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Taxation for M&A and Reinsurance, Part 2: Product Considerations

By Brian G. King, Philip P. Ferrari and Jeffrey Stabach

Taxing Times, December 2020


Editor’s note: the following article is the second in a series about taxation for mergers and acquisitions and reinsurance. See the June 2020 issue of Taxing Times for part 1,Proposed Regulations on Ownership Change Present Issues for Insurance Companies.”


The June issue of Taxing Times provided the first in a series of articles dealing with tax considerations for mergers and acquisitions and reinsurance. Continuing with this theme is the second article in the series, focusing on policyholder tax considerations. For most insurance policies sold or administered by life insurance companies, the Internal Revenue Code (IRC) has specific provisions that address how policyholders are taxed, including when and how income is recognized. For policyholders to receive the intended tax treatment, insurance companies must design and administer the contracts to meet specific qualification requirements imposed by the IRC. In addition, life insurance companies must also satisfy (1) tax information reporting requirements to inform policyholders and various taxing authorities (i.e., federal, state and local tax jurisdictions) when there is taxable income; and (2) tax withholding requirements where required by law or requested by policyholders. The tax qualification, reporting and withholding requirements, collectively referred to in this article as product tax compliance (PTC) requirements, are specific to each of the various types of contracts sold by life insurance companies (e.g., life insurance, annuities, long-term care insurance),[1] and also can vary based on the markets in which products are sold (e.g., qualified vs. nonqualified, foreign vs. domestic) or the time period when contracts were issued.  

When acquiring a life insurance business, buyers have a choice. They could simply assume the seller designed its products appropriately and is administering the business according to the PTC requirements and thus take the risk that the seller “got it right.” Alternatively, they can proactively spend the time and effort performing the necessary PTC due diligence to protect against incurring the potential costs they would be assuming, which can be tens of millions of dollars or more, if there are errors in the design or administration of the contracts and the systems intended to monitor and comply with the PTC requirements. Some buyers, particularly those that may be new to the insurance market, may not be aware of the PTC requirements (i.e., PTC risk) or otherwise appreciate the potential implications of failing to satisfy them; and hence, the need to evaluate PTC risk when performing due diligence relating to a potential acquisition.

Setting aside the product tax considerations under an acquisition setting for a moment, the unfortunate reality is that the complexity of the PTC requirements can result and has resulted in inadvertent instances of noncompliance for life insurance companies, exposing them to significant financial liabilities, the need to defend against lawsuits filed by affected policyholders and the potential for increased regulatory scrutiny from state insurance departments. In addition:  

  • Failing to meet the tax qualification requirements imposed by the IRC can affect how the issuing insurance company accounts for the contracts for tax purposes, potentially resulting in the filing of an incorrect corporate tax return.
  • For contracts that do not meet the tax qualification requirements, the rules for determining taxable income for policyholders may no longer apply, resulting in potential for the insurance company to incorrectly report taxable income or withhold an incorrect amount of tax. This could expose the insurance company to potential fines and penalties from the Internal Revenue Service (IRS), civil liability to policyholders and reputational risk in the marketplace. Further, policyholders could also be exposed to filing an incorrect tax return based on the taxable income reported by the insurance company.
  • If policy administration systems are the source of the error, system modifications would likely be needed to correct the error. Even more problematic is that policy-related data needed for ongoing administration could potentially be incorrect, requiring a redetermination of the policy values, something that policy administration systems are not well equipped to handle (e.g., if the policy administration system incorrectly determined cost basis, it would need to be redetermined so that the correct amount was used in the ongoing administration of contract).

While the above items highlight the consequences of getting the PTC requirements wrong, the path to remediating these errors can impose a significant burden on a buyer—financial and otherwise.  Remediation requires a large commitment of time and resources to quantify exposure, bring administrative systems into compliance, and bring nonqualifying policies into compliance, all of which may require uncomfortable communications with affected policyholders, regulators and the IRS.

Fortunately, there are circumstances in which insurance companies are able to voluntarily correct inadvertent errors that lead to qualification or reporting failures, but the processes involved are typically not without pain. While IRS remediation programs typically waive many of the penalties they could impose on insurance company that get either the qualification or tax reporting wrong, they often require the payment of compliance fees or toll charges, which can be significant. In addition, some remediation processes may require state insurance department involvement to the extent changes are needed to bring contracts’ terms into compliance with the PTC requirements.

Unless a buyer can proactively identify areas of PTC risk upfront during the sales process, it will likely inherit the burdens they create. The window may be limited for buyers to assess PTC risk, but in doing so, buyers have the opportunity to push these liabilities back to the seller in the form of a purchase price adjustment or a potential claim filed under indemnification provisions included in the sales agreement. With that in mind, this article is structured into three parts:

  • Part I provides an overview of the PTC requirements for business typically sold or administered by life insurance companies and common challenges they face in administering them.
  • Part II provides a framework for assessing PTC risk, recognizing that PTC risk can emerge from the failure to satisfy the PTC requirements due to errors in (1) the design of an insurance product (PTC design risk); and (2) the administration of the processes intended to maintain compliance with the PTC requirements (PTC administration risk).
  • Part III describes approaches for assessing PTC risk during the due diligence process of an acquisition, recognizing that there are practical limitations facing buyers due to compressed time frames and potentially limited access to information that would be needed to perform an in-depth, detailed PTC risk assessment prior to deal closing.

Part I: Challenges of Administering the PTC Requirements

Life insurance companies design and administer the contracts they sell according to requirements set forth in the IRC, related regulations and other tax guidance. Policyholders typically have an expectation that they will receive the tax treatment set forth in the IRC. Depending on the products involved, this treatment could include such items as the tax deferral of income accruing as cash value within a life insurance or annuity contract, exclusion of life insurance policy death benefits from taxable income or non-taxability of amounts paid under a qualified long-term care policy. In addition, the IRC sets forth requirements for life insurance companies to inform the policyholder, the IRS, state and potentially local tax jurisdictions when payments or distributions from those contracts may create taxable income for the recipient. This is typically accomplished by issuing one of the various types of Form 1099. There may also be requirements to withhold taxes due by policyholders with respect to such reportable income.[2] Non-compliant contracts or policy administration systems that do not correctly identify or calculate taxable income for policyholders or withhold the appropriate amount of tax would expose a potential buyer to penalties from the IRS, require updates to policy administration systems and likely require the need to remediate the qualification, tax information reporting and withholding errors with the IRS. As noted above, the cost for remediating these errors can be significant, and buyers will want these costs to be borne by the seller.

Effective management of the PTC requirements involves multiple areas within an insurance organization working together over the entire insurance product life cycle, i.e., from product design to policy issuance to ongoing policy administration to claims and benefit payments to the eventual termination or maturity of the contract. Each stage of the product life cycle has its own PTC requirements, requiring input from professionals with knowledge of the tax laws, contract laws, actuarial principles, insurance products, state and federal insurance regulations (e.g., SEC, NAIC and ERISA requirements), information technology (IT) architecture, sales and marketing restrictions and potentially other disciplines depending on the type of insurance product and the markets in which they are sold. The reality, however, is that not all life insurance companies give sufficient attention to all of these requirements. This is due in some situations to the failure to recognize at the appropriate levels of management within the organization the magnitude of the risks associated with the failure to manage PTC or the complexity of doing so. Even for those that do have such recognition, many organizations nevertheless do not have the diverse skill sets required to effectively monitor and apply these requirements. Buyers will want to make sure they assess the seller’s attentiveness to the PTC requirements as this may provide an indication as to whether potential errors exist in the design of it products or administration of its policies.

Within most insurance organizations, there is often a lack of centralized ownership of PTC requirements or even an understanding of who or what functional area should own or govern PTC. Regardless of where ownership of the PTC requirements lies within an insurance organization, it is probably fair to assume that most companies would not intentionally develop a product or administer policies in a manner that would cause them to fail the PTC requirements. Unfortunately, there may be no warning signs or alarms that go off when policies fail to satisfy them when a PTC requirement is overlooked or when there is an unintended flaw in a policy design or system otherwise developed to identify or prevent PTC errors. For example, one of the key values needed for determining taxable income from distribution of cash value from a life insurance or annuity contract is the policyholder’s “investment in the contract.” A policy administration system is typically programmed to identify the financial transactions that can increase or decrease the investment in the contract, make the appropriate adjustments to it when these financial transactions are processed and store the current value. When transactions are processed that could result in the need to report or withhold on taxable income, this value would be relied on for purposes of reporting and withholding the appropriate amounts. But what if the policy administration system was not programmed correctly? How and when do insurance companies determine if an error exists? In many cases, this can occur when someone has been tasked with reviewing or assessing the company’s adherence to the PTC requirements. Errors could also be discovered in connection with the development of a new insurance product or the conversion of one administration system to another, including where a buyer, for instance, is looking to convert the administration of acquired business to one of its own policy administration system. The conversion process may provide the buyer with an opportunity to assess the effectiveness of the seller’s historical administration of the PTC requirements.  Additionally, errors could be uncovered when a company assesses the impact of a change to the IRC or other regulations that impact the PTC requirements. Sometimes they are identified when there is a personnel change within an organization and the new individual assumes responsibility or ownership of compliance with the PTC requirements. In the context of an acquisition, a company may learn that it has issues or errors with PTC requirements as the result of the associated due diligence process. A buyer is presented with the opportunity to evaluate PTC compliance of an acquired block from both a product design and administration perspective, including the opportunity to assess management’s overall awareness of the PTC requirements. If it chooses to ignore this opportunity, it will likely own any PTC-related errors inherent in the block, including any errors in the underlying PTC requirements as defined, implemented, and managed to by the seller.

Part II: How to Assess PTC Risk

For a buyer to evaluate PTC risk, it requires an understanding of the qualification, tax reporting and other administrative requirements imposed by the IRC. As noted in the introduction, assessing risk related to noncompliance with PTC requirements can be undertaken from two different perspectives: PTC design risk and PTC administration risk. Before getting into a substantive discussion around how to assess PTC risk, there are some additional tax law complexities that a buyer should be aware of.  

Dealing with Uncertainty and Changes in the PTC Requirements
With respect to the PTC requirements, there are areas of the law where limited interpretive guidance exists as to how the law should be applied. In some instances, uncertainty in the tax law can lead to differing interpretations; thus impacting how a company designs or administers a product. Some interpretative differences may be reasonable, while others may pose materially higher levels of PTC risk. It is therefore important in assessing PTC risk for buyers to not only understand the PTC requirements, but also where there is uncertainty or variation in how companies interpret these requirements. As such, the buyer may need to examine and independently get comfortable with the tax technical positions that have been adopted with respect to the design of a product and how it has historically been administered.

An additional complexity that a buyer must consider is that the PTC requirements have changed over time and thus, different PTC requirements may apply to otherwise similar contracts depending on when such contracts were issued. PTC requirements that apply to insurance contracts generally are determined by contract issue date; therefore, having knowledge of the historical progression of laws and regulations impacting the PTC requirements is an important component for assessing PTC risk.

How to Assess PTC Design Risk
To address certain PTC requirements related to the qualification of contracts as insurance, companies will typically include specific provisions within the contract to confirm these requirements are satisfied. PTC design risk exists when contracts are designed or structured in such a way that may prevent the contract from meeting these requirements. For example, annuity contracts have PTC requirements relating to qualifications that are generally addressed through contract terms or provisions. As an example, Section 72(s) requires that nonqualified annuity contracts provide for specified distributions in the event the policyholder dies. If an annuity form does not include provisions providing for distributions upon the death of the policyholder that align with the Section 72(s) requirements, there is a risk that contracts issued under the annuity form may not qualify as an annuity for federal tax purposes.  

Buyers can assess PTC design risk by analyzing policy forms; however, it requires that the reviewer understand the PTC requirements, which can vary for different types of insurance contracts being reviewed.  

How to Assess PTC Administration Risk
Insurance companies place a heavy reliance on policy administration systems to perform the functions needed to ensure qualification and any related tax reporting and withholding requirements are satisfied.[3] PTC administration risk exists when potentially incorrect administration of insurance contracts could lead to qualification failures or tax reporting and withholding errors. For example, certain types of insurance contracts have tax qualification requirements that require ongoing monitoring for compliance that are typically managed by policy administration systems. These requirements are most commonly associated with life insurance contracts, and more specifically the administration or compliance testing requirements of the Sections 7702 and 7702A. Both Sections 7702 and 7702A apply actuarial tests for compliance that are used to limit the permissible gross premiums paid and/or cash values of a life insurance contract. The operational aspects of these tests generally require real-time monitoring of the relationship between gross premiums paid and/or cash values provided by the contract to the actuarial limitations defined in Sections 7702 and 7702A. Understanding how a policy administration system is programmed to perform these calculations and administer the actuarial tests is critical for assessing PTC administration risk, but is challenging in practice as it involves assessing the appropriateness of items such as:

  • the assumptions used to calculate the actuarial limitations, which will be unique to each policy form and insurance contract;
  • the assumptions used to determine cash value and gross premiums paid, including the type of financial transactions impacting these values;
  • how and when gross premiums paid and cash values are compared to their respective actuarial limitations; and
  • procedures in place for addressing administrative practices such as when gross premiums paid and/or cash values exceed their respective actuarial limitations.

Additionally, each type of insurance product sold or administered by a life insurance company has requirements relating to how the product is taxed in the hands of the policyholder (e.g., whether benefit payments or distributions of cash value are taxable, and if so, how the taxable amount of the payment is determined and any amount of tax the company may be required to withhold). To accommodate the reporting and withholding requirements, policy administration systems are generally programmed to identify the specific type of transactions that are subject to tax reporting and determine the amount of income to report and tax to withhold. So, PTC administration risk is also associated with the effectiveness of a company’s system in performing these functions.

The commentary above represents some of the functionality required by policy administration systems to confirm compliance with the PTC requirements. Assessing PTC administration risk is much more involved than assessing PTC design risk, as it generally requires “looking under the hood” of policy administration systems, evaluating the system for the methods and assumptions underlying both qualification testing and tax reporting capabilities via both a qualitative assessment (e.g., documentation reviews, interviews of key stakeholders) and quantitative assessment (e.g., risk-based sample policy transaction testing). 

One final note, unlike assessing PTC design risk, which can provide insights as to whether there is widespread exposure to noncompliance for policies affected by a design error, assessing PTC administration risk occurs at the policy level and generally requires a twofold approach for assessing exposure: (1) determine whether the error has caused noncompliance with the PTC requirements; and (2) determine the “cost” for correcting the error and preventing further exposure to noncompliance via administration. Both efforts can be time consuming and resource intensive to undertake. Further, the financial costs associated with errors are likely to grow over time due to the continuing accrual of income on contracts as the result of increases in cash values, as well as an increasing number of contracts that become subject to misadministration. As a result, the cost of waiting to identify and correct PTC administration errors can significantly exceed the current costs of doing so.

Risk-based Sampling Approach for Evaluating PTC Administration Risk
Because of the costs typically involved in carrying out a deep-dive assessment, purchasers of an insurance business may determine that a more practicable approach toward the process might be to first undertake a risk-based sampling approach similar to that described below where individual policies are selected to analyze how the policy administration system is applying the PTC requirements. Sampling involves the strategic risk-based selection of individual policies across product types with targeted characteristics to evaluate the methods and assumptions used in qualification testing and the determination of taxable income for tax reporting and withholding purposes. Typically, the development of a risk-based sampling approach requires a two-step process. The first step involves developing an inventory of the relevant PTC characteristics for each type of insurance product. Based on the inventory of product features, the second step would involve the selection of policies with specific characteristics that can be used to assess how the policy administration system is operating and whether the operation is consistent with the PTC requirements.  

While sampling can be an effective approach for buyers to assess PTC administration risk, it too can be resource intensive and time consuming. That is, while it is generally not as involved as a comprehensive testing process, it nevertheless requires the development of a testing plan, product and policy analysis for sampling, data requests and validation, and access to individuals with knowledge of the products being evaluated and the functionality of the policy administration system. Furthermore, given the breadth of product types and the relevant PTC requirements under the scope of the review, the sample size could be rather large to provide appropriate coverage to adequately assess PTC administration risk, particularly if the product portfolio includes various types of insurance products. 

Part III: Assessing PTC Risk During an Acquisition

One of the challenges acquirers face is how best to evaluate PTC risk, recognizing that there may be limitations on the amount of time, the availability of information and access to seller’s personnel needed to evaluate the risk. This section of the article provides insights for assessing PTC design risk and PTC administration risk in the context of an acquisition and how buyers can use the purchase and sale agreement to protect themselves against assuming a potential financial liability related to noncompliance with the PTC requirements.  

Typical of most transactions, a seller creates an “electronic data room,” where they place various documents and information that buyers can use in support of their evaluation of the block of business. Electronic data rooms generally include copies of policy forms and other product documentation that can be used for assessing PTC design risk. Evaluating PTC administration risk is typically going to be more challenging, as the type of information needed to assess this risk is beyond what is generally available in the electronic data room. As such, a buyer will need to be strategic and potentially creative in how they assess PTC administration risk. 

For most transactions, there are different phases leading up to the actual acquisition of the business, each providing a buyer with different considerations or opportunities for assessing PTC risk.  

Pre-acquisition: The period where several potential buyers evaluate the target block of business and decide whether to submit an offer to acquire the business. Time frames are typically compressed and may be limited to a month or two for potential buyers to complete their evaluation.

Pre-close: The pre-close period starts when a seller and a buyer have agreed in principle on the sale of the business and ends when the purchase and sale agreement is executed. Depending on the complexity of the transaction and the regulatory approval process, the pre-close stage can extend for several months or more.  

Post-close: The period following the date the purchase and sale agreement is formally executed and the buyer has assumed responsibility for the business and moves into the integration process.

The time and effort spent assessing PTC risk will likely vary throughout the acquisition process, with increased attention being paid to PTC design risk earlier in the due diligence process (e.g., pre-acquisition and pre-close). As the buyer moves forward through the acquisition process, attention will likely shift to PTC administration risk as it become more practical to assess this risk (i.e., pre-close and post-close) as sellers will likely be more willing to provide the access to the information and employees needed to effectively perform the assessment. The sections that follow provide additional considerations for evaluating PTC risk across the three general phases of an acquisition. 

Assessing PTC Risk Pre-acquisition
Developing an inventory of policy forms, policy administration systems and various product and policy demographics is key to understanding what needs to be assessed from a PTC risk perspective and allows buyers to develop a risk-based assessment approach by determining materiality of the business for each product and the administration systems in use. Obtaining data such as policy counts, issue date ranges, account values and amount of reserves for each product can help buyers prioritize what products and administration systems to focus on for the initial assessment of the PTC design and PTC administration risk respectively.  

During this phase, buyers are “kicking the tires” or looking for any red flags that could lead to material PTC risk exposure. If red-flag issues are identified, it will be important for buyers to consider the magnitude of potential exposure related to the identified items (e.g., potential costs for remediation with the IRS, cost of correcting and bringing policies into compliance, which may require death benefits to be increased or premiums returned to policyholders, penalties associated with tax reporting and withholding errors, costs for implementing changes needed to administration systems, etc.) and evaluate whether a purchase price adjustment is needed or, if material enough, consider walking away from the transaction.  

PTC design risk: Key steps for assessing PTC design risk during the pre-acquisition phase involve identifying the policy forms and other product-related information to assess, with the goal of identifying structural or design errors in the policy forms that could cause policies to fail to meet qualification requirements imposed by the IRC.  

PTC administration risk: During the pre-acquisition phase, buyers typically have limited access to the type of information needed to effectively assess PTC administration risk. However, there may be opportunities during pre-acquisition for buyers to gain an understanding of the seller’s awareness or knowledge of PTC requirements and the level of attention the seller paid to them. Buyers may be able obtain documentation of the methods and assumptions underlying policy administration, PTC-related procedures supporting the administration of the business, training and marketing materials, etc., that may prove useful in assessing PTC administration risk. It will also be important for buyers to assess reliance on manual vs. automated procedures for qualification testing and tax reporting and withholding functions. Given the complexity of the PTC requirements, overreliance on manual procedures could present a higher degree of PTC risk, particularly for certain types of insurance products and products with large in-force policy counts.

Buyers could also ask the seller (e.g., via a questionnaire or survey) about known errors related to PTC requirements, historical remediation of qualification failures or reporting errors with the IRS, reliance on tax opinions for product designs and other requests tailored to the product portfolio that might provide insight as to whether the seller has been diligent in its efforts to maintain compliance with the PTC requirements.  

If a buyer decides to extend an offer to purchase the business and proceed to the next phase of the acquisition process, it may find it beneficial to develop a plan for its detailed assessment of PTC risk during the pre-close and post-close phases, including the need to review additional policy forms for potential PTC design risk and to undertake a detailed assessment of PTC administration risk. Based on findings and knowledge gained pre-acquisition, a buyer can start to consider the types of representations it will require from the seller relating to the PTC risk. It is typical for a buyer to request that the seller make PTC-related representations, including items relating to the functionality of the policy administration systems. Examples of the type of representations that may be considered include whether all contracts:

  • qualify under Sections 101(f) and 7702, 72(s), 817(h) and other applicable product qualification rules;
  • that qualify as modified endowment contract, or MECs, under Section 7702A have been identified and administered as MECs; and whether there exist any inadvertent MECs;
  • that are intended qualify as life insurance contract under Sections 101(f) and 7702 are administered on systems that are properly designed to effectively:
    • monitor for compliance with the guideline premium test and cash value accumulation test of Sections 101(f) and 7702, as applicable;
    • monitor for compliance with the Section 7702A 7-pay test, as applicable; and
    • identify amounts includible in income under Section 72, as applicable to all life insurance and annuity contracts.

Assessing PTC Risk Pre-close
With regard to PTC-related representations, buyers often include provisions in the purchase and sales agreement that would indemnify a buyer for costs incurred that are related to any breach of any promises or representations made in the agreement. Indemnification periods are generally not indefinite. Since the assessment processes could take a substantial amount of time, buyers might find it beneficial to continue assessments to identify issues and the associated costs as soon as possible post-close, particularly where the identified issues require significant and potentially costly remediation (e.g., payments and fines to the IRS, cost for bringing policies into compliance, such as providing additional “free” death benefits, fixing policy administration systems).

Assessing PTC design risk: From a PTC design risk perspective, any remaining policy form not reviewed during the pre-acquisition phase can be reviewed pre-close to bring closure to the PTC design risk assessment. Interviews can be held with target company actuaries and other key stakeholders to discuss product design features that may have been red-flagged during the pre-acquisition.

Assessing PTC administration risk: During the pre-close phase, the buyer will typically be in a better position to assess PTC administration risk. At that point, it will likely have better access to personnel (who may become employees of the buyer post-close) and policy administration system information. Assessment for PTC administration risk performed during this phase can include interview sessions with personnel charged with administrative responsibilities as well as policy testing to support the risk-based sampling approach described previously. Both of these activities could help the buyer better understand how the block of business has been historically administered under PTC requirements.  

Buyers will likely have a strategy in mind as to whether they will be retaining the target’s existing policy administration system or converting the block to another platform for administration, and they can tailor the specific assessment activities accordingly.  Buyers looking to convert may be more focused on the quantitative aspects of PTC administration (i.e., did they get it right), while those buyers looking to retain the existing system may place a greater emphasis on the qualitative aspects of PTC administration, including the procedures and controls supporting administration, knowledge level of support staff, exposure to key man risk, etc.

If the PTC risk assessment results in the identification of errors that the buyer plans on submitting for indemnification under the purchase and sale agreement disclosing these items to the seller would enable the parties to perform additional analyses of the issues and develop a remediation plan. Ideally, it would be beneficial if both parties jointly agree on the PTC errors identified, the approach for resolving the issues and how remediation costs will be allocated between the buyer and the seller. However, buyers should be prepared for the seller to dispute potential claims and thus, have a plan for adjusting their remediation efforts as needed.    

Assessing PTC Risk Post-close
Once the buyer and seller execute the purchase and sale agreement, the execution date would typically start the clock on the indemnification period for the buyer to submit a claim for costs incurred associated with the PTC requirements. Indemnification periods can be as short as a few months or extend for several years; therefore, a buyer will need to plan its post-close and final PTC assessment activities to be able to timely quantify any potential exposure, costs and resulting claims.

Not all transactions are structured the same. Moreover, there tends to be wide variation in terms of where different insurers sit on the maturity spectrum in managing their PTC risk and the attentiveness that management pays to managing and mitigating PTC Risk. This suggests that buyers need to be flexible in their approach for assessing PTC risk based on the facts specific to the transaction.  

Concluding Thoughts

It is important for buyers to understand the degree of PTC risk they could be taking on when evaluating whether to purchase a block of business. Performing the proper analysis is often the most important step a buyer can take to avoid assuming a potentially large financial liability. A buyer must realize that if it chooses to ignore any potential PTC risk exposure, it will own any PTC-related errors inherent to the acquired block of business, including any errors in the underlying PTC requirements as defined, implemented, and managed to by the seller. Moreover, there is a need to assess PTC risk from both a product design and administrative perspective. In summary, the buyer’s key activities should include undertaking an assessment to identify errors in managing the PTC requirements, quantifying the financial liability or costs associated with remediating those errors, and planning for and filing a timely claim for reimbursements from the seller when errors are identified. 

As demonstrated throughout this article, assessing PTC risk is not easy. The PTC requirements are both complicated to understand and challenging to satisfy. PTC-related errors in the design and/or administration of contracts are common and do not go away over time. If left undetected, errors have the unfortunate consequence of growing, both in terms of the number of affected contracts and the liability exposure associated with their remediation. Buyers need to be aware that PTC risk is real and is a risk they should protect themselves from, undertaking the necessary and careful due diligence when acquiring business and doing their best to make certain they are not unknowingly inheriting problems and liabilities associated with such problems. Caveat emptor… buyer beware of PTC risk!


The views expressed by the authors are not necessarily those of Ernst & Young LLP or other members of the global EY organization, or the Society of Actuaries.

Brian G. King, FSA, MAAA, is a managing director with Ernst & Young LLP. He can be reached at

Philip P. Ferrari, ASA, MAAA, is a managing director with Ernst & Young LLP. He can be reached at

Jeffrey Stabach, FSA, MAAA, is a manager with Ernst & Young LLP. He can be reached at


[1]In addition to the provisions in the IRC that apply to the various products sold by life insurance companies, there are requirements that deal with specific aspects of insurance contracts (e.g., variable cash values) as well as rules relating to insurance contracts sold in contexts such as those involving an employer-employee relationship, business arrangements and estate planning.

[2] For purposes of this article, the authors are limiting the discussion of the IRC tax reporting and withholding requirements to the identification of the required transactions that can create taxable income for the recipient and the determination of the amount of such taxable income. The authors recognize there are many additional requirements associated with the tax reporting of income, including the selection of the appropriate tax information return (e.g., form 1099-R. 1099-MISC, 1099-LTC), the requirements for completing the information return, the need to obtain proper documentation from policy owners, withholding requirements, etc., that are beyond the scope of this article.

[3] While this article focuses on the administration systems used to manage compliance, it may be necessary to assess numerous manual policy administration processes that a company undertakes throughout the insurance product life cycle. Diligence around those processes is similarly significant.