IRC 7702/7702A The Ongoing Saga

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Life Insurance and IRS Codes 7702/7702A

Read about the latest 2021 updates to IRC 7702/7702A here.

Spotlight Issue 5 – 2011


I started my career as an actuarial trainee back in 1982. At the time, there was an amazing amount of controversy surrounding a new type of life insurance plan known as Universal Life (UL), which had only been on the market a few years at that time, but was quite a departure from the other insurance products of that era.

Unlike the more structured products of yesteryear, UL took an unbundled, fund-like approach to developing policy values and provided the insured with a fair degree of flexibility with respect to premium payments, death benefit options and the ability to make changes to the face amount during the life of the contract. Many of these concepts were either foreign to the more traditional products of the time (whole life and term) or not easily accommodated by the more structured and bundled design of these traditional products.

While the advent of UL was a boon to the life insurance industry, it wasn’t without controversy. One of the more relevant points at that time involved the presence of risk in a UL contract. This can be loosely defined as the amount of death benefit minus the fund value.

Early UL products had the potential for having very little risk (imagine something egregious like a $100,000 single premium for a $100,000 face amount policy), yet still had the potential to enjoy the tax benefits of life insurance (tax deferred internal growth of cash value and income tax free death benefits to the beneficiary, for example).

While there were several rulings during the early 1980s as the life insurance industry and other financial services industries lobbied for position, it wasn’t until Internal Revenue Code Section 7702 was brought into play under DEFRA (Deficit Reduction Act of 1984) that there was finally definitive guidance with respect to UL and other life plans. Life insurance contracts issued on or after January 1, 1985, were subject to 7702.

IRC 7702 was a defining change for the life insurance industry and created quite a stir when enacted. 7702 appeared complicated and would force insurance companies to augment the already expensive enhancements made to their administration systems to handle UL. Also, there appeared to be a good deal of gray area in 7702 that had many people scratching their heads.

In a nutshell, a life insurance contract subject to compliance under 7702 had to pass one of two tests selected at issue in order to meet the definition of life insurance and qualify for favorable tax treatment under Section 101. The first test is referred to as the Cash Value Accumulation Test (CVAT) and the second test the Guideline Premium/Corridor Test (GPT).

The CVAT works by comparing the cash surrender value to the net single premium required to fund future guaranteed benefits. The cash surrender value, per 7702, is not allowed to exceed the net single premium. Without getting into the details, the CVAT test describes the method used to develop the net single premium factors for a particular contract. By applying the net single premium factor to the cash surrender value, the least amount of death benefit that needs to be held for that particular policy month can be determined.

Many companies have built in automatic increases due to CVAT factors, so that the administrative system takes care of increasing the death benefit if the cash surrender value divided by the net single premium factor exceeds the death benefit. Of course, most companies are also careful to have such cases flagged to avoid any insured anti-selection, such as what might happen if an insured makes an unexpected and large premium deposit into a CVAT contract.

The Guideline Premium/Corridor Test involves two hurdles to clear; one to make sure that the premiums paid do not exceed the Guideline Premium limit and the other to make sure that the corridor is satisfied. The corridor sub-test is very similar to the CVAT in that a corridor factor is applied to the cash surrender value and requires that the death benefit be increased if the product exceeds the death benefit. The major difference between the CVAT and corridor sub-test of the Guideline Premium Test is that the CVAT factors can be substantially higher than the GPT corridor factors and the CVAT factors can vary from policy to policy, while the GPT corridor factors are a static set of factors.

Once again, the GPT portion of 7702 prescribed the method as to how the guideline premiums were to be determined with respect to items such as mortality, expense, interest, etc.



While it all seems clearer now, when 7702 came into play (1/1/85),there were many insurance company executives scratching their heads, not only with trying to understand IRC 7702 but wondering how to implement it on their systems.

This impact was more greatly felt at the medium and small size insurance companies where resource was at a premium, especially given the amount of sales that UL and like products were generating. It was not uncommon in those days for companies to leave the back-end administration low on the list of priorities, so getting the right amount of attention and resource on this type of project was not easy.

Most companies appeared to tackle the issue of getting 7702 up and running on their administrative systems for new business purposes. Even this seemingly simple step took a long time for many companies to accomplish, partly due to the amount of system modification needed to support 7702, but also due to the novelty of 7702 and the need for clarification. With certain elements of 7702, IRS guidance is still ongoing!

Compliance with 7702 is not an option for the vast majority of life insurance companies, it is a mandate. Not complying with 7702 can lead to a loss of life insurance status for an offending policy, which can lead to loss of tax deferral on cash value growth and income tax free death benefit proceeds for the insured, as well as a loss of the deductibility of the reserve for the insurance company.



Even with 7702 in place helping to level the playing field between the life insurance industry and other financial institutions, there were still controversies. Companies began to develop short-pay contracts and some agents started to market such contracts aggressively as well as equating such contracts as investments versus protecting against premature death.

The basic premise was to make a large lump sum payment into an interest sensitive insurance policy (such as UL) and continue to enjoy the ability to withdraw funds on a first-in-first-out (FIFO) basis along with the tax deferral of the inside buildup of the cash value. Indeed, one could deposit an amount up to the Guideline Single Premium at issue, still be in compliance with 7702 and enjoy the ability to withdraw funds on a FIFO basis.

So, while 7702 settled quite a bit of controversy, there was enough concern about the marketing of single and short-pay life insurance contracts subsequent to the enactment of 7702 that the legislators and industry lobbyists had at it once more, which resulted in a new class of life insurance contracts referred to as “Modified Endowments” or “MECs” for short as defined under the Technical and Miscellaneous Revision Act (TAMRA) of 1988.

A new section of the IRS code, Section 7702A, was added and made effective as of June 21, 1988. 7702A dealt with the definition of the modified endowment as well as the definition of a test used to determine if a contract was a “MEC” or “Non-MEC”.

Basically, a contract has to pass a 7-Pay Test, meaning that cumulative premiums paid have to be less than the cumulative 7-Pay Premium in order for a contract to retain a “Non-MEC” status. As mentioned, a MEC loses the favorable FIFO treatment on policy disbursement and is instead replaced with a last-in-first-out method of taxation (LIFO).

LIFO disbursements assume that any earnings that exist on the contract are taken first and cost basis is recovered last. This can lead to taxation issues for any disbursement on a MEC status policy if there are earnings in the contract. On top of that, 7702A added a 10% penalty for disbursements on a MEC status contract unless certain conditions were satisfied.

Like 7702, 7702A also described the method in which 7-Pay Premiums were to be developed (e.g. mortality and interest assumptions), and other important features of the contract. Unlike 7702, maintaining compliance under the 7-Pay Test in most cases only lasts 7 years while 7702 tests operate for the duration of the contract.

Compliance under 7702A can last for 7 years from issue, unless the contract is materially changed (such as by adding more coverage, for example). For contracts that are materially changed, the 7-Pay Test starts a new (which means another 7 years of monitoring the contract). 7702A also distinguished benefit reductions as separate and distinct from material changes and a benefit reduction occurring within the 7-Pay test period requires a retroactive determination of the 7-Pay test premium and a retroactive determination of compliance.

While noncompliance with 7702 has some very serious ramifications for both the insurance company and insured, noncompliance with 7702A is not always a problem. If, for example, an insured has a MEC status policy but has no intention of withdrawing or loaning funds from the contract, then there is no real issue since there is nothing to tax. Also, earnings must be present in the policy for taxation to occur (in a nutshell, the cash value of the policy has to exceed the cost basis in order for there to be gain). So, if there are no earnings (which can happen in a variable life insurance contract that’s been through a down market), there is once again nothing to tax.


More Items to Consider

While there are a lot of nuances and still some gray area in each of 7702/7702A, the laser like focus that many companies have placed on making sure that they’re compliant under each IRC has grown tremendously.

7702 was a major change to the life insurance industry and left many technical folks wondering how to best interpret and implement 7702 in their products and on their systems. Right as things were beginning to get a little clearer, along came 7702A and re-tilted the company apple cart.

So, for those of us who were present and working in the life insurance industry back in 1988, the addition of 7702A to an already full plate was daunting to say the least. Not to mention that the gray areas of each IRC left some companies in a quandary since the urge was to make the necessary changes to comply with each IRC, yet the unanswered questions made it hard to act without wondering whether the work involved to establish and implement the interpretation of the gray areas would have to be unwound at some point when further or final definition were added by the IRS via Revenue Ruling or Procedure.

During those early years, the focus was to get each of these IRCs up and running on the administrative/new business system. This way, the administrative system could do all the automated checking and provide warnings if a particular policy became non-compliant. Fortunately, both 7702/7702A provided for the ability of the insurance company to correct the contract by returning offending premiums to the policy holder within a specified time frame after failure.

While getting at issue calculation of the respective 7702/7702A premiums was the focus in the early days, it didn’t take long before we all realized that policy level changes that caused recalculations of the 7702/7702A premiums would also have to be implemented on the administrative system. Unfortunately, 7702 and 7702A differ in how recalculations are to be performed and this too had an adverse impact on company resources.

It also didn’t take long before companies realized that getting the 7702/7702A computations on their illustration software and inforce ledger software was in the critical path. 7702/7702A compliance can have a direct impact on premium flows into the contract, and illustration/inforce ledger systems had to have this capability to avoid, for example, selling a contract with premium flows that would later have to be altered in order to comply with 7702/7702A.

Accuracy is another measure that has grown in importance. In the 1990s, if your calculation of the 7702/7702A premiums were in the ballpark, that was fine. Nowadays, it is not uncommon for companies to have very strict tolerances (pennies) on the deviation of 7702/7702A premiums between their administrative and illustration/inforce systems. This means more effort in truly understanding the rounding rules of the administrative system so that they can be translated over to the illustration system amongst other things.

Many of the gray areas involving the more esoteric portions of 7702 (Force Outs and Recapture, for example) and 7702A (such as the Necessary Premium Test) have been flushed out over the years through various working groups and subsequent IRS Revenue Rulings and Procedures. There are still gray areas left, but these are diminishing over time.

Nonetheless, full implementation and administering of each of 7702 and 7702A has become a full time affair at many life insurance companies. While we have not delved into the many tentacles of 7702 & 7702A in this article, there are many nuances that surface with regularity.

Towards the end of the 1990s, the IRS came out with Revenue Procedure 99-27 which allowed companies to file for relief from MEC policies and restore them back to non-MEC status. I was involved in such a project and it involved developing a list of policies that were eligible for filing and then developing a “toll” charge for each policy (the toll charge went to the IRS). There was also a need to explain why the contracts had failed as well as why the offending premium was not returned to the policy holder within the specified time frame.

A lot of these inadvertent MEC failures occurred for various reasons, but primarily because administrative systems of the day required a tremendous amount of modification and testing to verify that 7702/7702A calculations and administration were working properly and this took years to accomplish. Also, there was still the need for further clarification of the gray areas in each IRC (which also has taken time to obtain clarity).

Anyway, 99-27 must have been successful for the IRS because it led to another set of MEC relief Rev. Procs. (2001-42 and 2008-39) as well as a 7702 relief Rev. Proc. (2008-40).


The Future

While life insurance taxation issues proliferated with the advent of 7702/7702A, these are by no means the only tax-related issues that companies have to successfully deal with every day. There are changes to the tax law occurring frequently that quite often involve life insurance and annuities.

As far as the future, I honestly think that companies will continue to hone in and get the 7702/7702A calculations working to an unprecedented degree of accuracy. It is important not only to continue to focus on getting 7702/7702A to function properly, but also to keep in mind that the tax law continues to change and that there are a lot of new product combinations out there that could lead to another IRC (such as 7702B which was developed for the tax treatment of qualified long term care insurance).


William “Bill” Aquayo
SVP, Actuarial Research
Insurance Technologies

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