Fair Value, Determined in Good Faith

Everything in a private placement policy that matters legally reduces to a percentage. No more than 55 per cent of account value in any one investment, 70 per cent in any two, 80 per cent in any three, 90 per cent in any four, tested at the end of every quarter. Percentages need a denominator, and a denominator needs a number for every asset in the account.

For listed securities that is trivial. For a book of hedge funds, private credit, private equity and real assets, it is the operational heart of the whole structure, and it is discussed almost nowhere. This article sets out what federal tax law actually requires, what state insurance law separately requires, what the accounting standards do that neither of the first two adopt, and where the three cadences fail to line up. It sits under our page on investment flexibility.

The entire federal standard is one sentence

Treasury Regulation section 1.817-5(h)(9) is the last definition in the regulation and it reads in full:

"The term value shall mean, with respect to investments for which market quotations are readily available, the market value of such investments; and with respect to other investments, fair value as determined in good faith by the managers of the segregated asset account."

That is the whole thing. Read what it does not say. It prescribes no methodology. It requires no independent appraisal. It mandates no audit. It sets no documentation standard. And it places the determination on a specific person: "the managers of the segregated asset account," which is neither the insurer's board, nor the policyholder, nor a valuation firm.

For a portfolio of listed equities the first limb applies and there is nothing to discuss. For everything a private placement policy is actually built to hold, the second limb applies, and the operative words are "fair value" and "in good faith." Good faith is a conduct standard. It asks how the number was arrived at, not whether it was right.

Why partnership interests are the problem

The regulation's own definitions make this unavoidable. Section 1.817-5(h)(6) provides that the term security "shall include a cash item and any partnership interest, whether or not registered under a Federal or State law regulating the offering or sale of securities," and excludes interests in real property and in commodities.

So a limited partnership interest in a private fund is a security for diversification purposes and has to be valued as one. It is also, by definition, an investment for which market quotations are not readily available. Every private fund position in a policy therefore sits squarely in the second limb of (h)(9), and the account's diversification percentages are only as reliable as a set of good faith judgments about assets nobody quotes.

The look-through rule compounds it. Where the conditions in section 1.817-5(f) are met, the account is treated as owning a pro rata portion of each asset of the fund rather than a single fund interest. Revenue Ruling 2005-7 confirms this cascades through tiers, holding that where a segregated asset account invests in one regulated investment company which in turn holds an interest in another, the look-through "requires that the Segregated Asset Account be treated as owning a pro rata portion of each asset of Fund 1 and Fund 2 for purposes of satisfying the diversification requirements of section 817(h)."

Follow that through and the valuation problem cascades with it. If the bottom tier holds illiquid positions, a good faith determination made three layers down by somebody the policyholder will never meet drives the concentration percentages at the top. The family's compliance rests on the marking discipline of a manager they did not select and cannot instruct.

The cadence, and why it is quarterly and nothing else

Section 1.817-5(c)(1) sets the rhythm:

"A segregated asset account that satisfies the requirements of paragraph (b) of this section on the last day of a quarter of a calendar year (i.e., March 31, June 30, September 30, and December 31) or within 30 days after such last day shall be considered adequately diversified for such quarter."

Four dates, plus a thirty day tail. That tail is doing real work for an illiquid book, because a private fund's quarter end net asset value frequently arrives forty five to sixty days later. The regulation gives thirty. Which means in practice the account is tested on estimates for positions whose final marks have not landed, and the discipline that matters is whether those estimates are made on a consistent basis or invented to fit.

No provision of section 1.817-5 requires valuation more frequently than that. Frequency is driven entirely by the testing dates, and there is no separate valuation rule hiding elsewhere in the regulation.

Drift is forgiven. Buying is not

This is the most useful provision in the regulation and it is routinely omitted from material about this subject. Section 1.817-5(d) provides:

"A segregated asset account that satisfies the requirements of paragraph (b) of this section at the end of any calendar quarter (or within 30 days after the end of such calendar quarter) shall not be considered nondiversified in a subsequent quarter because of a discrepancy between the value of its assets and the diversification requirements unless such discrepancy exists immediately after the acquisition of any asset and such discrepancy is wholly or partly the result of such acquisition."

Read it slowly, because it changes how an account has to be run. An account that passed at a quarter end does not fail later merely because values moved. A position that runs from 50 per cent to 62 per cent on performance alone has not broken anything. What creates a failure is a discrepancy existing immediately after an acquisition and caused wholly or partly by it.

So the operating discipline is not continuous rebalancing. Continuous rebalancing of an illiquid book is impossible anyway, and attempting it would raise a separate question about who is directing what. The discipline is a check before every acquisition. That is a much narrower obligation and a much more practical one, and it is the single point on which we most often find an account's procedures are silent.

The danger in practice arrives at the moments nobody is watching. A manager returns capital, which shrinks the denominator without anybody deciding anything. A capital call is funded into an account already concentrated, which is an acquisition. Or an illiquid position is marked up at the same quarter end as a purchase settles, which is exactly the fact pattern section 1.817-5(d) does not forgive.

Three cadences that do not line up

Here is the part that gets no attention at all, and it is the real subject of this article.

Federal tax law tests quarterly, under section 1.817-5(c)(1), against a good faith fair value standard that prescribes nothing.

State insurance law tests more often. The NAIC Variable Life Insurance Model Regulation provides at section 4D(5)(b) that "the assets of the separate account shall be valued at least as often as any policy benefits vary but at least monthly," and at section 6A(4) that they "shall be valued at least as often as variable benefits are determined but in any event at least monthly." Its valuation standard at section 6E is that "investments of the separate account shall be valued at their market value on the date of valuation, or at amortized cost if it approximates market value." That is a model regulation and it binds nobody until a state adopts it, with variations, so the applicable rule is the one in the insurer's domiciliary state rather than the model itself. But the direction is clear: monthly, at market value.

Accounting runs on a third clock. The underlying fund's audited financial statements measure fair value under ASC 820, defined as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date," within a three level hierarchy: quoted prices in active markets for identical assets at Level 1, other observable inputs at Level 2, and unobservable inputs at Level 3, which is where most private holdings sit.

So the same private credit position is being valued monthly for state insurance purposes, quarterly for federal diversification purposes, and annually to an audit standard, on three different definitions. Nothing requires them to agree, and in an illiquid book they frequently do not.

Be precise about the relationship. ASC 820 is a financial reporting standard. It is not the section 817(h) standard, and section 1.817-5(h)(9) does not incorporate it, reference a hierarchy or adopt an exit price notion. It is the practical benchmark because it is what the fund's auditors apply and therefore what the administrator receives. But a taxpayer defending section 817(h) compliance is defending good faith under (h)(9), not conformity with Topic 820. There is even a vocabulary trap: (h)(9) turns on whether market quotations are readily available, while ASC 820 turns on observable versus unobservable inputs. Those overlap. They are not the same test.

The registered fund world has written rules. Yours does not apply them

Anyone looking for a model of what disciplined fair valuation looks like should read SEC Rule 2a-5, adopted in 2020 with a compliance date of 8 September 2022, and then remember that it does not apply.

The rule requires a fund board, or a designated valuation designee under board oversight, to perform specified functions: periodically assessing and managing valuation risks including material conflicts of interest; selecting and applying methodologies consistently and reviewing their appropriateness; testing the accuracy of those methodologies, including identifying test methods and minimum testing frequency; and overseeing pricing service providers, including approving, monitoring and evaluating each one and initiating price challenges. A valuation designee must reasonably segregate fair value determinations from portfolio management, report to the board quarterly on material matters and annually on the adequacy of its process, and escalate matters materially affecting fair value within five business days.

That is a sensible governance framework and it applies to registered investment companies and business development companies. An insurance dedicated fund relying on the exclusions at section 3(c)(1) or 3(c)(7) of the Investment Company Act is not a registered fund and is therefore outside it. Note the parallel anyway, because Rule 2a-5(c) uses almost the same trigger as the tax regulation: "A market quotation is readily available only when that quotation is a quoted price (unadjusted) in active markets for identical investments that the fund can access at the measurement date, provided that a quotation will not be readily available if it is not reliable."

The practical use of all this is diagnostic. When we look at an account holding illiquid assets, the question is whether anybody has imported the substance of that discipline voluntarily, because nothing compels it. Frequently nobody has.

What happens if the number is wrong

This is where the stakes stop being administrative.

Section 817(h)(1) provides that a variable contract based on a segregated asset account "shall not be treated as an annuity, endowment, or life insurance contract for any period (and any subsequent period) for which the investments made by such account are not, in accordance with regulations prescribed by the Secretary, adequately diversified." The regulation says it again more explicitly: a contract not treated as insurance for any period by reason of a diversification failure "shall not be treated as an annuity, endowment, or life insurance contract for any subsequent period even if the investments are adequately diversified for such subsequent period."

Rebalancing next quarter does not fix it. The failure is permanent, and the income on the contract becomes taxable to the policyholder annually under section 7702(g) and (h).

The only way back is section 1.817-5(a)(2), which treats the account as compliant provided three conditions are met: the issuer or holder "must show the Commissioner that the failure of the investments to satisfy the requirements of paragraph (b) of this section for such period or periods was inadvertent"; the investments "must satisfy the requirements of paragraph (b) of this section within a reasonable time after the discovery of such failure"; and the issuer or holder "must agree to make such adjustments or pay such amounts as may be required by the Commissioner."

That last condition is administered through Revenue Procedure 2008-41, which sets out the process by which an issuer may remedy an inadvertent failure by entering a closing agreement under section 7121 and paying a toll charge. It superseded Revenue Procedure 92-25 and rendered Notice 2000-9 obsolete.

Put the two halves together and the significance of a valuation error becomes clear. A mark that pushes a single position over 55 per cent, in a quarter in which the account also bought something, is not a bookkeeping problem to be tidied up next quarter. It is a permanent disqualification unless the carrier goes to the Internal Revenue Service, admits the failure, fixes the account and pays. Which is a conversation the carrier is having about the family's contract, on the carrier's timetable. And the purchase leg is not an occasional event, because nothing arrives in kind: money goes in and the account buys, so the test is live in most quarters rather than a few.

Gates, side pockets and the authority that does not exist

Now the honest part. We searched specifically for guidance on how the diversification rules treat the things that actually happen to illiquid funds, and there is none.

No revenue ruling, revenue procedure, notice, regulation, private letter ruling or Federal Register preamble addresses how a side pocketed position is valued or counted for the quarterly test, whether a gated or suspended interest continues to be looked through or becomes a single investment, whether an inability to redeem affects whether market quotations are readily available for (h)(9) purposes, or whether the market fluctuation relief at section 1.817-5(d) covers a position whose weight rises because other positions were redeemed while the gated one could not be.

The section 817(h) guidance that does exist runs in entirely different directions: money market funds in Notice 2016-32, government sponsored enterprise paper in Revenue Procedure 2018-54, tiered look-through in Revenue Ruling 2005-7, and the correction procedure in Revenue Procedure 2008-41.

The nearest things to reason from are the market fluctuation rule, the good faith standard itself, and the knowledge that if the reasoning turns out to be wrong there is a correction route that costs money. Those are analogies, and we label them as analogies. This is a genuine gap in the law and a family holding gated positions inside a policy is operating in it.

What we look for in an account

Five things, none of which any rule requires and all of which distinguish a well run structure from one that has never been tested.

A written valuation policy for the account, naming who the managers of the segregated asset account are for (h)(9) purposes. Ask the question directly and see how long it takes to get an answer, and ask it again each time a new manager is added to the platform, because the answer can change with the mandate.

A documented pre-acquisition check, because section 1.817-5(d) makes acquisitions the trigger and nothing else. If the process is a quarterly review, it is checking the wrong thing at the wrong time.

A stated approach to estimates in the thirty day window, so that a fund's late net asset value is handled the same way every quarter rather than however it suits the number.

Reconciliation between the monthly state law valuation, the quarterly tax test and the annual audited figures, with the differences explained rather than ignored.

And a plan for what happens on a breach, including who talks to the carrier and how quickly, because the correction route requires the failure to be shown inadvertent and remedied within a reasonable time after discovery. Both of those are easier to establish when somebody was already watching.

The theme running through all of it is that the federal standard is deliberately thin. It asks for good faith and leaves the method to the people doing the work. In a book of listed securities that is unobjectionable. In a book of private funds it means the quality of the compliance is exactly the quality of the process nobody was obliged to build.

Frequently asked questions

How are illiquid assets valued for section 817(h) purposes?

Under Treas. Reg. section 1.817-5(h)(9), value means market value where market quotations are readily available, and otherwise "fair value as determined in good faith by the managers of the segregated asset account." The regulation prescribes no methodology, requires no independent appraisal or audit, and sets no documentation standard. Good faith is a conduct standard rather than an accuracy standard.

How often does a separate account have to be valued?

For federal tax purposes, quarterly. Treas. Reg. section 1.817-5(c)(1) requires the diversification test to be satisfied on 31 March, 30 June, 30 September and 31 December, or within 30 days after, which necessarily requires a valuation of every asset at each of those dates. Separately, the NAIC Variable Life Insurance Model Regulation, as adopted by a given state, requires separate account assets to be valued at least monthly.

Does ASC 820 apply to a PPLI separate account?

Not as the governing standard. ASC 820 is a financial reporting standard used in the underlying funds' audited accounts, and it is the practical benchmark administrators work from, but section 1.817-5(h)(9) does not incorporate it. A taxpayer defending diversification compliance is defending good faith under (h)(9), not conformity with Topic 820. The tests are also worded differently: (h)(9) turns on whether market quotations are readily available, while ASC 820 turns on observable versus unobservable inputs.

Does a position that grows past 55 per cent break the policy?

Not by itself. Treas. Reg. section 1.817-5(d) provides that an account which satisfied the test at a quarter end is not treated as non-diversified in a later quarter because of a discrepancy between asset values and the limits, unless the discrepancy exists immediately after an acquisition and is wholly or partly the result of it. Market drift is forgiven. A purchase that creates or worsens the breach is not.

What happens if the account fails the diversification test?

Section 817(h)(1) provides that the contract is not treated as life insurance "for any period (and any subsequent period)" in which the account is not adequately diversified, and Treas. Reg. section 1.817-5(a)(1) repeats that subsequent compliance does not restore it. The failure is permanent unless corrected. Treas. Reg. section 1.817-5(a)(2) permits relief where the failure is shown to the Commissioner to have been inadvertent, the account is brought into compliance within a reasonable time after discovery, and the issuer or holder agrees to pay what the Commissioner requires. Revenue Procedure 2008-41 sets out that process, which runs through a closing agreement.

Does the look-through rule make valuation harder?

Yes, and it cascades. Where section 1.817-5(f) applies, the account is treated as owning a pro rata portion of each asset of the fund. Revenue Ruling 2005-7 confirms the look-through applies through successive tiers, so a good faith fair value determination made at a lower tier drives the diversification percentages at the top. Compliance therefore depends on the marking discipline of managers the policyholder neither selected nor can instruct.

How are gated or side pocketed positions treated?

No authority addresses it. We searched for guidance on side pockets, gates and suspended redemptions in the section 817(h) context and found no ruling, regulation, notice or private letter ruling on any of them. The nearest points of reference are the market fluctuation rule at section 1.817-5(d), the good faith standard at (h)(9), and the correction procedure if the reasoning proves wrong. Those are analogies rather than authority.

Is there a start-up period for a new account?

Yes. Treas. Reg. section 1.817-5(c)(2) treats a segregated asset account that is not a real property account as adequately diversified until its first anniversary, and a real property account until the earlier of its fifth anniversary or the anniversary on which it ceases to be one. The relief is lost prospectively if, at a quarter end, more than 30 per cent of the amount allocated to the account is attributable to contracts entered into more than one year earlier, or more than five years earlier for a real property account.

Sources and authorities

Internal Revenue Code section 817(h)(1) and (h)(2). Treasury Regulation section 1.817-5, in particular paragraphs (a)(1) and (a)(2) on the consequences of non-diversification and inadvertent failure, (b)(1) on the concentration limits, (c)(1) on quarterly testing, (c)(2) on the start-up period, (d) on market fluctuations, (f) on look-through, and (h)(6) and (h)(9) on the definitions of security and value. Revenue Ruling 2005-7 on tiered look-through; Revenue Procedure 2008-41 on correcting an inadvertent failure; Notice 2016-32 on government money market funds; Revenue Procedure 2018-54. FASB ASC 820 and SFAS 157 for the definition of fair value and the three level hierarchy. SEC Rule 2a-5, 17 CFR 270.2a-5, adopted at Investment Company Act Release IC-34128, 86 FR 748, with a compliance date of 8 September 2022. NAIC Variable Life Insurance Model Regulation, model reference MO-270-1, sections 4D(5)(b), 6A(4) and 6E, which binds only as adopted by a given state. NAIC Statement of Statutory Accounting Principles No. 56 on separate accounts.

Our editorial standards explain how articles like this one are sourced and reviewed.

This article is educational only and does not constitute legal, tax, investment, accounting, or insurance advice. Several of the questions discussed here are unaddressed by authority, state insurance requirements differ, and the treatment of any particular account depends on its own facts. Engage qualified advisers in every relevant jurisdiction before acting.