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Taxation

Practical Approach to Due Diligence Planning

Patricia L. Brown

Are you checking everything that you should be when it comes to clients’ life insurance purchases?

We estate planners consistently strive to improve our expertise by logging thousands of hours of formal education, but many of us are strangely simplistic when examining life insurance and related financial products. We start and stop at triple-A rated companies as determined by Standard & Poor’s, Moody’s, A.M. Best, and Duff & Phelps.

Although AAA ratings have proved to be inaccurate more than once, we continue to rely on this standard because, if for no other reason, clients are not going to pay us by the hour to examine the 2,000-plus life insurance companies in the United States on an individual basis. But, based on a couple of developments during the past year, we may need to reconsider how we choose the companies behind the products we recommend to our clients. What was once a slam dunk—AAA ratings—has now become a moving floor.

The first jolt to our traditional thinking was applied by the Department of Labor (DOL) in March 1995, when it issued ERISA Interpretive Bulletin (IB) 95-1, offering updated ground rules on the "prudent man rule." Although this ruling applies strictly to plan fiduciaries who select annuities providers that sell so-called termination or benefit distribution annuities, it isn’t a far stretch to apply this rule to estate planning situations.

According to the DOL’s IB, the following considerations are among those that fiduciaries must follow in making an analytical and thorough selection decision. These factors help comprise the department’s view of the legal standard imposed on a plan fiduciary by ERISA section 404(a)(1)(A) and (B):

• Quality and diversification of the annuity provider’s investment portfolio;

• Size of the insurer relative to the proposed contract;

• Level of the insurer’s capital and surplus;

• Lines of business of the annuity provider and other indications of an insurer’s exposure to liability;

• Structure of the annuity contract and guarantees supporting the annuities, such as the use of separate accounts; and

• Availability and extent of additional protection through state guaranty associations.

Minimal Requirements for Plan Fiduciaries. Compliance with ERISA’s fiduciary rules, says DOL, minimally requires that plan fiduciaries conduct an objective, thorough, and analytical search for the purpose of identifying and selecting providers from which to purchase annuities. In conducting such a search, a fiduciary must evaluate a potential annuity provider’s claims-paying ability because the participants and beneficiaries have a paramount interest in the ability of the provider to make those payments.

The fact is that ratings agencies are indeed useful, but top ratings do not guarantee success. Conversely, a look at any one of DOL’s six considerations might have helped to identify problems with top-rated companies that failed before it was too late. Look at the DOL points again.

Quality and diversity of investments. Recall that Executive Life was heavily invested in junk bonds. When the market went south, the insurer was dragged down with the market.

Size relative to contract. One large contract, representing almost 10 percent of Mutual Benefit’s liabilities, was surrendered before the company succumbed.

Capital and surplus levels. Fidelity Mutual didn’t meet the test.

State guarantee protection. Exec-utive Life’s municipal guaranteed investment contracts were not protected by guaranty funds.

So rating companies aren’t perfect, but planners argue that they are the best resource that we have. Perhaps, but they shouldn’t be our only resource. First, top ratings don’t always translate into equally superior policy performance or satisfaction—two results we help our clients try to achieve. Second, large stock companies, with an inherent ability to increase equity, are typically favored over mutuals by raters. Yet, ask yourself, "Whom does the company favor?" Stock companies are in business to benefit their owner-stockholders. Mutual companies are owned by their policyowners. A mutual’s owner and policy-owner are the same. No conflict here.

Finally, ask yourself what constitutes a top rating. I know some planners who recite "triple-A, triple-A" like some kind of mantra. Best’s, the insurance industry’s oldest rating company, doesn’t even issue a triple-A. Is the top rating the only rating to consider when looking at insurance companies? Not according to the raters themselves. The top ten ratings from S&P, Moody’s, and D&P and the top seven from Best’s are considered secure/investment grade.

Another point made in the DOL’s IB is worth considering when examining life insurance companies: The lines of business of the provider and other indications of an insurer’s exposure to liability. Raters love not only size, but also diversity. Theoretically, diversity helps a company overcome the rough spots when one product line experiences problems, but there are two sides to this equation.

The companies that were hammered in the recent disability income (DI) insurance slaughter certainly are an advertisement for diversity. Many companies dropped this line altogether, while others drastically scaled back their DI offerings. Yet, other companies experienced only minor setbacks and continue as thriving DI specialists. How did these companies, not known for product diversity, survive and even thrive?

Another Due Diligence Tool. Although DOL’s update offers solid advice, it doesn’t tie up the information in a neat and easy-to-access package. But another development on the ratings front, almost as anonymous as the DOL update, may help. Most states have now adopted the risk-based capital (RBC) formula, adopted in 1993 by the National Association of Insurance Commissioners. This is a nationwide solvency standard used by state regulators that actually addresses three of the six criteria noted in DOL’s IB 95-1. The ratio ties together an insurer’s investment risk and quality, capital and surplus, and lines of business and exposure. One problem, however: Insurers and their agents can’t divulge their ratings or those of their competitors. Fortunately for estate planners, we can release this information, and it is not difficult to find.

Joseph Belth frequently explores ratings issues, including RBC, in his newsletter, Insurance Forum (812/876-6502). Four "action levels" are assigned to companies with ratings of 100 percent and below. I won’t look for companies with ratios below 200 percent, although industry experts say a company at 150 percent is not necessarily in trouble. RBC ratios are simply the amount of capital a company needs, based on the risk profile of assets and liabilities, divided by the capital a company actually has. You can easily translate the ratio yourself from information in annual financial statements by dividing line 27 by line 28.

Human nature being what it is, we estate planners like to stay with proven methods. My argument is that proven methods, such as eliminating any insurance company without a top rating from consideration, may be quick, but far from foolproof. Remember, the courts have ruled that subjective good faith is not a defense to a charge of imprudence.

How should we satisfy our due diligence requirements? First, require more from our clients’ insurance representatives. When they give us product information, are they comparing apples to oranges or similar products? I typically ask for a listing of any insurer’s entire product line, after learning of one company with an amazing twenty-six different whole life products.

Look also at how an insurance product is illustrated. Ask the company to detail, in writing, exactly how its products’ illustrations are created. A few companies detail their assumptions within the guidelines of the American Society of Chartered Life Underwriters and Chartered Financial Consultants Illustration Questionnaire. Ask for a copy of the completed IQ.

Finally, what if my client likes the agent, but I don’t? I’ll put my objections in writing because I never know when this might come back to haunt me. We can make recommendations, but we can’t enforce them.

Look at all of the ratings. As part of the total due diligence process, they are useful. But remember, the most important barometer we can use is to ask the question, "Are this company and this product in the best interest of my client?"

Patricia L. Brown is the principal with the law firm of Patricia L. Brown & Associates in Las Vegas.

Excerpted from The Practical Tax Lawyer, Summer 1996.

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