IRS Challenges Asset Drop Assumption In Actuarial Guideline 34

The February 2010 TAXING TIMES supplement has an excellent comprehensive article by Edward Robbins and Richard Bush on the many actuarial and tax issues involved with Actuarial Guideline XLIII (AG 43). One tax issue the authors discuss is the potential tax impact of the asset drop assumption in the Standard Scenario. This matter merits further consideration because the issue the authors have raised also applies to prior tax years in the context of a similar asset drop assumption in Actuarial Guideline XXXIV (AG 34), which provides guidance on the computation of CARVM reserves for variable annuities with guaranteed minimum death benefits (GMDB). AG 34 has been superceded by AG 43, but presumably will continue to apply for tax purposes for variable annuities with GMDB issued prior to 2010.

AG 34, like the Standard Scenario in AG 43, projects future guaranteed benefits by assuming an immediate drop in the value of the assets supporting the variable annuity contract, followed by a subsequent recovery at an assumed rate of return until the maturity of the contract. In a Notice of Deficiency issued to CIGNA on March 12, 2009, the Internal Revenue Service (IRS) contended that AG 34 reserves do not qualify as life insurance reserves, at least to the extent they are attributable to the asset drop assumption, and, therefore, are not deductible as tax reserves. The IRS’s inclusion of this issue in CIGNA’s Notice of Deficiency was a surprise to the company because the issue had not been raised by IRS agents in the audit of CIGNA’s tax returns. It also was a surprise to life insurance companies generally because the IRS National Office had been actively engaged in discussions with industry representatives on AG 43 tax matters and had not raised the asset drop assumption as a potential issue. In fact, Notice 2008-183 identified several tax issues of concern to the IRS for VACARVM (which became AG 43) and Principle-Based Reserves and did not mention this issue. The IRS also had issued a technical advice memorandum dealing with reserves computed using an asset drop assumption and never raised this as a problem.

The IRS’s legal theories behind its position in the CIGNA case are not well articulated in the Notice of Deficiency, but have been summarized in subsequent court filings. The IRS’s argument seems to be that the portion of the AG 34 reserve attributable to the asset drop assumption is not held for future unaccrued claims under the contract, a requirement for life insurance reserve qualification under section 816(b) of the Internal Revenue Code. IRS contends that, because the assets
in the variable annuity separate account are sufficient to fund the death benefit level if the annuitant were to die immediately, any reserves attributable to the asset drop assumption
cannot be held for the current guaranteed death benefits. The IRS made this argument in a technical advice memorandum issued before the adoption of AG 34 and before the enactment
of section 807(d) which requires tax reserves to be computed using CARVM as prescribed by the National Association of Insurance Commissioners (NAIC). The IRS further contends that the reserve is being held for potential losses on assets owned by the company (i.e., for an investment risk), relying on a 1967 revenue ruling. The ruling states that a potential loss on assets is speculative and merely a solvency concern, and characterizes a reserve held for an investment risk as a contingency reserve, not a life insurance reserve.