Accounting for the Purchase of Life Settlement Contracts

By Alan Reinstein and Cathleen L. Miller

FSP FTB 85-4-1 provides initial and subsequent measurement guidance, financial statement presentation, and disclosure guidance for entities acquiring life insurance contracts between the owner of a life insurance policy and an insurance company (regardless of whether the acquirer obtained the policies from the insured or from a broker). By definition, a life settlement contract contains three characteristics:

• The investor has no insurable interest in the insured’s survival, a requirement for an insured to purchase an insurance policy;
• The investor provides consideration to the policy owner of an amount in excess of the current cash surrender value (CSV) of the life insurance policy; and
• The investor receives the face value of the life insurance policy when the insured dies.

Previously, investors accounted for these contracts under FTB 85-4, Accounting for Purchases of Life Insurance. FTB 85-4 required investors to immediately expense the difference between the purchase price paid to the insured and the life settlement contract’s CSV, and recognize the insurance contract’s realizable (i.e., face) value as an asset.

The new FSP (FTB 85-4-1) requires investors to account for such investments using the investment method or the fair-value method. Upon acquiring these contracts, an investor must irrevocably elect to use one of these two methods for each life insurance contract, on an instrument-by-instrument basis. Documentation at the time of purchase, or a preexisting documented policy for automatic election, must support this election.

Advisors should be especially aware of this new guidance because it helps policy holders or investors understand the key risks and rewards for such transactions, as well as the effects the new accounting will have on financial statements. The accounting differences between the previous accounting treatment and either of these two methods could affect both the investor’s balance sheet and income statement significantly.

Comparison of Methods

Investment method. Under the investment method, an investor recognizes the initial investment at the transaction price plus all initial direct external costs, and capitalizes the continuing costs (e.g., policy premiums and direct external costs, such as broker fees and medical expenses) to keep the policy in force. Investors usually continue to pay the premiums on the insured’s life insurance policy. The investor should not recognize gains until the insured dies, at which time the investor should recognize in earnings the difference between the life settlement contract’s carrying amount and the proceeds of the underlying life insurance policy.

Although gains are not recognized until the insured dies, periodically the investor must test the investment asset for impairment as required under SFAS 142, Goodwill and Other Intangible Assets. The testing is necessary if the investor finds any information indicating that the expected proceeds from the insurance policy will be insufficient to recover the investment’s carrying amount plus anticipated undiscounted future premiums and capitalizable direct external costs when the insured dies. Key factors include changes in expected mortality or the policy issuer’s creditworthiness. Changes in interest rates, however, do not always require such tests for impairment. If impairment occurs, the investor should recognize an impairment loss (i.e., the difference between the investment’s carrying amount and its fair value), which is measured using current interest rates.

Fair-value method. Under the fair-value method, an investor recognizes the initial investment only at the transaction price, expensing such direct external costs as brokers’ fees and costs to acquire the life insurance contract as incurred. In subsequent reporting periods, the investor should remeasure the investment at fair value and recognize changes in fair value in earnings during the period in which the changes occur. In addition, investors should report premiums paid and net life insurance proceeds received (proceeds received less the balance in the investment account) on the same financial reporting line on the income statement as changes in fair value.

One major concern about this method is the determination of fair value. The AICPA Audit and Accounting Guide, Investment Companies, notes that the best evidence of fair value is the quoted market price in an active market. If this evidence is unavailable, a consistent and good-faith method, such as recent purchases of similar securities, should be used. Many members at the September 12, 2006, meeting of the National Association of Insurance Commissioners discussed this issue, stating that they believe no active and liquid secondary market exists for life settlement contracts and questioning whether a relevant and reliable fair value could be determined under the guidance of the FSP. The working group agreed to refer the issue to its valuation of securities task force for comment on the marketability of life settlement contracts and the preferred method of accounting.

Exhibit 1 summarizes the differences between the investment and fair-value methods, and Exhibit 2 provides sample journal entries under both methods.

Caveats. Viaticals parallel life settlement contracts, except that they normally arise for an insured with a terminal illness who needs funds to help pay medical and other expenses. Investors should note that the insured’s life expectancy estimates under viaticals are often less reliable due to the lack of published mortality tables for the specific circumstances, potential changes in an individual’s health, or medical advances. Investors should also carefully consider whether they can determine the fair value of such viaticals in applying the subsequent measurement provisions of the fair-value method in the FSP.

Investment groups, such as management investment companies, unit investment trusts, investment partnerships, and certain other entities regulated by the 1940 SEC Act, may be required to account for these contract investments at fair value, in accordance with section 1.32 of the AICPA Audit and Accounting Guide, Investment Companies; that is, they cannot elect to use the investment method.

Implementing the Standard

The FSP (FTB 85-4-1) applies to fiscal years beginning after June 15, 2006, with earlier adoption permitted if the investor has not yet issued first-quarter financial statements for the fiscal year of adoption. Because adopting the FSP represents a change in accounting principle, the investor recognizes a cumulative-effect adjustment to retained earnings at the beginning of the period of adoption, as required under SFAS 154, Accounting Changes and Error Corrections. The cumulative-effect adjustment equals the difference between the carrying amount under the previous method (FTB 85-4) and the new carrying amount under the FSP method (investment or fair value). An investor applies FSP provisions prospectively for new life settlement contracts acquired during the adoption fiscal year. Per SFAS 154, the required disclosures upon initial adoption include: the nature of and reason for the change in accounting principle (the adoption of FSP), and the amount of the cumulative effect recognized as an adjustment to beginning retained earnings. Exhibit 3 provides an example of recording and disclosure requirements for a change in accounting method related to the adoption of this FSP.

Financial Statement Presentation and Other Disclosures

Balance sheet. Investors must present on the balance sheet investments accounted for under the fair-value method separately from those accounted for under the investment method. This presentation can be accomplished by either:

• Presenting separate line items on the balance sheet for the investment assets’ carrying amounts accounted for under the fair value method and investment method; or
• Aggregating the investment assets’ carrying amounts and parenthetically disclosing the amount of investments accounted for under the fair-value method included in the aggregate amount.

Income statement. Investors must present on the income statement investment income from life settlement contracts accounted for under the fair-value method separately from those accounted for under the investment method. This presentation can be accomplished by either:

• Presenting separate line items on the income statement for investment income from contracts accounted for under the fair-value and investment methods; or
• Aggregating investment income and parenthetically disclosing the amount of investment income recognized under the fair-value method included in the aggregate amount.

Cash flows. Investors must follow the provisions of SFAS 95 (as amended) to classify cash receipts and payments related to investments in life settlement contracts based on the nature and purpose of the investments, as well as to disclose the investor’s policy of classifying cash flows related to such contracts. Investors will probably treat—

• cash initially paid and subsequent premiums paid as an investing outflow;
• the excess of the proceeds over the cash invested as an operating cash flow, similar to investment income; and
• the return of the premium amount as an investing inflow.

Some entities, however, treat investment trading activity as operating cash flows, and would treat life settlement contracts similarly. Referring to the example in Exhibit 2, the initial investment plus premiums (investment method: $125,000 + $15,000 per year; fair-value method: $100,000 + $15,000 per year) is a cash outflow in the investing section; the return of premium (investment method: $875,000; fair-value method: $950,000) is a cash inflow in the investing section; and the excess of the proceeds over the cash invested (investment method: $125,000; fair-value method: $50,000) is a cash inflow in the operating section of the cash flow statement.

Disclosure requirements. Investors must disclose their accounting policy for investments in life settlement contracts, including their policy for classifying related cash receipts and cash disbursements in the statement of cash flows. They should also separately present investments in life settlement contracts accounted for under the investment method and the fair-value method. The following information should be disclosed:

• The quantity and carrying value of life settlement contracts for the next five years from the balance sheet date, presented separately for each method as well as in the aggregate;
• Face value (death benefits) of the life insurance policies underlying the contracts;
• Life insurance premiums expected to be paid for the next five years for those contracts accounted for using the investment method; and
• Reasons for changes in the expected timing for realizing the proceeds from the investments in the life settlement contracts, and the method and significant assumptions (including mortality) used to estimate the fair value of the life settlement contracts, where applicable.

Exhibit 4 summarizes the financial statement presentations and disclosures as required by the FSP.

Accounting Effects and Limitations

In general, the effects of the new FSP (FTB 85-4-1) on an investor’s financial statements are an increase in both assets and income. Under the investment method, annual premiums are capitalized rather than expensed, which was the prior FTB 85-4 treatment. Unless the investment becomes impaired, this method consistently increases assets and income over the life of the investment, as compared to the prior treatment. Under the fair-value method, annual premiums are still expensed as they were under FTB 85-4; however, this new method requires an adjustment to fair value as well. Because life settlement contracts will presumably increase in fair value over the life of the insured, the fair-value adjustment will most likely increase assets and income over the life of the investment.

Although this new guidance offers good news for the investor’s financial statements, it also presents challenges. For example, the criteria (FSP FTB 85-4-1, para. 7) for periodically testing life settlement contracts under the investment method seem to ignore that investors normally do not know about changes in the insured’s health. The testing criteria also ignore that all states have associations which “guarantee” funds to policy holders in bankrupt insurance companies; these guarantees should reduce the risk of investment impairment. Working together through the National Organization of Life and Health Insurance Guaranty Associations (NOLHGA; www.nolhga.com), the state guaranty associations protect insurance consumers throughout the country. All insurance companies licensed to sell life and health insurance must be members of their respective state guaranty associations. A state insurance commissioner ascertaining that an insurance company faces financial difficulty first uses a “rehabilitation” process to help the company remain solvent. If that fails, the commissioner declares the insurance company insolvent and must ask the state courts to order the company’s liquidation. Since 1983, such associations have contributed $4.4 billion to protect more than 2.2 million policyholders.

Moreover, the value of whole life insurance policies for an insured expected to live for many years, written when prevailing interest rates were high, often declines along with those interest rates, assuming that all other key variables remain constant. Yet the FSP specifically states that changes in interest rates do not necessarily require a test for impairment under the investment method.

The fair-value method also presents measurement difficulties. While this method requires annual adjustments to the fair value of the investment, life settlement contracts currently have no active trading market in which fair value can be easily determined. Investors are advised to use good-faith estimates, such as the value of similar policies; however, measuring the “value” of “similar” policies is far from an exact science. For example, Insurance Company A may rate an individual very differently than Insurance Company B, resulting in inconsistent measures from contract to contract. Finally, some deferred income tax issues arise if, for example, the current tax code requires capitalizing broker fees while the fair-value method requires expensing.

While the criteria for measuring the fair values for investments in life insurance policies are being developed, the provisions of FASB’s FSP FTB 85-4-1 should provide clearer guidance and increased transparency for accounting for such investments. It also should help accountants and financial planners give investors better information about the risks and rewards of such investments.

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