Life Insurance Valuation
December 30, 2014 by Leigh Harter, Penton Business Media
Often, the value of a life insurance policy becomes an issue when there’s a contemplated or actual transfer of a policy. The transfer may involve an estate or gift matter or moving a policy to an irrevocable life insurance trust (ILIT). When an estate or gift matter is involved, theInternal Revenue Service requires that a Form 712 Life Insurance Statement be included in the returns. This form is a statement prepared by an insurance company that provides policy values as of the date of transfer. So, a trustee or financial advisor will likely request anIRS Form 712 from the subject insurance company.
Life insurance policies come in a variety of flavors but generally fall under the categories of whole life, universal life or term policies. Within each of these broad categories are numerous options, including variable whole life, variable universal life, guaranteed no-lapse universal life and various durations of level premium term insurance. Currently, a standardized and widely accepted valuation method for all policy types hasn’t emerged.
In October 2009, the National Association of Insurance Commissioners (NAIC) came out with the “Valuation of Life Insurance Policies Model Regulation.”1 The NAIC model regulations include complex formulas intended to provide a minimum standard of valuation for life insurance policies. At this time, it doesn’t appear that many life insurance companies have adopted these regulations.
Currently, life insurance companies and valuation experts use a variety of methods and analytical assumptions to determine the value of life insurance policies. These tools can have a material effect on the value of the policy. Consequently, it’s important for financial advisors and trustees to have a basic understanding of the various techniques used in life insurance valuation, including Form 712 policy valuations.
Three Valuation Methods
In general, insurance companies estimate the value of life insurance policies using one of the following three methods:
1) Cash surrender value (CSV);
2) Interpolated terminal reserve (ITR); or
3) Premiums plus earnings less reasonable charges (PERC).
CSV
The CSV is the value for which the policyholder could surrender her policy to the insurance carrier and receive cash back. Insurance companies will often reduce the CSV for surrender charges. For example, if a policy shows cash or accumulated value of$5,000 and a surrender value of$3,000, the carrier has reduced the CSV for surrender charges of$2,000 for early cancellation. If the CSV doesn’t reflect surrender charges, a financial advisor or trustee may wish to inquire about whether surrender charges are applicable to the subject policy.
Once a policyholder cancels and surrenders the policy, most insurance companies pay out the net CSV within a few weeks. However, many states allow insurance companies to defer payment for up to six months after cancellation. When this is the case, a valuation discount for the lack of liquidity of the CSV may be appropriate.
ITR
ITR is the most common method for valuing life insurance policies. Insurance companies typically use this method when the valuation date falls between anniversary dates of the subject policy. The analysis involves making a pro rata adjustment between the previous terminal reserve and the subsequent terminal reserve, plus the unearned premiums paid during the partial period. The terminal reserve of a policy is essentially the amount that—when combined with future premiums and investment income—will pay the future maturities (death benefit) of the policy computed using mortality rates and an assumed dividend or interest rate.
The constantly evolving landscape of insurance policy types has left room for interpretation of the primary components used in the ITR method. For example, variable universal life policies have valuation issues related to future reserve value because stock or bond market performance can affect the investment return of these policies. Consequently, the insurance company doesn’t know the terminal reserve value until the next anniversary date.
In addition, the definition of “reserve” used in the analysis can materially affect the value of a life insurance policy. That definition is subject to different calculations and interpretations, including: ?(1) statutory reserve, (2) tax reserve used for federal tax reporting, (3) Actuarial Guideline 38 reserve, and (4) deficiency reserve. It’s important to obtain and understand the definition of “reserve” used by the insurance carrier and ascertain the impact it has on the estimated value of the policy.
PERC
The PERC method is generally calculated as follows: (1) premiums paid from the date of issue, ?(2) plus dividends used to purchase paid-up insurance prior to the valuation date, (3) plus amounts credited to the policyholder from premiums and interest, ?(4) minus reasonable mortality charges and other charges, and (5) minus distributions, withdrawals or partial surrenders taken prior to the valuation date.
According to Revenue Procedure 2005-25, the general rule is to value the policy at the greater of the ITR or PERC. Other language in the Treasury regulations appears to leave the door open for alternate methods of life insurance policy valuation for federal tax related matters, such as estate and gift.
Fair Market Value
Theoretically, fair market value (FMV) is the standard of value used for federal estate and gift purposes. FMV is generally defined as the price at which a property would change hands between a willing buyer and willing seller, with neither under compulsion to buy or sell, and both having reasonable knowledge of the relevant facts.2 When conducting an FMV analysis of a particular asset, valuation experts will typically use market, asset or income approaches. Other than instances in which cash surrender value is used, it doesn’t appear as though insurance companies are paying attention to FMV in their efforts to value life insurance policies. This disconnect may provide a legitimate opportunity to dispute high valuation numbers.
Market approach. A valuation expert will consider pricing and financial metrics of market transactions involving similar policies to estimate the value of the subject policy. As such, the availability of relevant transaction information is critical to the process. Currently, there’s no transparent market that discloses important details of life insurance policy transactions. Consequently, use of the market approach is difficult to employ.
There’s a life settlement market that involves life insurance policy transactions. However, transaction data generally isn’t available, and the methods settlement companies use to price policies is proprietary. In addition, only certain types of life insurance policies are eligible for life settlement. Those policies are typically on insureds older than age 70 or who’ve experienced a significant change in health since the original issue date of the policy. If a policy being valued is eligible for life settlement, it may be desirable to obtain quotes from reputable life settlement companies regarding the policy’s value. These quotes may provide an appropriate estimate of the FMV of the policy. However, if the insured isn’t going to sell the policy, can a legitimate life settlement offer be obtained?3
Asset approach. A valuation expert will typically consider the liquidation value or replacement cost of the subject policy. For newly issued policies, FMV will generally be the premiums paid to date. For one-time, single premium policies that are paid up, the value of the policy will be an estimate by the insurance carrier of the replacement cost of an identical policy. For policies that have been in force for some time, and on which additional premiums are due, the greater of the CSV, ITR or PERC methods may be relevant.
In certain circumstances, it may be beneficial to retain a valuation expert to value the insurance policy when the number provided by the insurance company is substantially greater than the CSV. This approach may permit the opportunity to challenge some of the analytical assumptions used by the insurance company to determine the ITR or PERC value.
Income approach. A valuation expert will model the future cash flows of the policy and discount them back to the valuation date using an appropriate risk adjusted discount rate.
Life insurance policies are essentially financial instruments with characteristics and features that lend themselves to valuation using the income approach. Like many other types of financial instruments, life insurance policies require a stream of payments, have a cash reserve value, pay dividends ?and/or interest, are subject to tax consequences and provide a terminal payment. Each of these characteristics may affect the projected cash reserves, premium payments, dividends, interest income, income tax, capital gains tax and the eventual net death benefit.
Each policy has a unique set of characteristics, including the timing of cash receipts and payments, as well as the expected remaining life of the insured and credit quality of the insurance carrier. In other words, a life insurance policy is an illiquid financial instrument with characteristics that a valuation expert can model to determine FMV. Depending on the empirical data used in the analysis, the indicated value of the policy may be on a marketable basis. The value may assume that the subject policy is tradable in an active and liquid market. Typically, this isn’t the case. Accordingly, the valuation expert may consider applying a discount for lack of marketability (DLOM), given the illiquid nature of life insurance policies.
If an asset-holding company (for example, a limited liability company or partnership) holds the subject life insurance policy, valuation experts may apply a valuation discount for the lack of control and a DLOM of a fractional equity interest in such an entity. The valuation expert should consider these discounts because the value of a life insurance policy inherently assumes unilateral control over its disposition. An individual holding a non-controlling fractional equity interest in an asset-holding company wouldn’t have unilateral control over the life insurance policies and would be unable to liquidate these policies at her discretion.
Disputing the Form 712 Value
Whenever possible, it’s preferable to request an informal valuation of a policy, rather than request a ?Form 712. This approach will provide the opportunity to work with the insurance company and challenge the valuation assumptions used in the analysis.
The IRS considers the values on the Form 712 as estimated by unbiased and qualified experts in the area of life insurance valuation. Although a Form 712 must be filed with the subject returns, this requirement doesn’t preclude the filing of other valuation expert reports that may provide a different indication of value than the Form 712. When this is the case, the expert report filed with the IRS must be comprehensive and provide a sensible and reasonable approach to the value of the subject policies, as well as explain why the Form 712 value is incorrect.
If a Form 712 provides an indication of value greater than CSV, it may be beneficial to retain an independent life insurance professional, as well as a valuation expert familiar with life insurance policies, to challenge the Form 712 values. This type of analysis typically involves the identification of the relevant features of the policy, such as the age of the insured, actuarial life expectancy, risk profile of the insurance company, expected premium payments, expected dividend payments, interest rates, market rates of return, income tax issues, capital gains tax issues and death benefit. The proper analysis of these components results in a projection of future cash flows. The valuation expert then discounts these cash flows at an appropriate risk adjusted discount rate to conclude the FMV of the policy as of the valuation date.
If the components used in the analysis are based on transactions involving marketable securities, the application of a valuation DLOM may be appropriate. ?The magnitude of the DLOM will depend on the liquidity of the policy, timing of the future cash flows and the assumed holding period of the policy.
Lessons Learned
Some lessons learned by financial advisors who’ve experienced an unpleasant surprise following the receipt of a Form 712 are:
1) Whenever possible, create and implement a plan of action that will result in the lowest transfer costs and policy valuations. This technique will require some investigative homework to determine the valuation methods used by each relevant insurance company.
2) Whenever possible, start with informal requests for policy valuations by each insurance company for the policies in question. Direct these requests to the advanced underwriting or actuarial departments, not to the policy service department.
3) If a Form 712 isn’t necessary, the policy owner should request written assessments of policy values. If the financial advisor disagrees with the values provided, she can then have a dialogue with the insurance company regarding valuation issues.
4) If a Form 712 is necessary, the policyholder should still consider requesting an informal assessment of the policy value. If the estimate seems out of line, a dialogue with the insurance company might provide results that are more favorable than they would be subsequent to the issuance of a Form 712.4
Endnotes
1. “Valuation of Life Insurance Policies Model Regulation,” National Association of Insurance Commissioners, Model Regulation Service ?(October 2009).
2. Fair market value (Internal Revenue Code Section 83; Treasury Regulations Section 25.2512.1; Treas. Regs. Section 20.2031-1).
3. Donald O. Jansen, “Evaluating the Different Forms of Life Insurance Policies and Complexities in How They are Valued,” Notre Dame Tax and Estate Planning Institute (November 2014).
4. Stephan Leimberg and Keith Buck, “Life Insurance Valuation—What Practitioners Need to Know,” Estate Planning (May 2010).
