#328 | Rising Rates and Section 7702

I don’t think it’s an overstatement to say that the biggest shock in the life insurance industry in the past decade was the Section 7702 rate change that came into effect at the beginning of 2021. It was both swift and severe, a huge change that came into effect with virtually no warning. Every company selling Whole Life had to drop everything and scramble to reprice their entire portfolio or face the prospect of gaping holes in their product lineups. On the Universal Life side, every product sold after 1/1/2021 was already under the new 7702 rate but no carrier had the ability out of the gate to quote the new tax limits, setting off a mad rush to make reporting, contract and in some cases pricing updates.

In all of the chaos, the messaging got a bit muddled. The general perception in the market seems to be that the 2% rate being implemented across the industry is the new Section 7702 rate. That’s not the case. In fact, the 2% rate was a transitional provision that expired at the end of 2021, barely after the ink dried on all of the newly released products because it expired at the end of 2021. We are already living in the post-2% world. We just don’t know it yet. We’ve been lulled by the smoothness of the transition.

This new world is uncharted territory for the life insurance industry. From 1985 until 2021, the Section 7702 rate was locked at 4%. From 2022 onward, the Section 7702 rate is designed to float over time to generally reflect the prevailing interest rate environment. It’s a fundamentally different regime than what existed before, one that can dynamically adapt to keep life insurance tax limits in-tune with the prevailing interest rate environment. That means we, as an industry, need to prepare for not just the prospect but the inevitability of periodically (and somewhat predictably) changing tax premium and corridor limits.

First, let’s tackle when the rate will change. Section 7702 states that the 7702 Rate will change in an “adjustment year,” subsequently defined as “the calendar year following any calendar year that include the effective date of a change in the prescribed U.S. valuation interest rate for life insurance with guaranteed durations of more than 20 years.” In other words, the 7702 Rate will change with the valuation rate changes.

That’s good news for insurers who might rightfully concerned about constantly changing tax limits. The valuation rate is specifically designed to change infrequently. In order for the valuation rate to change, the reference rate, which we’ll discuss next, has to have moved enough for the valuation rate itself to shift 50bps – and the reference rate itself is rounded to the nearest 0.25%. Since 1983, the valuation rate has changed just 6 times, which is an average of a little more than 6.5 years between each change. The reason why the 2% 7702 rate from 2021 hasn’t changed yet is because the valuation rate hasn’t had an adjustment year. But when that happens, the 7702 rate will be up for a potential revision.

This leads us to the second question – how the Section 7702 rate will change. The new law states that the “insurance interest rate” to be used for tax purposes is the same valuation rate as above. This effectively links the valuation rate with the 7702 rate, which theoretically makes a lot of sense. So how does the valuation rate change? It’s trickier than it looks.

My first pass through the valuation model regulation left me with the distinct impression that the valuation rate directly reflects the “reference rate,” which is a rolling average of the Moody’s Seasoned Corporate Bond Index. However, this simple understanding didn’t line up to what I saw in the data. For example, bond yields in the 1980s were north of 10%, but the valuation rate never got above 6%.

Part of the issue is that the reference rate is based on the lesser of a rolling average of the Moody’s index over the past 36 months and the rolling average over the past 12 months. It’s an interesting structure because it tends to drop faster than it increases, forcing carriers to be more conservative as rates drop but not allowing them to release reserves as rates increase. But still, this lesser-of rolling average concept can’t explain the gap between real-time market interest rates and the valuation rate.

I went back to the regulation and read it more carefully. It turns out that the valuation rate is a formula based on the reference rate, but not linked on a 1-to-1 basis. At the risk of using an analogy that will only make sense to a couple of folks, the valuation rate formula is like the Fox DPX2 rear shock on my mountain bike – it has a resting position (“sag”), a primary shock absorber and a separate excess pressure chamber that kicks in when the primary absorber taps out.

For the valuation rate formula, the resting position for the reference rate formula is 3%. The primary shock absorber adds 35% of the difference between the current Moody’s rate and 3% to the reference rate, which can be positive or negative, but only applies to Moody’s rates below 9%. For Moody’s rates above 9%, the excess pressure chamber kicks in, adding 17.5% of the difference between the Moody’s rate and 9%. Add all 3 together and you get a relationship to the Moody’s rate that looks like this, where the black dotted line is a 1-to-1 with the Moody’s rate and the yellow line is the valuation rate.

This three-part valuation rate function stabilizes the rate against big swings in interest rates in either direction. Hence, the reason why the ultra-high rates of the 1980s translated to a much more modest valuation rate. What this means for Section 7702 is that it’s not so simple to just say that if the Moody’s index rolling averages get above 4%, then the Section 7702 rate is going to go to 4%. It has to flow through this formula first. To get to a 4% valuation rate that would trigger the maximum 7702 Rate of 4% and essentially revert Whole Life to where it was prior to the new 7702 regime, you need to get to nearly a 6% Moody’s rolling average. Market rates are certainly higher right now, but they’re not that high.

However, let’s assume for a minute that interest rates froze where they are right now. What would happen? Take a look at the table below. Remember that the applied valuation rate only changes if there’s enough of a move in the calculated valuation rate to force a 50bps move in the applied valuation rate, hence the stepped changes for the applied valuation rate. These are month-end figures because that’s how the model regulation calculates the rates, hence the reason for the smoothness.

What this graph is saying, essentially, is that if rates froze where they were today, we’d see an increase in the applied valuation rate from 3% to 3.5% in 2025, the first adjustment year since the new Section 7702 regime. That would automatically trigger a reset in the Section 7702 rate to equal the valuation rate, which would be 3.5%. At that moment, all Whole Life products priced with guaranteed rates below 3.5% – which is almost every Whole Life product on the market – would have to be repriced back up to 3.5%. It would be a seismic shift, a huge disruption, a reversion back to nearly the pre-2021 world of Whole Life. And based on this math, it’s coming down the tracks like a freight train in just 3 years.

Except that just as the train is bearing down on us, the switch flips and the train diverts safely on to a side rail, leaving the industry wincing and bracing for the impact. In Section 7702, the “insurance interest rate” is defined as the lesser of the valuation rate or the 60-month average of the mid-term AFR. It’s difficult to overstate the impact of this little paragraph, so let me put it into perspective – the August 2022 mid-term AFR is just 3.15%, a full 1.35% less than the current Moody’s index. And on top of that, the valuation rate is the lesser of the average over the 36 months or 12 months, but the AFR formula uses the rolling average over the past 60 months. Take a look at the same chart above but now with the mid-term AFR frozen at the August level:

Based on this graph, even with a valuation rate adjustment in 2024, the Section 7702 rate would still stay frozen at 2% thanks to the exceedingly generous mid-term AFR provision in the new 7702. It’s pretty wild, actually, that the industry managed to lobby for this provision. The way the 7702 rate is written, heaven and earth must move in order for the rate to increase because of the 60-month AFR clause – but the rate relatively quick to respond to falling rates thanks to the 12-month Moody’s rolling average in the reference rate. 7702 is written in such a way that it seems the 2% rate is going to stick around for quite a while.

But not forever. A continued rising interest rate environment will eventually but inevitably increase the Section 7702 rate. The 2% products that we’re selling today might be seen in the future as the golden age of accumulation life insurance products, particularly for Whole Life. Although it’s a long way off, we shouldn’t lose sight of the potential for change in the future. Clients who want accumulation products should take advantage of what we have right now. Time flies, even in life insurance.