SECTION 2. BACKGROUND

.01 In general, a life insurance company must pay tax on its life insurance company taxable income, which is defined in section 801(b) to mean life insurance gross income less life insurance deductions. Life insurance gross income is defined in section 803(a) to mean the sum of (i) premiums, (ii) net decreases in certain reserves under section 807(a), and (iii) other amounts generally included by a taxpayer in gross income. Section 805(a)(2) authorizes a deduction for the net increase in certain reserves under section 807(b). The reserves taken into account under section 807(a) and (b) include life insurance reserves. Accordingly, clear reflection of taxable income of a life insurance company requires an appropriate measurement of the company’s life insurance reserves.

.02 Methods of computing life insurance reserves are set forth section 807(d). Section 807(d)(1) provides generally that the amount of the life insurance reserve for any contract shall be the greater of the net surrender value of such contract under section 807(e)(1) or the federally prescribed reserve determined under section 807(d)(2). This amount cannot, however, exceed the amount that would be taken into account with respect to that contract in determining statutory reserves ( i.e., the aggregate reserve amount set forth

in the issuer’s annual statement). Section 807(e)(1) states that the net surrender value of any contract shall be determined with regard to any penalty or charge that would be imposed on surrender but without regard to any market value adjustment on surrender. Section 807(d)(2) provides that the federally prescribed reserve for a contract is computed using (a) a tax reserve method, (b) the greater of the applicable Federal interest rate or the prevailing State assumed rate, and (c) the prevailing commissioners’ standard tables for mortality and morbidity.

.03 With respect to annuity contracts, section 807(d)(3)(A)(ii) and 807(d)(3)(B)(ii) requires the use of a tax reserve method that is the Commissioners’ Annuity Reserve Valuation Method (CARVM) prescribed by the National Association of Insurance Commissioners (NAIC) which is in effect on the date of the issuance of the contract. Likewise, with respect to life insurance contracts, section 807(d)(3)(A)(i) and 807(d)(3)(B)(i) requires the use of a tax reserve method that is the Commissioners’ Reserve Valuation Method (CRVM) prescribed by the NAIC which is in effect on the date of the issuance of the contract. Other parameters, such as the interest rate and appropriate mortality tables, are likewise generally determined as of the date the contract is issued.

.04 Under section 816, an insurance company is a life insurance company if the sum of (1) its life insurance reserves, plus (2) unearned premiums, and unpaid losses (whether or not ascertained), on noncancellable life, accident, or health policies not included in life insurance reserves, comprise more than 50 percent of its total reserves. Life insurance reserves are defined as amounts (1) computed or estimated on the basis of recognized mortality or morbidity tables and assumed rates of interest, and (2) set aside to mature or liquidate, either by payment or reinsurance, future unaccrued claims arising from life insurance, annuity, and noncancellable accident and health insurance contracts (including life insurance or annuity contracts combined with noncancellable accident and health insurance) involving, at the time with respect to which the reserve

is computed, life, accident, or health contingencies. Reserves must be required by law to qualify as life insurance reserves.

.05 Section 7702(a) defines a life insurance contract as any contract that is a life insurance contract under the applicable law, but only if such contract (1) meets the cash value accumulation test of section 7702(b); or (2)(A) meets the guideline premium requirements of section 7702(c), and (B) falls within the cash value corridor of section 7702(d). A contract meets the guideline premium requirements if the sum of the premiums paid under such contract does not at any time exceed the guideline premium limitation as of such time. The term “guideline premium limitation” means, as of any date, the greater of the guideline single premium, or the sum of the guideline level premiums to such date. The term “guideline single premium” means the premium at issue with respect to future benefits under the contract. The determination of the guideline single premium is based, in part, on reasonable mortality charges that meet the requirements (if any) prescribed in regulations and that (except as provided in regulations) do not exceed the mortality charges specified in the prevailing commissioners’ standard tables (as defined in section 807(d)(5)) as of the time the contract is issued.

.06 Two reserve methodology projects are underway with the American Academy of Actuaries (AAA) and National Association of Insurance Commissioners (NAIC). Proposed AG VACARVM would set forth a new Actuarial Guideline that would constitute CARVM for variable annuities. See “Actuarial Guideline VACARVM—CARVM for Variable Annuities Redefined,” NAIC, 9/29/2007. An Actuarial Guideline is an interpretation by the NAIC of existing state valuation law and regulations. Proposed Life PBR would set forth a principles-based approach for calculating statutory reserves on life insurance contracts. This second project would take the form of a section of a proposed valuation manual that would be adopted pursuant to a proposed change to the standard valuation law. See “VM–20: Requirements for Princi

February 4, 2008 363 2008–5 I.R.B.

PBR is adopted, the Treasury Department and IRS may publish guidance that would (i) require the continued use of statutory reserves for purposes of the reserve ratio test, even if those reserves are determined under Proposed AG VACARVM or Proposed Life PBR; (ii) require the continued use of CARVM or CRVM, as applicable, under such terms as applied before the adoption of Proposed AG VACARVM or Proposed Life PBR; (iii) apply principles similar to those of Prop. Reg. § 1.801–4(g) to ensure that reserves with respect to life insurance and annuity contracts are appropriately accounted for in the reserve ratio test of section 816(a); or (iv) require the use of only the standard scenario amount (in the case of Proposed AG VACARVM) or deterministic reserve (in the case of Proposed Life PBR) for purposes of the reserve ratio test.

.02 Qualification of contracts as life insurance contracts. Likewise, some commentators have asked whether the adoption of Proposed Life PBR would render it impossible for issuers of life insurance contracts to satisfy the requirement of section 7702(c)(3)(B) that reasonable mortality charges not exceed the mortality charges specified in “the commissioners’ standard mortality tables” as defined in section 807(d)(5). The Treasury Department and IRS think it is inappropriate for a change in statutory accounting under section 807(d) to effect a wholesale change in the standards for qualification of contracts as “life insurance contracts” under section 7702. To prevent this result, if Proposed Life PBR is adopted, the Treasury Department and IRS may (i) exercise the authority under section 7702(c)(3)(B) either to prescribe mortality tables or to permit the continued use of the 1980 Commissioners’ Standard Ordinary mortality and morbidity tables (1980 CSO tables) or the 2001 Commissioners’ Standard Ordinary mortality and morbidity tables (2001 CSO tables), as appropriate, to satisfy the reasonable mortality charge requirement of that section; or (ii) provide a reasonable interpretation of the prevailing commissioners’ standard mortality tables under section 807 that would not render the cross reference in section 7702(c)(3)(B) meaningless. See section 3.05, below.

.03 Contract-by-contract versus aggre- gate reserves . The Treasury Department and IRS believe that the standard scenario

ples-Based Reserves for Life Products,” NAIC, 9/29/2007.

.07 The purpose of Proposed AG VACARVM is to interpret the standards for the valuation of reserves for variable annuity and other contracts involving certain guaranteed benefits similar to those offered with variable annuities. The aggregate reserve for contracts falling within the scope of Proposed AG VACARVM would equal the greater of a standard scenario amount and a conditional tail expectation (CTE) amount. The standard scenario amount would be the aggregate amount of the reserves determined by applying a standard scenario to each of the contracts falling within the scope of the guideline. The CTE amount would represent the average of a specified percent of the largest accumulated deficiencies produced by a projection of the contracts falling within the scope of the guidance (and the assets supporting those contracts) over a range of stochastically generated scenarios using prudent estimate assumptions. For example, CTE (70) would equal the average of the largest 30 percent of the present value of accumulated deficiencies. Proposed AG VACARVM would include a methodology for allocating the aggregate reserve to the contracts falling within the scope of the Guideline. Once effective, Proposed AG VACARVM would affect all contracts issued on or after January 1, 1981. .08 The purpose of Proposed Life PBR would be to define the minimum valuation standard under a principles-based approach for individual life insurance policies. The reported aggregate reserve for policies falling within the scope of Proposed Life PBR would equal an amount computed using a stochastic method (stochastic reserve), but not less than an amount calculated using a seriatim, deterministic method (deterministic reserve). The deterministic reserve would be determined using a seriatim ( i.e., contract-by-contract) approach based on a projection of net cash flows over a single scenario, using prudent estimate assumptions for parameters or variables that are not prescribed. The stochastic reserve would be calculated in the aggregate based on a projection of net cash flows over a range of stochastically generated scenarios, using prudent estimate assumed

values for all parameters and variables that are not prescribed or stochastically modeled, and then applying a prescribed CTE level. Proposed Life PBR would require that a reserve based on company-specific and industry experience serve as the basis for identifying ( i.e., mapping to) the NAIC prescribed table that must be used. Like Proposed AG VACARVM, Proposed Life PBR would include a methodology for allocating the aggregate reserve to the contracts falling within the scope of Life PBR. A company would be permitted to exclude certain policies from the stochastic modeling requirement if the policies met certain prescribed conditions.