#259 | Section 7702 Q&A

The Section 7702 Christmas Miracle Update

It’s been a whirlwind start to the year for the life insurance industry. Since publishing The Section 7702 Christmas Miracle on January 5th, it has amassed an unbelievable 16,000 reads – a testament to the degree to which the changes to Section 7702 caught the industry off-guard and folks wanted to read about what was going on. I put a preface at the top of the article saying that it was an “evolving” situation and that has certainly proven to be true. I’ve also been asked some phenomenal questions about the impacts on particular nooks and crannies of the market that I think are worth exploring. As such, it’s time for an update and I think the best way to do it is in a more conversational Q&A format rather than an article. I would also add, again, that I’m still learning a lot in the process and my answers to some of these may change. I’ll keep it updated. Enjoy!

When will these changes take effect?

Well, that depends. The interest rate in Section 7702 was changed to 2% on 1/1. For Whole Life products, guaranteed premiums, cash values and death benefits reflect what is currently priced into the product, meaning that the contracts will need to be updated before the new rules to take effect for the purposes of that contract. For Universal Life, however, the answer is much murkier. The only portion of the 7702 calculations that is hardcoded into the contract is the GPT/CVAT corridor. “Updating” a Universal Life policy is means fixing the illustration system, compensation and policy charges – not reworking the contract. Early indications are that the only refiling required is in the Statement of Variability, which details how the bracketed portions of the contract filing will change (and to what degree).

What happens if a client pays a premium based on the new limit into a policy?

Most Universal Life contracts have a provision that says, basically, that any amount paid into the policy that would cause it to unintentionally become a MEC will be refunded to the client but the maximum non-MEC premium is not defined within the contract. Therefore, technically, a client could fund up to the new 7702 premium limits into any policy issued after 1/1/2021 and, according to the contract, the life insurer shouldn’t refund the money based on the old 7702 limits (because they’re not in the contract). Officially, life insurers are going to say that they haven’t updated their contracts and their illustrations will reflect the old 7702 limits. But in reality, the client can already overfund the policy to the new 7702 limits – but it’s going to be a potential administrative nightmare to get it done and, if the policy is under CVAT, then you’ll have the new premium limits combined (strangely enough) with the old, contractually defined CVAT corridor.

Do the new limits apply to in-force policies issued prior to 1/1/2021?

No, they do not. Any policy sold prior to 1/1/2021 operates under the old 7702 rates. A client with a policy issued 3 years ago can’t suddenly fund the policy at a higher level because of the new 7702 rates. The only wrinkle, however, is in the event that the policy is “reissued” as a result of a material modification or the addition of a benefit (such as a rider) that causes the policy to be reissued. As of right now, my understanding is that these circumstances are going to be very limited and will vary by carrier.

Are there “firesale” opportunities in the market because of Section 7702?

No, not really. Net of all changes, Universal Life policies are going to look very similar to what they do today, they’re just going to be remapped to the new pricing and compensation geography. For Whole Life products, companies will very likely reprice certain products to much higher premium levels. This results in less attractive guarantees but likely more attractive non-guaranteed performance. If a client is completely focused on guaranteed values, then yes, it’s a firesale. If a client is focused on a balance between guaranteed and non-guaranteed values, then they should be aware of what’s coming and decide what they want to do. If a client is focused on non-guaranteed values, then they might want to wait. It depends.

What’s going to happen with Whole Life products?

As mentioned above, prices are going to increase across the board as carriers move their guaranteed rates down from 4% to somewhere between 3.75% (the Non-Forfeiture Rate for 2022) and 2%. You might see a company reprice its Whole Life 100 product to a 3% rate, its 20 Pay Whole Life to a 2.5% rate and its 10 Pay Whole Life product to 2.25% – increasing guaranteed premiums in every circumstance. I think it’s also possible that we see the end of 10 Pay Whole Life because that product was created as a result of CVAT/MEC limitations under the old 7702 rates and, instead, companies will introduce 7 Pay Whole Life products for accumulation. This will allow Whole Life to compete heads-up against Universal Life products that have long been sold on 7 Pay (or even shorter) designs.

How is compensation going to change?

Carriers basically have 3 choices – maintain current compensation structure at the current levels, maintain the compensation structure at new levels or rework the structure altogether. So far, my feeling is that companies are going to take one of the first two choices, at least for now. However, I also think that some companies will look to rework compensation for their next product launches, most of which were slated for later this year or early next year. Furthermore, my hunch is that companies will attempt to create some sort of hybrid compensation structure that still has a Target premium based element with heavy excess premium components to balance compensation across different funding patterns. But no matter what happens, there’s going to be a lot of different approaches and compensation is going to become very much a part of the competitive landscape again.

How will case design change?

For low premium, death benefit-oriented designs, case design won’t change except in one-off scenarios.  On the accumulation side, however, I think there will be the potential for a movement away from GPT and towards CVAT for three reasons. First, as discussed in the previous article, the new CVAT corridor is much tighter and more comparable to the GPT corridor, reducing the benefit of using GPT by about half. Second, CVAT is simpler to administer. GPT designs hinge on using a face amount option switch and face amount reduction, all occurring at least 7 years in the future. There’s a broad understanding in the industry that this is going to be a looming problem considering how poorly administered most life insurance policies are. CVAT, by contrast, can offer efficient funding and accumulation without any required future policy changes.

Second, the gap between the Option 2 Guideline Level Premium and the maximum 7 Pay non-MEC premium is wider under the new rates, particularly for younger clients. For example, under the old 4% rate, the Option 2 GLP is $26,046 and the 7 Pay premium is $30,615, which means that someone using GPT is going to only be able to fund to 85% of the 7 Pay premium whereas they’d be able to fund the policy up to the full maximum non-MEC limit with CVAT. But under the new 2% rate, the Option 2 GLP is just 75% of the 7 Pay premium ($48,214 vs. $63,316). However, these differences will vary by company because GPT premium calculations include non-COI policy expenses and CVAT does not. As the issue age rises, the gap lowers – at 45, the GLP/7 Pay ratio is 84% and at 55, it’s 95%. For younger clients, the extra benefit of being able to fund all the way to the 7 Pay limit may be enough to chip away at the advantage of the tighter corridor with GPT.

How do the new 7702 rates impact Private Placement Life Insurance?

The short answer is that the impact to PPLI is the same as retail products – higher maximum non-MEC premium limits and tighter CVAT corridors. However, PPLI is actually less effected from a compensation standpoint than retail products because it doesn’t have the same issues with Target-based compensation that retail products do. However, that doesn’t mean it’s immune. Some PPLI products may need to be repriced because the life insurer was baking in a certain margin for profitability in the COIs and now there’s going to be less insurance coverage and, consequently, less COI charges and less COI margin. But on the whole, PPLI is well positioned to benefit from the new higher maximum non-MEC premiums.

What impact does this have on premium financing?

That depends on the reason for the premium financing. In traditional premium financing, there’s always a balancing act between overfunding of the policy, which creates more interest drag and initial collateral exposure, and the long-term potential death benefit IRR. Funding to the maximum limit may not be the optimal choice. For premium financing for the purposes of illustrating retirement income, this is going to make the policy accumulation slightly more efficient (again, 10-20bps), which will add to the “arbitrage” being illustrated to the client. It’s hardly a windfall for premium financing promoters, but it does provide more design flexibility and some designs will benefit more than others.

Will there be a tsunami of 1035 Exchanges, particularly in BOLI/COLI?

For corporate and institutional buyers, life insurance is used as a balance sheet asset primarily for its accumulation properties with the death benefit viewed as a kicker. Newly sold COLI/BOLI products will be 10-20bps more efficient because of higher maximum non-MEC premiums and thinner CVAT corridors. In theory, that would open up a huge opportunity to exchange in-force contracts with new ones. I’m not so sure. The acquisition expenses associated with buying a new COLI/BOLI product are probably in the neighborhood of 7% of the exchanged value (3% for state and federal premium taxes, 2% for compensation and another 2% for carrier profitability). It would take many years of a 0.1% increase in efficiency to make up for the new acquisition costs. But more importantly, the efficiency of the new products comes at the cost of lower death benefit coverage and the death benefits add real economic value to the COLI/BOLI buyer. I would argue that, for COLI/BOLI buyers, this is actually a neutral trade (death benefit payouts for accumulation efficiency) and absolutely not reason enough to exchange from an old contract into a new one.

As an advisor, do I have a fiduciary duty to tell my client to wait/hurry up?

No. This is not about a “better” or “worse” product. This is about tradeoffs. In Whole Life, the new products will have worse guarantees and better non-guaranteed performance. In Universal Life, the accumulation efficiency may increase but at the cost of death benefit coverage, which is – I shouldn’t have to remind anyone – is valuable and ostensibly the reason for the sale in the first place. However, it’s probably a good policy to tell clients that the change is coming to see if it might make sense to move quickly or wait based on their particular situation.

Is there an impact to LTC linked-benefit products?

Yes. Virtually all linked-benefit products set their death benefits at the CVAT corridor limit. If you put in a $100,000 single premium, the initial death benefit of (say) $200,000 is the CVAT corridor limit. Under the new 7702 rates, that corridor might be something like $150,000. This will allow companies selling LTC linked-benefit products to lower the death benefits and either pocket the profitability or (more likely) increase the LTC benefits. In other words, it lets insurers put more weight on the LTC side of the equation and less weight on the life insurance side. Is that a good thing? From an actuarial standpoint, it’s an even swap. But for marketing purposes, it’s probably a good thing.

Will this allow Whole Life to compete better with Indexed UL?

Yes. Whole Life has been hamstrung into 10 Pay variants using CVAT whereas Indexed UL products are often sold in 5 and 7 pay designs using GPT. This creates an inherent accumulation advantage for Indexed UL. But with Whole Life switching to a 7 Pay design and operating on a thinner CVAT corridor, Whole Life will claw back most of that advantage. Couple that with Indexed UL caps continuing to fall and AG 49-A clipping the wings of any leveraged IUL strategy and it’s possible that some of these new Whole Life products will illustrate very similarly to Indexed UL. And I would add that if that’s the case, the argument for buying an Indexed UL product becomes, shall we say, rather speculative.

If the 7702 rates can reset, then are we going to go through this every year?

Possibly – but that’s highly unlikely. The rate can reset every year, but it won’t because of the smoothing mechanisms built into the formula. The 7702 rates will change when the Valuation Rate changes. The Valuation Rate is based on a formula using average market interest rates spread out over time. It takes some outsized swings in rates (like we saw in 2020) to make the Valuation Rate move enough to reset. However, we should get used to a regime where the 7702 rates do change every few years and, in some cases, even more frequently. This is certainly not a one-and-done fix. However, it’s also worth noting that the 7702 rates can never go higher than the 4%/6% that was in effect prior to 1/1/2021.

Is there a consensus on how to handle the transition to the new 7702 rates?

Yes and no. There’s consistent high-level agreement on the major points, but there are a lot of rare situations where there’s not much clarity on what to do and where, even more importantly, obscure contractual language will dictate that carriers handle these situations differently. Of note, particularly, are post-issue transactions like face increases, face decreases, rider additions – things like that. Very few clients actually exercise these rights but it’s possible that, as strange as this sounds, some companies might start to market these options because they believe that it gives the client some sort of advantage under the new rules.

Where should I go if I want to read more about 7702?

Uhh, are you sure you want to do that? Ok, well, have fun:

Let me illustrate… §7702 and §7702A specifications (nongnu.org)

I’ll add to this post as I get more questions. Feel free to send questions to me directly at bobby@lifeproductreview.com.