BDO Accounting for life settlement contracts has evolved very little
over the years since the US Financial Accounting Standards Board (FASB) published, in 1985, FASB 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 (IASB) 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 IASB 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) GAAP (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.
CAYMAN FUNDS | 2012 67
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