This paper summarizes the determination of the fair market value of certain permanent life insurance policies for purposes of transferring, gifting or selling the policy from one individual or trust to another. Historically, life insurance companies offered two types of life insurance: Annual Renewable Term Insurance and Whole Life Insurance. Over time, new types of policies have evolved, such as Universal Life and Variable Life, which have been difficult to reconcile with the outdated Internal Revenue Service (“IRS”) guidelines for valuation. As a result, insurance companies are uncertain how to properly value certain policies, which has led to inconsistent valuations across life insurance companies. Accordingly, this paper focuses on alternative valuation methods of certain difficult to value life insurance policies, even after an IRS Form 712 has been issued.
Fair Market Value
The two Treasury Regulations (“Treas. Regs.”) applicable to valuing life insurance policies, Treas. Regs. §§ 20.2031-8 and 25.2512-6, were last amended in 1974. These Treas. Regs. are tailored to historically common policies, namely, Annual Renewable Term and Whole Life. An Annual Renewable Term policy has no reserves, thus the valuation is determined by looking to the “unearned premium1.” In order to determine the fair market value of a Whole Life policy (that has been in effect for several years with premiums remaining), insurance companies frequently use the interpolated terminal reserve value (hereinafter “ITR value”)2. Typically, the cash surrender value and the ITR value are very similar because the insurance company is aware of how much reserve is necessary each year based on the amount of future premiums to be received and the expected death benefit3.
In the 44 years since the IRS amended the Treas. Regs. regarding valuation of life insurance, new life insurance products have entered the market. For example, a Universal Life policy is a flexible premium policy, thus the terminal reserve value is not known until the end of the policy year. As a result, it is difficult to apply the Treas. Regs. currently used to determine the fair market value of these new types of policies4.
Furthermore, today there are several types of reserve values, including: tax reserve, statutory reserve, AG 38 reserve, and deficiency reserve. It is unclear which reserve an insurance company should use to calculate the fair market value of a policy. In addition, a few insurance companies use the cash surrender value, or the cash accumulation value, or the California Method (the average of the cash surrender value and the cash accumulation value), as the ITR value. The different options available for the reserve value has led to different methodologies for calculating the ITR value, which has resulted in different insurance companies arriving at vastly different fair market values for similarly situated policies.
IRS Form 712
Generally, in order to determine the fair market value of a life insurance policy, an owner will request an IRS Form 712 from the insurance company. The insurance company will then complete the form and certify that the information is “true and correct.” However, once an insurance company has developed a particular methodology (based on the type of reserve value calculation) for determining fair market value, the company is unlikely to change their methodology because they have an interest in ensuring equal treatment among policy holders who request an IRS Form 7125.
A dilemma occurs when the IRS Form 712 is returned with a value different than expected. If the owner chooses to use another value as the fair market value, it is recommended that the owner provides a full explanation regarding how the value was determined. This explanation is important in order to clarify that the transaction was actually a sale and not a gift, for example, in the event of a sale from an individual to his or her irrevocable grantor trust or from one grantor trust to another.
Consider the following example, which is based on a study by a life insurance company and cited from a Leimberg Services LISI Newsletter, for an insured who bought a combination of six policies each with a $5,000,000 face amount from three different companies6: