in premium paying. In a nutshell, for those wanting to “maximum fund” their permanent life insurance plans, the amount of premium they can now put in (and still stay within 7702 guidelines) just went up significantly. In other words, those wishing to use life insurance to build tax-advantaged cash values can now put in much more premium than they could before the change.
That’s the upside. There’s a downside, too.
For whole life insurance, the drawback is evident. With guaranteed rates being lower, so will guaranteed cash values. So one of the most advantageous elements to owning a whole life contract (the guaranteed cash values) will no longer exist. Is that a big deal? Only time will tell. The other downside of 7702 hits those of us selling these plans. Even though the amount of premium the IRS allows to fund these plans increases, the structuring of these plans under the new guidelines will force the death benefit to drop.
This, in turn, reduces the target premiums and commissions. The lowered death benefits can also be considered a downside to the change, but in most cases, the death benefit isn’t a primary consideration when max-funding these plans.
Impacts of AG-49A and Section 7702
The three primary themes of Dickens’s classic novel (revolution, sacrifice, and resurrection) can also be observed in the changes to these two crucial life insurance regulations. The changes are indeed revolutionary. Never in our industry have we seen such change enacted in such a short amount of time. These adjustments will likely improve the industry, but this change will be tedious, costly, and probably confusing.
There are sacrifices to be made.
Commissions will likely be lower. Guaranteed cash values will also suffer, as will death benefits. As stated earlier, the costs, time, and hassles of making these product changes to comply with the new guidelines will be a huge sacrifice for all involved. But ultimately, A Tale of Two Cities is about resurrection. About rebuilding a faltering foundation into something that can flourish and thrive into the future.
This is also what these recent changes in AG 49-A and Section 7702 enact—a resurrection of some of the least appealing elements of permanent life insurance into versions of themselves that can flourish in the future to bring even more value to those we serve going forward. The coming year will undoubtedly be tumultuous as carriers work feverishly to comply with these two regulation changes.
This great effort and expense will bring about changes in permanent life insurance policies that serve our clients’ needs more effectively and efficiently. After all, that’s what we all should be striving for from our first day until our last.
AG 49-A and Section 7702 Impact Summary
Actuarial Guideline 49-A
- Better transparency for the consumer
- Stricter guidelines for illustrating multipliers, bonuses, and other enhancements
- Significant costs to change or update products and illustration software for some carriers
- Generally lower maximum illustrated rates in illustrations
- Limits illustrations to a single benchmark index account (BIA) for all index strategies
- Mandates that the hedge budget for the BIA may not exceed the company’s annual net investment earned rate (ANIER)
- Lower § 7702 minimum interest rates, effective January 1, 2021
- CVAT 2.00%, GPT 4% rate for 2021, and floating rate after that
- Policy owners, advisors, and carriers will all be impacted by § 7702 changes.
- Net Positive for the industry-greater flexibility, greater accumulation potential
- Net Positive for permanent accumulation sales
- Possibly Net Negative for permanent death benefit sales and commissions
Policy owners can put more premium dollars into life insurance policies, exposing greater funding to tax-free compounding. Accumulation products should be more attractive and more efficient.
Carriers will reassess their product portfolios, update product designs, refile products in every state, and reconfigure illustration, product management, and administration systems. Carriers will also be forced to overhaul compensation to account for radical premium changes.
Financial professionals will need to review all in force accumulation policies and consider timing and available products to sell as changes are implemented throughout 2021. Suitability and appropriateness will be an essential exercise. The compensation formulas will change.
The content within this article is for educational purposes only and does not represent legal, tax or investment advice. Customers should consult a legal or tax professional regarding their own situation. This article is not an offer to purchase, sell, replace, or exchange any financial product. Insurance products and any related guarantees, features and/or benefits are backed by the claims paying ability of an insurance company. Insurance policy applications are vetted through an underwriting process set forth by the issuing insurance company. Some applications may not be accepted based upon adverse underwriting results.