However, like most assets a value is required for an insurance policy when it is transferred in situations such as a pension distribution, a sale or gift from an individual to a trust, or in a split-dollar arrangement. Historically, while advisors have often relied on a safe harbor value for insurance policies, this method may not always be accurate and may yield results not representative of fair market value. This article focuses on the benefits associated with obtaining a fair market valuation to attain a more accurate and supportable value.
Often times, when a life insurance policy needs to be transferred, an advisor—unaware that a fair market valuation is a viable option—will follow IRS safe harbor guidelines and request the policy’s value from the insurance company for reporting purposes. The insurance company typically provides the Interpolated Terminal Reserve (ITR). An ITR value is a value calculated from the policy’s reserve value at a particular point in time. Regulations provide that this value is estimated as the difference between the policy’s reserve value at the date of the last premium payment and the projected reserve value at the date of the next premium. For many types of policies and in many circumstances, ITR is not necessarily an appropriate or accurate measure of a policy’s fair market value.
A fair market valuation of a life insurance policy however, will consider values based on the income approach and the market approach. The value conclusion is the greater of the results from each approach, which can be a much truer assessment of the policy’s fair market value.
The income approach generally focuses on the discounted cash flows of premiums and death benefits determined by a stochastic (i.e., having a random probability distribution or pattern that may be statistically analyzed) mortality-based model. For each year the payment is the death benefit multiplied by the subject’s expected mortality, less the planned premium multiplied by the subject’s survival rate (Payment = (Death Benefit x Expected Mortality) – (Planned Premium x Survival Rate)). Even though individuals die at discrete events (a person only dies once and completely), a stochastic method, rather than a deterministic method, is used when projecting future mortality-based cash flows because it is impossible to predict exactly when a person will die. A life expectancy is a period of time before which an individual has a 50% chance of dying. The stochastic method is the equivalent of calculating the present value at every discrete time period (i.e., every year) then weighting the outcomes by the likelihood that each will occur.
The market approach on the other hand considers what the policy could be sold for based on the sale of similar policies. While a settlement market for life insurance policies does exist, it is very narrow and most policies would be excluded due to the age of the insured and policy type. It is therefore often more appropriate to consider the policy’s liquidation value—the amount the carrier would distribute upon surrender.
As stated above, life insurance policies are unique assets, and asking the question, What is the fair market value of a life insurance policy?, can result in complex and inconsistent answers. Policies are illiquid assets that are regulated at the individual state level and guidance on aspects of their taxation has not been updated in over 40 years. Meanwhile, insurance policies themselves have evolved into many different forms since that time. One of the main limitations with ITR is that it is generally understood to be applicable only to whole life contracts (not necessarily to universal life, variable life, level term insurance, etc.).
ITR is most typically used to value a life insurance policy for transfer tax purposes and is provided by the issuing life insurance carrier via Form 712, Life Insurance Statement. A policy’s terminal reserve is the amount of money that the life insurance carrier has set aside by law to guarantee the payment of policy benefits and is determined once a year. The ITR is a mid-year estimate of the terminal reserve value determined by adding the current year’s increase to the prior year’s reserve.
With the advent of non-guaranteed unbundled or deconstructed policies in the 1980s and 1990s—flexible premium adjustable life, commonly also known as universal life—different industry reserve requirements were introduced. For this type of policy, the carrier uses a different test than the test designed for whole life policies. To make things even more complicated, there are multiple reserve values tracked by insurance carriers today that were not used back when the regulations on ITR were issued. These reserves include (1) tax reserves, used to determine a carrier’s federal income tax, (2) statutory reserves, required for a carrier’s financial statement filed with state insurance departments, and (3) Actuarial Guideline (AG) 38 reserves, reserves required by the National Association of Insurance Commissioners (NAIC) for all universal life policies that employ secondary guarantees, with or without shadow account funds. Guidance on ITR has never been updated to account for these newer life insurance products or multiple reserve values.
Determining the fair market value of a life insurance policy can present clients with both opportunities and challenges. However, reliance on the ITR value and IRS safe harbor rules can result in tax implications that do not align with the fair market value of the policy. A qualified valuation can help provide a supportable and more accurate determination of the fair market value when transferring an insurance policy.
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