Small Tax Law Change May Have Big Impact on Life Insurance Sales and Values

A narrow but far-reaching federal tax law change tucked inside the year-end omnibus spending and coronavirus relief bill applies some new math to the interest rates used to define certain life insurance policies. The updates—enacted as part of the Consolidated Appropriations Act, 2021 (H.R. 133)—could usher in a healthier sales environment for life insurers and a higher savings opportunity for consumers, experts say.

What Changed?

The law amends the Internal Revenue Code’s Section 7702, which defines how policies qualify as life insurance contracts under the tax code. It also spells out how much money can accumulate inside a life insurance policy without being currently taxed.

To qualify as life insurance for federal tax purposes, these policies must meet one of two tests—the cash value accumulation test or the guideline premium test. They are designed to cap the proportion of cash value to the total face amount of a policy and the amount of premiums that can be paid.

Previously, the limits in the code required life insurers to credit interest rates of 4% on the cash value of permanent life insurance and other long-term life insurance policies in order for the policies to maintain coverage until death. The issue? Section 7702 was written in 1984—when interest rates were much higher than the historic lows of today. 

Without adjusting the outdated rates to better match current, pandemic-influenced economic conditions, insurer groups feared issuing new permanent life insurance policies would be threatened, right along with the rates of return the companies generate on the investments that support their life insurance contracts payouts.

Those concerns were significant, given that permanent life insurance policies currently make up 59% of the individual life insurance market, according to data from the American Council of Life Insurers (ACLI).

“COVID’s impact on already historically low interest rates has pushed the design and funding of permanent life insurance policies to a breaking point,” says Paul Graham, ACLI’s senior vice president for policy development. “With these changes, the dramatically reduced interest earnings can now be made up for by premium dollars that the policyholder will put in, so that policies can reach their intended death benefit over the life of the policy.”

The new law drops the key interest rate used in creating life insurance policies to 2% for 2021, and ties future rates to periodically updated benchmarks after that. The reduction is effective Jan. 1, 2021 for new policies. If market interest rates normalize in the future, Section 7702 would revert to prior rates.

What’s the Impact?

Section 7702 was created to differentiate between genuine life insurance policies and investment vehicles posing as them, to make sure that only the true policies received favorable tax treatment.

The new provision should help permanent life policies continue to be characterized as tax-advantaged life insurance contracts and avoid being classified as other investments whose benefits would be taxable as ordinary income. 

What’s more, the revision makes it more feasible for insurers to offer and sell permanent life policies, notes Michel Leonard, CBE, vice president and senior economist at the Insurance Information Institute. And for consumers and policyholders, the change may create the opportunity for greater financial security, generally increasing the amounts that policyholders can contribute to cash-value life insurance accounts. (Permanent life policies have a savings component, building cash value that policyholders can tap.)

What’s Driving Life Insurance Need?

The law change is also noteworthy in light of the fact that consumers’ goals in purchasing life insurance are changing—with more of them relying on these policies for financial and retirement security.

More than half of American adults (54%) own some type of life insurance, according to LIMRA consumer research. But reasons for owning it have shifted in the past two years. Covering final expenses declined as a motivation in 2020, LIMRA found, while saving for retirement increased.

And while the COVID-19 pandemic contributed to a decline in life insurance sales in the first half of 2020, LIMRA predicts that most whole life and term products will return to pre-pandemic sales growth in 2021 and 2022.