Life is change. That’s why as life goals change, life insurance needs change as well.
Over time, the original need for coverage — like having young children or providing for income replacement — may no longer matter to clients after retirement. They may own policies they no longer need or can afford, especially if one of the policyholders is in poor health. What’s more, sustained low interest rates and the volatility of equity markets may have drastically affected older policies so that original premium funding levels cannot sustain coverage.
The best way to keep track of these changing client situations is through a regular policy audit or policy review, as discussed in our prior blogpost.
During the past several years, our Policy Analysis & Comparative Evaluation (PACE) report has uncovered many underperforming policies. However, before considering a reduction in face amount, surrendering coverage or transferring ownership, a serious effort should be made to determine the contract’s true value.
At first glance, the value would appear to be the policy’s surrender value. Yet that may be the worst way to determine valuation. Nor does it provide a method to assess a term life policy. In fact, our research indicates that most valuation methods are inadequate and outdated, use inconsistent data, and fail to consider the health of the insured(s).
So how should a life insurance policy be valued?
4 Ways of Determining Life Insurance Policy Value
1. Fair Market Value (FMV). The IRS defines fair market value to be the price at which property would change hands between a willing buyer and a willing seller.
2. Interpolated Terminal Reserve (ITR). Interpolated terminal reserve refers to the method by which the reserve on any life insurance policy between anniversaries is determined. This is done by valuing insurance policies for gift and death tax purposes, regardless of whether the policies are current at the time of transfer. The calculation is determined by making pro-rata adjustment upward between the previous terminal reserve and the next terminal reserve. For certain term policies of long duration, the value is determined by reducing pro-rata adjustments. ITR works well for traditional whole life policies and annual renewable term. However, for universal life and term products used today, the ITR value can be grossly inaccurate.
3. Premiums plus earnings, less reasonable charges (PERC). PERC is calculated as premiums paid from the date of issue, plus dividends used to purchase paid-up insurance prior to the valuation date, plus amounts credited to the policyholder from premiums and interest, minus reasonable mortality charges and other charges, and finally, minus distributions, withdrawals or partial surrenders taken prior to the valuation date.
4. Revenue Procedure 2005-25. The general rule is to value the policy at the greater of ITR or PERC. Other language in Treasury regulations appears to leave the door open for alternate methods of life insurance policy valuation for federal estate- and gift tax-related matters.
Why Get an Independent Appraisal?
The first step in valuation may simply be to ask the existing carrier for an appraisal. But this step should serve as a floor, rather than a ceiling. (We recommend advisors and fiduciaries request an informal estimate of ITR over the phone, because once a formal Form 712/ITR value is requested from the carrier, the request is considered irrevocable in certain tax situations.)
We recommend an independent analysis from a qualified life insurance appraiser, one that takes into consideration real-time data from the secondary market and the specific life expectancy of the insured, including health and lifestyle credits.
An independent, market-based valuation will provide a valuable time-stamped, mark-to-market appraisal that meets the IRS’s willing buyer/willing seller fair market value definition. In addition, a qualified appraisal will provide certainty to complicated planning scenarios, which tend to differ from standard appraisal methods used by insurance carriers.
Eager Buyers Changing Life Insurance Valuation
The growth in the secondary market has started to alter how the marketplace thinks about life insurance. Rather than being a financial investment with fixed beginning and end points, financial analysts are applying valuation criteria typically seen in private equity, with clear entry and back-end liquidity or exit strategies on the part of contract owners. This has resulted in far more generous payouts and greater acceptance of viatical or life settlements. A secondary market solution can be used to:
- Reduce or eliminate future premiums
- Create more financial security and comfort during retirement
- Adapt to business changes – no longer need key-man or buy/sell insurance
- Fund long-term care
- Create short-term liquidity
- Obtain valuations for M&A or bankruptcy
- Generate liquidity by selling policies to fund projects
Best Practices Today
Before surrendering a life insurance policy for its cash value, or reducing the face amount, ask us about the secondary market. We believe value greater than the surrender value may be available, especially for universal life and term insurance products.
For more information about how you can take advantage of this lucrative and growing market, email AdvancedPlanning@highland.com.