Subchapter L: Can You Believe It? Prevailing Standard Mortality and Morbidity Tables May Be Adjustable for Tax Reserves

Life insurance companies sometimes find that standard mortality and morbidity tables do not provide adequately for their statutory reserve liabilities for a variety of products. As a result, adjustments to statutory reserves are being made to standard mortality and morbidity tables frequently based, at least to some degree, on company or industry experience. Recently, this has been the case particularly for disability income and group annuity contracts. The tax question inevitably arises: can the company-specific adjusted statutory assumption for mortality or morbidity be used for tax reserves? The answer is—it depends on whether the prevailing standard table can be “adjusted as appropriate” under I.R.C. § 807(d)(2)(C).

Let’s review the basic rules. I.R.C. § 807(d)(1) generally provides that the life insurance reserve for any contract is the greater of the net surrender value of the contract or the federally-prescribed reserve (FPR). The FPR is determined by using (i) the tax reserve method applicable to the contract, (ii) the greater of the applicable federal interest rate or the prevailing state assumed interest rate, and (iii) the prevailing commissioners’ standard tables for mortality and morbidity. The tax reserve is then capped by the statutory reserves with respect to the contract set forth in the annual statement.

I.R.C. § 807(d)(5)(A) provides that the prevailing commissioners’ standard tables means, with respect to any contract, the most recent commissioners’ standard tables prescribed by the National Association of Insurance Commissioners (NAIC) that are permitted to be used in computing reserves for that type of contract under the insurance laws of at least 26 states. There is an important exception to this general rule. In addition to providing that the tax reserve is based upon the prevailing standard mortality table, I.R.C. § 807(d)(2)(C) provides that the prevailing table can be “adjusted as appropriate to reflect the risks (such as substandard risks) incurred under the contract which are not otherwise taken into account.”

The prevailing mortality table required to be used for tax reserves is a table that reflects “standard” mortality for the benefits to which the table relates. An adjustment to the table is appropriate under I.R.C. § 807(d)(2)(C), and may even be required, when an evaluation of insureds indicates that the mortality risks are not standard in relationship to the table. This can occur in life insurance when a contract is sold without underwriting (guaranteed issue) or when the insured lives are unhealthy or likely to be. In these circumstances, an extra premium generally is charged for the nonstandard risk and a reserve adjustment is made. The same is true for annuities if the annuitants are too healthy compared to standard lives. When an objective characteristic of the annuitants, or underwriting of the risks, reflects a likely deviation from the standard mortality under the applicable table which results in increased longevity risk, an extra premium is charged and extra reserves are established. Thus, for both life insurance and annuities, an adjustment to the standard table may be needed when risks are not reflected in the prevailing table for standard mortality. This is most likely to occur when the objective nature of the insured lives or underwriting indicates that the risks are nonstandard and, typically, an extra premium is charged for the coverage.