Without doubt, the passage of the Pension Protection Act of 2006, which extends the Health Insurance Portability and Accountability Act’s favorable treatment of combination life and long term care policies to combination annuity and LTC contracts, has been one of the most dramatic events affecting the insurance industry in years.

The most compelling implications of the PPA relate to its favorable tax treatment of (1) benefits paid out in case of chronic illness and (2) charges to cover the cost of protection.

As previously discussed, the payment of benefits to cover LTC in an annuity is income tax-free. Now, let’s expand on that.

1. If a contract is a reimbursement contract, in which insureds submit claims and are paid for qualified LTC benefit expenses incurred, then all such payments are truly and totally free of income tax.

2. Other contracts are of a per diem nature, which means that the company pays a fixed monthly (or perhaps daily) benefit regardless of the expenditures actually incurred. For such contracts, the Act, or more precisely, Section 7702B of the Internal Revenue Code, stipulates a per diem rate, which changes annually with the rate of inflation. For 2008, the rate is $270 per day.

For such contracts, assuming a 30-day month, the contract could pay $8,100 monthly on a tax-free basis. Excess amounts payable would be subject to tax.

Further, one cannot buy a reimbursement contract and a per diem contract in order to get potentially an incremental layer of income tax-free benefits. The law will limit the actual tax-free amount in such cases.

3. The Act may lead to greatly increased exchange activity. Let’s assume a variable annuity had been purchased (post-HIPAA) with a $100,000 deposit and now has a value of $400,000. If the annuitant needs to utilize these funds in the current setting, he would have to take withdrawals on a last-in, first-out (LIFO basis), and thus pay tax on dollars needed for care. Effectively, he would have to bump up his withdrawals so that the after-tax value of the withdrawal would cover the LTC expenses.

Now let’s say, however, that the annuitant exchanges this VA for a contract that also provides an additional $200,000 of LTC protection. When dollars are paid out from this new contract to reimburse for LTC expenses, they all will be income tax-free. More precisely, portions of gain so paid out will not be taxed. Thus, the second contract effectively has been transformed from a tax-deferred vehicle to a tax-free vehicle when funds are used to pay for LTC expenses.

4. Initial payments of benefit, to the extent they result in reduction of cash value, may reduce the contract’s basis. The tax law is not completely clear on this point.

The treatment of charges is also favorable under these contracts. Consider:

Ordinarily, within deferred annuities, a distribution is taxed on a LIFO basis, meaning that the first dollars of withdrawal are presumed to come from contract gain, and only when the gain has been distributed will payments reduce basis.

But, in combination annuities, the LTC provisions (or separate rider) are treated as a separate contract, and so charges taken from the annuity to pay for the LTC are considered distributions.

Nevertheless, under the new law, such charges will not result in taxable income. Dollars are presumed to come first from basis, and then from gain, should the basis have been reduced to zero. The law specifically states that the charges will not result in taxable income, even the charges coming from gain. We do caution that this favorable treatment applies only for distributions made to cover the charges for qualified LTC coverage, as defined by the law.

The amount of development activity taking place today is solid evidence that the value of such benefit and charge treatment has been recognized.

Cary Lakenbach, FSA, MAAA, CLU, is president of Actuarial Strategies, Inc., Bloomfield, Conn. E-mail him at caryl@actstrat.com