Federal Income Taxation of Life Insurance Companies: Pending Principle-Based Reserve Calculation Raises Federal Taxation Concerns

The pending NAIC principle-based model would use principles to govern reserve valuation as a way to more accurately capture the underlying risk of the contract by using principles of risk management, asset adequacy analysis and stochastic modeling. The principle-based approach is a consistent methodology that can be applied across all products.

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In Notice 2008-18 , the Service identified issues that may arise as a result of adopting a principles-based approach for calculating statutory reserves for life insurance companies. Notice 2008-18 identifies areas in which the Treasury Department and the Service have concerns... eight federal income tax issues that may arise if Proposed Life PBR and Proposed AG VACARVM are adopted.

Continued Taxation of Issuers Under Part 1 of Subchapter L

Reserves determined under the proposed methodologies may not constitute "life insurance reserves" under Section 816(b). The Treasury Department and the Service think it would be inappropriate to apply a literal application of the 50% reserve ratio test of Section 816(a), such that all life insurance companies would be taxed as nonlife insurance companies, due solely to changes in the statutory reserve methodology.

The Treasury and the Service may publish guidance...

Qualification of Contracts as Life Insurance Contracts. The adoption of Proposed Life PBR may make it difficult for issuers of life insurance contracts to satisfy the requirement of Section 7702(c)(3)(B) that reasonable mortality charges not exceed the mortality charges specified in "the Commissioners' standard mortality tables" as defined in Section 807(d)(5)...

Contract-by-Contract Versus Aggregate Reserves. The Treasury Department and Service are concerned that a portion of the reserves under the proposed rules would not represent an expected value of a company's obligations with respect to the underlying contracts...

Prevailing State Assumed Interest Rate. In the case of Proposed Life PBR, the absence of a single, prescribed interest rate may mean that taxpayers should be allowed to determine tax reserves simply using the AFR and not the greater of the AFR or prevailing state assumed interest rate...

Prevailing Mortality Tables. The Treasury Department and Service are concerned that determining an aggregate reserve stochastically and, after the fact, using the reserve to "map" to one of a large number of NAIC-approved mortality tables would not satisfy Section 807(d)(2)'s requirement to use the prevailing Commissioners' standard tables to determine the tax reserve for a contract...

Application of Transition Rules to In-Force Contracts. If the proposed reserve rules are adopted, the new rules would apply for federal income tax purposes only to contracts issued after the date of adoption--not to previously issued contracts in force on that date, regardless of the applicability of the new rules to previously issued contracts for regulatory purposes...

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1-6A Federal Income Taxation of Life Insurance Companies § 6A.08