VM-20 Deterministic Reserves in Federally Prescribed Reserves

The March 2016 edition of TAXING TIMES contained this author’s article that presented actuarial and legal analysis to support the conclusion that the stochastic components of Actuarial Guideline 43 and VM-20 principle-based reserves (VM-20 or PBR) are, and will be, properly included in federally prescribed reserves under I.R.C. § 807(d). In that article, I left consideration of the deterministic gross premium reserve component of PBR (Section 4 of VM-20) for another day. That day has come.

Much of the legal analysis in my article relating to stochastic reserves applies equally to the deterministic reserve component of VM-20. Two points in that article need to be reemphasized as we consider the deterministic reserve component of VM-20. The first important point is that the plain language of I.R.C. § 807(d)(3) requires the deterministic reserve to be taken into account as part of the VM-20 tax reserve method. Federally prescribed reserves must be computed using CRVM as prescribed by the NAIC. Because the deterministic reserve is an integral part of NAIC-prescribed CRVM, it cannot be ignored in the tax reserve computation. Statements found in the legislative history that some have interpreted to suggest that CRVM for tax purposes must be interpreted to have an 1984-era meaning cannot override the clear statutory language that requires post-1984 NAIC changes to CRVM to be the updated tax reserve method for newly issued contracts.

The second point made in my prior article is that a CRVM provision in a reserve for moderately adverse conditions does not mean that a portion of the reserve can be considered a non-deductible “surplus reserve.” Most NAIC-prescribed reserves deductible as federally prescribed reserves incorporate prudent assumptions, and the deterministic reserve contains prudent assumptions in the same sense as other in deductible CRVM reserves. Rather than rehash these points in more detail, this article will focus on two other matters. First, I will debunk a myth: gross premium reserves are not included in deductible life insurance reserves because only net premium reserves qualify. In fact, I will point out how several other types of gross premium reserves are taken into account in federally prescribed reserves.

After that, I will offer suggestions as to how to incorporate the VM-20 deterministic reserve in federally prescribed reserves.

IRS NOTICE 2008-18

Several arguments have emerged to support the contention that gross premium reserves cannot be deducted. Some of these arguments are suggested in Notice 2008-18, and others have been raised informally by IRS personnel and other tax professionals, but the IRS has never issued formal guidance on how or whether gross premium reserves are taken into account in federally prescribed reserves under I.R.C. § 807(d). In general, the objections to gross premium reserves fall into three categories: (1) the reserve may include a nondeductible provision for unaccrued expenses; (2) the reserve fails to satisfy prescribed computational requirements for life insurance reserves in I.R.C. § 816(b); and (3) the reserve may contain nondeductible deficiency reserves. Upon examination, none of these objections bears up well to scrutiny to deny a tax reserve deduction for most gross premium reserves, and particularly not for the deterministic component of VM-20. Let’s examine these objections one at a time.

RESERVE FOR EXPENSES

One commonly expressed concern with qualification of gross premium reserves for a tax reserve deduction is that they take into account expenses. Treasury regulations provide that reserves for unaccrued expenses are not deductible insurance reserves. These regulations are derived from the seminal Supreme Court case of Maryland Casualty Co. v. United States, from which the definition of life insurance reserves in I.R.C. § 816(b) was developed. In Notice 2008-18, the IRS questioned whether the deterministic reserve component of VM-20 implicitly includes a provision for ordinary business expenses and, therefore, does not qualify in whole or in part as an insurance reserve. My March 2016 TAXING TIMES article explained in some detail why the stochastic component of VM-20 does not include a reserve for future expenses. The same considerations apply equally to the deterministic reserve component of VM-20. In short, the inclusion of future expenses in VM-20 is comparable to the “loading” factor implicit in net premium reserves, i.e., the difference between the gross premium and the valuation net premium. Future gross premiums less future estimated expenses in the gross premium reserve formula are the actuarial corollary to net premiums in a net premium reserve. That is, gross premiums less expenses can be considered net premiums, just as net premiums in a traditional net premium reserve method are net of loading for assumed expenses (and profit). Consideration of expenses in gross premium reserves, therefore, does not mean that a portion of the reserve is held for extra-contractual ordinary business expenses within the meaning of Treas. Reg. § 1.801-4(e).