Section 101(a)(1) of the Internal Revenue Code (IRC) is pretty straightforward. It excludes life insurance death benefits from the federal income tax. But what is life insurance? The IRC defines “life insurance contract” in § 7702. However, in A Matter of High Interest: How a Quiet Change to an Actuarial Assumption Turbocharges the Life Insurance Tax Shelter, Andrew Granato characterizes that provision as “obscured by layers of mathematics.” Under recent amendments, writes Granato, this “highly technical approach” to the definition of life insurance abuses the § 101 exemption by expanding the definition of life insurance in a manner that effectively subsidizes the wealthy through tax expenditures on their behalf.
Life insurance comes in two basic types. First, there is “term” or pure life insurance. The cost of a term policy is based on the risk taken on by the insurance company that the insured will die within a certain time, triggering the company’s obligation to pay the death benefit to the beneficiary. This type of policy has no cash value because the owner paid only for the death benefit—the insurance company’s promise to take on the risk. At any given time, the policy’s value is the unexpired portion of the premium paid.
Cash value life insurance is the other type, a broad category of policies that includes many subtypes. Each premium paid in a cash value policy includes two elements. The first is the amount at risk, or the cost of the insurance, and the second is an investment element. The investment element gives this type of policy an ongoing value, hence the name “cash value” insurance. Amounts paid into the investment element are invested and earn returns. Although the investment component may be used by the insurance company to subsidize the at-risk payments, as in a form of cash value insurance called “whole life,” it also functions as an income tax-advantaged investment for the policy owner.
And here is where the income exclusion can be exploited. As Granato writes, the savings in a cash value life insurance policy “is taxed like life insurance – in other words, not taxed.” So without limitations on the definition of a life insurance policy, one could “simply take a normal investment, call it a life insurance policy, and enjoy a tax-free existence.” To qualify as life insurance, a policy should have a substantial risk element (think term insurance), and not simply function as an investment fund. Otherwise, any investment fund could avoid income tax consequences by adding a small life insurance feature.
Section 7702 was enacted to prevent such abuse, mainly by implementing technical tests to ensure that a policy’s cash element is kept within certain limits. For nearly thirty years, these tests, which represented a compromise between Congress and the industry, remained largely intact. Recently however, as part of the 2020 COVID-19 omnibus relief bill, Congress made changes to § 7702. According to Granato, “an almost completely unnoticed amendment to some of § 7702’s technical assumptions…substantially relaxes the definition of ‘life insurance’ and allows contracts that look much more like normal investment contracts to claim life insurance tax status.”
Even before the recent amendments, life insurance policies, as constrained by § 7702, remained “highly tax-favored.” But life insurance ownership by ordinary Americans, particularly cash value life insurance, dropped quite a bit between 1989 and 2013. A number of factors contributed, including a long-term period of low interest rates, as well as the fact that, for most Americans of ordinary wealth and income, tax-advantaged investments such as qualified retirement accounts and § 529 education plans were sufficient. And yet, “total assets held in the general accounts of the life insurance industry still hit all-time highs nearly every year.” According to Granato, this is because the cash savings element of policies has increased, and “the share of life insurance reserves that were held by individuals in the top 1% of the wealth distribution skyrocketed, from 13% at the end of the 1980s to an all-time high of 31% today.” Granato traces this development to the fact that the industry has catered to the very wealthy, and ultimately did so by successfully lobbying for changes to § 7702. Congress recently delivered these changes, “without a fight.”
Granato’s article, written from the standpoint of someone with the mathematics background to analyze the § 7702 tests, is thorough and technically sophisticated. And yet, it is not filled with mathematical equations or targeted to the financial economist. It begins with a clear and simple explanation of the tax rules necessary to understand the potential for life insurance to serve as a tax-advantaged investment opportunity. It then offers a very useful encapsulation of the history of the definition of life insurance, from its beginnings in the common law to the “statutory compromise” reached by Congress and the industry.
Granato explains how decreasing the “guaranteed rate of interest crediting” on a policy will allow the policy owner to “stuff the policy with substantially more cash, ” and thereby “reduce the insurer’s net amount at risk on the policy while permitting the policyholder to receive the preferential tax treatment.” The tests used in § 7702 are designed to constrain these types of excesses. They are carefully explained, in a manner that makes sense without a math-heavy analysis. Throughout the paper, Granato gives helpful summaries of his points and also includes a number of helpful charts, including some “infographics” illustrating the workings of § 7702. I found myself following his explanation of § 7702’s original “guideline premium and cash value corridor tests,” and understanding how they ensured that the industry couldn’t use “excessively pessimistic mortality tables and excessively low minimum crediting of interest” to reduce their risk.
After explaining how the long-term trend in low interest rates reduced the return to the insurance industry, creating a particular motivation on its behalf for changes to § 7702, Granato explains recent amendments to the statutory tests. Essentially, these tests ensure that “insurers will be able to sell life insurance products with a greater investment orientation and less net amount at risk in low-interest rate periods than they were under the previous § 7702 formulation.” There is more, including how the industry has catered to the well-off with “private-placement life insurance” and the impact of the new § 7702 on federal tax revenues. He concludes with a summary of his concerns and recommends, among other things, the elimination of nontaxation of “inside buildup,” the accrual of interest on the cash value of life insurance.
In sum, because he has the ability and inclination to “do the math,” Granato deftly brings to light a costly tax dodge for the wealthy that was heretofore mostly buried in obscurity. In fact, as Granato points out, “[t]he only law review article to principally engage with § 7702 was published in 1988.” (P. 4 n.7.) Here’s hoping that this timely and insightful article will serve as an impetus to reversing ill-advised changes in the statute and a return to more sensible policy.
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