Actuary/Accountant/Tax Attorney Dialogue on Notice 2013-19 and The Statutory Reserves Cap

Note From the Editor:
As we have in past issues, we are presenting a dialogue on a current life insurance company federal income tax issue, in this case the guidance issued earlier this year on the treatment of deficiency reserves with respect to the “statutory reserves cap” of Internal Revenue Code section 807(d)(1), which limits the federally prescribed reserve to be no greater than the statutory reserves for the contract. The guidance is in response to an item in the Department of the Treasury 2012- 2013 Priority Guidance Plan calling for a Notice clarifying whether deficiency reserves should be taken into account in computing statutory reserves under section 807(d)(6). The discussion is among three individuals who are familiar to readers of TAXING TIMES: Edward Robbins of Ernst & Young LLP; Peter Winslow of Scribner, Hall & Thompson, LLP; and Mark Smith of PricewaterhouseCoopers, LLP. Mark, please start us off with some background on the statutory reserves cap issue.

Mark: The statutory reserves cap has received more attention in the past three or four years than perhaps any time since 1984. In addition to the activity related to Actuarial Guideline (AG) 43 and life principle-based reserves (PBR), which has been the subject of much discussion in these pages, on Feb. 27 of this year the Internal Revenue Service (IRS) released Notice 2013-19.1 Notice 2013-19 concludes that the statutory reserves cap of section 807(d)(1) includes deficiency reserves, acknowledging that deficiency reserves are included in “the aggregate amount set forth in the annual statement” with respect to life insurance reserves. The fact that deficiency reserves are excluded from the federally prescribed reserve does not affect this conclusion. The Notice thus resolved an issue for which guidance had been promised for several years. We’d like to talk about that Notice, and also about the statutory reserves cap more generally. To begin, though, it would be useful to talk through some of the history of life insurance reserves and where the statutory reserves cap came from.

From 1959 to 1984, a life insurance company’s taxable income was computed under a complex, three-phase system that baffled many who were not privy to the mysteries of insurance tax accounting. Ironically, one of the less complex elements of that system was the calculation of underwriting income, or at least the determination of the amount of life insurance reserves. Under the Life Insurance Company Tax Act of 1959, the starting point for computing life insurance reserves was simply the company’s statutory reserves.

In 1984, Congress scrapped the three-phase system in favor of a single-phase system that bore a closer resemblance to that which applies to taxpayers in other industries. For life insurance reserves, section 807(d)(2) sets forth rules for computing a federally prescribed reserve, which is generally based on National Association of Insurance Commissioners (NAIC) prescribed valuation methods, prevailing mortality tables, and the greater of tax-prescribed or prevailing state assumed interest rates. Under section 807(d)(1), the federally prescribed reserve for a contract is bounded by a floor, which is the net surrender value of the contract, and a cap, which is the amount taken into account with respect to the contract in determining statutory reserves.