What is the Interpolated Terminal Reserve?

The interpolated terminal reserve is a mid policy year calculation on a life insurance policy's reserve used most often to determine the market value of a life insurance policy.  The value of the interpolated terminal reserve is something close to the policy's cash value, but the two are not the same.

Because life insurance policies are assets that can transfer ownership from one legal entity to another, calculating the fair market value of a policy has several important tax applications.

How to Calculate a Policy's Interpolated Terminal Reserve

As a policy owner, you cannot calculate a policy's interpolated terminal reserve.  The calculation requires proprietary information unique to the life insurance company that issued the policy.  This means only the insurance company can perform the calculation and arrive at a policy's interpolated terminal reserve at any given point.  Life insurance companies will also take care of completing tax forms that often necessitate such a calculation–chief among them IRS form 712.

The calculation is precisely as its name implies, an interpolation of the life insurance policy's reserve in between policy anniversaries.

On its face, this sounds like a lot of mathematical gymnastics that overcomplicate the situation.  Why perform the interpolation at all?  Consider the fact that at the beginning of a policy year, a life insurance policy will have a value based on premiums paid to that point and the reserve created by the life insurance company with those premiums.  As time progresses through the year, the value of the policy's reserve changes and this could impact the fair market value of the policy.  Using the value of the reserve at the beginning of the policy year, or the anticipated value of the reserve come the end of the policy year is one way to make an approximation.  But the interpolation is a much more precise and, arguably, a fairer way to arrive at the policy's value.

But why then, do we care about any of this?

Gift Tax Implications of a Life Insurance Ownership Transfer

All life insurance policies are assets that have some value that we must calculate if we transfer ownership of the policy.  And when I say all life insurance policies, I mean all life insurance policies–including term life insurance.

If I, for example, choose to give a life insurance policy I own to a charity of my choice, I need to know what the value of that gift is should I decide to transfer ownership of the policy immediately.  The interpolated terminal reserve will give me the answer I seek.

Calculating the interpolated terminal reserve, tells me the value I gifted to the charity.

Less common today than about a decade ago, some people choose to transfer ownership of a policy to adult children in an attempt to remove life insurance proceeds from their gross estate (tax law changes during the President Obama administration significantly decreased the number of people who are subject to the estate tax, and this is why this practice is less common).  So long as the transfer falls outside of the lookback period, the death benefit does not count as an asset in the grantor's estate.  But transferring ownership of a policy to someone else in this fashion can create a gift tax liability that is often larger than one realizes.  This happens because the interpolated terminal reserve is the taxable amount, and this is often more than the cash surrender value of a policy.

Another, far less common, situation is the ownership transfer of a life insurance policy owned by someone where the insured is someone different from the owner.  Consider a situation where Hank owns a life insurance policy on his brother Jeff.  Hank's health is declining with this age and he is in the process of moving assets to his children to avoid a possible Medicaid claim to his assets should he require Medicaid assistance with nursing home expenses.  If Hank transfers ownership of this life insurance policy that insures his brother's life, to his son John, Hank makes a gift to John in the amount of the interpolated terminal reserve of the policy.

Estate Tax Implications of Life Insurance Ownership

Life insurance policy face amounts count as an asset in one's estate for estate tax purposes.  This calculation is very easy to determine, it's simply the death benefit amount of the policy.  But owning a policy insuring someone else's life and transferring ownership upon the death of the owner results in an asset value calculation that is more complicated.

Let's assume for a second that Jane owns a life insurance policy insuring her brother Jake's life.  Jane passes away and leaves the life insurance policy to her daughter Janice.  If Jane's estate is large enough to incur an estate tax liability, the interpolated terminal reserve of the policy she owned on Jake is an includable asset in her estate.  In fact, it doesn't really matter who Jane leaves the policy to upon her passing.  The fact that she owned the policy when she died makes it includable in her gross estate.

A Unique Value Calculation for Tax Purposes

Life insurance is a unique asset with a nuanced approach to valuation when it comes to transferring ownership of the asset.  It's highly advisable that you approach life insurance ownership transfers with caution and seek out the expertise of a professional when dealing with such situations.