Life insurance is a confusing topic in and of itself. Start a conversation about life insurance at your next cocktail party and see what happens. The subject is guaranteed to cause eyes to glaze over, even among many professionals. To rid some of that glaze from your eyes, here's an overview of four significant issues that emerged last year within the context of life insurance. We'll discuss the effects
Life insurance is a confusing topic in and of itself. Start a conversation about life insurance at your next cocktail party and see what happens. The subject is guaranteed to cause eyes to glaze over, even among many professionals.
To rid some of that glaze from your eyes, here's an overview of four significant issues that emerged last year within the context of life insurance. We'll discuss the effects of: 1) the 2010 Tax Act on your client's current insurance needs; 2) a Delaware Supreme Court ruling that's contrary to earlier decisions; 3) changes in product availability and pricing; and 4) the rising popularity of premium finance.
Post-2010 Tax Act
At first blush, affluent clients (those with an individual net worth of between $1 million to $5 million) may be tempted to surrender some or all of their existing life insurance coverage. The 2010 Tax Act's increase in gift and estate tax exemptions, reduction in top tax rates and spousal exemption portability may appear to favor reducing in-force life insurance coverage originally purchased to create liquidity to offset estate taxes. But this may be a mistake, because the 2010 Tax Act provides only interim relief that will expire at the end of 2012. Thus, most advisors will likely suggest retaining existing coverage.
On the other hand, individuals will continue to have a compelling need to use irrevocable life insurance trusts (ILITs) to minimize their reduced (and possibly temporary) transfer tax liability. And, as uncertainty is likely to plague the transfer tax environment in the near-term, trust-owned life insurance (TOLI) continues to be a proven standby in these turbulent times.
The increased gift tax exemption amount has opened up a different funding paradigm for ILITs. In the past, the cornerstone for funding an ILIT was Crummey withdrawal powers, enabling donors to maximize their annual gift for annual exclusion amounts. But, the current $5.12 million lifetime gift tax exemption presents a unique opportunity for donors to make simple, but very large, completed gifts to an ILIT for those who need estate liquidity. And large completed gifts to ILITs last year and in 2012 avoid the administrative burdens of Crummey notices. By carefully selecting both the most appropriate product type and a favorable premium payment schedule, very affluent individuals (clients with individual net worth of over $5 million), can secure, for relatively small dollars in the near-term, significant amounts of life insurance death benefit protection, with premiums guaranteed for life by the carriers. Perhaps accelerating or front-loading large gifts to an ILIT, but deferring or back-loading premium payments, may be appropriate.
Because it's also unknown whether Congress will extend portability after 2012, credit shelter or bypass trusts should continue to be used to shield assets from estate tax appreciation after the death of the first spouse and before a surviving spouse's death. Traditional use of testamentary trusts may also save state estate taxes at the death of the surviving spouse. Creditor protection, second marriage planning and avoidance of probate are other reasons that trusts, including ILITs, continue to be important tools in these uncertain times.
For clients who prefer simplicity, now may be a good time to unwind and cancel existing split-dollar plans or loans. Private split-dollar plans or loans can often be unwound in cashless transactions with only gift/generation-skipping transfer (GST) tax consequences. Unwinding employer-sponsored split-dollar plans and loans generally has potential income tax consequences for the parties, so extra scrutiny is appropriate.
While there may be an impulse to take advantage of the current enhanced gift/GST tax exemption amounts by accelerating funding through one or two-pay policies, advisors must seriously consider whether their client-insureds can tolerate modified endowment contract (MEC) status of the policy during their lifetimes. A MEC policy has potentially adverse income tax consequences during a client-insured's lifetime if the policy cash value exceeds the policy basis when the policyholder borrows or withdraws against the policy cash value. While the treatment of the death benefit remains income tax-free, withdrawals and policy loans drawn against the cash value of a MEC policy when there's gain in the policy will generally be taxed as income first and return of basis second.
On Sept. 20, 2011, in PHL Variable Insurance Company v. Price Dawe 2006 Insurance Trust,1 the Delaware Supreme Court held that an issuing carrier can challenge a life insurance policy for lack of an insurable interest even after the two-year contestability provision in the policy expired. The Delaware court's ruling is contrary to earlier decisions by New York's and Michigan's high courts, but is consistent with decisions in most other states. The Delaware ruling adds to the uncertainty and cost of settling policies in the secondary market in states whose courts have yet to rule on this issue.
Price Dawe was the beneficiary of a family trust, which he established to own a large life insurance policy. PHL Variable Insurance Company (PHL) issued a $9 million life insurance policy on Price's life. The policy contained a standard two-year contestability period. A little more than a month after the policy was issued, a third-party investor bought the beneficial interest in the family trust; Price died three years after the policy was issued.
After Price's death, the family trust, as beneficiary, filed a claim for the death benefit and PHL contested the policy, asserting that Price had misrepresented his income and assets to obtain the policy. Most importantly, PHL alleged that Price never intended to retain the policy and planned from the outset to transfer it to the third-party investor. PHL contended that the policy was stranger-owned; Price and the family trust were nothing more than strawmen to conceal the real transaction.
The Delaware Supreme Court answered three questions. First, does Delaware law permit a carrier to challenge the validity of a life insurance policy based on the lack of an insurable interest after the expiration of a two-year contestability period? The court said “yes,” holding that a life insurance policy lacking an insurable interest is nothing more than a wager on human life and is void as against public policy. The policy never comes into force, making the incontestability provision inapplicable. Thus, a carrier can deny a claim for death benefit even if it's filed more than two years following issuance of the policy.
Second, does Delaware law prohibit an insured from obtaining a policy on his own life and immediately transferring the policy to a person without an insurable interest in the insured's life, if the insured never intended to provide insurance protection to a person with an insurable interest in his life? The court said “no,” but qualified its answer by stating that an insured's right to obtain a policy with the intent to immediately transfer the policy is limited to a legitimate bona fide sale of a policy taken out in good faith. The relevant inquiry turns on who procured or effected the policy and whether that person satisfied the insurable interest requirement. When the insured, rather than a third party lacking an insurable interest in the insured, has ultimate financial responsibility of premiums, this is strong evidence that the transaction is bona fide. If a third party, without an insurable interest in the insured, pays the premiums by providing the funds to the insured, the insured doesn't “procure or effect” the policy.
Third, does Delaware law confer on the trustee of a Delaware trust established by an individual, an insurable interest in the life of the insured when, at the time of application for life insurance made by the trustee, the insured intends that the entire beneficial interest in the trust be transferred to a third-party investor with no insurable interest in the insured's life? The court said “yes,” but qualified its response by stating that the insured must both initially create and fund the trust. If a third party funds the trust as part of a pre-arranged plan and the insured provides nominal funding, the substantive requirements of Delaware law are missing.
Availability, Pricing and Changes
All insurance companies have reserving requirements; that is, they must retain a certain amount of capital for each policy sold. No-lapse universal life (also referred to as guaranteed universal life or GUL) has high reserving requirements and because of that, new GUL policies became more expensive. In the past, these products were the least expensive permanent policies available in the marketplace and as such, were extremely popular in estate planning. But today, the pricing differential between GUL and accumulation-type policies has narrowed.
GUL policies have inherent constraints that are disadvantageous to an insured. First, a GUL policy has limited or no cash surrender value (CSV). CSV offers the premium payer the ability to recover costs if the policy is no longer needed. It also offers a premium payer the ability to later move into a new product, if one becomes available, using the cash value of the old policy as seed money and provides flexibility to structure premium payments.
In 2011, as a result of sustained low interest rates and increased capital reserve requirements, many insurance companies repriced or discontinued their GUL policies. To be competitive, insurance companies issued hybrid products with shorter guarantee periods and greater CSV.
In managing life insurance policies, an insured wants to get the greatest reward for the amount of risk taken. Obviously, the least amount of premiums paid prior to an insured's death means a better policy return. CSV universal life policies allow for funding to maximize this return. Within certain parameters in the policy, a premium payer can pay the least amount possible in any given year or series of years. If a “better” policy comes along, the CSV can be used to reduce the cost of the new policy. Compare this to GUL policies, in which there's little, if any, CSV to pick up the slack.
A second problem with GUL policies is that if a premium payer remits less than what's necessary, pays after the grace period or skips a payment, these actions may affect the guarantee. Because the guarantee is based on an undisclosed “shadow account,” with more aggressive earnings (higher) and pricing assumptions (lower), the amount necessary to make up for underpaid, late or unpaid premiums can be substantial due to the lost interest. But, very affluent individuals continue to buy GUL policies because of their ability to fix or lock in premiums forever and shift all investment and mortality risk to the carrier.
In 2011, there was a big shift to indexed policies — whose CSV is in part determined by the performance of a chosen securities index (these policies are also known as equity indexed universal life or EIUL). EIUL policies are often illustrated at high rates — such as 8 percent — to show the potential upside of having such a policy. But 8 percent is an unrealistic crediting rate on policies today. Moreover, most agents typically illustrate the 8 percent as a constant return over many decades, which is a “hoped for” investment impossibility aimed at winning a beauty (sales) contest.
Because there's a minimum return guaranteed regardless of the index performance, there's also downside protection. But the high assumed rate of return can mask high expenses and mortality costs, so to get a better idea of how the product will really perform, potential policyholders should ask for an illustration assuming a 4.5 percent or 5 percent rate of return.
Caution: EIUL policies are very profitable to insurance companies — that's why they're featuring them. EIUL policies are the most difficult to understand of all the permanent-type policies available. Insurance companies often use simplistic explanations to describe EIUL policies, but they don't tell the whole story and many insurance personnel aren't adequately trained to understand the product's nuances. Potential policyholders can go to www.SamuelsonDesign.com for information about EIUL policies.
Premium Finance Sales
Many very affluent individuals are being approached to buy life insurance by borrowing the money to pay premiums (known as “premium finance” sales). While there are merits to premium finance, it's often oversold. Illustrations for these programs may appear to offer free insurance, but this isn't really the case: these programs are complicated and are based on many different assumptions projected over a long period of time.
Most of the loans made in premium finance are done within the estate-planning context, for example, setting up an ILIT to receive the loan and then own the policy. Before entering into a premium finance transaction, it's important to understand the basics, which include:
Amount of loan: In most cases, premiums will be payable over a number of years, and a new loan will be made each year to pay that year's premium.
Renewability of loan: The assumption is that the loan will be renewable for the whole term illustrated. But in fact, loan renewability is conditional on a lender's willingness to make the loan, as well as a borrower's financial qualification on each loan renewal date. Most loans are conditionally renewable for a short period of time, as little as one year, but preferably five years.
Loan interest rate: Unless interest rate swaps are used (that is, when one stream of future interest payments is exchanged for another, based on a certain principal amount), the interest rate will fluctuate. Usually the interest rate is based on the London InterBank Offer Rate (LIBOR) or prime rate, plus some additional percentage. When it's used, LIBOR plus 1.75 percent to 2 percent is the norm, but it varies daily. The rate itself can be based on a specific term. Interest rates are often projected for a long period of time, sometimes for the life of the insured, and in the current economic environment, those rates are at or near all-time lows. But remember: They won't stay that way. Check the history of those rates (for example, at www.moneycafe.com) to get a better idea of how they've behaved in the past, so that your client isn't betting on a low-ball rate lasting for a long time. Make sure that illustrations show realistic rates going forward; it's better to err on the high side.
Interest payments or accruals: Interest may be paid or accrued. While in some cases interest may be accrued, unless the loan is for a short term, accrual should be avoided. Since the ILIT is borrowing the money, the ILIT must pay any interest due. If the ILIT isn't already funded in some way, the grantor will have to make gifts to the ILIT to pay that interest. Make sure those gifts are taken into account when doing gift planning. If the ILIT grantor is considering premium finance to minimize taxable gifts, there may be a better way to do so using a split-dollar arrangement.2
Collateral: To insure that the loan will be repaid, these loans are always collateralized. The first collateral is the CSV of the life insurance policy in the ILIT. As in all life insurance policies, the CSV will vary according to economic conditions such as bond and mortgage rates. The guarantor is also required to put up stand-by collateral in case the cash value of the insurance is insufficient to cover the loan. Additional collateral will have to be put up if the value of the policy and/or existing collateral deteriorates.
Personal guarantees: Regardless of whether the ILIT can cover repayment of the loan, the insured typically has to guarantee repayment; this guarantee is personal and unconditional. If the lender calls the loan, repayment will have to be made in full, regardless of the cash value of the life insurance. If the guarantor has to make a repayment on behalf of the ILIT, it's considered a gift.
Payment of principal: While many illustrations show loans being repaid far in the future or at death, the terms of the note usually allow the lender to terminate as soon as the next premium payment due date. That's why the continuing creditworthiness of the guarantor is a factor; if the lender isn't satisfied with the borrower's financial condition, the lender can terminate the loan. Unless there's a provision to the contrary, the lender can terminate the loan without cause and demand repayment.
Life insurance illustrations: These are just that — illustrations. They use current economic and insurance company circumstances projected far into the future. For those illustrations to actually come true, an individual has to assume that nothing will change in the interim. Wanna bet?
Premium finance may look like an attractive way to acquire EIUL policies. But remember, EIUL policies are often illustrated at high (unrealistic) earnings assumptions and a level rate of return. Actual returns will vary, and the order of the actual returns will greatly affect the outcome. If the success of the premium finance program depends on the success of the insurance policy, be certain your client sees illustrated rates in the 4.5 percent to 6 percent range.
Arbitrage: Premium finance illustrations often show arbitrage — that what a person can earn on his money will be more than what it will cost to use loans to pay premiums. Needless to say, the earnings assumptions are rosy. Unless your client is an extremely sophisticated investor, ignore that part of the illustration.
Disclosures: Clients are asked to sign disclosures stating that they consulted with professional advisors and were aware of the risks of the transaction. If things go wrong, those who sold the program will use the disclosure to prove that your client was adequately warned.
Many premium finance sales are made based on, “Trust me because you don't understand it and I do.”3 So when advising your client, make sure he considers the following eight points before making his decision to finance life insurance premiums:
- Don't buy insurance unless it's needed.
- Ask for illustrations showing high loan interest rates.
- Ask for life insurance illustrations based on low projected crediting rates.
- If the financed insurance is going to replace existing insurance, have the salesperson give a year-by-year comparison of the current program and the proposed program.
- If someone can't explain the program so that you or other professionals can understand it, don't do it.
- If you request information and don't get what you ask for, don't make the deal.
- Review disclosures carefully. Find out what can go wrong. Ask the program salesperson to identify and illustrate the risks. Consult an advisor to review the disclosure.
- Have an exit strategy. If you don't have a good plan to end the program (other than death), don't enter the program.
- PHL Variable Insurance Company v. Price Dawe 2006 Insurance Trust, Case No. 174 (Del. Sup. Ct. Sept. 20, 2011).
- See Lawrence Brody and Richard Harris, “Private Split-dollar Arrangements,” Trusts & Estates (May 2010) at p. 42.
- For some actual cases about premium finance transactions, see Deborah L. Jacobs' highly entertaining and informative article, “Wild Pitch,” Forbes (July 18, 2011), www.forbes.com/forbes/2011/0718/investing-candiotti-plank-jackson-cobb-baseball-wild-pitch.html.
Richard L. Harris, far left, is the managing member of Richard L. Harris LLC in Clifton, N.J. Melvin A. Warshaw is general counsel to Financial Architects Partners in Boston