OOS-2014-Summer-Final

Life insurance valuation, continuedOf course, there is no consistency on which method(s)are used by the carriers. As a result, there is a significantdifference in values given by carriers on similar contracts.Recent cases that tell a different storyAs discussed earlier, Rev. Rul. 59-60, although used to valueunmarketable stocks, sets the standard across so many levelsand truly summarizes the process of valuing an asset—including,in the opinion of the authors, a life insurance policy intoday’s environment. As a foundation, it states that “[a] soundvaluation will be based upon all the relevant facts, but theelements of common sense, informed judgment, and reasonablenessmust enter into the process of weighing those factsand determining their aggregate significance.” 25So, how are the recent cases consistent with life insurancevaluations? Although most of the recent cases have focused onincome tax issues, which still consider an analysis of ITR, thecourts have quickly realized this is not a simple process. Asthe tax court noted in Schwab v. Comm’r. (Feb. 7, 2011), “thefair market value of [life] insurance contracts can be a slipperyconcept.” 26 On appeal, the Ninth Circuit cited this quoteand added “a particular method for ascertaining value may beappropriate in one situation but inappropriate in another.” 27Although the case involved a dispute over the value of a distributionfrom a welfare benefit plan under 402(b), the case doeshighlight how one rule cannot be applied across all contracts.Specifically, in Schwab, the tax court ruled that the participantsin a terminating welfare benefit § 419A(f)(6) multipleemployer plan were required to include in income the FMVof the variable universal life insurance policies distributed tothem. Even though the net surrender value was a negativevalue, the court took a different approach than others to findthat the FMV to be included in income was the value of thepaid-up insurance coverage remaining on the policies as of thedate of distribution—much like a cash flow analysis, which iscommonly used by appraisers in determining FMV. 28In the Estate of Kahanic, the tax court found, by applying asimilar valuation methodology as in Schwab, that a life insurancepolicy was included in the decedent’s estate because thepolicy was worth more than zero. 29 What was also interestingin this case was the fact that the court realized there was anadditional value in a no-lapse feature that extended coveragetwo years after the decedent’s death. Therefore, looking at allthe parts and not just the ITR, the court supported an alternativemethod for valuing a life insurance policy.The tax court found in Matthies v. Commissioner that theinterpolated terminal reserve value method did not apply in asituation valuing a life insurance policy sold by a profit-sharingplan to the taxpayer. 30 Instead, the “entire cash value,” not reducedby surrender charges, was the applicable standard underSec. 402. 31 Again, the court realized that there may be morethan one way to establish the value of a life insurance policy.Other methods—willing buyer and willing sellerWe started with a foundational rule that the FMV of an assetis measured by the price at which an asset would changehands between a willing buyer and a willing seller under nocompulsion to sell. Ironically, this methodology has not beenwidely considered in valuing a life insurance policy until recently.Of course, also until recently there has been no marketfor a life insurance policy other than surrendering a contractback to the issuing carrier. However, there are other optionsavailable in today’s mature secondary market. 32The secondary market for life insurance has reached atipping point in the frequency and volume of transactions,the regulations implemented by the states and the overalltransparency throughout the market. The secondary marketfor life insurance has continued to grow for many reasonsin spite of the credit crisis in 2008, and it has helped policyowners garner billions over the stated cash surrender value oftheir contracts. Both domestic and global buyers are attractedto the secondary life insurance market due to the relativelystrong performance of life insurance carriers during the 2008-2009 downturn. Life insurance is also appealing to investorslooking for non-correlated assets because it is not tied to theequity markets or other traditional markets. In addition, sophisticatedbuyers such as pension plans, reinsurers, privateequity, municipalities and others have realized that they candeploy large amounts of capital while benefiting from an agingpopulation that has a more predictable mortality. 33The methodology to estimate the FMV of a client’s life insurancepolicy in the secondary market is similar to valuing otherassets. Specifically, the process employs standardized industrypractices and analytics to combine an analysis of the insurancecontract, policy values, required capital outlay (premiums), thelife expectancy of the insured(s) and a comparison to contractsthat have sold in recent history. Because almost all policytypes may qualify for settlement, newer policy structures andfeatures can be evaluated by the market to determine if, forexample, a policy feature truly adds value or is just a marketingfeature created by the insurance company to sell the initialcontract. After evaluating all parts, a value can be providedbased on what a willing buyer would pay if a policy ownerwas willing to sell. 34 Although there is no specific authoritypertaining to the use of the secondary market for valuing a lifeinsurance policy, in the authors’ opinion it is now a reasonableplace to seek additional information when analyzing the FMVof a life insurance policy and should be a component in theprocess. In fact, failure to consider such a value may triggersignificant transfer taxes and/or fiduciary liability—especiallyif the value is significantly higher than the ITR.ConclusionAs with other assets, there is no one simple method todetermine the value of a life insurance contract. What hasmade this process even more complicated is the fact that lifeinsurance policies have become much more complex and aredesigned with so many layers of features that most professionaladvisors are unaware of the complexities inherent insuch a contract. Furthermore, each carrier has determined itsown methodology for calculating reserves, therefore removingany consistency in the process. As highlighted in Rev. Rul. 59-60, the FMV of an asset is “based upon all the relevant facts,but the elements of common sense, informed judgment andreasonableness must enter into the process (emphasis added) ofweighing those facts and determining their aggregate significance.”Knowing this, relying on outdated valuation methodsprovided in 40-year-old regulations to report the transfer ofa life insurance policy is telling only part of the story andis unreasonable. An appropriate analysis must include ITRprovided by the carrier as well as an analysis of the value aflabaroutofstaters.org 16 State-to-State — Summer 2014