A gap in insurance GAAP? New life insurance markets demand new accounting method.

There's a new philosophy in the marketplace about life insurance, and we believe it warrants a change in the accounting method used for this popular investment product. Traditionally, life insurance has been viewed as a legacy paid to designated beneficiaries after the insured's death. But in recent years policyholders have begun to view it as an underused asset, a source of significant financial resources they can tap while they are still living by selling their insurance to third parties. With the emergence of the multi-billion-dollar viatical and life settlement markets to facilitate these purchases, some accountants have begun to question the appropriateness of FASB Technical Bulletin no. 85-4, Accounting for Purchases of Life Insurance, that adopted the cash surrender method as the only generally accepted method of accounting for these assets. Many CPAs feel it fails to properly reflect the investment nature of life insurance purchases in these markets, resulting in financial reporting that lacks adequate transparency.

FASB argued in the technical bulletin that there is no justification to support recording insurance contracts at amounts other than agreed amounts (such as cash surrender value). However, we believe that because viatical and life settlement contracts are sold for amounts that exceed the cash surrender value, and because recent litigation has sought to classify the trading of interests in life insurance contracts as securities, there is compelling justification for recording such contracts at amounts greater than the cash surrender value.

We believe it's time to change the method of accounting for life insurance, and in this article we'll describe an alternative method we think FASB should consider.

CURRENT GAAP: THE CASH SURRENDER VALUE METHOD

Under the cash surrender value method, when a policy is purchased by a third party, the difference between the acquisition cost and cash surrender value is recognized as a loss. Initially, the amount of the reported asset is limited to the policy's cash surrender value. When additional premiums on the policy are paid, the reported asset amount increases only as the cash surrender value increases; any remaining amount is charged to expense. When the insured dies, the difference between the current cash surrender value and the policy's face amount is recognized as a gain.

Though the cash surrender value method is easy to apply, its economic soundness is subject to criticism for two primary reasons. First, any asset amount on the balance sheet is limited to the policy's cash surrender value. Second, income is greatly distorted because loss is recorded at acquisition, premiums are charged to expense (except to the extent the cash surrender value is increased) and no income is recognized until the insured's death.

THE NEW MARKETPLACE

Viatical settlements. A viatical settlement is a sale of a life insurance policy by a terminally ill patient to investors. The National Viatical Association estimates that $50 million worth of policies were sold in this way in 1990, $1 billion in 1999 and an estimated $4 billion in 2001.

The process starts when a third party solicits insurance agents or financial planners to find patients with AIDS or other terminal illnesses who are willing to sell their policies in return for an immediate cash payment. The third party determines how much to charge investors for each policy. The discount, usually ranging from 10% to 40% of the policy's face value, is based on the insured's life expectancy. The third party then markets its life insurance policy inventory through its network of insurance agents and financial planners, who earn commissions based on the face amount for identifying and arranging for the sale of policies to investors.

Life settlements. In life settlements, insurance contracts commonly are purchased from insured policyholders who are in their retirement years, or who have significant medical conditions but are not terminally ill; policyholders in both categories benefit during their lifetimes from selling their policies. Policies of patients with AIDS are unpredictable, but those of policyholders with cancer, cardiovascular disease, diabetes, Alzheimer's disease and amyotrophic lateral sclerosis (Lou Gehrig's disease) are appealing to buyers because estimates of life expectancy are reliable. Both markets are growing, however, and the dollar amount of life settlement transactions is expected to exceed $10 billion over the next five years.

With viatical settlements burgeoning into the broader sector of life settlements, many insure& now sell their policies to investors using settlement companies--a largely unregulated market that divides policies into fractional interests. Following recent attempts to sell these interests as securities under the Securities Act of 1933 and the Securities Exchange Act of 1934, several states have begun to enact statutes to regulate viatical settlements.

ALTERNATIVE ACCOUNTING OPTIONS

The cash surrender value method has a number of serious shortcomings when it comes to fairly accounting for the new breed of life-insurance products.

* It penalizes the policy purchaser and significantly distorts income over the policy's life. If a policy has a cash surrender value, the purchaser's cost will undoubtedly exceed this amount, resulting in a sizable loss for financial reporting purposes on the acquisition date. For term policies without cash surrender values, the purchaser's entire cost is recognized as a loss. Recognizing this loss in either circumstance is unduly conservative and unjustified. To make matters worse, a large gain is recognized when the insured dies.

* It limits the amount reported as an asset on the statement of financial position to the cash surrender value. This limitation implies that a purchased life insurance policy does not have future benefits above its cash surrender valued--but the purchaser clearly is paying more precisely because it does have greater benefits. Indeed, the viatical market establishes market values that in all cases exceed the policies' cash surrender value.

Despite FASB's support for the cash surrender value method, many alternatives have been proposed. Those that are cost-based (such as ratable charge methods) have the same limitations but are more complex than the cash surrender value method; they have been considered and rejected by standard-setting bodies and observers. Revenue-based alternatives, such as the pro-ratable income and present value income methods, also have been proposed. They allow recognition of income before the insured's death as well as recognition of and increase to the asset amount reported in the balance sheet. We propose a third alternative, referred to as the investment method. We'll discuss each of the three below.

Pro-ratable income method. This method capitalizes the cost of a policy at acquisition. It assumes the company purchasing the life insurance contract intends to continue paying the premiums, if any, on the policy until the insured's death, and therefore also capitalizes the premiums. The difference between the carrying amount of a policy (acquisition cost plus capitalized premiums plus income recognized) and its face value is recognized as income ratably over the insured's life expectancy. At date of death, the remaining difference between the face value of the policy and its carrying amount is recognized as a gain. Although this method recognizes income during the life of the policy, it does not take into account the time value of money.

Present value income method. The present value income method is similar to the pro-ratable income method in that both capitalize the acquisition cost of a policy and of additional premiums, but the two differ in the way they recognize income. The present value income method recognizes the difference between the present value of future benefits to be received less the present value of future premiums to be paid and the carrying amount of the policy as income (or loss) each year until the death of the insured. At date of death, it recognizes a gain equal to the difference between the face value of the policy and its carrying amount.

A compromise: The investment method. Like the revenue-based methods, the investment method capitalizes the cost of the policy and the premiums needed to keep it in force, but no income is recognized until the insured dies. Estimating the insured's remaining life therefore is unnecessary.

As in the cash surrender value method, the difference between the carrying amount of the policy and its face amount is recognized as a gain at the death of the insured, although the amount of the gain is significantly reduced. The advantages of the investment method are reduced volatility of income measurement, more realistic asset valuation and ease of implementation.

COMPARING THE METHODS

The three alternative methods are conceptually more realistic than the cash surrender value method for two reasons. First, each reports an asset in the balance sheet at amounts that properly reflect the investment nature of the purchased policies. Second, none distorts income by recognizing a loss in the income statement in the year of purchase, later to be followed by a significant gain on the insured's death. Rather, income (or loss) is recognized over the policy's remaining life or, in the case of the investment method, at date of death.

In spite of their conceptual advantages, the pro-ratable income and the present value income methods require subjective measurements that make them difficult to implement. Under the present value income method, an appropriate discount rate must be determined. Under both methods, the amount of income recognized each year depends on an estimate of the insured's life expectancy. The investment method is much easier to implement, since income is not recognized until date of death, and it produces comparable results. The investment method therefore is the best alternative for accounting for purchases of life insurance.

NEW MARKET DEMANDS NEW METHOD

We believe the cash surrender value method of accounting for life insurance contracts is no longer justified for several reasons:

* New viatical and life settlement markets have developed since the writing of Technical Bulletin 85-4.

* The clear intent of life settlement companies is to treat these contracts as investments, and the argument that they are investments is compelling based on SEC litigation that attempts to treat fractional interests in these policies as securities.

* The rapid growth of these markets demands an accounting method that more clearly reflects the underlying philosophy of these purchases.

* Most important, the cash surrender value fails to provide transparent reporting because it distorts income and undervalues the future benefits of life insurance policy investments.

The investment method is not as conservative as the cash surrender value method in recognizing a loss at acquisition. It does not distort income. And it is easy to implement because it does not require estimates of the insured's life expectancy. We believe FASB should adopt the investment method of accounting for life insurance.

JAMES H. THOMPSON, CPA, PhD, is professor of accounting in the Meinders School of Business at Oklahoma City University in Oklahoma. His e-mail address is [e-mail]. GREGORY M. LARSON is a staff accountant with a public accounting firm in Oklahoma City. His e-mail address is [e-mail].