Welfare Plan Cost of Insurance (I know this is a DB board)

[Gary]

I have been presented with a 419 welfare benefit plan.

The benefit is only a life insurance policy.

419 says that the employer can deduct the "cost of insurance" and the remaining cost for the premium is considered W-2 income to the participant.

The policy is a life insurance policy with a cash value build-up and a guaranteed interest rate of 2% and a higher assumed interest rate (say 6%) in the illustration

The actuary must determine the level premium cost of insurance and has the authority to make this calculation using assumptions he deems reasonable.

Some of the materials out there on this type of plan indicate that it is expected that 75% of the premium would constitute the cost of insurance. However, based on my calculations it would require close to a 2% interest assumption and an available mortality table to me (namely IAM83).

My question does anyone have an opinion (and reason for it) as to what are appropriate assumptions regarding interest and mortality for such an analysis?

Thanks.

[Ron Snyder]

You raise a lot more questions that you have asked:

1) A life insurance policy is not a welfare benefit plan.

2) A "419 plan" generally refers to a plan that seeks to be exempt from the tax deduction limitations imposed by IRC sections 419 and 419A by purporting to comply with IRC 419A(f)(5) (collectively bargained plans) or 419A(f)(6) (10 or more employer plans). Which is this? I would run away from either type of plan as fast as possible.

3) 419 says that as long as a deduction may be taken under another section of the IRC, it may be taken under 419 to the extent permitted. Sections 419 and 419A don't authorize tax deductions; they simply limit them. Which IRC section authorizes the deduction for a life insurance policy?

4) The current and guaranteed interest rates may or may not be relevant, subject to the answer to #3) above.

5) An actuary is not required under IRC 419 but is required under IRC 419A to justify the deduction amount claimed.

6) The portion of the premium going to provide current death benefit coverage versus the portion used to build up cash value will vary based on the issue age. 75% will be accurate at one age but not another.

7) The IAM 83 table is an annuity table, not a mortality table. The CSO tables are used for insurance rate calculations (i.e., CSO 2001).

8) I have an opinion on what is an appropriate range of interest rates for such calculations. I currently use assumptions between 5 and 7 percent with the CSO 2001 table.

[Gary]

Thanks for your opinions.

What is your rational for choosing an interest rate between 5 and 7%? Is it just an assumption to tie into an approximate rate of return over the life insurance policy duration based on current rates?

WOuld you be able to email me or advise me as to where I can obtain the q's for the CSO table you purport to use? I realize the table I specify is an annuity table. While it is different to the CSO table it still does have mortality rates, albeit perhaps not the most appropriate rates.

Thank you.

My email is gmevorah@waagelaw.com and tel number is 858-657-0246 x223.

Gary

[Gary]

Vebaguru,

FYI,

I was presented with a policy that had a face amount of $9,000,000 for aninsured age 37.

I used 4.5% from a report found at the TowersPerrin web site that provides that the maximum statutory valuation and non-forfeiture interest rate of 4.5% for 2004 and 2005 issues of life insurance products.

And the 2001 valuation basic mortality table in a report at actuary.org. My understanding is that the CSO 2001 table is derived from the above table.

Based on the above assumptions I determined a level premium at age 37 of $85,985. The actual premium is roughly $150,000 per year. The calculated amount is only 57% of the actual premium. Lower than expected, but perhaps not surprisingly less than the 75% rate mentioned earlier due to the fact that the insured is relatively young.

Curious to get your observations on the above story if you have a chance.

Without trying to get into too much detail I presented some basic components above. One of the big observations I have is what exactly is the applicability of "maximum statutory valuation and non-forfeiture interest rate" to the calculation done above?

Thanks.

[Ron Snyder]

I choose an interest rate between 5 and 7% because those are my reasonable expectations of returns to be obtained over the life of the contract.

There are a number of actuarial tables that can be downloaded from the Society of Actuaries website. Try Table Manager

The face amount of $9,000,000 certainly doesn't sound like a group term life insurance arrangement, and gives rise to more concerns about the validity of the "419 plan".

4.5% doesn't offend my sensibilities. But the way home offices select interest rates is typically different from how independent actuaries do: HO actuaries look at returns on investments currently available as of the date of issue for the applicable period and then deduct the home office's "spread" that they need for operating expenses and general overhead, typically 1.5%-2.0%. If an insurance company can obtain 6.5% in the market, they will credit 4.5% interest to an insurance contract.

My observations are that the rates you calculated might still be a little high, but they are defensible. But I would be much more concerned about the other issues I raised.

The "maximum statutory valuation and non-forfeiture interest rates" do not apply to 419 plans nor to section 79 plans. They have to do with determination of statutory reserves for life insurance companies. Rather than using GAAP accounting, insurance companies are required to use "statutory accounting" in preparation of their financial statements.

[Gary]

The plan I refer to is a single employer welfare benefit plan.

You mention "the rate an insurance company can obtain in the market".

How are we defining market in the case of an insurance company? i.e. I presume an insurance company invests their pool of funds in the market, but would the market for an insurance company be conservative, such as greater than 50% in fixed income products of treasuries or corporate bonds?

And your point is well taken regarding that say if an insurance company can expect to receive 6% on their funds, then after a reduction for their expenses might only provide a rate of say 4% for the policy contract and so on.

Thanks.

[Ron Snyder]

Insurance company investments are regulated tightly, with limits on the portion of the percentage of their funds in any single security or investment. Some companies link returns under insurance contracts to yields on specific corporate bonds they acquire. Sometimes they use an investment rate that is a composite return of their overall investment portfolio, including stocks or stock options in case the market goes up.

[Gary]

Regarding the mortality table:

You suggest the CSO 2001 table and it has rates for non smoker, smoker and composite rates.

In choosing the most appropriate I have a situation that has one policy using preferred non smoker rates and theother using standard non smoker rates.

With that said and based on the mortality tables stated above, it would seem that a preferred table could use the CSO 2001 non smoker and a standard non smoker could use the CSO 2001 composite, since the composite has higher q's than the non smoker.

Any opinions on that determination? Any other views or interpretations?

Thanks.