The Sixth Circuit Gets it Right in American Financial–an Actuarial Guideline can Apply to Prior Contracts when the Interpretation was a Permissible Option at the Time the Contract was Issued

In American Financial, the Sixth Circuit held that a life insurance company subsidiary of American Financial Group could compute its tax reserves by using Actuarial Guideline (AG) 33 once its statutory reserves were conformed to AG 33. Providing a breath of fresh air, the court got it exactly right. The court said that if a reserving method prescribed by the National Association of Insurance Commissioners (NAIC) permitted several reserving approaches at the time a contract was issued, then tax reserves can follow statutory reserves when the company changes to another interpretation specified in a new AG. The change is permitted as long as the new AG adopts an approach that was one of the prior permissible options. The court did not say that actuarial guidelines always have retroactive effect, however. For example, the court left open whether a new AG can apply to prior contracts where the NAIC changes its mind and issues an actuarial guideline that adopts a previously impermissible interpretation. Before discussing the American Financial case in more detail, it may be useful to provide some background on what the statute requires and the Internal Revenue Service’s (IRS’s) ruling and litigating positions.

Basic Tax Reserve Rules

Under I.R.C. § 807(d), life insurance reserves are required to be computed in accordance with the “tax reserve method” (CRVM for life insurance and CARVM for annuities) prescribed by the NAIC which is in effect on the date of the issuance of the contract. After the CRVM or CARVM reserve is computed, using the federally prescribed interest rate and mortality table, the reserve is capped by the statutory reserve and floored by the net surrender value on a contract-by-contract basis.

Where there are state-by-state variations on the interpretation of CRVM and CARVM as of the contract issue date, the legislative history provides some general rules as to which interpretation to use for tax reserves. First, the company is required to use the method prescribed by the NAIC as of the date of issuance of the contract, and take into account any factors recommended by the NAIC for the contract. The NAIC-recommended factors to be taken into account are those generally addressed in model regulations or actuarial guidelines prescribed by the NAIC. Second, where no such factors are recommended by the NAIC, or for contracts issued prior to the NAIC’s adoption of a regulation or actuarial guideline, companies are to look to the prevailing interpretation of the Standard Valuation Law (SVL), i.e., the interpretation that has been adopted by at least 26 states. The 1984 Blue Book states that, in general, life insurance reserves are computed by starting with the assumptions made for statutory reserves and then making the adjustments required by I.R.C. § 807(d), indicating that, absent an NAIC actuarial guideline or a prevailing interpretation of the states, the tax reserve method should follow the interpretation of the SVL used by the company for its statutory reserves.