Options for Inclusion of Stochastic Reserves in Federally Prescribed Reserves

In Notice 2010-29, the Internal Revenue Service (IRS) provided “interim” guidance on the treatment of tax reserves for variable annuity contracts computed under Actuarial Guideline (AG) 43. The Notice announced the IRS National Office’s interim conclusion that only the Standard Scenario Amount portion of AG 43 reserves, and not the Conditional Tail Expectation Amount (CTE Amount), should be included in federally prescribed reserves under I.R.C. § 807(d). No rationale for this conclusion was offered. The Notice did not say whether the CTE Amount should be included in “statutory reserves” as defined in I.R.C. § 807(d)(6) for purposes of capping a contract’s deductible federally prescribed reserves by the amount of statutory reserves allocable to the contract. Instead, the reserve capping issue, left unresolved by the Notice, was added to the IRS’ Priority Guidance Plan where it has remained an open project for several years. Recently the scope of the uncompleted project was updated and revised in the 2015–2016 Priority Guidance Plan to refer more generally to the tax treatment of stochastic reserves (including VM-20 principle-based reserves (PBR) for life insurance and possibly VM-22 for fixed annuities) and to other tax reserve matters related to stochastic reserves, and not just the statutory reserves cap. This expansion of the issues being considered by the IRS for guidance is beneficial for several reasons. Guidance will be needed on PBR issues when, and if, VM-20 for life insurance policies becomes effective—commonly expected to be for 2017. More importantly, the interim conclusion of Notice 2010-29 that the CTE Amount cannot qualify as federally prescribed reserves needs to be further examined, especially in light of recent court decisions that call into question the Notice’s interim guidance to the extent it departs from National Association of Insurance Commissioners (NAIC) reserve requirements.

This article presents legal analysis of the issues relating to whether the CTE Amount in AG 43 and the stochastic component of PBR under VM-20 are included in federally prescribed reserves and concludes that, in this author’s opinion, they are. The article also presents options for giving effect to the tax adjustments required by I.R.C. § 807(d) to the extent they are relevant to stochastic reserves.

BASIC TAX RESERVE RULES

The computation of life insurance reserves under I.R.C. § 807(d) involves a three-step approach. First, an actuarial reserve—the federally prescribed reserve—is computed on a contract-by-contract basis. Then, this reserve is compared to the net surrender value of the contract. The larger amount is the tax reserve, except, under the final step, the deductible tax reserve for a contract is capped at the amount of statutory reserves. “Statutory reserves” for this purpose generally refers to the aggregate amount of reserves with respect to the contract that are set forth in the company’s annual statement.

The computation of the federally prescribed reserve begins with the company’s statutory reserve and modifies that reserve to take into account three requirements of I.R.C. § 807(d): (1) the tax reserve method applicable to the contract; (2) the prevailing state assumed interest rate or the applicable federal interest rate (AFIR), whichever is larger; and (3) the prevailing commissioners’ standard tables for mortality or morbidity. Other related Internal Revenue Code (“Code”) sections require further adjustments, eliminating from the federally prescribed reserve any portions attributable to net deferred and uncollected premiums, excess interest guaranteed beyond the end of the taxable year, and deficiency reserves. Except for these prescribed adjustments and several other miscellaneous adjustments applicable to specific types of contracts, the methods and assumptions employed in computing tax reserves should be consistent with those used in computing the company’s statutory reserves.