Life settlement valuations: a US perspective


Life settlement valuations: a US perspective

To be accurately assessed, life settlement contracts, like many other assets, require a nuanced approach. Muzaffar Soomro and Corwin Zass take a look.

Accounting for life settlement contracts has evolved very little over the years since the US Financial Accounting Standards Board (FAS B) published, in 1985, FAS B Staff Position (FSP) Technical Bulletin 85-4, Accounting for Purchases of Life Insurance, where the amount that could be realised under the insurance contract as of the date of the statement of financial position should be reported as an asset, and the change in cash surrender or contract value during the period is an adjustment of premiums paid in determining the expense or income to be recognised under the contract. 

This ruling was the basis for investors until the release of the 2006 FSP Technical Bulletin 85-4-1, Accounting for Life Settlement Contracts by Third-Party Investors, which effectively introduced the whole concept of ‘life settlements’, where the investor chooses between an investment method or a fair value method. 

The International Accounting Standards Board (IAS B) and the FASB have issued draft exposures that require life settlement assets to be accounted for and reported using fair value accounting, instead of allowing a choice between fair value and the investment method based on original purchase price. Audit standard setters have also developed auditing standards that apply to any assets that are fairly valued. With the accounting profession continuing to clarify accounting principles and the expectation of a convergence between these two regulatory bodies, all stakeholders participating in the life settlement asset space can benefit from transparent and uniform valuation methods and resulting reporting. 

Specifically, the following accounting and auditing standards apply to life settlement assets: 

Guidance contained in auditing standards issued by the Auditing Standards Board of the American Institute of Certified Public Accountants and accounting standards contained in Accounting Standards Codification are: 

• AU Section 328 (AU§328): Auditing Fair Value Measurements

and Disclosures;

• AU Section 329 (AU§329): Analytical Procedures; and

• FASB Accounting Standards Codification (ASC§820): Fair Value Measurement and Disclosure. Equivalent International Financial Reporting Standards (IFRS) guidance issued by IAS B and the International Standard of Auditing (ISA ) issued by the International Auditing & Assurance Standards Board, is as follows:

• IAS 32 Financial Instruments: Presentation;

• IAS 39 Financial Instruments: Recognition and Measurement;

• IFRS 7 Financial Instruments: Disclosures;

• International Standard of Auditing 540 (IAS§540): Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures; and

• International Standard of Auditing 520 (IAS§520): Analytical Procedures. 

FASB ASC§820.10, formerly FASB 157 and 159, lays out the framework for the fair value hierarchy and prioritises the inputs to valuation techniques. The inputs (variables and methods used) are determined by the lowest level, Level One through Level Three, in which the fair value measurement falls. Life settlements (or payout annuities, structured settlements, and reverse mortgages) fall into the Level Three category since the fair value is based on an unobservable future event—the death of the insured. 

Furthermore, any Level Three assets where value is dependent upon a future unobserved outcome (ie, the insured’s death) GAA P (ASC§820.10.05 through 820.10.65—previously FASB 157) further requires the use of the best information available in the corroboration of the valuation methodology. The outcome of these methodologies must then be reconciled and disclosed by the asset holder. Life settlement assets are no different from any other balance sheet item, for those audit clients with well-documented and controlled processes, the auditor generally ‘audits’ the entity process, controls and calculations rather than run alternative models (discussed below) that may need to be reconciled to the entity’s estimates. The audit client should strive for clear documentation that links estimates to the input data sources and forms the basis for the key model assumptions. These workpapers will aid auditors in evaluating whether management has a ‘reasonable basis’ for its estimates of fair value. 

Audit preparation 

Independent auditors rely on AU§328 to understand the processes used to produce the balance sheet entries, including fair value estimates, along with their respective controls. The objective has not changed over time and simply requires the auditor to assess the completeness, accuracy (reasonableness), and consistency of the methodology, assumptions, and data used in those balance sheet computations. 

Another option open to auditors is to independently produce a valuation using relevant fair value data and compare the results with the entity’s estimates. However, the estimates of the entity are generally open to challenge only when they fall outside of a ‘reasonable’ range of outcomes as assessed by the independent auditor. 

Audits of life insurance based assets (or liabilities), which covers mortality derived programmes such as Life Settlements, which require an actuary to be part of the audit team. The actuary will work in partnership with the audit partner to review the approach and computations of the entity’s estimates and to assess the reasonableness of the assumptions used in such estimates. 

As discussed above, the keys to a successful audit are driven by the level of clarity and transparency of the supporting work papers along with the completeness and thoroughness of the underlying controls which affect the computation of any estimates, regardless of the type of asset (or liability). Best practice has an audit client producing formal quarterly valuations to minimise the impact of potential material changes between the fiscal year end and the preceding quarter-end. If an audit client relies on outside consultants to produce the estimates, the audit client must take responsibility for the values posted in the filed balance sheet, and thus have thorough documentation on how they used the consultants’ estimates. The audit client must coordinate with the consultants to ensure there exists proper resources to answer any audit team enquiries. Lastly, the audit client must have supportable documentation that outlines changes in methodologies used between financial periods. Beyond consistency, the audit client needs to support what changes were made but, more importantly, why they made the change. 

Life settlement valuations 

Under these new fair value accounting standards, the owner of a life settlement portfolio would be required to prepare fair valuation estimates for audited financial statements. The key point is that ASC§820 requires the estimation of what a third party participant would pay to purchase the life settlement, not what the entity itself would pay. While on the surface these may appear similar, there are some entities which believe there is mispricing in the market and seek to take advantage of the mispricing. The key to a good valuation is whether it produces a reasonable estimate of what a third party would pay, and whether there is sufficient support for the assumptions and methods used in deriving the estimate. 

“The key point is that ASC§820 requires the estimation of what a third party participant would pay to purchase the life settlement, not what the entity itself would pay.”

Portfolio managers must use a methodology that can establish, at least annually or quarterly when plausible, a fair value compliant with ASC§820.10. Acceptable statistical methods (such as Bayesian) are valid for compliance with AU§328 (ISA§540) to arrive at a weighted average fair value per policy (and thus the sum will be a fair value of the portfolio). Annually, the difference between the prior period value and the newly established value will be clearly documented, transparent and available to be consistently used year after year in a fair valuation. 

Historically, life settlements have been priced using two methods: the point-to-point method and the actuarial method (sometimes referred to as the probabilistic cash flow method). The point-to-point method assumes that the policy will mature on the valuation date plus the determined life expectancy (LE) of the insured. Premiums are paid until the maturity date and the death benefit is received on the maturity date. This method can significantly underestimate the value of policies which have large premiums after the LE date. The point-to-point method is not appropriate under fair value accounting. 

Actuarially sound pricing

The actuarial method is currently used by virtually all purchasers of life settlements. This method assumes that a portion of the death benefit is received and a portion of the premium is paid at each interval in the valuation. The benefit amount received is based on the probability of the insured’s death in the interval, multiplied by the death benefit. The premium is based on the probability of being alive at the beginning of the interval. The net amounts are discounted to arrive at the value. 

The actuarial method thus requires four key inputs: the mortality rates, the discount rate, expenses and the life insurance premiums. Any life settlement valuation must deal with following variables, each of which affect the resulting valuation, some more than others. 

Mortality rates 

• What mortality table serves as the basis in the determination of the mortality multiple?

• How was each of the LE estimates (as provided by different LE underwriters) used in the valuation? Were LE estimates combined, individually projected, etc? How ‘accurate’ are the LEs?

• How does the valuation handle future industry mortality table changes? 

Discount rate 

• Does the valuation use a different discount rate for each policy?

• Does the valuation use a single discount rate regardless of length of the LE, or are multiple rates used based on the duration? Is there any reflection of a risk premium over a risk-free rate?

• Does the rate incorporate credit risk (ie, defaults on payment by the insurance carrier)?

• What methodology is used to select the discount rate(s)? Expenses

• Does the valuation reflect the cost of ongoing and forecast maintenance expenses (trust, premium payments, collection of death benefits, etc)? 

Life Insurance Premiums 

• Has the valuation validated that the policies are currently in force and that the premium schedules provided will keep the policies in force?

• Is the premium assumption (premium amount and mode of payment) consistent with the way in which the policies are currently administered? 

Purchase price development 

The following steps outline the typical approach used by buyers of portfolios of these types of assets.

1. Each life settlement policy at the point of underwriting will have at least two, and possibly three, commercial LEs—ideally producing a portfolio of policies based on the perspective of the same commercial LE underwriters for the entire portfolio. (Respectable LE underwriters will produce a report containing the underlying survival function for each insured case.)

2. Each policy will be priced independently for each commercial LE using the same probabilistic (ie,actuarial method) pricing model. The starting point is to average the LE underwriters’ prediction. In other cases, the purchaser may require the offer to be priced based upon a specific commercial LE only, no matter how many LEs may have been discarded at the time of pricing. Another example we have seen is to place higher weights on certain LE underwriters versus others (supporting documentation is required to describe the rationale for using uneven weights).

3. The buyer will also take into account any fees paid during the acquisition (such as due diligence or to facilitators), along with the cost of maintaining and servicing such policies.

4. If a buyer and seller come to an agreement, then the buyer will initially lock in the weights used for the LE underwriters that produce the accepted offer. This means the initial pool valuation will in essence reflect the weighted average of the assessments produced by the LE underwriters. 

Financial statement estimates 

Upon the successful purchase of life settlement policies, the following steps outline a fair value-based estimation process:

1. The pool size dictates if there exists any credibility. There are a number of various perspectives on how big a pool must be to reach “credibility”. Some of the rating agencies state that credibility is reached when a pool exceeds 300 policies, while some views in the academic area see the need for 1000+ policies. Regardless of pool size, a best practice is the continual assessment of the experience as it develops. For life settlements, this is no different. The asset holder must compare “actual to expected” mortality results. Over the long term, this sort of pseudo-mortality study will produce insight to the accuracy of the LE underwriters’ predictions. Common statistical analysis, such as Bayesian, will provide the basis to refine the weighting factors.

2. The other key point is to regularly update the LEs to current valuation date (ideally by having newer LE assessments and by mathematically bringing the LE estimate forward to the valuation date from the date of the LE assessment). Run two sets of portfolio valuations, one based on individual LE underwriters, which will define the bounds of the valuation, and another to represent the best estimate which relies on a management chosen weighted average of the LE providers.

3. A valuation report should illustrate the weighted average portfolio value as well as the individual policy values, and their associated weights (whether updated or not, discussed above). It is customary, absent better precision which comes with portfolio size, the portfolio “fair value” ranges between the lowest and highest values and tends to be represented by the average of the LE provider results.

4. Other metrics or analyses provide insight into the assets movement from period to period. Examples include trend analysis and distribution profiles such as average age, average face amount, distributions by insurance carrier, etc.

5. Finally, there must be a written document that accompanies the mathematical output of the valuation. We suggest the assembly of a document supporting the assumptions and methodologies used for the valuation. This document should be updated each valuation period and will provide some historical perspective to the valuation of the assets. 


In the valuation of any asset, the presence of valuators who fully understand the practical and theoretical nuances of that asset is, simply, vital. Over the years we have seen meaningful differences with life settlement valuations, and related supporting documentation, which include as part of the valuation process, either in part or full, input from a reputable third party actuarial consultant, versus those that exclude an actuarial consultant. 

The objective of a valuation for financial statement purposes is to develop a reasonable estimate of the amount a third party would pay to purchase the asset. The valuation should reflect the riskiness of the investment and appropriately capture the volatility of its fair market price. A valuation process as described above should give an investor the means to understand risk-adjusted performance better, and to make better-informed decisions about whether to maintain, decrease or increase its position in this asset class. 

Muzaffar Soomro is a partner at BDO Cayman Ltd. He can be contacted at: 

Corwin Zass is principal & consulting actuary at Actuarial Risk Management, an independent member of the BDO USA Alliance. He can be contacted at: 

Muzaffar Soomro has more than 17 years of experience in the financial services industry. He has worked in various capacities in investment funds including audit, fund setup, fund administration and accounting, transfer agency, custody, liquidations, and compliance. 

Corwin Zass is a US life actuary with the BDO USA Alliance firm, Actuarial Risk Management. He brings close to 20 years of insurance and risk management experience, from customisable risk transfer solutions to design of insurance-linked investments, to a global set of clients.

Cayman Funds