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Marya P. Robben is a lawyer in the Minneapolis, Minnesota, office of Linquist & Vennum. Bob Cohen is a Principal of Tamar Fink, Inc., a life insurance agency in Minneapolis, Minnesota.
In the current economic climate, litigation over estate planning is increasing and will continue to increase. One area that is already seeing litigation relates to life insurance issues with estate planning. The recent case of In re Stuart Cochran Irrevocable Trust, 901 N.E.2d 1128 ( Ind. Ct. App. 2009), illustrates this exact issue. Attorneys, clients, fiduciaries, and other advisors often mistakenly view life insurance as a stagnant asset that does not need to be managed, amended, or even overhauled. This error can be extremely costly. If the attorney learns to identify life insurance policies in jeopardy, he or she can improve an estate plan while assisting the trustees to fulfill their fiduciary duties. The attorney thereby mitigates possible fiduciary liability. For that reason, each attorney should understand the problems and solutions related to planning with life insurance.
Identifying the Problem
At first, attorneys and clients may wonder if there is even a problem. The problem is that life insurance policies underperform for many and varied reasons. The insurance policies at issue are almost all commonly known policies—universal life, variable life, whole life, and second-to-die. The policies are often sold as an investment; indeed, even the IRS recognizes that life insurance has an investment component. See Rev. Rul. 2009-13. Yet, after the sale is made, the insurance agent and the policy owner often forget about the investment element of the plan; they forget that the policy has risk.
The second question advisors and clients ask is what caused this problem. In short, rate of return assumptions at the time of sale versus current and/or future market conditions cause many of the problems with life insurance policies, placing them in jeopardy. When a policy is placed in force, insurance companies base the viability of that policy on certain assumptions—such as interest earnings, dividend rate, and life expectancy, to name a few. If, for example, a policy is sold based on the assumed annual rate of return of 8% (or even a 12% rate of return, which is the maximum assumption permitted on variable life policies), and the actual, subsequent rate of return does not achieve that assumed 8%, the policy underperforms. An underperforming policy is one in which the annual premiums cannot support the policy for the initially expected length of time. If the model presented at the time of sale presumed an 8% annual rate of return, the model might have shown the policy would be in force until the insured attained the age of 90. When the policy in fact only earns 2%, however, the policy may only stay in force until the insured attains the age of 70—unless the owner elects to start paying a substantially increased premium (again with little certainty that the increased premium will carry the policy to the desired term). In the current economic climate, many policies have had a negative annual rate of return, and policies are failing at a higher rate.
Another component of the problem is that trustees have a fiduciary duty to stay informed about the trust assets—and yet they do not stay aware of issues with a life insurance policy in a trust. The Uniform Prudent Investor Act requires trustees to invest and manage trust assets as a prudent investor would do on their own behalf. The Act requires the trustee to consider the purposes, terms, and other trust circumstances while exercising reasonable care, skill, and caution. When a trustee views the insurance policy as a stagnant asset that needs nothing more than a periodic premium payment, problems with the policy arise quietly, build over time with no oversight, and emerge when a letter to the trustee from the issuing carrier states that the policy is in jeopardy of lapsing. It is an uncomfortable and possibly expensive scenario that leaves the trustee, and possibly the attorney for the trustee, at risk.
In the Stuart Cochran Irrevocable Trust case, the corporate trustee of an irrevocable trust recognized the issue with the insurance policy in a trust and was aware of its fiduciary duties. In that case, the trust held variable life insurance with a death benefit of approximately $8 million. Although that seemed favorable, the trustee requested in-force illustrations of the policies and discovered that the policies were not going to remain in force for as long as originally projected or intended—they were scheduled to lapse because of underperformance. The trustee had documented this properly. It decided to replace the existing insurance with approximately $2 million in guaranteed death benefit, recognizing that while it was notably less coverage, it would not lapse. The trustee had this documented as well. Unexpectedly, the insured died shortly thereafter—at a time when the $8 million would have still been in force. The beneficiaries sued the trustee. The court ruled that the trustee did not breach its fiduciary duties because the Prudent Investor Act does not apply a test of hindsight. Rather, the court pointed out that the trustee diligently monitored the trust asset and made a decision that seemed prudent at the time. The court noted the trustee worked with other professionals in making this prudent decision.
With these problems and issues in mind, an attorney can broach the subject with a client by asking when he or she last had the policy reviewed. The client may not know or will not know that a review is necessary. At that point, the attorney can explain that the client's current insurance agent or other properly authorized representative can request a current in-force illustration of the policy to determine whether it is performing as intended and for how long it will remain in-force with the current premium structure. The attorney can also explain to a trustee and insured client that requesting such a review is the way in which the trustee should monitor the basic strength and viability of the trust asset. Whether anything more needs to be done depends on what the in-force policy illustration reveals.
Types of Policies at Risk
Part of assisting clients is to help them understand the type of policy they have, how it operates, and what puts it at risk. Each type of policy has advantages and disadvantages, and each may be at risk of underperforming for a different reason.
A universal life insurance policy is an interest rate dependent and driven policy. Many universal life policies must earn an interest rate at or near the rate proposed at policy inception to perform at expected levels. In the 1980s, interest rates were extremely high and insurance agents may have modeled policy projections based on 12% (or higher) annual rates of return, which may have seemed reasonable given the economic environment at that time. A disparity between the "proposed" and "actual" rate of return may reveal a compromised plan and death benefit.
A variable life policy is a security. It is not dependent on interest rates but rather on the stock's market performance for its long-term viability. The policy owner self directs premium dollars into "sub-account" (mutual fund look-alike) funds, which are then professionally managed in hopes of meeting the "point of sale" assumed rate of return. In the late 1990s, the stock market was soaring and rates of return were adequate to support the death benefit. As a result, insurance agents may have modeled policy projections based on 8%, 10%, or even 12% annual rates of return and may have represented to the client that it was a conservative rate of return given the economic climate at that time. Current stock market returns are causing variable policies to underperform and ultimately, lapse. Note that the projections require a constant, static, annual rate of return, not an average rate of return, which often produces very, very different results.
A whole life policy, driven by the carrier's profitability and dividend scale, can provide the guarantees lacking in many previous policy alternatives, yet still requires monitoring given past "vanishing premium" proposals. Should a carrier's actual dividend decrease from the dividend projected at the point of sale, more, sometimes many more, premium payments will be required than were proposed at the policy's inception. This can create a serious cash flow problem for the client given the possible large discrepancy between the total premium dollars that he or she was prepared to commit given the initial sales proposal and the actual premium dollars he or she will need to commit given the reality of the policy's performance and need for unanticipated premium deposits.
A second-to-die policy also can be at issue. It might be a second-to-die variable policy, a second-to-die universal policy, or a second-to-die whole life policy. Although this type of policy could be at risk for the same reasons discussed above, there is another variable silently at work that, if not monitored closely, can undermine the viability and therefore the death benefit of the plan. At the first death of a second-to-die policy, nothing happens. The death benefit is not paid out until both insureds have died. Given advances in both medicine and technology, a second-to-die policy needs to be funded properly and projected at rates of return achieved not over one lifetime, but two. Because insureds now live longer (as the data supports), it is more likely that one will outlive the plan, possibly leaving the beneficiary with nothing but disappointment and maybe even litigation.
If one insured on a second-to-die policy has died, the policy should be reviewed for improved underwriting, more favorable pricing, and so on. If the first insured to die was highly "rated" (meaning the person was more expensive to insure), then the surviving insured may be able to save premium dollars by replacing the policy with a true single-life policy and using his or her more favorable health circumstances and the updated, lower cost of insurance tables.
There is good news in all of this. After the client has an in-force illustration prepared and thoroughly reviewed, options exist for the attorney to help the client understand what he or she has, how it works, and what to expect moving forward. Similar to many choices clients face, the options can range from the straightforward end of the spectrum to the more involved and complex.
One option is to keep the policy. If the policy is performing at or close to the projected performance, the client can certainly choose to keep the policy as is. If the client is a trustee, the trustee can place the in-force review report in the trust file and note that it continues to meet the objectives of the trust. This is an excellent step toward documenting fulfillment of fiduciary duties. Imagine for one unpleasant moment the opposite—a policy lapses such that the trust has nothing, the beneficiaries sue the trustee for breach of fiduciary duty, the trustee receives a request for production of documents in which the beneficiary requests copies of all in-force review reports, and the trustee has none because he did not monitor the policy. That is a bad scenario—unless you are the attorney for the beneficiary. By comparison, litigation might be stopped before it starts if the trustee can produce the documentation described above.
A second option is to explore a new, improved policy. If the policy is underperforming and the insured remains insurable, the policy owner can turn to the marketplace to explore the new policy options available. It is very possible that improvements can be made. In some situations, the premium may decrease, the death benefit may increase, or possibly a guaranteed policy may be obtained; all of which are more favorable options. Of course, it is possible that after exhausting options in the insurance market the client will determine a better option does not exist. The process still has its inherent value for a trustee because the trustee can now document that even though the current trust asset is underperforming, it is the best option available. Again, that insulates the trustee from potential future claims of breach of fiduciary duty.
Finally, a third option is to explore a life settlement in the right situation. Life settlement is an option whereby the owner of an existing life insurance policy sells the policy itself before the death of the insured into a secondary marketplace for a lump-sum value in excess of the policy's cash surrender value. Before making that decision, however, the attorney can assist the client to understand the benefits of the transaction. An eligible situation is one in which the insured is at least 70 years old, and the policy owner no longer needs, wants, or can afford the death benefit. A life settlement may also be a liquidation option for an estate plan. This can be useful when the policy's original purpose is no longer needed, such as after the children have grown and the mortgage has decreased, or the buy-sell agreement is no longer needed because the business is sold or bankrupt, or as a result of some other transitional event. If the life insurance is no longer needed, the client can seek a life settlement of the insurance policy as a way of eliminating the premium expense and receiving cash in excess of the policy's cash surrender value to be used for other planning purposes and at his or her discretion. If a life settlement is a possibility, the attorney should make sure to work with someone who is very familiar with the secondary insurance market to ensure the best arrangement and highest sales proceeds are negotiated.
Each of these solutions has income tax implications that attorneys and advisors need to be aware of. On May 1, 2009, the IRS issued two revenue rulings addressing this. First, Rev. Rul. 2009-13 explained three scenarios involving the sale or surrender of an insurance policy that was owned by the individual insured. Second, Rev. Rul. 2009-14 explained three scenarios involving the tax implications from the perspective of the new owner after a life settlement—that is, the buyer of a policy on the secondary market. For most trusts and estates lawyers, Rev. Rul. 2009-13 is important to understand for two reasons: (1) to determine on the planning side whether surrender or life settlement will result in a net positive for the client and (2) on the administration side, to ensure the amount and nature of the income for a surrender or sale are properly reported on the applicable income tax return.
For estate planning clients—the sellers—the three situations addressed in Rev. Rul. 2009-13 are important to understand. The table above summarizes the information in the ruling.
By understanding the income tax implications of the sale or surrender of a life insurance policy, advisors can assist clients in understanding which available option is the best one for the situation overall. In addition, the advisors can assist the client in reporting the transaction properly after it is complete.
Life insurance is not a stagnant asset. The buy-and-hold option may no longer work and, indeed, can lead to a dissatisfied client or even liability exposure. When sending Crummey letters, when reviewing buy-sell agreements, when discussing retirement planning, and in many other situations, the attorney and client should request a new in-force illustration and full review of insurance policies. The attorney can add value and improve a client's situation by suggesting this. The attorney also can help a trustee fulfill fiduciary duties and mitigate or eliminate fiduciary liability by ensuring that policies are fully reviewed and interpreted on a very regular basis.
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