Among other perplexing issues facing clients these days is what to do with life insurance policies that are calling out for attention, sometimes very loudly. Clients might be hearing that they need to increase their premiums to support the death benefit. Or, they're being told that they need to extend liberally the number of years that premiums will be required before their policies are self-sufficient. Many are finding that their latest policy illustrations are projecting significantly less death benefit than they were anticipating for income replacement or estate liquidity needs. Others are seeing projections of far less cash value than they had been anticipating and planning on for retirement. As a result, a lot of personal financial planning and estate planning that was carefully predicated on a number of things going right, now has to be revisited. And the recent changes in the estate and gift tax laws, which may or may not be permanent, will certainly require extended visiting hours.

While this kind of news is never welcome, it's coming at a particularly inconvenient time for many clients whose cash flow, whether from earned or unearned income, is constrained by a number of forces that aren't expected to abate any time soon. And even when cash flow isn't constrained, those increased or extended premiums on trust-owned policies can be creating pressure from a gift (or generation-skipping transfer) tax perspective. In other words, the client may have plenty of money, but those increased or prolonged premiums are threatening to exhaust the client's exemptions, something that was never anticipated when the client's trust purchased the policy.

For some clients and some policies, it's not about money or taxes at all. It's about whether the role of the policy in the clients' long-term financial plan should be revisited in light of changes in their needs and priorities. Finally, it might well be that the policy has no role to play at all and should be surrendered or sold.

In Good Company

Clients aren't the only people who are perplexed about all this. Many estate planners, trustees of life insurance trusts and life insurance agents are also buffeted by these winds, albeit perhaps for different reasons. Of course, some of those winds are, well, just a lot of hot air. Consider the countless clients and trustees who are being told that policies are underperforming, inappropriate, beyond the point of resuscitation, fertile crescents of litigation and so on. In truth, many of these policies are just fine. They aren't underperforming; they just might have been underdescribed. A little tweaking, both of the policy and the ear of the source of the hot air, is all that's required.

The factors at play in these perplexing issues are as multi-dimensional and multi-directional as the range of potential solutions. Therefore, clients, planners, trustees and agents need a process for gathering the facts, identifying the issues and then coming up with cogent, intuitive recommendations.

Regardless of whether the concerns about the policy were first raised by the client, the trustee, the estate planner or the agent, they'll all have to be at the table sooner or later. Otherwise, the right questions won't be asked, the right data won't be gathered, the full range of possible solutions won't be explored and, eventually, the client will be looking for new guests at the table. So, let's assume that the process I'll describe will be conducted by that team and maybe some players to be named later.

Gathering the Data

The starting point will be the “as sold” illustration, meaning the policy illustration that the agent provided (and perhaps the client signed) when the policy was sold. This illustration shows what the client originally bought, meaning the policy name, type, issue date and underwriting classification. It also shows the policy construct, meaning (as applicable for the type of policy) the base/term blend, the dividend option, the death benefit option, the then-current assumptions with respect to such non-guaranteed elements as the dividend interest rate or credited interest rate, the planned premium amount and the number of years the client expected to pay the premium, the existence of any explicit surrender charges and, of course, the pattern of projected cash value and death benefit at “relevant” ages.

The next critical pieces of information are the in-force illustration and the most recent policy statement. The in-force illustration looks like the “as sold” version but starts with the current year's values, benefits and so forth. This illustration should be run at the current and reduced dividend scale or credited interest rate, as applicable. The current policy statement from the carrier also has a lot of helpful information. It can tell us some things that the illustration won't, such as the policy owner and beneficiary. Depending on the type of policy and the nature of the client's concern, the team would look at the illustration and the statement to determine:

  • Have any changes been made to the original policy construct, such as a change to the dividend option on a whole life policy or the death benefit option on a universal life policy?
  • How long will the current premium support the death benefit? Is the policy underfunded, meaning that at the current premium, the policy will lapse well before the client is expected to? Or, on the other hand, as I'm finding a lot these days, maybe the policy is overfunded and doesn't need anywhere near the current premium to support the death benefit to a targeted age that's well beyond when the client is expected to look a little pale.
  • When will the policy be self-sufficient (that is, when will it require no further cash premiums to support the death benefit)?
  • If the policy is variable universal life (VUL), how is the cash value invested and how is the policy being managed?

Questions for the Client

The illustrations and policy statement will suggest some questions that will help further define the issues and then point the team in the right direction to find some solutions. For example, we might now ask the client:

  • Putting aside cost for the moment, do you still need all of the insurance? Do you still want all of the insurance? The difference between “need” and “want” is critical. The former suggests a clinical assessment about the need for liquidity or the income needs of survivors. The latter suggests that the client might have a critical assessment of the survivors, period. (We'll address the impact of the new estate tax rules later.)
  • If you do still need or want the insurance, to what age do you want to support the death benefit? I've found that many clients who were originally told to fund a policy to support the death benefit to age 100+ now scoff at that notion. The scoff can result in a significantly reduced outlay.
  • If applicable, do you still think an increasing death benefit is necessary or appropriate?
  • If applicable, are you still comfortable with a current assumption flexible premium policy or would you like to explore a product with a more assured premium?
  • Is the nature of the need still the same or would the insurance serve a different purpose today? A client who no longer feels he needs the insurance for liquidity, its original purpose, might very much want to hold on to the policy as a tax-advantaged investment, but reshape it and the funding pattern, if possible, to accentuate growth of cash value.

A Representative Sampling

It just isn't possible to cover all of the outcomes that could arise from adequately probative discussions with the client, thorough data gathering and fair presentation of the alternatives for dealing with the policy. Therefore, I'll describe some of the more typical scenarios that planners might encounter in this context.

Dealing with a cash crunch

Let's assume that a client has owned a policy for many years. He indicates that he needs and wants the insurance. However, he's been told that he'll have to pay the premium for many more years than originally projected (if it's a whole life policy), or he'll have to increase the premium significantly to support the death benefit to the originally targeted age of 100+ (if it's a current assumption universal life policy (CAUL)). Unfortunately, the same economic forces that are extending the premium payments or driving them up have driven his cash flow down. He would like to know his options. Before exploring more radical steps, I propose that the client consider the following:

If the policy is whole life, there's likely to be little or no flexibility to alter the premium. Therefore, the agent will provide an illustration that shows a change of dividend option from purchasing paid-up additions to reducing the premium, with the client paying the net premium until the dividend covers the whole premium. (Be sure to find out whether the client can change the option back at any time without evidence of insurability.) Alternatively, the client could suspend premiums altogether, if only for a while. But this would cause the policy to finance the premiums with internal policy loans that will accrue interest and reduce the death benefit. If the client isn't buying green bananas, as it were, then the fact that the policy will labor under a growing debt burden won't be too much of a concern. Long-term, however, the policy loans could seriously erode the value of the policy and narrow the options for managing it considerably. In any case, be sure the illustration shows year-by-year values and benefits well beyond the client's life expectancy so he can truly appreciate the long-term impact of these approaches.

If the policy is a CAUL or VUL product, determine how much the premium can be reduced and still support the death benefit to a targeted age. Notwithstanding the downdraft in credited interest rates or investment returns, the client shouldn't be surprised to find that the policy can actually get along just fine with a considerably lower premium than what he's been paying. Meanwhile, if applicable, determine whether a change from an increasing death benefit option to a level death benefit option will make a significant difference in the premium.

If the policy is no-lapse universal life (NLUL), revisit the duration of the no-lapse guarantee. Does the client still need to support the death benefit to that age? If not, ask the agent to illustrate the premium required to guarantee the death benefit to whatever age the client thinks is reasonable. Also ask the agent to illustrate the “catch-up” premium in case the client decides to “re-extend” the guarantee sometime down the road.

In addition to exploring the possibilities with the premium, consider whether the policy could be managed differently for what could be a lower outlay over time. For example, if the policy is VUL, perhaps it was struggling but is now coming back, albeit in fits and starts. Perhaps the client is still comfortable with VUL as a concept but wants to reduce some of the volatility in performance so that his outlay can be more predictable. If so, he might revisit the asset allocation of the cash value and then, depending on the policy's features, reallocate a growth portfolio to a more balanced portfolio, whether using one of the “turn-key” portfolios offered by the carrier or fashioned by the client from among the policy's array of investment choices. Perhaps the client could explore a policy's automatic rebalancing feature. Finally, the client could consider allocating a portion of the cash value to a fixed account from which the carrier will take monthly costs of insurance and expenses, rather than taking those charges pro rata from all of the funds.

If the needs have changed

Assume now that the client's concerns about survivor income or estate liquidity have given way to concerns about accumulating assets for retirement. Assume further that current cash flow isn't an issue but the client believes that he just shouldn't pay any more money into the policy. After all, he no longer needs “insurance,” so he's inclined to surrender the policy and put the money elsewhere. In a case like this, however, the client can explore a redeployment of the policy, that is, by giving it a new role in his overall planning. Indeed, depending upon the type of policy and how it's constructed, the client's policy might be a very attractive investment vehicle under current tax law. The cash value grows tax-deferred and can be accessed on a tax-free basis through withdrawals and loans (assuming it's not a modified endowment contract). Also, any residual death benefit will pass to the client's beneficiary income tax-free. In light of potentially increased tax rates on investment income after 2012, including the 3.8 percent Medicare tax in 2013, the traditional tax advantages of cash value life insurance might be very appealing to a client trying to reduce the tax on investments earmarked for retirement.

Again, the nature and extent of the redeployment will depend on the policy type and construct. If the policy is whole life, there will be little flexibility with regard to the premium or other aspects of policy design. Therefore, the redeployment will be more a function of the client's thinking about the policy than actually tinkering with it. If the policy is an efficiently constructed whole life/term blend, he may be able to put substantially more premium into the policy without evidence of insurability. If it's NLUL, the client can likely increase the premium (now viewed as an investment contribution) without evidence of insurability. However, an NLUL policy of this vintage probably wasn't designed to generate robust cash values on a current assumption basis. So, it's not likely to impress the client as an investment vehicle.

If the policy is CAUL or VUL, however, more fundamental design changes could be feasible. For example, the agent can illustrate an increase in the premium up to the client's new “defined contribution” for the number of years that the client wishes to make that contribution. And, to the extent allowed by the carrier and by the tax law (to preserve the income tax character of the policy as life insurance), the agent can illustrate a reduction in the death benefit to reduce the “drag” of the costs of insurance on cash value accumulation. Then, the agent can illustrate the maximum tax-free cash flow that the policy can generate for a given number of years without requiring more premium to support the death benefit beyond the client's life expectancy.

Estate liquidity

At first blush, the combination of a $5 million exemption and a 35 percent estate tax rate suggests that some clients will no longer need the coverage or will be able to reduce the amount of coverage they now maintain. At second blush, however, dropping or culling that coverage could be premature (and ill-advised) if the temporary nature of these favorable provisions proves to be just that … temporary. Therefore, it follows that a client/insured who drops or reduces his insurance coverage over the next couple of years could rue the day if (1) the estate tax reemerges in 2013 with a much wider net, and (2) the underwriters are no longer impressed by the client's medical reports.

That said, if the policy itself has a flexible premium structure, the client could choose to reduce the premiums to the minimum required to support the death benefit until the future provisions are clarified or, at least, until the next “temporary” set of rules puts things in limbo long enough for the client to consider that things are “permanent.”

Exchange the policy

Assume that the client still wants the insurance but is unhappy with the carrier, the type of policy or the required outlay. The client wants to explore an exchange or, more likely, one is being proposed. While the team can explore an exchange, the client should clearly understand some things up front. The threshold presumption is that the existing policy should be preserved. The proposed replacement bears the burden of showing that it can legitimately meet the client's needs more effectively than the existing policy. And, of course, the client should never cancel a policy until its replacement is in force!

Exchanges can make a lot of sense, but some proposed exchanges call for additional scrutiny. For example, the team would question a proposed exchange that's supposedly intended to “rescue” the client from a very adequate policy that at most should be tended to more carefully but certainly not replaced. And, the team would question an exchange involving another carrier (an external exchange) when the current carrier hasn't been consulted for what it might offer (an internal exchange).

On that score, it's absolutely critical for the client and the team to understand the difference between the internal exchange and the external exchange and why it's usually best to start with the incumbent carrier. That carrier might have an internal exchange program that offers incentives for the policyholder who otherwise wants a different policy to stay with that carrier. The internal exchange might involve less rigorous underwriting, waiver of a surrender charge on the old policy so the full account value can be exchanged for the new policy, reduction or elimination of the agent's commission on the new product and reduction of certain sales loads and taxes normally assessed at policy issue. If the incumbent carrier doesn't have such a program or, even if it does, doesn't offer a competitive product of the type now desired by the client, then so be it. Meanwhile, even if the carrier is the same (an internal exchange), check the illustration for the replacement policy to be sure it's coded for an internal exchange.

A common scenario today might involve a client whose irrevocable life insurance trust (ILIT) owns a whole life policy. The latest in-force illustration projects that several more premiums will be required before the policy is self-sufficient. If the dividend scale is reduced, self-sufficiency will be even further delayed. The client wants to maintain the current amount of insurance, but his investment income is down. He would like to reduce the cash gifts to the ILIT or eliminate them, if possible.

The trustee can start by asking the agent for an illustration that depicts a change in the dividend option from buying paid-up additions to reducing the premium, with the ILIT paying the balance of the premium. That will reduce the client's cash gifts to the ILIT, but self-sufficiency will be postponed even further. The client tells the trustee to keep looking. So now, the trustee explores an exchange to a new policy that, buffered by the cash value from the current policy, might allow the client to maintain the death benefit to a targeted age but at a sharply reduced outlay. The client indicates that he's willing to be examined for a new policy but, for now, the agent will do an informal underwriting to get preliminary (but still pretty reliable) indications of what underwriting classification the carriers, including the incumbent carrier, would issue on a new policy.

Once the underwriting indications are firm enough to render meaningful illustrations, the agent will show the trustee both CAUL, NLUL and variations on the theme of each, illustrated at the lowest premium, if any, needed to support the current death benefit to the client's targeted age under “reasonable” assumptions for the CAUL or the no-lapse guarantee for the NLUL. Of course, the team will need to discuss which assumptions are “reasonable” and what should be the targeted age. There will also be myriad illustrations depicting alternative scenarios for premium payments, that is, paying a tolerably higher amount for a few years to hasten self-sufficiency or stretching out a lower payment for many years. And the exchanged cash value may support an even greater death benefit than the existing policy now provides, with no further outlay or at an outlay that the client can live with (until he dies). Once some decisions have been made, some parameters established and some choices winnowed down, the agent might “spreadsheet” the remaining competing products and scenarios to enable the client and trustee to see the projected or guaranteed premiums, cash values and death benefits of each well beyond the client's life expectancy. And the spreadsheet should be amply supplemented with explanations about how the policies work and the “what ifs.” When all the returns are in and all precincts have reported, the CAUL policy just might appear to credibly support the existing (or a greater) death benefit sufficiently beyond life expectancy at an illustrated outlay that's considerably lower than the whole life policy. Maybe the NLUL policy will do the same, albeit at a guaranteed premium. But then again, all premiums, cash values and death benefits and intangible factors considered, it might appear that the best option is to stay the course with the existing policy. Whatever the outcome, a careful process will go a long way to ensuring that the decision to stay or move was an informed one.

Sell the policy

Another option for dealing with the policy that might be available to the client is to sell it in the life settlement market. Based on various criteria for the client/insured, the policy and other factors, the agent can advise the client and team about the marketability of the policy. The agent can also advise the client and team about the steps involved in a life settlement.

The client should understand that the sale of the policy is likely to trigger gain. So, the team should review Revenue Ruling 2009-13 with the client and explain the tax implications of the sale (gain is ordinary to the extent of the amount of “inside build-up” that would have been ordinary income upon surrender and capital gain thereafter, but the basis is reduced by the cost of insurance charges). Of course, if the policy is owned by an ILIT that's a grantor trust as to the client, then the client must understand who gets to keep the cash and who gets the tax bill!

Does the life settlement make sense? It depends. Will the sale and reinvestment of the after-tax proceeds of the life settlement leave a larger amount of money to the survivors than if the client kept (and kept paying premiums on) the policy? Ask the agent to determine the lowest premium outlay projected to support the death benefit to just beyond life expectancy. Then compare on an annual basis, the “premium-cost-adjusted” death benefit from the policy to the after-tax result of investing the (after-tax) proceeds of the life settlement to see the “crossover” year. That leaves only one variable, which is beyond the scope of this article. But one way to get an independent assessment of life expectancy might be to see if the client can get a quote for a substandard immediate annuity. If he can, he should hold on to the policy!

Donate to charity

A gift of the policy to charity can offer a number of benefits, including an income tax deduction for something the client doesn't want anymore anyway. However, it's not a given that the charity will accept the gift. Many charities have guidelines for policy acceptance. The guidelines will typically consider such criteria as the age or life expectancy of the insured(s), the amount and number of remaining premiums, the type of policy and the ratings of the insurer. The insured and the policy might meet those criteria. On the other hand, they might not.

The already challenging tax and valuation issues associated with donating a policy were made even more so by Rev. Rul. 2009-13 and the existence of the life settlement market. The prospective donor will have to sort through these issues with his advisors and, of course, comply with the reporting requirements for a gift of a policy (Form 8283, appraisal, etc.). (See “Life Insurance Appraisals,” by Alan Breus, this issue, p. 56.) At the end of the day, the well-advised donor will have to decide if, in light of his particular facts and circumstances, the charitable donation of the policy is an appealing way to meet his objectives.

A Wise Policy

Life insurance policy management is a critical aspect of comprehensive financial and estate planning. It's also widely ignored. Policy management can ensure that these valuable assets remain ports in the storm of today's economic and tax uncertainties.

The views expressed herein are those of the author and do not necessarily reflect the views of Ernst & Young LLP. This document should not be construed as legal, tax, accounting or any other professional advice or service. No one should act upon the information contained herein without appropriate professional advice after a thorough examination of the facts of a particular situation.

Charles L. Ratner is the national director of personal insurance counseling at Ernst & Young LLP, in Cleveland