Opinion ID: 3014809
Heading Depth: 2
Heading Rank: 3

Heading: Lapse Rates and “Lifing Analysis”

Text: A central part of McCarthy’s valuation was his “lifing analysis,” that is, the method by which he estimated the expected life of each contract as of 1987. McCarthy used historical lapse rates to determine the probability that each group’s contract would lapse in any given year. These lapse rates were used to compute the expected life of each contract, which was essential to calculating its fair market value. 5 McCarthy used historical data from Capital’s 5 Essentially, the FMV of one of Capital’s contracts in 1987 equaled (a) the present value of all future premium payments on that contract, minus (b) the present value of all future claims paid out under 30 1982-1986 experience that “indicated that each group contract had a 2.2-percent to 7.5-percent probability of lapsing from year to year, depending on factors such as group size and duration of the contract.” 122 T.C. at 255. The Tax Court had two objections to McCarthy’s lifing analysis: first, that McCarthy did not take into account the uncertainty in the insurance market in 1987, and second, that he did not take into account certain “human elements” that influence lapse rates.6
First, the Tax Court found that the lapse rates did “not account for foreseeable (as of January 1, 1987) and significant changes in the health insurance marketplace.” 122 T.C. at 255-56. More specifically, the Court found that McCarthy did not consider the impact that increased competition from HMOs and other new insurance products would have on Capital’s lapse rates. In 1987, the argument goes, a willing buyer could have predicted that increased competition would lead to greater lapse rates, and thus that contract, over (c) the expected life of the contract. Cf. Sunset Fuel, 519 F.2d at 783 (“[The value] of a particular account is a function of the flow of future income . . . discounted by the risk of discontinuance or nonpayment of that particular account . . . .”). Since premiums would normally exceed claims, this present value would be higher for contracts with a long expected life than for those with a short life. Lapse rates were used to determine the expected life of each contract, and thus its expected value. 6 Earlier in its opinion, the Tax Court also suggested that McCarthy “incorrectly assumed a 20-year useful life for all of petitioner’s separate health insurance group contracts.” 122 T.C. at 249. Capital points out that McCarthy simply used 20 years as the maximum cutoff for projections, not as an assumed useful life for all of the contracts. In its criticism of McCarthy’s lifing analysis, however, the Tax Court seems to have correctly understood the 20-year cutoff. 122 T.C. at 255 (“[I]n his attempt to account for the reality that not all of petitioner’s group contracts would remain in existence for 20 years, petitioner’s expert utilized historical lapse rates . . . .”). We therefore assume that its earlier error regarding the 20-year assumption did not affect the Tax Court’s decision. 31 would have valued Capital’s contracts at a rate lower than McCarthy ascribed to them using historic lapse rates. Capital submits that this line of reasoning reflects a misunderstanding of the evidence. Capital’s CEO testified that, in the 1980s, Capital was aware of the competition from HMOs, but expected that this competition would not significantly affect its market share or lapse rates because central Pennsylvania, where Capital operates, has a traditional market with relatively few hospital choices and a strong organized-labor presence. McCarthy testified that he took the competitive situation into account, but determined that most of the “competitive factors” that led to lapses had already taken effect in the 1982-1986 period that he used to determine lapse rates. The Commissioner’s experts reasoned that “[i]n the presence of such significant market changes, the assumption that future lapse rates would be consistent with past lapse rates is, at best, problematic,” and that the lapse rates were “speculative in the extreme, given what was going on in the group health insurance market at the time.” We are unconvinced. First of all, McCarthy, unlike the Commissioner’s experts, seems to have spoken to Capital management and considered circumstances unique to Capital’s central Pennsylvania market, while the Commissioner’s experts considered only the national health insurance market. Capital presented evidence that its market was (for reasons suggested above) uniquely resistant to the competitive pressures introduced by HMOs and PPOs; therefore, McCarthy’s calculations based on Capital’s own past data may well have been more accurate than the Commissioner’s projections based on national trends. Furthermore, there does not seem to be any evidence that McCarthy’s lapse rates were incorrect. Instead, Capital’s evidence tends to show that subsequent experience proved Capital’s projections correct: it has not lost significant market share to HMOs, and its historic lapse rates from 1987 were very close to those predicted by McCarthy. McCarthy’s table of historically derived lapse rate assumptions—ranging from a 2.2% lapse rate for groups of 10-24 members whose contracts had been in effect for over ten years to a 7.5% rate for groups of 1-9 members whose contracts had been in force for under one year — squares relatively well with Capital’s actual 1987-1994 experience. McCarthy testified that the experienced lapse rate by number of contracts was 32 5.6%, while the lapse weighted rate by total premiums lost was just under 3%. As McCarthy explained, the former number corresponds reasonably well to his predicted lapse rates for small groups, which were the most numerous, while the latter corresponds quite well to his predicted rates for large groups, which made up the bulk of Capital’s premiums. Of course, it is theoretically possible that McCarthy’s predicted lapse rates were speculative, but nonetheless turned out to be correct. But the general accuracy of his predictions is certainly strong evidence that they had a foundation in reasonable analysis rather than speculation. The Commissioner denies that McCarthy’s lapse rate predictions were accurate, although he has not pointed to any statistical evidence to refute the numbers we have cited above. Instead, the Commissioner cites a Capital marketing plan from 1993, which states that “[s]ignificant losses from existing accounts are being incurred from HMO’s,” and that the Berkshire Health Plan PPO had “targeted Blue Cross and Blue Shield customers and [had] been successful in enrolling a significant number of accounts through selective underwriting.” This document certainly supports the Commissioner’s thesis that Capital faced competition from HMOs. But McCarthy’s testimony was that this competition had already developed by the 1982-1986 period that he used to estimate post-1987 lapse rates, and that his use of historical rates therefore accurately captured Capital’s 1987 expectation of future rates. He testified that, based on discussions with Capital executives, he concluded that “the phenomena [of increased competition, including from HMOs and PPOs] had really already developed in the period of time I used for purposes of the lapse study . . . . And so I felt, after listening to them, that based on the situation in 1986, it was not necessary to modify those experience rates that i [sic] had derived for purposes of projecting in the future.” Without any contradictory evidence, we have no choice but to accept McCarthy’s representations that his predicted lapse rates turned out to be accurate. Moreover, his procedure—relying on recent historical rates that he concluded incorporated the developing changes in the insurance industry, and discussing his predictions with Capital management to get a sense of their predictions as of 1987—does not strike us as “speculative in the extreme.” The Tax Court appears to have ignored Capital’s 33 evidence that McCarthy’s lapse rates were accurate, and to have unduly credited the Commissioner’s experts’ conclusory assertions that those rates were speculative. We thus reject as clearly erroneous the Tax Court’s conclusion that “petitioner’s expert largely ignored the industry changes of which petitioner’s management, as of January 1, 1987, was aware.” 122 T.C. at 25657.
Tax Court also rejected McCarthy’s lifing analysis because it found that McCarthy did not consider various “human elements” that would influence lapse rates, viz., various subjective factors that might make customers cancel their at-will contracts. It held that “These human elements associated with petitioner’s group contracts created a significant element of unpredictability with regard to the useful life of petitioner’s group contracts.” 122 T.C. at 257. The Tax Court’s conclusion here reflects a fundamental misunderstanding of McCarthy’s method, if not of the nature of the insurance industry and actuarial methods. McCarthy took into account the human factors in the way that all actuaries do: actuarially. He divided the contracts into groups based on distinctions that he found relevant, computed average lapse rates, and used them to project future lapse rates. Capital quite wittily cites Ehrhart v. Comm’r, 57 T.C. 872, 873 (1972) (“Actuaries are highly skilled mathematicians who deal with various contingencies affecting human life.”), for the proposition that an actuary of McCarthy’s experience is well equipped to deal mathematically with the human factors affecting the lapse rates of insurance contracts. Furthermore, the Tax Court did not identify any “human factors” that McCarthy’s valuation failed to take into account. The Tax Court’s reliance on Ithaca II, supra, 17 F.3d at 689-90, and Globe Life & Accident, supra, 54 Fed. Cl. 132, is misplaced. Those cases concerned workforces, which are much harder to value than insurance contracts; the valuations involved there were far less careful and thorough than McCarthy’s valuation here; and those cases concerned amortization (where precise lapse rates are essential) rather than deductions for the direct loss of contracts. Because it ignored undisputed evidence and misunderstood 34 the nature of McCarthy’s calculations, the Tax Court’s rejection of Capital’s lifing analysis on the theory that McCarthy failed to take into account any subjective “human factors” was clearly erroneous and must be set aside.
In his appellate briefs, the Commissioner builds on the Tax Court’s findings by arguing that McCarthy’s lapse rate assumptions were flawed in other respects. Specifically, McCarthy only used average rates for contracts of a given size and age, and did not calculate different rates for different kinds of coverage or contract, different premium payment histories, changing sizes, or financial condition of the client group. Capital responds that McCarthy complied with actuarial principles in coming to his conclusions, and that the Commissioner has not shown that McCarthy’s valuations would be different if he took into account the more specific factors that the Commissioner urges. We agree with Capital. McCarthy’s efforts were thorough, and it appears to be undisputed that he followed actuarial standards. The Commissioner has identified some factors that he did not consider, but this alone does not seem to be a reason to reject McCarthy’s lapse rate calculations. As the Tax Court has previously stated, “lapse rates may be determined from a statistical analysis of actual past experience of policies in force at specified intervals of time or from an informed judgment of a person who has had experience in the field.” Union Bankers, 64 T.C. at 816. Simply put, it would be impossible for McCarthy to take into account every factor that might distinguish one contract from another. McCarthy did not classify contracts based on what percentage of individuals in each group was left-handed, but the Commissioner would not be heard to argue that this was a flaw in his methodology. The Commissioner cannot invalidate McCarthy’s methodology simply by pointing to factors that McCarthy neglected; instead, he must also make a reasonable case that such a factor would have changed his conclusions. The Commissioner has not even attempted to do so here, and we see no reason to reject McCarthy’s lifing analysis.