The IRS has released a notice to alert life insurers to federal income tax issues that may arise out of the adoption of proposed Actuarial Guideline VA-CARVM and a proposed principles-based reserving system that is being developed by regulators at the National Association of Insurance Commissioners, Kansas City, Mo.

Advocates of the new reserving framework that is being developed are weighing in on the notice.

AG-VACARVM establishes reserving for variable annuities with guarantees. The principles-based reserving project at the NAIC is a huge collaboration that has been underway for the past 3 years and has involved the work of commissioners, regulators, actuaries and life insurers. PBR, if implemented, could also apply to health insurers.

Work on elements of PBR–including a new standard valuation law and a valuation manual–are progressing, but the one element that has remained unknown is how Treasury wants to address any change to tax treatment.

In the notice, the Treasury Department and Internal Revenue Service identify areas in which they have concerns. Among these issues are:

–The need for possible guidance that would require the continued use of statutory reserves for purposes of the reserve ratio test, even if those reserves are determined under the proposed AG VA-CARVM or PBR.

–Requiring the use of the standard scenario amount for AG VA-CARVM, a more conservative reserving approach, or the deterministic reserve for purposes of the reserve ratio test.

–That 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.”

In order to prevent such a result, the notice says Treasury and IRS may exercise the authority under Section 7702 to prescribe mortality tables or to permit continued use of the 1980 Commissioners’ Standard Ordinary mortality and morbidity tables or provide a reasonable interpretation of the prevailing mortality tables.

Treasury and IRS are requesting comment on these issues. Comments are being sought on the status of any efforts to model AG VA-CARVM and PBR on a company-by-company and product-by-product basis or on an industry-wide basis; how those 2 projects limit or broaden the discretion of Treasury and IRS to provide guidance; and the use of gross premium valuation and how it will differ from current valuation methods.

Treasury and IRS also question how revising assumptions and parameters annually are consistent with the existing statutory framework.

The notice asks for comments to be submitted on or before May 5, 2008, referencing Notice 2008-18.

The text of the notice can be read at Document Link.

Those who have been working on the issue offered their initial reaction.

“We’ve been expecting this. The notice from Treasury and IRS is a positive step forward in efforts to modernize reserve calculations for life insurance and variable annuities,” says Whit Cornman, a spokesperson for the American Council of Life Insurers, Washington.

“ACLI has been communicating with Treasury and IRS for over a year now on the potential effect of these changes on companies’ tax reserves,” he adds. “Notice 2008-18 is a formal solicitation of comments on issues identified through the dialogue between the life insurance industry, Treasury and IRS.”

The issues raised by Treasury and the IRS are the same as those identified at the beginning of the PBR process by regulators, insurers and actuaries, according to Scott Harrison, executive director with the Affordable Life Insurance Alliance, Washington. There are no surprises and that is a positive, he continues. The willingness of Treasury and the IRS to seek industry input is also a positive, he adds.

The notice suggests that Treasury and the IRS want to keep the issue a regulatory matter rather than seek a change to the tax law in Congress, another positive, according to Harrison. There is enough flexibility within the tax code to interpret PBR without changing the law, he adds.

Although he cautions that testing will still be needed to be done to confirm revenue neutrality if PBR is enacted, Harrison says there is a belief that no tax revenue will be lost for the government. The reason, he explains, is that for many companies PBR will reduce required reserves to their economic level and that lower level will reduce tax deductions companies can take.

If testing proves correct, the reduced deductions should be offset by lower cost of capital resulting from reserves that have been freed, Harrison says.

The PBR process would not in any way reduce the authority of Treasury and the IRS, he says.

Donna Claire, a life actuary with Claire Thinking, Fort Salonga, New York, who is spearheading the work of many actuaries working on the project, says now there is something concrete to which advocates of PBR can respond. What the notice is saying, she explains, is that there are certain requirements in the tax code that have to be complied with and that the new framework has to work within those requirements.

The American Academy of Actuaries, Washington, welcomes the efforts of the Treasury Department and the IRS to work together on the tax treatment of the principles-based approach for life insurance statutory reserves, according to spokesman Andrew Simonelli. The recent Treasury notice is an important step, and the Academy looks forward to continue working with Treasury and the IRS on this important effort, he adds.

At press time, regulators involved with the PBR project at the NAIC including Kansas actuary Larry Bruning and Thomas Hampton, commissioner of the District of Columbia, could not be reached for comment.