By Espen Robak
When changing the ownership of a life insurance policy by gift or sale, many advisors report to us that their client experienced a sticker shock. As an example, an attorney called to say his client had a $20 million term policy with an annual premium of $120,000. A case for a very modest value, right? Yet, the insurance carrier sent him a Form 712 with a reserve value of almost $3 million. That would scupper the proposed transfer to a trust – but should it?
This article will look at how we approach the valuation of life insurance policies where there is a gap between the reported ITR values and the appropriate fair market values: in particular, universal life (UL) and term life policies. But the same principles apply to other policy types, and to receivables and notes resulting from split-dollar arrangements. These are all assets that pay a relatively predictable amount, at an unpredictable (and often far into the future) point in time.
All About Future Cash Flows
As with many other “fixed income” assets like these, Fair Market Value is best analyzed using a discounted cash flow (DCF) framework. In this valuation technique, the expected future cash flows of an asset are used to compute their total aggregate “present value” using a discount rate. The discount rate is the equivalent of an interest rate, only going in reverse. And the rate is greater the greater the uncertainty of future cash flows.
Mortality and Expected Future Values
With life insurance policies and related assets the cash flows take place at maturity of the policy, i.e., the death of the insured. But that date is not just uncertain, it’s completely unknowable (in most cases). So rather than assuming a single cash flow at a certain point in time – the insured’s life expectancy – the best way is to calculate the expected future cash flows in each year. The expected value equals the amount that would be paid times the probability of payment. And with life insurance policies, this probability is derived from mortality tables.
So far, so good. An analysis of the contracts and the proper application of mortality tables yields a cash flow forecast. That’s the easy part. The real challenge is calculating the present value of the projected cash flows. In other words, the critical challenge, as with so many other valuation exercises, is the discount rate: the research and analysis required to formulate a discount rate conclusion, and how to support it.
Discount Rates for Insurance Policies
Insurance policies are not securities. In other words, they’re not tradable instruments. That doesn’t mean there’s no market for them. It just means they’re illiquid. Illiquid assets are worth less than liquid assets, which in the DCF framework is just the same as saying they have higher discount rates. So, how much higher?
When answering that question, we look to data sources on transactions in fixed income assets. This page contains a brief overview of common situations where life insurance may be transferred. It also has a link to request a white paper on how to determine mortality and discount rates for such valuations. Bottom line: this is a research-heavy task.
Finding the data takes a lot of research because illiquid assets sell so infrequently and – not coincidentally – when they sell, they sell for the most part in unreported transactions. But with a combination of published studies and our own sleuthing, we have been able to find some indications. Together, they form the analysis we currently rely on for these valuations.
Discount Rate Research
When searching for analogue assets we first address the issue of comparability. We want illiquid instruments so we avoid securities and securitized assets, other than as a starting point for the analysis. And the comparability with any kind of equity security is likely poor. The three main asset classes we have relied on in our valuations over the last several years are private notes, structured settlements, and life settlements.
- Private notes. The market for buying notes is both opaque and illiquid, which provides good comparability with life insurance. However, the credit risks involved can often be significantly greater than for life insurance. Overall, the discount rate indications here indicate a very wide range.
- Structured settlements. These are often payable over long periods of time and the market is poorly established and documented. Transfers often require court orders or approvals, which also limits the transferability. However, there are studies available on this market. The discount rates indicated are high, but showing some consistency over time.
- Life settlements. This is clearly the most comparable market. Luckily, it’s also the market where we have the most information. Discount rate indications vary over time, depending on the flow of investment capital to the main buyers, who include hedge funds and publicly traded companies
Considering all of these indications, and our analysis of the market for fixed income instruments in general, we typically see a discount rate range of 12-16 percent as representative for where real investors would deploy capital. This, of course, depends on expected maturities, the size of the item being valued, and other factors. In addition, variations from these ranges can be expected for similar but not identical instruments, such as split dollar receivables and notes.
Finally, we also see significant value in the research summarized herein for valuing private notes. This topic has come to the forefront in recent years in tax valuations. The IRS has challenged the valuation of intra-family notes over years, especially in cases where the reported fair market value deviates from the face value by significant amounts. However, the market for private notes is illiquid and the interest rates commonly charged (often AFR) represent inadequate return, in most such situations. When that’s the case, the verdict is clear: in the DCF framework, the indicated value is at a (sometimes significant) discount to face.