Valuation of Insurance in Force for Tax Purposes

Where an election is made under I.R.C. § 338 to treat an acquisition of the stock of an insurance company as an asset acquisition, Prop. Treas. Reg. § 1.338-11 provides that the deemed asset sale and purchase shall be treated as if it occurred by assumption reinsurance for tax purposes. To determine the gain on the ceding company’s deemed sale and the tax basis to the deemed reinsurer, allocation of the total purchase price to particular assets requires a determination of the fair market values of the assets. For purposes of determining the portion of the total consideration allocable to the insurance in force, Prop. Treas. Reg. § 1.338-11(b)(2) has a special rule that provides that fair market value “is the amount of the ceding commission a willing reinsurer would pay a willing ceding company in an arm’s length transaction for the reinsurance of the contracts if the gross reinsurance premium for the contracts were equal to old target’s tax reserves for the contracts.”

It is unclear what this means and how it would effect, if at all, an actuarial appraisal of insurance in force. It is possible that reference to tax reserves in the proposed regulations could go to the very heart of the assumptions that are made by the actuary. To appreciate this, it may be useful to describe some of the basic principles of an actuarial appraisal that set this type of appraisal apart from valuation techniques generally applied to intangible assets in other industries.

When appraisers in other business contexts use an income approach to value income-producing contractual rights, they typically look to anticipated future cash flows that they assume will be generated from ownership of the intangible asset, and then apply a discount rate to determine the asset’s present value. An actuarial appraisal uses the same general income approach to valuation of insurance in force, but with a major variation—it uses distributable earnings based on statutory accounting for the assumed future income stream, instead of future cash flows. The reasoning behind the variation for an actuarial appraisal is that the use of cash flows would misstate true economic value to a purchaser because the cash cannot be distributed to the owners until profits emerge under statutory accounting principles.