#357 | The Multi-Verse of 7702 Rates

This article was written by Steve Cox, FSA, MAAA, who is the Head of Life Insurance at Life Innovators.

Earlier this year, I wrote an article talking about the impact of rising interest rates on Section 7702. The main takeaway is that it didn’t look to me like we would see an increase in the Section 7702 rate despite the fact that interest rates have gone up. This topic came up between Steve and I while we were discussing a Life Innovators project and Steve decided to dig further than I did – and, from what we can tell, further than virtually anyone else has – to really understand what it would take for the Section 7702 rate to change. Some of what he found is pretty surprising and left me with a new appreciation for how thin the margins really are between a huge future adjustment and the maintenance of today’s status quo. Enjoy!

Full Article

There is no doubt that the changes to Section 7702 put in place as a part of the second 2020 Covid-related relief package have led to the birth of the Greatest Generation of accumulation-oriented products that we have ever seen, particularly in Whole Life. Short-pay whole life sales, which are insensitive to premium per thousand, but ultra-sensitive to accumulation potential with minimal NAR drag, saw a resurgence with several companies launching these low-guarantee, high dividend, strong accumulation products. That may have been the outcome of the changes to Section 7702, but it certainly wasn’t the intent.

Instead, the changes to Section 7702 were necessary to avoid an impending disaster by the mismatch between the floating non-forfeiture rate, which determine how surrender values materialize, and the fixed 4% Section 7702 rate that has prevailed since 7702 was written in the mid-1980s. For the first time, non-forfeiture rates were slated to fall below the Section 7702 rate to 3.75%. It was as if matter and anti-matter were going to try to exist in the same area of space.  Nobody knew exactly whether the physics of that world would be a black hole of insurance products, a quasar-like explosion of regulatory activity or beginning discussions with the IRS about 7702, potentially resulting in an attack on the tremendous tax benefits of life insurance from over-zealous lawmakers.  Something had to give.

Then came Covid.  This life-altering global catastrophe led to government action on nearly every front. Thanks to several industry groups, changes were included in Congress’ Consolidated Appropriations Act in December of 2020. The new regulations and new calculations led to a 2% minimum nonforfeiture rate and a new lower bound for 7702 calculations, which reflected the environment of the time, where the Moody’s Seasoned Corporate Bond average was 2.72% and the IRS Applicable Federal Rates (AFR) were a lowly 0.48%. Companies swiftly responded with 2% products geared for accumulation and, with that, we entered the era of the Greatest Generation of accumulation-oriented products.  

However, the real change to Section 7702 isn’t about a 2% rate – it’s about the fact that now the 7702 rate is designed to float with the prevailing interest rate environment. Currently, Moody’s Seasoned Corporate Bond rates are around 5.25%, up 250 bp from the end of 2020.   AFR’s are a robust 4.15%, up over 350 bp. If the original 2% rate set for 2021 was meant to reflect the rate environment at the time, then it stands to reason that the Section 7702 rate will now need to reflect the rate environment as it stands today. Will the Greatest Generation of accumulation-oriented products come to a swift end – or is there more to the story?

Setting 7702 Rates

At the center of the question of how Section 7702 rates will change is a new term: the Insurance Interest Rate (IIR), which is the rate to be used for Guideline Level Premium and CVAT calculations.  In the simplest terms, the IIR is the lower of two interest rates:  1) the Long Valuation Rate, and 2) a rolling average of AFR’s called the Applicable Federal Interest Rate (AFIR).   While this might seem like a pretty simple formula, there’s actually a lot to unpack:

• “Lower of” – the fact that the IIR is the lower of these two rates is a huge win for the industry.  It creates a bias to a lower rate, and keeps downward pressure on the 7702 rate in a wide variety of interest rate movement scenarios.  It is predisposed to be a relatively low rate.
• Long valuation rate – the long valuation rate has been a well-known term in actuarial circles for decades, stemming from the Standard Valuation Law (SVL).  It is the rate that is used to set reserves for life insurance products.  Because it is used for reserves, and because reserves are intended to be conservative, its design is to create a low rate and thus, higher reserves. It’s worth a quick review of how this rate is developed, to understand how this conservatism is created in the rate.  It is based on the lesser of a 12-month and a 36-month rolling average of Moody’s Seasoned Corporate Bond rates.  Once again, “lesser of” appears in definitions, creating a bias to stay low.  Further, it is the lesser of a short-term rolling average and a longer-term rolling average.   The net effect of this is that in a decreasing rate environment, the 12-month average will allow it to respond more quickly to those low rates.  Alternatively, in an increasing rate environment, the result will respond more slowly since the 36-month calculation will lag the environment. Now, an immediate counterpoint may jump to your mind: it uses corporate bond rates, so it will be “pulled up” by corporate spreads.  Wouldn’t a truly conservative formula ignore corporate spreads?  A fair point – which is duly addressed in the next item.
• A 35% “dampening factor” – While the SVL uses a corporate bond rate, it has an interesting factor in the formula that results in dampening any variance of that bond rate away from an anchor point of 3%.  The SVL rate for most life insurance is:  3% plus 35% of the difference between the Moody’s rate and 3%.  It is, as mentioned, anchored at 3%, and only lets 35% of any variance from 3% sway the result.  That 35% dampening factor applies whether the Moody’s rates are in excess of 3% (a world we mostly know), or whether they are below 3% (a world we saw during Covid).  It can be viewed that 3% is the default rate, unless rates are materially variant from that anchor point. 
• The AFIR is based on a 60-month average of mid-term AFR’s.   Broadly speaking, this is a five-year average of treasury rates between 3- and 9-year duration.   Think of it as a 5-year average of 5-year treasury rates.   What are the implications of this as an additional “minimum” rate?  Two things come to mind.   First, they are treasury rates, not corporate bonds, so the impact of corporate spreads does not exist in this rate.   Second, it’s a 5-year average – – meaning that in an increasing rate environment, this average rate will lag the SVL approach of 12-month and 36-month averages.   Yet another factor to keep the IIR low in an increasing rate environment.

You see a recurring theme of factors in place to prevent the Insurance Interest Rate from getting too high.  The SVL calculation will keep it anchored around 3%.   The AFIR component will take over when rates are materially lower than 3% for a sustained period of time.   When rates get materially in excess of 3% for a sustained period of time, the 35% dampening factor will keep the rate from spiking. It takes a lot more than just a current interest rate environment above 4% to actually cause the Insurance Interest Rate to stay above 4%.

So… Are We Headed for Any Kind of Change?

All that said – we are, perhaps, in the early phases of a sustained higher rate environment.  As noted earlier, AFR’s are over 4%, hitting 4.15% in April of 2023.  Corporate bond rates are over 5%, with the Moody’s seasoned bond average hitting 5.23% in March of 2023.  Applying that 35% dampening factor to the current 200 bp corporate excess over the 3% anchor rate yields nearly 75bp of pull on that anchor, leading to a rate of 3.75%.  This would portend a potential change in the IIR in the near future.

However, there are more factors at play. Sneaking into the language of the new bill is a concept of an Adjustment Year.   In short: regardless of the calculation of average corporate bonds rates and average AFR’s, the IIR can only change in a year if the long life valuation rate changes.  Nothing changes in the IIR unless the valuation rate changes, and the various factor changes have to trip a new rate coincidental to the year when the valuation rate change is triggered.  Which could be an interesting and impactful twist.   If a valuation rate change happens in year X, then the IIR could change in year X+1.   Not X, not X+2.  The formulas must create the change in X+1.  There is a bit of “the stars must align just right”, which we will see in a moment.

One of the other key limiting factors is, believe it or not, the effect of rounding. Long valuation rates are always rounded to the nearest 25 bp, while the IIR is always rounded to the nearest whole percent.    And layered on top of that is a rule that the long valuation rate only changes if the calculated rate change is 50 bp or more. Taken together, rounding reduces the frequency of adjustment years and ensures that adjustments to both the long valuation rate and the IIR are large enough to matter.

Where We Go From Here

Long valuation rates are currently 3.00%, and have been for some time.  As noted above, the long valuation rates are triggered by sustained changes in corporate bond rates (the Moody’s Seasoned Corporate Bond Rate, which you can find here.  If today’s rates stay where they are, a change to 3.50% in the long valuation rate will be triggered for 2025 issues.

That, in and of itself, has a nice benefit for life products by having reserves calculated at 3.5% instead of 3.0%, which would be felt by more reserve sensitive products (e.g. term, GUL).  This also triggers an increase in the maximum nonforfeiture rate (the maximum moving from today’s 3.75% to a new 4.50% – – the maximum nonforfeiture rate is simply 125% of the long valuation rate, of course rounded to the nearest 25 bp). The probability of this change seems fairly high – Moody’s rates would have to average 4.00% for the next 14 months to avoid that change (versus today’s 5.23% rate).

Now hits the new critical Adjustment Year concept.   With long valuation rates changing for 2025 issues, we would then look to see if a new IIR for use within Section 7702, would be in effect for 2026 and later issues.  Using today’s rates, the new IIR would be the minimum of the long valuation rate (3.50%) and the 60-month average AFR which would be calculated, in this instance, through the end of 2023.  Yes, rates through 2023 would determine the IIR for 2026. It’s a bizarre little quirk in the regulation that has some huge implications.

Rolling forward with today’s rates, this 60 month lookback from 2019 to 2023 would produce a 60-month average of 2.04%.  Thus, no change in the IIR, no change in 7702 rates, no change in the minimum nonforfeiture rate. If the regulation was written ever-so-slightly differently where the 7702 rate was based on rates through 2024 (in this example), rather than 2023, then that 60-month average (assuming no change from April 2023 rates) would be 2.52% – which would round to 3.00%, thereby triggering a new minimum 3% 7702 rate for 2026.  But, thankfully, it is not written as such – 2026 looks to be an Adjustment Year, but no adjustment to the Section 7702 rate would happen.

Furthermore, there is no “catch up” of the rate.   The IIR would not recalibrate for 2027 – because the IIR can only change the year following a valuation rate change.  Valuation rates are predisposed to not change frequently – so the 2025 change would likely be in place for a few more years, meaning no Adjustment Years and therefore no changes to the minimum Section 7702 rate. It’s quite an amazing result that buys the industry a lot of time before Section 7702 will change, assuming we don’t see drastically increasing rates between now and the end of the year. The Greatest Generation of Accumulation Products will live on, narrowly avoiding a reckoning at the hands of rising interest rates.

However, rising interest rates do have a direct effect on maximum non-forfeiture rates, which look like they’ll be increasing from the current 3.75%, to a new 4.50%. This will allow companies to have the ability to use guaranteed rates in Whole Life of all the way up to 4.5%, allowing for a huge amount of flexibility in pricing. Some companies may deploy these higher rates for protection and guarantee-oriented Whole Life products in ways that could open up whole new corners of the market.

In short, the particular way that interest rates have risen has given us the ability to have the best of all worlds – highly efficient accumulation-oriented products that leverage the 2% minimum 7702 and rich protection-oriented products that push the limit all the way to 4.5%. Whether life insurers actually take advantage of the 4.5% is a separate question, but the opportunity will be there. And you can be sure that at least a few life insurers will avail themselves of it.

Obviously, interest rates are unpredictable and can be fickle.    The path that we appear to be on today could be shifted off course tomorrow.   Similarly, some of the (arguably) odd – and oddly favorable – results of the current regulations could get addressed by its detractors. It would not be surprising to see some sort of reaction to this critical full percent rounding issue, the definition of an Adjustment Year, or the endpoint of the AFR 60-month average calculation. Any tweaks to these seemingly arcane elements of the language could dramatically change the outcome.

But for now, we should enjoy the Greatest Generation while we have it.