Pub. 2 2021 Issue 3

cbak.com 6 In Touch Changes Are Coming Fast BY RICHARD BRATTEN, FSA, CFA, REGIONAL MANAGING DIRECTOR, BANK COMPENSATION CONSULTING, AN ENDORSED CBA PROVIDER Congress Strikes! The Consolidated Appropriations Act (CAA) was signed into law on Dec. 27, 2020. As you probably know, virtually any legislation passed at the federal level is a potpourri of goodies or, maybe not so goodies depending upon your point of view! The CCA included a change in the interest rates that are used by insurance companies for the purposes of determining whether a contract qualifies as a life insurance product under 26 U.S. Code § 7702. The immediate effect of this change is to reduce the relevant interest rate for one of these tests from 4% to 2% to reflect life insurance product economics in this ultra-low interest rate environment. You’re probably wondering if this is something that only an actuary like myself would care about. While there may be something to that, this change is having immediate and profound effects on life insurance products, including single premium products such as Bank-Owned Life Insurance (BOLI) as well as individual whole life and universal life annual premium products. What does it all mean for you? Today, I’ll address the impact on BOLI products. Chocolate Cake? Many of you have heard me speak about BOLI like a chocolate cake. The single premium put into a BOLI policy creates the Cash Value (CSV), which is the chocolate cake. That chocolate cake comes with a thick layer of icing! The icing, in this case, is the Net Amount at Risk (NAR). That is the amount of additional life insurance that comes with the cake. The chocolate cake + the layer of icing adds up to the insurance policy’s total Death Benefit (DB). So, Entire Delicious Desert = Chocolate Cake + Icing and, Death Benefit = Cash Value + Net Amount at Risk. Life Insurance is Special Life insurance has some excellent tax benefits that reflect the long-standing tax policies supporting the ability for consumers to purchase affordable life-long permanent insurance coverage. One of these tax benefits is tax deferral. The Cash Value compounds that are within the policy, without being taxed along the way (I’m simplifying here — there are many rules governing the taxes/penalties you might pay if you withdraw cash or surrender the policy instead of holding it until the death of the insured person.) When the Death Benefit is paid out to a beneficiary(ies), that Death Benefit payment is generally not taxed. Since life insurance gets this important tax treatment, the IRS has certain requirements to make sure that someone doesn’t create an investment product that they call “life insurance” just to get the tax-advantaged treatment. How does one test to see if something is an insurance product? Enter “26 U.S. Code § 7702, Life Insurance Product Defined,” or just 7702 as we call it. One of the tests, and the one that is generally applied to BOLI products, goes like this: you must have a certain amount of icing on your cake. If you don’t have a thick enough layer of icing, then it’s not insurance. Pretty simple, eh? And you thought actuaries were so complicated. Testing for Insurance So what is the correct amount of icing needed for the chocolate cake? The test calculations vary for insurance policies based on the age and sex of the person being insured. For a 45-year-old male, the ratio of icing to cake has to be about 3 to 1. That’s a thick layer of icing! For a 65-year-old male, the ratio of icing to cake only has to be about one to one. So for a 45-year-old male and a BOLI premium of $100,000, the NAR has to be at least about $300,000. That’s a lot of icing. That means a total Death Benefit of about $400,000. For a 65-year-old male and a BOLI premium of $100,000, the NAR has to be at least about $100,000. Not as much icing is required. That means a total Death Benefit of about $200,000. E n d o r s e d P a r t n e r