How to Determine Fair Market Value for a Life Insurance Buy Out

There’s a moment in nearly every defined benefit plan that owns life insurance when the participant has to write a check to the plan to buy the policy out.

The size of that check isn’t up to the participant. It isn’t up to the insurance company either. It’s dictated by an IRS revenue procedure most people have never heard of, and getting the number wrong can unwind a decade of careful tax planning in a single transaction.

This article walks through the mechanics — the PERC amount, the interpolated terminal reserve, the dividends and adjustments that get layered on top, and the practical workflow for executing a clean buy-out.

Why a safe harbor exists

The intuitive answer is to use the cash surrender value. The problem is that CSV has very little to do with what the IRS considers fair market value — especially in the early years of a permanent policy, when surrender charges and front-loaded commissions can compress CSV down to a small fraction of premiums paid.

Buying the policy out at that depressed number is precisely the abuse the IRS spent the early 2000s shutting down, and Revenue Procedure 2005-25 was the response: a safe harbor formula designed to make sure participants can’t extract value from the plan at fire-sale prices.

When a participant buys a life insurance policy out of a defined benefit plan (sometimes called a “swap-out”), the policy must be sold at fair market value to avoid creating a taxable distribution or a prohibited transaction. The valuation rules are governed primarily by IRS Revenue Procedure 2005-25, which provides a safe harbor formula.

Historically, plans valued policies at cash surrender value (CSV), which is straightforward but easily manipulated. A perceived abuse known as “pension rescue” involved purchasing a life insurance policy inside a qualified plan funded with the maximum pre-tax dollars possible, then distributing or selling the policy to the participant when the net cash surrender value was at its minimum — usually the earliest years — at the lowest defensible valuation.

The cash surrender value of the insurance contract was temporarily depressed so that it was significantly below the premiums paid, the contract was distributed or sold to the employee at that depressed value, and then the CSV increased significantly after transfer. The IRS shut this down in 2004 and issued Rev. Proc. 2005-25 to define FMV more robustly.

The Rev. Proc. 2005-25 safe harbor — the “greater of” test

So how is fair market value actually calculated? The answer involves two competing valuation methods, a “greater of” test, and an Average Surrender Factor that produces very different numbers depending on where the policy is in its life cycle.

FMV is the greater of two amounts:

1. The PERC amount (Premiums + Earnings − Reasonable Charges) The variable PERC amount is the aggregate of: (1) the premiums paid from the date of issue through the valuation date without reduction for dividends that offset those premiums, plus (2) dividends applied to increase the value of the contract (including dividends used to purchase paid-up insurance) prior to the valuation date, plus or minus (3) all adjustments credited or made available under the contract. Essentially, this captures what’s been put into the policy — gross of surrender charges.

2. The ITR / reserve-based amount The sum of the interpolated terminal reserve (ITR) and any unearned premiums plus a pro rata portion of a reasonable estimate of dividends expected to be paid for that policy year based on company experience, then multiplied by an “Average Surrender Factor” of at least 0.70 under the safe harbor.

You take the higher of these two figures. The point of using the greater number is that you can no longer cherry-pick a depressed CSV — the PERC amount essentially adds back the surrender charges and acquisition costs that the insurer subtracted in early years.

Important nuances

• Form 712 from the insurance carrier is the standard source document. It reports cash value, premiums paid, terminal reserve, and other data the actuary or TPA needs to run the calculation. Most insurers will quote a “Rev. Proc. 2005-25 value” if asked.
• Dividends on deposit are added on top of the policy FMV; they aren’t subsumed in the formula.
• Health of the insured isn’t factored under the safe harbor, even though under general FMV principles a terminally ill insured would dramatically increase the true market value. If health has materially deteriorated, the safe harbor floor may not actually reflect true FMV, and a higher number may be required — a real-world issue in viatical and life-settlement contexts.
• Nondiscrimination: Under Rev. Rul. 2004-21, the right to buy the policy out must be available to all participants on a nondiscriminatory basis — you can’t just offer it to the owner.
• Method of payment: The participant must pay cash (or other non-plan assets) to the plan equal to the FMV. Done correctly this is a non-reportable, non-taxable event — the participant simply ends up owning the policy personally, and the plan ends up with cash equal to the policy’s value.

Practical workflow

The TPA or plan actuary requests a Form 712 from the carrier as of the valuation date, runs the PERC vs. ITR-based calculation, and certifies the higher number as the purchase price. The participant wires that amount to the plan trust, and the trustee re-titles the policy to the participant individually (or to an ILIT, which is a common estate-planning move to keep the death benefit out of the participant’s gross estate, though transfer-for-value rules under IRC §101(a)(2) need to be checked).

One last thing worth noting: this is a niche but heavily scrutinized area. Auditors review policy records carefully during plan examinations, and getting the FMV wrong can cascade into disqualification risk, excise taxes under §4975 if treated as a prohibited transaction, and reopened personal tax returns. Most practitioners get the carrier’s Form 712 and a written FMV opinion from the TPA before executing the swap-out.

How Does the PERC and ITR Compare to the CSV

The relationship changes dramatically over the life of the policy, and the whole point of the Rev. Proc. 2005-25 formula was to address the fact that CSV is the lowest of the three values in the years where the swap-out is most attractive — namely, the early years.

Here’s the general pattern for a typical permanent (whole life or universal life) policy:

Early years (roughly years 1-5)

• CSV is dramatically depressed — often a small fraction of premiums paid. A policy where the participant has paid $50,000 in premiums might have a CSV of $20,000-$35,000 because of surrender charges and front-loaded acquisition costs (commissions, underwriting, etc.).
• PERC is much higher than CSV — it’s roughly equal to cumulative premiums paid (plus dividend additions, with no reduction for surrender charges). So PERC stays near $50,000 in the example above.
• ITR-based value is also higher than CSV — the interpolated terminal reserve is calculated on statutory mortality/interest assumptions and doesn’t bake in surrender charges. Even after the 0.70 Average Surrender Factor haircut, it typically beats CSV in these years.
• Practical result: FMV ≈ PERC, typically larger than the CSV.

Middle years (roughly 5-15)

• Surrender charges grade down to zero (the exact schedule depends on the policy).
• CSV rises rapidly and starts catching up to PERC.
• Meanwhile, the 0.70 Average Surrender Factor permanently haircuts the ITR-based amount, so ITR × 0.70 is actually the lowest of the three by this point.
• Practical result: FMV is usually still PERC, but the gap with CSV is shrinking.

Late years (15+)

• Surrender charges are gone. CSV equals gross cash value.
• Interest credits, dividend accumulation, and paid-up additions push CSV upward faster than premiums alone.
• CSV often exceeds PERC at this point. ITR × 0.70 lags both.
• Practical result: CSV becomes the practical floor — the safe harbor formula might produce a number lower than CSV, but no rational participant would buy a policy for less than its CSV (they could just surrender it). So FMV ≈ CSV in mature years.

Here’s roughly how the three values move over the life of a typical whole life policy with level $10K annual premiums. Numbers are illustrative for a whole life policy:

Practical Implications

The three values diverge most dramatically in the first 5-10 years, which is exactly when the “pension rescue” abuse occurred — CSV could be a tiny fraction of PERC, and selling at CSV would let the participant strip value out of the plan at a deeply discounted price. The safe harbor closes that gap by forcing the comparison to PERC, which essentially recaptures the surrender charges and acquisition costs.

By roughly year 10-15 (when surrender charges fully expire on most permanent policies), the three values converge, and CSV starts to dominate as the policy’s internal earnings outpace cumulative premiums. From that point forward, FMV ≈ CSV and the safe harbor formula doesn’t really constrain anything — it produces a number, but CSV is naturally higher.

This is why timing matters enormously for swap-outs. If the goal is to minimize the participant’s out-of-pocket purchase price, the math doesn’t really get more favorable by waiting — CSV keeps growing. But if the goal is to escape the safe harbor’s haircut on the “pure insurance” component, the swap-out gets cleaner the longer you wait, because the formula’s premium-add-back stops mattering once CSV exceeds PERC.

One more nuance: for universal life and variable universal life, the same general pattern holds, but the curves can be steeper or flatter depending on the cost structure. VUL policies with high M&E charges and surrender schedules can have an even more depressed early CSV, making the PERC vs. CSV gap wider in early years.

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