A life insurer must use its updated morbidity tables (not the original ones) to compute tax reserves for long-term care policies

Plain-English summary

Life insurance companies get tax deductions for the reserves they must hold to pay future claims, and Internal Revenue Code § 807(d) sets rules for how those tax reserves are computed, including which actuarial tables to use. This Technical Advice Memorandum addresses a company that reinsured blocks of long-term care (LTC) insurance. For LTC policies, the industry regulators (NAIC) never issued a standard "prevailing" morbidity table, so the company built its own tables. After a state insurance audit found the company had used the wrong mortality table and understated its statutory reserves, the state required corrections; the company took the chance to also update its morbidity (claims-cost) assumptions to newer, more favorable experience, and it used those updated "Year 5" tables for its state statutory reserves. The dispute: for federal tax reserves, could the company keep using its original morbidity tables from when the policies were issued, while using the updated tables for state purposes? The IRS National Office said no. Because there was no prevailing NAIC standard morbidity table for these policies, § 807(d)(5)(C) and Treasury Regulation § 1.807-1(a) apply, and that regulation requires using the same morbidity tables used for the NAIC annual statement, which are the updated Year 5 tables. The IRS rejected each of the taxpayer's arguments, including that the original tables were "prevailing" tables and that Notice 2010-29 required freezing the issue-date assumptions. The practical effect: the company must compute its tax reserves using the updated tables, changing the size of the § 807(f) 10-year reserve adjustment.

Ruling snapshot

• Question: For long-term care policies with no NAIC prevailing morbidity table, must the tax reserves under § 807(d) be computed using the morbidity tables used at issuance, or the updated tables used for statutory reserves as of Year 5?
• Outcome: Advice (National Office concluded the updated Year 5 morbidity tables must be used; taxpayer's position rejected)
• Key authorities: IRC § 807(d)(2), (d)(3)(A)(iv), (d)(5)(A)-(C), (f); Treas. Reg. § 1.807-1(a); IRC §§ 805(a)(2), 816(e), 7702B(b); Notice 2010-29; American Financial Group v. United States, 678 F.3d 422 (6th Cir. 2012)

Full text (IRS public release)

                          INTERNAL REVENUE SERVICE
                NATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM

                                             July 25, 2018

                                                  Third Party Communication: None
                                                  Date of Communication: Not Applicable
Number:                201844009
Release Date:          11/2/2018
Index (UIL) No.:       807.03-01
CASE-MIS No.:          TAM-108643-16

Director
Director of Field Operations, Compliance Practice Area (West)

Taxpayer's Name:                        -----------------------------------------------------------
Taxpayer's Address:                     -----------------------------
                                        ---------------
                                         -----------------------------------------
Taxpayer's Identification No            -----------------
Year(s) Involved:                       ---------------
Date of Conference:                     ----------------------


LEGEND:


State 1     =    -----------
Year 1      =    -------
Year 2      =    -------
Year 3      =    -------
Year 4      =    -------
Year 5      =    -------
Year 6      =    -------
Year 7      =    -------
Amount A    =    ------------------
Amount B    =    ------------------
Amount C    =    ------------------
Amount D    =    --------------------
TAM-108643-16                                2

ISSUE:

Whether the federally prescribed reserves for Taxpayer's reinsured risks under long-
term care insurance contracts as of the close of Year 5 and thereafter should be
computed under section 807(d) of the Internal Revenue Code1 using the morbidity
assumptions Taxpayer used at the times the contracts were issued or the morbidity
assumptions Taxpayer used for statutory reserves as of the close of Year 5 and
thereafter.

CONCLUSION:

The federally prescribed reserves for Taxpayer's reinsured risks under long-term care
insurance contracts as of the close of Year 5 and thereafter should be computed under
section 807(d) using the morbidity assumptions Taxpayer used for statutory reserves as
of the close of Year 5 and thereafter.

FACTS:

Taxpayer is a life insurance company under Part I of Subchapter L of the Internal
Revenue Code. Taxpayer is a member of a consolidated group that files its federal
income tax return based on a calendar tax year.

Taxpayer files its National Association of Insurance Commissioners' ("NAIC") annual
statement with State 1's Department of Insurance ("DOI"). The NAIC annual statement
is maintained on a statutory accounting basis and conforms with Statutory Accounting
Principles ("SAP"). The NAIC Accounting Practice and Procedural Manual ("APPM"),
which includes the SAPs, was adopted as a component of the prescribed or permitted
practice of the DOI. State 1 insurers are subject to the APPM.

Taxpayer enters into reinsurance and retrocession agreements under which it assumes
risks of long-term care insurance policies. Taxpayer is required to compute and report
reserves for these reinsurance and retrocession agreements to comply with state
regulatory requirements. Under these requirements, there are three types of reserves
for long-term care insurance policies: the unearned premium reserve, the active lives
reserve, and the disabled lives or claim reserve.

The issue in this case involves the computation of the active lives reserve for a block of
long-term care insurance policies issued in Year 1 and subsequent years ("Block of
Policies"). Taxpayer acquired the risks in the Block of Policies through multiple
retrocession agreements covering policies written by several direct writers. The
retrocession agreements provide for reinsurance of guaranteed renewable (non-

1
 Unless otherwise indicated, all section references are to the Internal Revenue Code of
1986, as of Year 5 and Year 6.
TAM-108643-16                               3

cancellable) individual long-term care insurance policies on an indemnity coinsurance
basis.2

The NAIC's Health Insurance Reserve Model Regulation ("Model Regulation")
provides the reserve method as well as the basis (mortality, morbidity,3 interest, and
termination4 assumptions) with which the active lives reserves for long-term care
insurance must be computed.5 Model Regulation, Section 4.B. (referring to the active
lives reserves as contract reserves). Pursuant to Section 4.B.(2)(b)(ii) of the Model
Regulation, the required minimum reserve for long-term care insurance policies issued
after 1991 is the reserve calculated on the one-year full preliminary term method. A
one-year full preliminary term method generally requires the reserve to be computed
with an assumption that effectively treats the first year of coverage as term insurance
with a first year terminal reserve of zero and a valuation net single premium
determined as of the beginning of the second policy year.

In calculating the active lives reserves, section 4.B.(1)(a) of the Model Regulation
requires the use of minimum morbidity assumptions. Appendix A of the Model
Regulation provides tabular morbidity standards for some types of contracts, but not for
guaranteed renewable (non-cancellable) individual long-term care insurance policies,
such as the Block of Policies.

Section 4.B.(1)(a) of the Model Regulation provides that for policies for which there are
no standard morbidity tables a reserve shall be computed based on tables established
for reserve purposes by a qualified actuary. Section 4.B.(1)(a) of the Model Regulation
requires that the morbidity tables contain a pattern of incurred claims cost that reflects
the underlying morbidity and not be constructed for the primary purpose of minimizing
reserves. In determining the morbidity tables, section 4.B.(1)(a)(i) of the Model
Regulation requires the actuary to use assumptions that represent the best estimate of
anticipated future experience but not to incorporate any expectation of future morbidity
improvement. Section 4.C. of the Model Regulation provides that a reserve may be
computed using alternative assumptions if such alternative assumptions produce a result
at least as high as that required under minimum standards.



2
  Long-term care policies are generally written on a guaranteed renewable basis.
Section 816(e) provides that guaranteed renewable health insurance contracts are
treated in the same manner as non-cancellable life and health insurance contracts.
3
  Morbidity is the probability and expected cost of claims that may be filed for care under
the contract and that are used to determine the amount of the reserve.
4
  Termination or lapse rate is the rate that contracts are voluntarily terminated.
5
  While State 1 has not directly adopted the Model Regulation, the provisions of the
Model Regulation are incorporated in the Appendix of the APPM. State 1 insurers are
subject to the APPM.
TAM-108643-16                                 4

Section 4.D. of the Model Regulation provides that insurers must annually review the
prospective contract liabilities to determine the continuing adequacy and
reasonableness of the tabular reserve while giving consideration to future gross
premiums. Thus, to comply with the Model Regulation, Taxpayer must annually review
the liabilities for the Block of Policies.

Taxpayer provides long-term care policy administration to all of the companies it
reinsures under an administrative agreement that runs for the life of the last
policyholder. Administrative duties include policy design, pricing, and the filing of both
the policy forms and actuarial memorandum with the state regulator under a letter of
authorization from the direct writer allowing Taxpayer to file on its behalf. The pricing is
done using Taxpayer's best estimate of assumptions, including the mortality rate, the
morbidity rate, and the lapse rate. Taxpayer also utilizes the the mortality rate, the
morbidity rate, and the lapse rate to calculate the direct writing company's statutory
reserves and reports such reserves to the company.

There have never been commissioners' standard morbidity tables prescribed by the
NAIC that were permitted to be used in computing reserves for the Block of Policies
under the insurance laws of 26 states. For both pricing and statutory reserve purposes
for the Block of Policies, Taxpayer initially used morbidity tables ("Original Morbidity
Tables") that reflected assumptions based on government nursing home tables and
made adjustments using the experience data of its cedants (direct writers and
antecedent reinsurers) because Taxpayer did not have its own credible experience
data. Pursuant to a regulatory audit by the DOI for Year 2 through Year 3, the DOI
determined that Taxpayer used the incorrect mortality table for its statutory reserve
methodology. Taxpayer incorrectly used "joint life mortality tables" instead of "second to
die mortality tables" for the Block of Policies containing joint life second to die policies in
determining statutory reserves. The lifespans under the "joint life mortality tables" were
shorter than the "second to die joint mortality tables." As a result, using the incorrect
shorter lifespans produced a lower reserve than would have been calculated had the
longer life span from the second to die mortality tables been used. Consequently, the
DOI determined that Taxpayer's statutory reserve was too low.

Effective for Year 5, the DOI required Taxpayer to change its joint life mortality
assumptions, thereby causing the amount of the statutory reserve to be significantly
increased. In order to minimize the amount of the required statutory reserve increase,
Taxpayer requested a special accommodation from the DOI to modify other reserve
assumptions as well. Specifically, Taxpayer requested that the DOI permit it to use
current assumptions (as of Year 5) based on its experience for morbidity and lapse rate
in computing its reserves for the Block of Policies. Although the lapse rate had been
less favorable than originally anticipated (causing the total reserve to increase a bit
more), Taxpayer's morbidity experience had been more favorable than originally
anticipated (causing the total reserve to decrease significantly), which served to reduce
the amount of the overall statutory reserve increase following the correction of the
mortality assumptions. The DOI accommodated Taxpayer's request and allowed
TAM-108643-16                               5

Taxpayer to use the updated assumptions for both its lapse and morbidity assumptions.
In addition, the DOI did not consider the change in the morbidity assumption to be a
permitted practice that departs from the Model Regulation.6

When updating the morbidity assumptions, Taxpayer continued to use the morbidity
assumptions based on government nursing home tables but adjusted those tables using
its own experience instead of the experience of its cedants. With these updated
assumptions, Taxpayer established revised morbidity tables that it used to compute
statutory reserves for Year 5 ("Year 5 Morbidity Tables"). For statutory purposes,
Taxpayer also changed its mortality assumptions for Year 5 and revised the lapse rate
assumptions.

For federal tax purposes, Taxpayer incorporated the changes to the mortality, lapse,
and morbidity assumptions in the computation of the tax reserve for the Year 6 federal
income tax return. The amount of the adjustment (the difference in the amount of the
reserve attributable to the revised assumptions) would have been taken into account
ratably over 10 taxable years pursuant to section 807(f). Accordingly, the amount of the
proposed adjustment, Amount A, would be spread out over 10 years, thereby
decreasing taxable income for Year 6 through Year 7.

Subsequently, Taxpayer asserted that although it was proper to change the mortality,
lapse rate, and morbidity assumptions in the computation of the reserves for statutory
purposes, it was only proper to change the mortality and lapse rate assumptions (and
not the morbidity assumptions) in the computation of the reserves for federal tax
purposes. In other words, Taxpayer wanted to continue to use the Original Morbidity
Tables for purposes of computing the reserve for tax purposes despite the fact that it
used Year 5 Morbidity Tables for statutory reserve purposes.

If Taxpayer were to use the Year 5 Morbidity Tables for statutory purposes and the
Original Morbidity Tables for tax purposes, the Year 5 reserves for each policy in the
Block of Policies would be larger for tax purposes than for statutory purposes. In
addition, the amount of the tax reserve for some of the Block of Policies would have
been capped by the statutory reserve for those polices, as provided by section
807(d)(1). If the Taxpayer were to use the Year 5 Morbidity Tables for tax purposes for
Year 5, the amount of the section 807(f) adjustment would be Amount B (an additional
Amount C in excess of the Amount A). Amount B represents the increase resulting from
the tax reserve being subject to a statutory cap limit of Amount D.

6
 The DOI notes that the change in the morbidity assumption is not a permitted practice
provided the tables and calculations still satisfy the general requirements of the
prescribed accounting practice. In addition, the DOI notes that it is "generally true that
an insurer would be expected to notify the [DOI] of a significant change in claim
assumptions and, if such change reduces calculated reserves, would seek prior
approval from the [DOI]."
TAM-108643-16                                 6

In determining the amount of the reserves for the Block of Policies for tax purposes,
Taxpayer used the appropriate interest rate based on the year the Block of Policies
were issued. The reserve method prescribed by the NAIC for each of the Block of
Policies when it was issued was the one-year preliminary term method, as required by
section 807(d)(3)(A)(iv)(I). Taxpayer correctly used the one-year preliminary term
method in the calculation of the active lives reserves for both statutory and tax
purposes. In addition, Taxpayer computed the amount of the reserves for each policy in
accordance with the statutory cap limitations in section 807(d)(1).

LAW:

Section 805(a)(2) allows an insurance company to take a deduction for increases in
certain life insurance reserves. More specifically, section 807(b) provides that if, for any
taxable year, the closing balance of "the items described in subsection (c)" (which
includes life insurance reserves) exceeds the opening balance, the excess is taken into
account as a deduction under section 805(a)(2). By contrast, if the opening balance
exceeds the closing balance, the excess is included in gross income under section
803(a)(2).

The method of determining life insurance reserves for use in computing an insurance
company's taxable income is prescribed in section 807(d). For this purpose, the
reserve for a contract is generally equal to the greater of (a) the net surrender value of
such contract or (b) the amount of the reserve determined under section 807(d)(2). In
no event may the reserve for any contract exceed the amount taken into account with
respect to that contract as of that time in determining the statutory reserves (reduced by
any deferred and uncollected premiums taken into account in determining the statutory
reserves). Section 807(d)(1)(flush language); see also section 811(c).

Section 807(d)(2) provides that the reserve for any contract must be determined using
(i) the tax reserve method applicable to that type of contract, (ii) the greater of the
applicable federal interest rate or the prevailing state assumed interest rate, and (iii) the
prevailing commissioner's standard tables for morbidity or mortality adjusted as
appropriate to reflect the risks (such as substandard risks) incurred under the contract
which are not otherwise taken into account.

Section 807(d)(3)(A)(iv)(I) provides that the tax reserve method for purposes of section
807(d) for other contracts that are not life insurance contracts, annuity contracts, and
noncancellable accident and health contracts (other than a qualified long-term care
insurance contract, as defined in section 7702B(b)) is the reserve method prescribed by
the NAIC which covers such contract (as of date of issuance).

Section 807(d)(5)(A) provides that the term "prevailing commissioners' standard tables"
means, with respect to any contract, the most recent commissioners' standard tables
prescribed by the NAIC which were permitted to be used in computing reserves for that
type of contract under the insurance laws of at least 26 states when the contract was
TAM-108643-16                               7

issued. Section 807(d)(5)(B) provides that if the prevailing commissioners' standard
tables are changed, the issuer may use the prior prevailing commissioners' standard
tables for the next three years. If there are no commissioners' standard tables
applicable to a contract when the contract is issued, section 807(d)(5)(C) provides that
the mortality and morbidity tables used for purposes of section 807(d)(2)(C) shall be
determined under the regulations prescribed by the Secretary. When the Secretary by
regulation changes the table applicable to a type of contract, the new table shall be
treated (for purposes of section 807(d)(5)(B) and for purposes of determining the issue
dates of the contracts for which it shall be used) as if it were a new prevailing
commissioner's standard table adopted by the 26th state as of a date specified by the
Secretary, but no earlier than the date the regulation is issued.

Section 1.807-1(a) of the Income Tax Regulations provides that if there are no
prevailing commissioners' standard tables applicable to an insurance contract when the
contract is issued, then the mortality and morbidity tables set forth under the regulation
are used to compute the reserves under section 807(d)(2). Section 1.807-1(a), row 12,
specifies that for noncancellable accident and health insurance (active lives reserves)
issued after 1983, the insurer must use the tables used for NAIC annual statement
reserves.

Section 807(f) provides that if the basis for determining any item referred to in section
807(c) as of the close of any taxable year differs from the basis for determining that item
as of the close of the preceding taxable year, then so much of the difference between
(i) the amount of the item at the close of the taxable year, computed on the new basis
and (ii) the amount of the item at the close of the taxable year, computed on the old
basis, as is attributable to the contracts issued before the taxable year, is taken into
account ratably over 10 taxable years (either as an increase or decrease in taxable
income), beginning with the year following the year of change.

ANALYSIS:

   I.     The Tax Reserves for the Block of Policies Must Be Computed using the Year
          5 Morbidity Tables that Were Used on the NAIC Annual Statement.

Section 807 provides specific rules for computing life insurance reserves, including the
use of the prevailing commissioners' standard tables for morbidity or mortality adjusted
as appropriate to reflect the risks (such as substandard risks) incurred under each
contract that are not otherwise taken into account. Section 807(d)(2)(C). The term
"prevailing commissioners' standard tables" means, with respect to any contract, the
most recent commissioners' standard tables prescribed by the NAIC that were permitted
to be used in computing reserves for that type of contract under the insurance laws of at
least 26 states when the contract was issued. Section 807(d)(5)(A).

If there are no commissioners' standard tables applicable to a contract when it is issued,
the mortality and morbidity tables to be used for purposes of calculating the life
TAM-108643-16                                8

insurance reserves must be determined under regulations prescribed by the Secretary.
Section 807(d)(5)(C). Section 1.807-1(a) sets forth the mortality and morbidity tables to
be used to compute reserves if there are no commissioners' standard tables applicable
to an insurance contract when the contract is issued.

For long-term care insurance products, there has never been a prevailing
commissioners' standard table for morbidity, so no such table existed when the Block of
Policies were issued. Accordingly, section 807(d)(5)(A), requiring the use the prevailing
commissioner's standard table when the contract was issued, does not apply. Instead,
section 807(d)(5)(C) applies. Section 807(d)(5)(C) provides that if there are no
commissioners' standard table applicable when a contract is issued, the morbidity table
is determined under regulations prescribed by the Secretary. Section 1.807-1(a)
specifies the tables that taxpayer must use to compute reserves for different types of
contracts. The Block of Policies are "noncancellable accident and health insurance
(active lives reserves)," as described in section 1.807-1(a), row 12; and therefore,
Taxpayer must use the "[t]ables used for NAIC annual statement reserves."

The tables that are to be used for the NAIC annual statement reserves are prescribed
by the Model Regulation. The Model Regulation specifies morbidity standards in its
Appendix A for some types of contracts but does not specify a particular morbidity table
for the Block of Policies. The Model Regulations state that if no morbidity standards are
specified in its Appendix A (as is the case here), then the morbidity tables used must be
established by a qualified actuary based on assumptions that represent the best
estimate of anticipated future experience. Model Regulation, section 4.B(1)(a). Neither
the Service nor the Taxpayer argues that the Year 5 Morbidity Tables were not
established by a qualified actuary. Thus, we assume the morbidity tables were
established by a qualified actuary. In addition, the Year 5 Morbidity Tables were
acceptable to the DOI and otherwise met the requirements of Section 4.B(1) of the
Model Regulation. Accordingly, the Year 5 Morbidity Tables must be used to compute
the reserve for tax purposes.

   II.        Taxpayer's Position

Taxpayer makes several arguments that we have determined are not persuasive.
These arguments are discussed below.

         A.      Taxpayer Argues that Section 807(d)(5)(C) and Section 1.807-1(a)
                 Require Continued Use of the Tables Used when the Polices Were
                 Issued.

Taxpayer's position is that the "prevailing commissioners' standard tables" are defined
in section 807(d)(5) exclusively by reference to tables that existed "when the contract
was issued." Taxpayer contends that although section 1.807-1(a) by its terms is not
limited to tables used for annual statement reserves in the year of contract issuance,
when read in conjunction with the statute, the regulation is limited by a temporal
TAM-108643-16                                9

requirement that the specified table can only refer to tables used for annual statement
reserves in the year the contract is issued. Taxpayer argues that because section
807(d)(5)(A) defines the term "prevailing commissioners' standard tables," and that
definition is determined as of the time the contract was issued, the tables used pursuant
to section 807(d)(5)(C) cannot change after the contract is issued.

Taxpayer misreads the statute. The requirement to use "prevailing commissioners'
standard tables" to determine the tax reserve for a contract only applies when there is a
prevailing commissioners' standard table for that contract. "Prevailing commissioners'
standard tables" are the most recent commissioners' standard tables prescribed by the
NAIC and permitted to be used under the insurance laws of 26 states when the contract
was issued. Section 807(d)(5)(A). There were no standard tables for the Block of
Policies when they were issued (let alone a standard table that was permitted to be
used by 26 states). Accordingly, section 807(d)(5)(C) is applicable because "there
[were] no commissioners' standard tables applicable to any contract when it [was]
issued." As discussed above, section 807(d)(5)(C) refers to the Treasury regulation,
which requires the use of the morbidity tables used for the NAIC annual statement
reserves. The Year 5 Morbidity Table is that table. Accordingly, Taxpayer is required to
use the Year 5 Morbidity Tables when computing its tax reserves for Year 5 and Year
6.7

7
  A treatise on life insurance reserves for tax purposes agrees that in situations like the
one at issue, the updated tables used for statutory purposes should be used to compute
reserves for tax purposes instead of the tables that were used when the contracts were
issued. (The below quotation references mortality tables instead of morbidity tables, but
the analysis is the same.)

       The regulation [1.807-1] does not have the limiting language that says the
       reserve is the annual statement reserve in effect at the time the contact
       was issued. Moreover, the Code requirement to use the mortality table in
       effect when the contract was issued is limited to the prevailing table. The
       language in the Code does not restrict the use of a different table when
       there is no prevailing table. Permitting the use of a new table when the
       statutory annual statement table is the table used to compute tax reserves
       is consistent with the result reached in American Financial Group v. United
       States, [678 F.3d 422 (6th Cir. 2012)] in which the court held that when a
       statutory interest rate and statutory reserve method are used in computing
       tax reserves (where the NAIC has issued no guidance or there is no
       prevailing view of the states), if a company changes its annual statement
       reserve method or interest rate, then tax reserves must be computed
       using the new statutory method or interest rate.

Edward L. Robbins & Richard N. Bush, Tax Basis Assets and Liabilities of U.S. Life
TAM-108643-16                               10

      B.     Taxpayer Argues that the Original Morbidity Tables are Prevailing Tables.

Taxpayer argues that the NAIC has prescribed tables for long-term care insurance
reserves in the Model Regulation, that these tables are "prevailing tables" for purposes
of section 807(d)(5)(A), and that therefore, such tables that existed when the contracts
were issued must be used to compute reserves for tax purposes.

Taxpayer misinterprets the definition of "prevailing commissioners' standard tables" in
section 807(d)(5)(A). For there to be a "prevailing commissioners' standard table" with
respect to a contract, there must have been a commissioners' standard table prescribed
by the NAIC and permitted to be used by at least 26 states with respect to that contract.
There were no standard tables when the Block of Policies were issued.

Instead of prescribing standard tables for long-term care contracts, the Model
Regulation requires the actuary to establish his own table (within certain parameters).
Model Regulation, 4.B.(1)(a) ("Contracts for which tabular standards are not specified in
Appendix A shall be valued using tables established for reserve purposes by a qualified
actuary."). These are not "commissioners' standard tables," the existence of which is a
prerequisite for section 807(d)(5)(A)'s required use of commissioners' standard tables
that existed when a contract was issued.8 Because there were no commissioners'
standard tables when the Block of Policies were issued, there can be no "prevailing
commissioners' standard tables" for the Block of Policies.

      C.     Taxpayer Argues that Requiring the Use of Year 5 Morbidity Tables is
             Inconsistent with Notice 2010-29.

Taxpayer argues that the Service's position in this case is inconsistent with previously
published guidance, such as Notice 2010-29, 2010-1 C.B. 547. Notice 2010-29
provides interim guidance on issues that arise under sections 807 and 816 as a result of
the adoption of Actuarial Guideline 43, (a new Commissioner's Annuity Reserve
Valuation Method ("CARVM") effective December 31, 2009). As relevant to Taxpayer's
argument, Notice 2010-29 provides that Actuarial Guideline 43 cannot be applied to
determine the tax reserve for contracts issued prior to its effective date. This is
consistent with section 807(d)(3) which specifically requires that the tax reserve method
to be used is CARVM "which is in effect on the date of the issuance of the contract."
See 807(d)(3)(B)(ii). Thus, Notice 2010-29 merely reiterates section 807(d)(3)(B)(ii)'s
requirement that the method used to compute the reserve must be that which was in
effect when the contract was issued.


Insurers (2014) at 137.
8
  For sake of comparison, a standard table that is prescribed by the NAIC would be
"The 1964 Commissioners Disability Table" that must be used for disability income
benefits due to accident or sickness for contracts issued after January 1, 1965.
TAM-108643-16                                  11

In contrast, there is no requirement that the morbidity tables used to compute the tax
reserves for the Block of Policies for a given year be the same morbidity tables that
were used when the Block of Policies were issued. Section 807(d)(5)(A) imposes such
a requirement if there was a prevailing commissioners' standard table in existence when
the contract was issued, but there was no prevailing commissioners' standard table
when the Block of Policies were issued. Because there were no prevailing
commissioners' standard tables for the relevant contracts, section 807(d)(5)(C) applies.

As stated above, section 807(d)(5)(C) defers to regulations, and these regulations
require that the morbidity tables used for purposes of determining the tax reserve are
those tables used for the NAIC annual statement. The Year 5 Morbidity Tables were
used for the annual statement, so they must also be used to compute the tax reserves.

       E.     Taxpayer Argues that the One-Year Full Preliminary Term Method
              Requires the Use of Original Morbidity Tables.

Taxpayer agrees that the reserve method to be used in this case is the one-year full
preliminary term method.9 Taxpayer argues, however, that the one-year full preliminary
term method requires the use of the NAIC's morbidity assumptions [that existed when
the Block of Policies were issued] and that the Year 5 Morbidity Tables do not include
the required morbidity assumptions. As a consequence, Taxpayer believes that use of
the Year 5 Morbidity Tables is inconsistent with the one-year full term preliminary
method and cannot be used to determine the reserves for tax purposes.

Taxpayer's argument ignores the fact that section 807(d) dictates what morbidity tables
must be used to compute tax reserves, regardless of what morbidity tables would
otherwise be used under the NAIC prescribed method. Specifically, section 807(d)(2)
provides, as relevant here, that the tax reserve for a contract must be determined using
(A) the tax reserve method applicable to such contract, (B) a certain interest rate, and
(C) the prevailing commissioners' standard tables for mortality and morbidity. Where
there are no commissioner's standard tables applicable to the contract, as is the case
with the Block of Policies, then section 807(d)(5)(C) requires that the mortality and
morbidity tables to be used are those prescribed in the regulations.

As discussed above, the Treasury regulations state that the morbidity tables to be used
for the Block of Policies are those used for the NAIC annual statement. The morbidity
tables used on the NAIC annual statement for Year 5 and Year 6 are the Year 5

9
  Section 807(d)(3)(A)(iv) provides that for a contract not described in section
807(d)(3)(A)(i), (ii), or (iii), which the policies are not, the tax reserve method applicable
to the contract is the reserve method prescribed by the NAIC that covered the contract
on the date of issuance. The one-year full preliminary term method was the prescribed
method when the policies were issued; this is consistent with the Model Regulation.
Model Regulation, section 4.B.(2)(b)(ii).
TAM-108643-16                                12

Morbidity Tables. Accordingly, the Year 5 Morbidity Tables must be used to compute
the tax reserves.

       F.     Taxpayer Argues that the Year 5 Morbidity Tables Are Not Permitted by
              the NAIC Model Regulation.

Taxpayer argues that the Year 5 Morbidity Tables are not authorized by the NAIC Model
Regulation. Taxpayer claims that under the Model Regulation, morbidity assumptions
can never change from those established at contract issuance, in part because "best
estimate" assumptions are generally understood to be no better than those submitted
for original pricing.

Even if it is general practice to not update the assumptions, we do not need to address
general practice, only the specific facts of this situation. These facts are unique in that
Taxpayer used incorrect mortality tables for its original pricing, which must have been
significantly different than the pricing that would have been if Taxpayer had used the
correct mortality tables. It has not been made clear to us why in this situation Taxpayer
is bound to its original pricing assumptions or the authority under which Taxpayer is
prevented from updating its original pricing assumptions. Taxpayer clearly updated its
assumptions for statutory purposes, and the DOI agreed to this update. Moreover, the
DOI did not consider the change in the morbidity assumptions to be a permitted practice
that departs from the Model Regulation. Because the Model Regulation does not
preclude changes to morbidity tables to reflect current experience, Taxpayer's revised
morbidity tables are not prohibited by section 1.807-1(a).

As a variation of this argument, Taxpayer attempts to argue that Taxpayer's Year 5
Morbidity Tables are a state variation. That is, whenever the Taxpayer must obtain DOI
approval to adopt more favorable reserve assumptions (resulting in reserve weakening),
such approval is a state variation that is prohibited for tax purposes. That is, the
approval is a state variation from the Model Regulation.

Here, the Model Regulation and the state rule are identical and both permit such a
change. There is no state variation. The obligation to seek approval from the DOI to
change reserve assumptions does not make this a state variation from the Model
Regulation.

CAVEAT(S):

A copy of this technical advice memorandum is to be given to the taxpayer(s). Section
6110(k)(3) of the Code provides that it may not be used or cited as precedent.