for the Purchase of Life Settlement Contracts
Reinstein and Cathleen L. Miller
2007 - Purchasing life insurance policies from the elderly or terminally
ill is becoming an increasingly popular investment tool (see Charles
Duhigg, “Late in Life, Finding a Bonanza in Life Insurance,”
New York Times, December 17, 2006). These policies are
often called speculator-initiated life insurance (spin-life) policies,
life settlement contracts, or viaticals. In response to the growth
in these investments, FASB issued new authoritative guidance relevant
to accountants, financial planners, investors, and insurance professionals.
In March 2006, FASB issued Staff Position (FSP) FTB 85-4-1, Accounting
for Life Settlement Contracts by Third-Party Investors. This
guidance amended the current authoritative standards, FASB Technical
Bulletin (FTB) 85-4, Accounting for Purchases of Life Insurance,
and SFAS 133, Accounting for Derivative Instruments and Hedging
Activities. It addresses accounting for investments in life
insurance contracts (life settlement contracts) and viaticals (life
settlement contracts for the terminally ill).
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
- 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
- The investor
receives the face value of the life insurance policy when the
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.
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.
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
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.
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.
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.
1 summarizes the differences between the investment and fair-value
methods, and Exhibit
2 provides sample journal entries under both methods.
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.
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.
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
Statement Presentation and Other Disclosures
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:
separate line items on the balance sheet for the investment
assets’ carrying amounts accounted for under the fair
value method and investment method; or
the investment assets’ carrying amounts and parenthetically
disclosing the amount of investments accounted for under the
fair-value method included in the aggregate amount.
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
separate line items on the income statement for investment income
from contracts accounted for under the fair-value and investment
investment income and parenthetically disclosing the amount
of investment income recognized under the fair-value method
included in the aggregate amount.
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—
initially paid and subsequent premiums paid as an investing
- 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.
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.
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
insurance premiums expected to be paid for the next five years
for those contracts accounted for using the investment method;
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,
4 summarizes the financial statement presentations and disclosures
as required by the FSP.
Effects and Limitations
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.
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.
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.
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.
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.
Reinstein, DBA, CPA, is the George Husband Professor of
Accounting, and Cathleen L. Miller, PhD, CPA, is
an associate professor of accounting, both in the school of business
administration at Wayne State University, Detroit, Mich.