Using Life Settlement Transactions to Value Split-Dollar Loan Receivables
Large Estates
For large estates which often plan on using life insurance with large premiums to reduce the value of the estate, split-dollar life insurance offers an attractive method for funding the premiums with favorable gifting consequences. However, the IRS has begun cracking down on the valuation of the split-dollar loan receivables transferred by the loan holders. One of the primary issues has been the use of life settlement transactions to determine the value of the split-dollar loan receivables for gift or estate tax purposes.
Characteristics of Life Settlements
The characteristics of life settlements and split-dollar loan receivables are not similar; therefore, they are not comparable. Using life settlement transactions as a basis for determining the discount rate to apply to split dollar loan receivables inflates the discount rate, which in turn undervalues the receivable. Life settlements include more risk factors and greater underwriting, transaction, and oversight costs than split dollar loan receivables; therefore, life settlements require a higher rate of return/discount rate. The figure below summarizes the risk characteristics of the Life Settlement industry:[1]
Life Expectancy
Life expectancy and modeling error is less significant for healthy, long–lived policies, as is typical with split-dollar loan receivables. The main risk in the Life Settlement industry involves life expectancy estimation.[2] The underestimation of life expectancies for Life Settlements could possibly lead to losses, due to the ongoing premium payments not present with split-dollar loan receivables. Statistically, the probability that an individual will live longer than their life expectancy is 50%.[3] To make up for this, life insurance policies that are purchased in the Life Settlement market are typically for insureds with health impairments, and with a higher discount rate.
In a study performed on open-end funds in U.S. Life Settlements, the realized returns found for 2003 to 2010 were 4.9%.[4] During the same period, the London Business School Study calculated expected IRRs ranging from 11.0% to 18.8%.[5] The risks associated with Life Settlements, and specifically with life expectancy estimates, cause realized returns to be much less than expected returns.
[1] Perera, Nemo and Brian Reeves, Risk Mitigation for Life Settlements, The Journal of Structured Finance, Summer 2006, p. 56
[2] Januario, Alfonso V. and Narayan Y. Naik, Testing for Adverse Selection in Life Settlements: The Secondary Market for Life Insurance Policies, London Business School, July 23, 2014, p. 7
[3] Perera p. 59
[4] Braun, Alexander, Nadine Gatzert and Hato Schmeiser, Performance and Risks of Open-End Life Settlement Funds, Journal of Risk and Insurance 79, pp. 193-229
[5] Januario p. 23
Mr. Conroy has more than 20 years of consulting and business valuation experience, concentrating on complex estate and gift valuation matters. He provides business valuation and financial consulting services to companies in a broad range of industries. Working with domestic and international clients, Mr. Conroy has performed thousands of business appraisals involving gift and estate tax, financial reporting, mergers, and acquisitions (valuations for buyers/sellers, fairness, and solvency opinions), litigation support, expert testimony, and other company requirements (including stock options and ESOPs). Mr. Conroy previously worked with the national valuation firm CBIZ Valuation Group, LLC here he was a senior manager. Prior to that, he taught chemistry and physics to high school and college students at Xavier College in Ba, Fiji, for two years as a U.S. Peace Corps volunteer.