Trustees, picture this: You are at the table with the beneficiary children of one of your most successful clients. You are reviewing the estate of their deceased parent. You have the unpleasant task of explaining that the insurance policy that was purchased 15 years ago had lapsed several years prior to Dad's passing. Result: nothing to lighten the tax bill.
Most trustees do not adequately manage the life insurance policy assets held inside the trust. According to a 2003 survey in the May issue of Trusts and Estates, of 297 professional trustees, 83 percent have no guidelines or procedures for review of irrevocable life insurance trust, or ILIT, assets. The same survey reported that of 513 family and friend trustees, 71 percent had not reviewed the insurance assets inside the ILIT trust in the past five years.
The ILIT is a popular vehicle for solving estate tax-liquidity problems confronting many family business owners, entrepreneurs and real estate investors. Many trustees assume that the policies inside the ILIT perform well enough to achieve the objectives of the grantors. Due to lower rates of interest credited to policy values and lower dividend scales, policy performance may be in question.
It is not uncommon to have multimillion-dollar policies inside insurance ILITs for tax-planning purposes. In the survey of professional trustees mentioned above, the policies are at least 5 years old and have death benefits of 10 million or more. Policies usually have greater ultimate value than the other investment or real estate assets held by the client.
Most individuals or trustees review their investment portfolios with a professional on a regular basis, yet neglect to do the same regarding the life insurance assets.
Another issue relative to insurance trusts is the estate tax law. The law has been a moving target over the past few years. In some cases, the policy may no longer be necessary for liquidity purposes, at least under current law. A careful analysis of the options is required. It may make sense to keep the policy depending on the internal rate of return on the death benefit. Another option available is a possible sale of the policy in the secondary market if it is no longer needed, commonly known as a life settlement.
The challenges of life insurance policies are numerous; consequently, it is important to work with an expert. The trustee should have an expert to call on for an independent review of the policies inside the trust and the individual should be a credentialed professional with more than 10 years experience in the industry.
These primary issues need to be addressed in the policy review.
Objective: What is the minimum objective of the policy? Is the objective the same today? Has the situation changed since the trust was established?
Premiums: Premiums should be analyzed from the standpoint of adequacy to support the policy through life expectancy. In some cases, it may be necessary to increase the premium. Conversely, is there sufficient cash accumulated in the policy to allow for a reduction or elimination of premiums?
Death benefits: Is the death benefit appropriate for the client today?
Health status: What is the client's health status? Has their health deteriorated and, therefore, their insurability in question? Conversely, because of medical advances, underwriting for certain conditions may have improved in the past several years, improving pricing for the client.
Market conditions: The life insurance industry is intensely competitive. Mortality charges inside of policies have reduced significantly over the past few years. It is now far less expensive to purchase a "guaranteed death benefit" than it was five years ago. Clients may be in position to significantly increase their death benefits without raising their premiums.
Lapsing policy: Lapses occur when there is either inadequate premium flow into the policy or inadequate policy cash values. Due to a number of factors, many policies are in danger of lapsing well in advance of original projected target ages.
This is the greatest risk faced by trustees. If the policy lapses, the beneficiary will receive nothing. This may become a source of litigation against the trustee.
Policy review steps
The review process should include the following steps as part of an analysis:
Inforce ledger: This report is furnished to the owner by the insurance company. This report will show the current status and project the future performance of the policy. It will enable evaluation of premium adequacy and reveal any issues with lapsing of coverage.
Original sales illustration: This is the report that formed the basis of the policy at time of issue.
Market place review: Compares the policy to the newer policies available today. A 1998 study by bank trustees found that in 75 percent of the policies over 5 years old, the death benefit could have been increased by 40 percent without any increase in premiums.
Company strength: The financial health and ratings of the insurance company should be documented.
The estate plan: How does the insurance trust fit into the current estate plan? The review process assures that the policy stays relevant to the client's objectives. A full review should be conducted every three to five years.
Trustees, individual and corporate, have a fiduciary duty to manage the assets for the benefit of the trust beneficiaries. They need to complete regular policy audits. It is a good policy.
Leyden is a Chartered Life Underwriter with 22 years experience in the field. He is past president of The Society of Financial Service Professionals. Views expressed here are the writer's.