NU Online News Service, June 10, 2004, 1:42 p.m. EDT, Washington – The Internal Revenue Service should revise a proposed safe harbor for the valuation of life insurance contracts.[@@]

Representatives for insurance agents and insurers made that argument at a recent IRS hearing on proposed life policy valuation regulations. The proposed regulations, issued in February, were developed partly in response to concerns about Section 412(i) defined benefit pension plans.

It is appropriate for the IRS to establish guidelines for valuing life policies for tax purposes, but the proposed regulations have serious shortcomings, industry representatives said.

One part of the proposed regulations establishes a new safe harbor for fair market value. The safe harbor value is the sum of all the premiums paid on the policy, plus all earnings, minus reasonable mortality charges and other reasonable charges actually charged and expected to be paid.

Under the proposal, the cash surrender value of the policy can be treated as the fair market value so long as it is at least as large as the safe harbor value.

But Lawrence Raymond, secretary of the Association for Advanced Life Underwriting, said life insurance agents have concerns about the IRS approach. He testified on behalf of both AALU and the National Association of Insurance and Financial Advisors, which are both based in Falls Church, Va.

In general, Raymond said, agents are concerned about the establishment of uniform valuation standards for most purposes under the Internal Revenue Code.

Raymond noted that in issuing its proposal the IRS was concerned about perceived problems involving the distribution of life insurance contracts from retirement plans. But, as proposed, the safe harbor appears to apply to several life insurance valuation scenarios, including distributions or sales from retirement plans, compensatory transfers, and estate and gift tax transactions, he said.

“Because of the diverse nature of these scenarios and the underlying contracts, we urge the IRS to exercise care in establishing uniform valuation standards that are targeted at a problem of limited scope,” Raymond said.

The safe harbor formula should be simplified by eliminating the cash value standard, Raymond said.

The AALU believes that the PERC amount–which stands for premiums, earnings and reasonable charges–should be the safe harbor standard, regardless of cash value.

Elimination of the cash value standard would simplify the determination of fair market value, Raymond said. The cash value would not have to be determined, and all contracts could use the safe harbor, whether or not the cash value exceeded the PERC amount, he said.

The IRS proposal does not define how cash value should be determined. If the IRS eliminated the cash value standard, the safe harbor would not depend on non-defined factors that potentially could be manipulated, Raymond said.

The IRS should include a reduction for surrender charges in the PERC calculation, Raymond added.

Potential surrender charges are relevant, he said, because insurance contracts often are surrendered for unplanned and unanticipated reasons.

In many cases, Raymond said, the only option for liquidating an insurance contract is to surrender it, because there is no effective marketplace.

The failure to include surrender charges in the safe harbor is an inherent weakness in the IRS proposal, Raymond said.

Mark Canter, senior counsel with the American Council of Life Insurers, Washington, also criticized the safe harbor, arguing that, in effect, it provides no safe harbor at all for bundled traditional life insurance products.

These policies comprise the majority of all non-variable permanent life insurance in force as well as new sales of non-variable policies, Canter said.

The authors of the regulations appear to have been thinking about the characteristics of universal life contracts, which are different from traditional, ordinary life contracts, when they came up with the safe harbor formula, Canter said.

In traditional policies, Canter said, there are no periodic calculations based upon a formula contained in the contract and there are no explicitly stated mortality or expense charges.

Although the cash value for universal life contracts should be close to the safe harbor formula value, the safe harbor formula value always will be higher than the cash value for traditional life products, Canter said.

The safe harbor value for traditional life policies will be too high because the safe harbor formula provides no mechanism for reducing the sum of premiums paid by the mortality charges and other expenses, since they are not specifically stated in the traditional life contract, Canter said.

“Thus, the safe harbor will never be available for these contracts,” Canter said.