New Section 7702 Legislation Makes Major Changes to Life Insurance in 2021

Updated April 26, 2021

The revisions to code section 7702 in last December’s spending bill represents the first major change to MEC-Testing, premium limits, and standards for whole life guarantees since the 1980’s.

Below is a short video, clickable table of contents, and FAQs outlining:

  • why insurance companies lobbied for these changes 
  • how the 7702 interest rate changes will affect future whole life insurance policies 
  • how this new 7702 legislation will affect future indexed universal life (IUL) policies differently

Long story short is that IUL will be getting a little bit better, but the guarantees of Whole Life policies will be getting much worse from the revisions to IRS code section 7702.

The guarantees of future Whole Life policies will be getting significantly watered-down. However, clients can lock in the stronger lifetime guarantees of classic Whole Life for a short time until these newer product offerings are approved by the Department of Insurance. (Watch Hutch’s 2-minute video or use the clickable table of contents below).

You can also click on any of the topics to skip directly to them:  

What is this recent change to IRC 7702 by Congress all about?

Buried deep into the 5,593-page bill are some monumental revisions to IRC section 7702. This section of the code dictates the premium limits for life insurance policies before they are considered a MEC (Modified Endowment Contract) and receive adverse tax treatment by the IRS. This recent revision represents the first major change to life insurance funding parameters since 7702 was originally enacted in the 1980’s.

IRC 7702 determines the interest rate assumptions in multiple different life insurance calculations. Specifically, code section 7702 determines how much premium is allowed in a given life insurance policy before a policy is considered a Modified Endowment Contract (MEC). It also determines how strong Whole Life’s underlying guaranteed growth rate will be, as well as the amount of paid up insurance will result from electing the reduced paid-up (RPU) non-forfeiture option.

Why life insurance companies wanted this change to section 7702 and what it did for them

Life insurance companies had been pushing for this change for a couple years so they could continue operating a sustainable business protecting American policyholders amid continually declining interest rates. You see, the interest rate parameters that were set originally set forth in code section 7702 were static. Even though a figure like 4% seemed to be extremely conservative assumption in the 1980’s, the interest rate environment of 2020 put it in a completely different light.

Since interest rates have been steadily declining since IRC 7702 was originally enacted, life insurance companies were put in a bad spot when the fed drastically cut rates in 2020 responding to the economic turmoil of COVID-19.

Although yields inside the insurer’s general accounts were declining, the products they offered were tied to this older 7702 interest rate assumption derived in the much higher rate environment of the 1980’s. Furthermore, the guaranteed growth rate set promised in Whole Life policies was based on these same outdated parameters.

According to the WSJ, US House staff said the changes to code section 7702 were necessary “to reflect economic realities” and give consumers “access to financial security via permanent life-insurance policies.”

Many life insurance products would no longer be sustainable given the current economic environment without a major change to the outdated interest rate assumptions from the 1980’s. This would obviously hurt the solvency most life insurance companies and the reliability of the life insurance industry as a whole.

How the necessary changes to code section 7702 will affect future funding parameters for accumulation-based life insurance products

By slashing the 7702 interest rate assumptions to something more fitting with the times, it allowed life insurance companies to maintain a sustainable business model and continue to be a bedrock for American families.

Unlike with death benefit-focused insurance products where clients are trying to pay the least amount of premiums possible for the most amount of coverage, accumulation-based products are optimized by paying the most amount of premium for the least amount of death benefit (to lower the underlying costs).

Once these new products are redesigned and approved by the various State Departments of Insurance, clients will be able to put in substantially more premiums for the same amount of death benefit. The exact ratio is still unknown and will obviously vary by age, health, product type, etc.

Remember, 7702 was originally enacted by Congress to keep wealthy clients from avoiding future taxation by requiring a certain ratio of death benefit for any desired premium amount. 

Try my simple analogy on for size to understand what this means.

In the 1980’s the original mandate of section 7702 essentially required an oversize envelope to accommodate a stack of $100 bills, even though before they would allow a small envelope to house the same stack of cash. Needless to say, bigger envelopes result in higher shipping costs for the same stack of bills.

For this simple analogy:

  • The size of the envelope = death benefit required (before & after 7702)
  • Stack of $100 bills = any given amount of desired premium
  • Shipping rate = ongoing cost of insurance charges

This new change to 7702’s interest rate factor will potentially allow you to stuff in more $100 bills into the same oversized envelope or use a much smaller envelope in 2021 for the same size stack of $100 bills. Either of which would obviously lower your relative shipping rate per bill.

Many people that would’ve previously considered themselves too old or unhealthy for accumulation-based life insurance may be pleasantly surprised with the new parameters. This is especially true since these changes will also apply to survivorship or 2nd-To-Die Policies, where the cost savings will be compounded inside these policies that need 2 people to die before they pay a death claim. 

How this change to code section 7702 specifically affects IUL policies (as well as VUL policies)

Probably the biggest concern that clients have with IUL, VUL, or any non-guaranteed product on a Universal Life chassis (UL), is the potential for increasing fees. Although many pundits overplay this risk like it’s a big scary monster under the bed, well-informed clients have learned that this risk can be substantially mitigated by paying the maximum allowable premiums for the first 4-7 years. Guess what, the new 7702 rates further reduce this risk by allowing you to either:
  1. Pay more premiums into the same amount of death benefit (which the fees are largely based on)
  2. Or, wrap less death benefit around the same premiums
Prior to the revisions to the 7702 interest rate, some industry veterans were speculating that further declines of interest rates may do away with using permanent life insurance as an accumulation/retirement vehicle entirely. This is because it would be so difficult to generate a decent return over and above the internal charges based on the old section 7702. But alas, “New 7702” to the rescue! Now with a leaner more efficient life insurance wrapper, carriers can keep their promises and clients should be able to earn a competitive growth rate relative to alternatives of a similar risk profile in any interest rate environment. For IUL specifically, lower caps and participation rates can be paired with lower fees and lower loan rates (assuming your particular product & company is chosen and designed properly) Update (April 26, 2021) – Now that two different IUL companies have come out with their new products, we have confirmed that there is an advantage to stuffing more premium into less death benefit permitted by the 7702 interest rate changes. However, the advantage is not quite as drastic as we had originally thought. It appears that insurance companies have repriced their internal IUL fees to cope with the low interest rates they expect on their investment portfolio. To clarify, there is still a net benefit for IUL’s cash value accumulation due to 7702, it’s just not as good as we had hoped.

(Note: whereas the 7702 interest rate change has no adverse effects on IUL products designed for accumulation, there are two major aspect of the new section 7702 will negatively impact future Whole Life products, and render today’s Whole Life policies as a classic vintage offering. Read below for more). 

How this change to 7702 will specifically affect future Whole Life policies

Here’s the good news and the bad news for future Whole Life insurance policies with the new 7702 revisions:

  • Good News (Kind of): the new lower 7702 interest rate changes will allow bigger front-loaded premiums into the same amount of whole life death benefit. Or, less death benefit will be needed to wrap around the same premiums required to carry a new whole life policy. This seems like good news (like it is for IUL) but remember with Whole Life your guaranteed cash value contractually crawls toward your death benefit (read more at BankingTruths.com/Guaranteed). So if your cash value has to grow closer to your death benefit every year on a guaranteed basis do you really want less of it?
  • Bad News (Part 1): the new lower 7702 interest rate will slash future Whole Life policies’ guaranteed cash value growth rate in HALF. (Remember that any PUA payments as well as dividends purchasing PUAs are added directly to the guaranteed cash value balance and ride on a growth trajectory dictated by the 7702 rate whenever your whole life policy was originally purchased). So the old guarantees (which you can still get until they shelf the old products) should be twice as good as the new ones.
  • Bad News (Part 2): the new lower 7702 interest rate will cut the future reduced paid-up (RPU) non-forfeiture option substantially. You can read more about how the reduced paid up non-forfeiture option works, but essentially this is your contractual rip-cord when you want to be done paying premiums. Once the RPU option is elected, a whole policy is shed of mortality charges and then the cash value grows toward the death benefit on a guaranteed basis. The new lower IRC 7702 rate will make the RPU assumptions much less favorable than what exists with today’s whole life policies. Similar to my question above, if your cash value has to grow towards your death benefit in a Whole Life policy that’s elected RPU status, do you want more guaranteed death benefit or less?

What does this mean?

It means that even though the newer Whole Life policies will accommodate more premiums, the guaranteed lifetime growth of these new policies will be compressed. So, much more of the cash value growth will be tied to the company’s fluctuating dividend scale (which is something they can change), and less of your total growth will be derived from the company’s guaranteed cash value trajectory that is baked in by contract.

So unlike with IUL where you may want to wait for the new and improved version, with Whole Life you will most likely want to lock in the current classic version without the compressed guarantees.

Don’t get me wrong, whole life companies will undoubtedly create future products that are competitive, but the total return will be tied to non-guaranteed factors, which they can toggle, unlike the guaranteed cash value component.  Often the most attractive feature of Whole Life is the guaranteed growth that clients can stack in their favor by adding term riders and paying disproportionate PUA payments). This guaranteed feature will be watered-down in future versions of the product due to the recent changes to code section 7702.

Obviously, the new 7702 interest rate changes will help whole life companies run a sustainable business and keep these promises to existing policyholders. So those who acquired these older products can continue enjoying these soon-to-be EXTINCT guaranteed parameters.

The last time the top-performing Whole Life company shelved a mispriced product, they gave agents just over a week’s notice to sell the old product before it went away for good because they didn’t want a fire sale on a product that way no longer a sustainable offering for them.

The guarantees of future Whole Life policies will be getting significantly watered-down. However, clients can lock in the stronger lifetime guarantees of classic Whole Life for a short time until these newer product offerings are approved by the Department of Insurance. (Watch Hutch’s 2-minute video take below)

FAQs about the change to 7702

No it does not. Your existing Whole Life or IUL policy would use the section 7702 interest rate parameters and premium limits that were in place at the time of issue.

(Update April 26, 2021: Certain carriers are allowing retroactive 7702 interest rate changes for policies initiated in 2021, but before their product line was approved).

It depends. Every carrier will be different. They must have their legal teams review the new IRC 7702 revisions, actuaries must then design the products, and only then can the State departments of insurance approve the product. Afterward, the carrier must adjust illustration software to accommodate the new product launch. Some carriers are saying Spring, others are saying summer, some are saying by year-end.

(Update April 26, 2021: Certain IUL carriers are starting to release the new products with updated 7702 assumptions. More to follow shortly).

Most likely no, but this is case dependent. Whenever you roll existing cash value into a new policy via 1035 exchange, the “rollover amount” is considered a premium and will be subjected to any premium load charged by the new policy. Even if the new contract is substantially more efficient, your cash value will have to take a step back to take strides forward.

This is something we often to model for new incoming clients with older policies. We often find they are more comfortable retaining older policies if they are decent, although in the worst cases it may make sense to switch. Most often though we can help them optimize the existing policy so that it no longer requires future premiums. That way they can keep their old policy and optimize it, while diverting new money premiums into a more efficient offering.

Schedule a custom call to discuss your rollover options and best course of action for your situation going forward.

Well that all depends, and we must disclose that you always run the risk of becoming less healthy or dying while you wait. However, assuming you stay healthy, the new IUL seems like it will be worth waiting for, while the old Whole Life has some clear advantages that will soon be obsolete (namely the stronger guaranteed growth rate and RPU parameters).

(Update April 26, 2021: Definitely lock in the old Whole Life while you still can. If you are interested in the new IUL, we can start to show you some of the new offerings now with more soon to be releasing each week/month)

Feel free to schedule a quick call to discuss your optimal options.

Most likely yes, since the industry lobbied hard for this change throughout 2020. Let’s face it, the old parameters were antiquated and costing them money. For that reason, we expect to see all life insurance companies create new products adopting these new parameters thereby making their business more sustainable.

Final Thoughts on the Recent Changes to IRC 7702

The recent changes to code section 7702 brought about by the Consolidated Appropriations Act of 2021 were necessary for the sustainability of the entire life insurance industry as we know it. By updating the antiquated interest rate and guaranteed assumptions originally set forth in the 1980’s, insurance companies can continue offering competitive accumulation products while maintaining promises to prior policyholders.

Clients who cherish the iron-clad guarantees of Whole Life insurance may want to lock them in with the current product offerings that will soon be extinct.

For those looking to maximize their upside potential with IUL/VUL and aren’t as concerned with the fluctuating fees at the core of these products, the upcoming changes will minimize this risk even further by allowing them the opportunity for growth on larger premiums outrun compressed charges.

Although these major changes to section 7702 will undoubtedly reshape the industry as we know it, they ensure that life insurance will remain a relevant and viable tool not only at the death of our clients but for full enjoyment throughout their lives as well.

John “Hutch” Hutchinson, ChFC®, CLU®, AEP®, EA
Founder of BankingTruths.com

Book Your Custom and Confidential Consultation