A client's lack of sophistication and guidance regarding trust-owned life insurance (TOLI) can put estate-planning lawyers in the hot seat. Most states have now enacted the Uniform Prudent Investor Act (UPIA), which imposes a higher standard of care and greater liability on trustees of irrevocable life insurance trusts (ILITs) than the prior prudent investor standard. As such, the UPIA has indirectly
A client's lack of sophistication and guidance regarding trust-owned life insurance (TOLI) can put estate-planning lawyers in the hot seat. Most states have now enacted the Uniform Prudent Investor Act (UPIA), which imposes a higher standard of care and greater liability on trustees of irrevocable life insurance trusts (ILITs) than the prior prudent investor standard.
As such, the UPIA has indirectly placed a heightened standard of care and exposure on lawyers who are involved in advising clients on initial policy selection and funding, subsequent policy performance evaluation and restructuring. At least 10 of the states have responded in varying forms to the difficulties of ILIT trustees managing TOLI under the UPIA, by enacting statutes that specifically relieve ILIT trustees of management responsibility and liability.
So what exactly is the role of a lawyer when guiding a client who wants to implement a long-term life insurance program held in trust? Because the answer is complex, I'm going to address the question in a two-part article. In this part, I examine a lawyer's potential duty of care to trust beneficiaries; the current product considerations challenging policyholders and carriers; and the enactment in some states of statutes exonerating trustees from responsibility and liability for managing life insurance. Part 2, which will appear in early 2012, will focus on recommending different trustee management styles for life insurance and suggesting how a lawyer can help a trustee discern settlor guidance and intent to increase the likelihood of a successful outcome for the beneficiaries.
Communicate TOLI Basics
Life insurance policies have become more complicated over the last few decades. Product variety has proliferated to satisfy consumer demand. Carriers are more nimble today and, with improved automation and efficiency, can introduce or discontinue products faster than ever. What's an estate-planning lawyer to do?
Most competent estate planners know how to draft a flexible ILIT. Unfortunately, few estate-planning lawyers explain to the settlor-insured or ILIT trustee certain basic information about TOLI; failure to discuss certain issues can produce less than optimal outcomes for beneficiaries. Estate-planning lawyers should thus discuss with the settlor-insured or ILIT trustee:
- The purpose of TOLI;
- How the ILIT is integrated into the settlor-insured's overall estate plan;
- The time horizon for the ILIT;
- The funds that the ILIT trustee will require not only to pay premiums, but also to monitor the performance of the policies;
- The health of the settlor-insured;
- Gift management and tax reporting responsibilities;
- The investment risks and economic assumptions inherent in the policy and its appropriateness for the settlor-insured;
- The TOLI management expectations of the settlor-insured and the extent to which they have been communicated to the ILIT trustee; and
- If the ILIT trustee is a non-professional, such as a settlor-insured's family member, friend or business colleague, acknowledgement by the settlor-insured and ILIT trustee that they understand the trustee can delegate management responsibilities for the TOLI to a professional.
Privity and Duty of Care
The liability of an estate-planning lawyer for breach of duty was historically based on the privity between the lawyer and his client. While a client could bring an action against a lawyer, a third party could not. However, in all but a handful of states, this rule of privity has eroded.1 In most states, a beneficiary harmed by a lawyer's negligence may bring a malpractice claim against the lawyer, even though the beneficiary wasn't the lawyer's client.2 Courts have found that an estate-planning lawyer owes a duty to intended, third-party beneficiaries under certain factual circumstances.3
Presumably, settlor and beneficiary interests are aligned when it comes to the intent of and purposes for an ILIT: maximizing wealth transfer and estate liquidity and minimizing costs. But a lawyer's role is far more complicated than merely being a scrivener. A lawyer must counsel the client about the relative merit, or lack thereof, of the client's goals and intentions. If a lawyer believes that a client's views or assumptions are mistaken, that lawyer has a professional responsibility to tell the client.
Even if ILIT beneficiaries can't challenge a failed life insurance program, can the personal representative of a settlor's estate succeed in a lawsuit, on behalf of the estate, against the estate-planning lawyer? In 2010, in Estate of Schneider v. Finmann,4 New York's highest court, the Court of Appeals, relaxed the strict privity requirement, which had previously held that neither an estate nor its beneficiaries may maintain a malpractice action against a lawyer who advised a decedent regarding his estate plan. The court held there was sufficient privity between the personal representative of the estate and the decedent's estate-planning lawyer to maintain a malpractice action when a life insurance policy death benefit was included in the decedent's taxable estate. The court noted the unfairness of a doctrine that left an estate without recourse against a negligent estate-planning lawyer,5 stating:
The estate's personal representative shouldn't be prevented from raising a negligent estate-planning claim against the lawyer who caused harm to the estate. The estate-planning lawyer surely knows that minimizing the tax burden of the estate is one of the central tasks entrusted to the professional.6
An estate-planning lawyer advising a settlor-insured on TOLI faces a dilemma. Settlor-insureds often choose trustees not for their financial skills, but for their loyalty or family position. Thus, a trustee without significant financial experience will likely rely on the lawyer's advice. And, although it's the settlor-insured who typically determines the original life insurance products with which to fund the trust, it's the trustee who will be held liable to trust beneficiaries for prudently monitoring and maintaining the trust. If a trustee has greater liability, the lawyer who advises him will inherently assume a corresponding heightened duty. This responsibility presents a dilemma for the lawyer who wants to advise the trustee to the fullest extent, but not cross the line between providing legal advice and investment advice.7
Perhaps most troubling for an estate-planning lawyer advising a settlor-insured about TOLI is the possibility that the lawyer may have a continuing duty of care, at least to a non-professional ILIT trustee. There's a general trend toward greater lawyer liability, evidenced by both the UPIA and the courts' relaxation of privity requirements: “[It] thus seems a reasonable proposition to conclude that an attorney may have a duty not only to the client, but also to the trustee of the client's ILIT.”8
The UPIA requires a trustee to demonstrate a process for selecting and managing all assets held in the trust. The relevant standard under the UPIA for an ILIT trustee to consider is:
- Assessing risk tolerance in light of “the purposes of the trust and the relevant circumstances of the beneficiaries;”
- Taking into consideration general economic conditions and expected tax consequences of investment decisions or strategies;
- Adequately diversifying the trust assets; and
- Considering an asset's special relationship or special value, if any, to the purposes of the trust.9
In re Stuart Cochran Irrevocable Trust10 is the first case analyzing an ILIT trustee's duty under the UPIA. Cochran teaches estate-planning lawyers that:
- An ILIT trustee should have sufficient expertise to be able to analyze and monitor the premium adequacy of the policies or should delegate this authority to someone else if the trustee lacks such expertise;
- A trustee should always investigate a variety of investment alternatives;
- A prudent trustee should obtain information about the health and life expectancy of the insured before making changes to a policy; and
- A trustee's duty of loyalty is owed to the ILIT beneficiaries, not to the settlor-insured.
Challenges of Products
The days of managing TOLI as a custodial tool, rather than a real trust asset, are long gone. Passive management of TOLI may have been sufficient 30 years ago, in an era when the only available permanent product on the market was a traditional guaranteed whole life policy. Today, ILIT trustees and advisors to insureds must understand a broad spectrum of different life insurance products, styles and policyholder risks. These range from market-sensitive, variable products in which the policyholder assumes all investment risk, to fully guaranteed, limited cash value accumulation, no-lapse secondary guarantee products, in which the carrier assumes investment and other risks. Let's look at the challenges of managing life insurance products from both the policyholder's and the carrier's perspective.
Universal life (UL) products were born in the early 1980s during an era of high interest rates. In UL policies, the policyholder forgoes the certainty of higher guaranteed premiums in exchange for lower flexible premiums. The carriers use conservative interest rates and mortality assumptions in calculating their reserves. Many UL policyholders, however, didn't fully appreciate the consequences of the carrier's transfer of the premium adequacy risk to the policyholder. If interest crediting rates dropped (as they did) or the carrier decided to raise more money from policyholders to cover increased current assumption costs,11 then more premiums would have to be paid to maintain the current death benefit coverage.12
In a current assumption UL policy without a lifetime secondary guarantee of premiums, there are guaranteed and non-guaranteed components to the cash value in the contract. The guaranteed policy components are the contractually specified maximum carrier charges and minimum carrier crediting rates applied to the policy cash value; these components can't be changed unilaterally by the carrier. The non-guaranteed components, such as the crediting rate and mortality or other expense charges applied to the policy cash value, can be changed by the carrier and will impact future premiums.
Illustrations for policies containing non-guaranteed components, such as current assumption UL policies, aren't predictive.13 The problem with illustrations for policies with non-guaranteed elements is that, except for the guaranteed policy elements, the methodology is often designed to portray the lowest possible premium with the most hopeful non-guaranteed results over many years, using a constant rate of investment return.14 Moreover, illustrations of policy expense factors, such as cost of insurance, use current assumptions of favorable carrier claims experience projected indefinitely into the future.
In the 1980s and early 1990s, as interest rates fell, carriers began to respond to policyholders' disappointment by encouraging them to purchase UL products. In the post-2000 era, many carriers began to emphasize a secondary guarantee on new universal life policies (SGUL). These SGUL products provided that if the policyholder paid the required premium when due, the policy wouldn't lapse, even if the carrier subsequently changed its policy crediting rate, cost of insurance (mortality) or persistency assumptions and the policy had no cash value.
These SGUL products shift the investment and other traditional policy risks from the policyholders to the carriers. While policyholders and insureds were happy with their newfound certainty over future premium payments, carriers and their state insurance regulators were in conflict over how the carriers should best establish adequate reserves to reflect these long-term premium guarantees.
Over the past decade, the National Association of Insurance Commissioners15 pressured carriers to set aside more capital on their balance sheets for SGUL products. State regulators were concerned that carriers had underpriced these products in their race to grab market share and didn't fully understand the extent of policy lapse experienced with them. The expanding secondary (life settlement) market has turned policy lapse projections upside down, as policies on unhealthy insureds with currently substandard mortality now persist (in the hands of a life settlement investor) to a greater degree than policies on insureds of average health and life expectancy. The primary risk in an SGUL policy for an ILIT trustee is that someone must monitor long-term carrier financial strength and solvency.16
Life insurance carriers are in a bind today. Their most popular product for estate-planning customers, SGUL policies, requires the highest reserves, places extra pressure on their capital and attracts special scrutiny of state insurance regulators. Moreover, the current sustained low interest rates earned by carriers on their bond portfolios means that any hoped-for spread between the minimum guaranteed crediting rate on SGUL policies and actual carrier investment yields has evaporated. In 2009, at least six major carriers discontinued or significantly modified their SGUL policies and eight major carriers increased premiums on new SGUL products.17 Despite this trend, new carriers, seeking national name brand recognition and greater market share, are jumping into the SGUL market.
Carriers unwilling to provide lifetime guarantees on new policies have pulled back from the SGUL market and some have introduced new highly competitive and flexible “hybrid” policies, featuring limited duration premium guarantees until anticipated life expectancy (perhaps age 90). If the insured is alive after age 90, the carriers project that a hybrid policy will perform much like a traditional current assumption UL policy, with sufficient cash value projected to be available at life expectancy, but the policyholder shares in the risk of future investment performance and premium adequacy beyond life expectancy. A major benefit of hybrid policies for the carriers is reduced reserve requirements when compared with SGUL policies, and there are reduced premiums for policyholders, at least through life expectancy.
Life insurance carriers continue to be concerned with the current sustained period of very low market interest rates and bond yields. A byproduct of the current low interest rate environment is that some carriers are now limiting permissible premium payment patterns, such as back-loading significant premium payments beyond life expectancy on new SGUL policies. Carriers are also restricting single pay or front-loaded premiums at a time when the minimum guaranteed crediting rate on a new policy is the same or lower than the actual returns available when investing such premiums.18
Carriers are clearly challenged: “One thing should be clear in the face of the current and uncertain future interest rate environment: Doing nothing and waiting for things to return to ‘normal’ is not a defensible strategy.”19
Estate-planning lawyers whose clients implement TOLI plans now face an additional challenge. Banks and trust companies are increasingly unwilling to accept responsibility and liability for managing TOLI. The costs of managing TOLI, by delegation to a third-party administrator, can't be recovered from the ILIT assets or the settlor-insured. Banks and trust companies serving as ILIT trustees recognize they are in a precarious position. The UPIA holds professional trustees to a higher standard of care than non-professionals.20
National banks must also demonstrate compliance with the life insurance risk management standards of the Office of the Controller of the Currency.21 Some banks and trust companies serving as ILIT trustees now outsource their TOLI risk management and compliance responsibilities to third-party administrators. One May 2003 Trusts & Estates article22 revealed that 83.5 percent of professional ILIT trustees had no guidelines or procedures for handling TOLI, and 96.3 percent had no policy statements on how to handle life insurance investments.Banks and trust companies were in the habit of serving as ILIT trustees as a “loss leader,” in the hope of capturing other assets under management that were more profitable and deferring profitability on ILIT assets until the death benefit was paid. Institutions can no longer continue this practice if they must pay an outside third-party administrator to monitor their TOLI portfolios.
Rather than try to comply with the UPIA by paying a third-party administrator to assume management responsibilities for TOLI, some professional trustees operating in certain states appear to have taken a different approach. At least 10 states23 have already enacted statutes in varying forms that specifically eliminate the trustee's duty to manage TOLI under the UPIA. Under these state statutes, the ILIT trustee is relieved of liability if the policy fails to perform as the settlor-insured had anticipated. Bar associations in some states have lent their support in enacting such legislation.
Consider, for example, the comments in a recent report to its members by the Ohio State Bar Association Section on Estate Planning, Trust and Probate (EPTP) Law, concerning pending legislation:
[The Ohio State Bar EPTP Section] has determined that Ohio's Uniform Prudent Investor Act, imposes overly onerous duties with respect to trustees' administration of life insurance policies, subjects trustees in such instances to an unwarranted greater risk of liability, and unnecessarily increases the costs of trust administration, relief from all of which would be appropriate.24
In explaining the proposed legislation to bar members, the Ohio State Bar EPTP Section found that the duties of a trustee under the UPIA, and the increased liability they bring, adversely offset the overall utility of traditional ILITs.25 It concluded that:
… the most practical solution, and the one it recommends, is to enact a ‘savings statute’ that specifically exempts trustees from certain duties with regard to life insurance policies held as trust assets, without concern as to whether such trust was an ‘ILIT.’26
Florida also recently enacted a statute that relieves an ILIT trustee of the duty and liability under the UPIA regarding the management of TOLI.27 For the Florida statute to apply to policies in the ILIT, either the ILIT (the trust agreement) must expressly make the statute applicable to policies owned by the trust, or the trustee must give qualified beneficiaries advance written notice that the statute will apply to the trust.28 Beneficiaries have 30 days to object; otherwise the statute will automatically apply at the end of the 30 days.29
An estate-planning lawyer may owe a duty of care to third parties, such as beneficiaries of an ILIT. UPIA's high standards for investment management are aimed at protecting beneficiaries by ensuring that trustees are attentive and will adopt monitoring procedures as well as modern portfolio theory. Delivery of the TOLI death benefit is a bedrock of sound estate planning, but managing the process can be challenging for the settlor's estate-planning lawyer.
- Stephanie Casteel, Letitia McDonald, Jennifer Odom and Nicole Wade, “The Modern Estate Planning Lawyer: Avoiding the Maelstrom of Malpractice Claims,” ABA Probate & Property (November/December 2008), at p. 46.
- See, e.g., Biakanja v. Irving, 49 Cal.2d 647 (1958); Lucas v. Hamm, 56 Cal.2d 583 (1961); Heyer v. Vlaig, 57 Cal.App.3d 914 (1976).
- Estate of Schneider v. Finmann, 2010 N.Y. Slip Op. 05281 (June 17, 2010).
- The court in Schneider didn't relax the privity requirements to allow beneficiaries or other third-party individuals to sue for malpractice without evidence of fraud, collusion or other special circumstances.
- See Schneider, supra note 4.
- Edward Weidenfeld, “Professional Liability Issues for Estate Planning Attorneys Working with Life Insurance Products,” BNA Tax Management Estates, Gifts and Trusts Journal (1999), at p. 258. In some states, lawyers and accountants have been permitted to expand their services by acting as agents in life insurance transactions, as part of an expanded estate-planning process in which they participate as counselors, advisors, draftsmen and trustees. See Patrick Collins and Dieter Jurakt, “The Decision to Replace Trust Owned Life Insurance,” www.schultzcollins.com/files/Replacing_Trust_Owned_Life_Ins_Policies.pdf.
- Weidenfeld, ibid., at p. 252.
- Mark Teitelbaum, “Trust-Owned Life Insurance: Issues Trustees Face; Decisions Trustees Need to Make,” Journal of Financial Service Professionals (July 2005), at p. 38.
- In re Stuart Cochran Irrevocable Trust, 901 N.E.2d 1128 (Ind. Ct. of Appeals 2009).
- Investment earnings, mortality, expenses and persistency are the primary factors that influence policy performance. Universal life (UL) policies provide a crediting interest rate. It takes time for investments in a carrier's fixed income laddered portfolios to be passed through to policyholders. For UL policies, the cost of insurance represents the mortality charge. Continued mortality improvements (such as greater longevity) have reduced insurance charges in new life insurance products. Expenses, or in the case of UL policies, loading charges, cover the carrier's expenses. Technology improvements have reduced carrier expenses to issue and administer policies and are fairly predictable. Persistency is the percentage of policies not terminated by lapse. A lapse occurs when a premium necessary to maintain the policy in full effect isn't paid or when a policyholder surrenders a policy. Actual surrenders or lapses in excess of those assumed in pricing may result in additional costs to persisting policyholders through less favorable non-guaranteed assumption charges. See Harold Skinner and Wayne Tonning, The Advisor's Guide to Life Insurance (ABA paperback 2011), at pp. 131-135, 309, 311-313, 329.
- Lawrence Rybka and R. Marshall Jones, “Guesses, Projections, Promises and Guarantees,” Journal of Financial Service Professionals (July 2005), at p. 3: “This was a risk that was seldom explained by insurance agents and rarely understood by policyholders. Many insureds and trustees perceive the quoted premiums as a promise.”
- Richard Weber, “Trust-Owned Life Insurance (TOLI) Fiduciary Liability: What Trust Drafters and Trustees Need to Know to Best Serve Trust Beneficiaries,” written speech delivered at the Kasner Estate Planning Symposium (Sept. 30, 2009) at p. 4.
- The National Association of Insurance Commissioners is a voluntary association of insurance commissioners from the 50 states and the District of Columbia, who have responsibility to regulate life insurance. See generally www.naic.org.
- Other risks with a no-lapse guarantee UL policy include little or no cash value, limited upside performance, requirement of timely payment and general lack of understanding by most advisors of how the “shadow account” maintained by the carrier operates.
- Albert Gibbons and Stephan Leimberg, “Are No Lapse Guarantee Products Disappearing? Forever?” Estate Planning (January 2010), at p. 20.
- Kate Kinkade, “A Look at Life's Changing Climate,” California Broker, (April 27, 2011) www.calbrokermag.com/editors-column/life's-changing-climate-by-kate-kinkade/.
- John Fenton, Mark Scanlon and Jaidev Iyer, “Insights: Interesting Challenges for Insurers,” Towers Watson (March 2011), www.towerswatson.com/assets/pdf/3976/TowersWatson_Low-interest-rate_-NA-2010-18363.pdf.
- Uniform Prudent Investor Act Section 2(f). A trustee who has special skills or expertise or is named trustee in reliance upon the trustee's representation that the trustee has special skills or expertise, has a duty to use those special skills.
- See Office of the Controller of the Currency (OCC) Reg. 9.5 and 9.6.a: “If a [national bank serving as ILIT trustee] subsequently determines that it lacks the expertise to evaluate the premium adequacy risk or that the asset is inappropriate for the objective of the account and the needs of the beneficiaries, the trustee has an affirmative duty to inform the beneficiaries and recommend restructuring to achieve a suitable level of risk and expected return in accordance with OCC Reg. 9.6c. Unless otherwise agreed, grantors and beneficiaries may reasonably assume, at the time the trust policy is accepted and at all times during which the trustee maintains the management control, the trustee has determined that (1) scheduled premiums are adequate to sustain the policy for the insured's lifetime, and (2) the insurance product and the underwriting carrier are suitable to successfully achieve the trust's objectives under the trustee's risk management procedures.” E. Randolph Whitelaw and Richard Weber, “Trust-Owned Life Insurance: Risk Management Guidance for Fiduciaries,” Estate Planning (September 2005), at p. 18.
- Richard L. Harris and Russ Alan Prince, “The Problem With Trusts Owning Life Insurance,” Trusts & Estates (May 2003), at p. 62.
- Alabama, Delaware, Florida, Maryland, North Dakota, Pennsylvania, South Carolina, Tennessee, West Virginia and Wyoming.
- Report of the Ohio State Bar Association Section on Estate Planning, Trust and Probate Law to its Council of Delegates (2011), at p. 55.
- Often non-institutional third parties serve as irrevocable life insurance trust (ILIT) trustees. In most instances, such trustees lack the knowledge, training and resources to fulfill their duties, which are normally not even desired by the settlor of the trust or will become overwhelmed if they serve as trustee of multiple ILITs. Institutional trustees, who have the sophistication to appreciate such duties, must charge significant fees to be adequately compensated for performing such (normally not desired) duties or for taking the risk of the settlor being uncooperative in allowing the trustee to perform them at all. The unfortunate and foreseeable result is that ILIT administration is costly, risky and impractical, thus giving informed potential trustees pause before accepting the role of trustee, and uninformed trustees a minefield of potential liability to navigate. Ibid., at p. 57.
- Florida Statutes Section 736.0902.
Melvin A. Warshaw is general counsel to Financial Architects Partners, LLC in Boston
“I Can See the Whole Room!… and There's Nobody In It!” (48 in. by 48 in.) by Roy Lichtenstein, sold at Christie's Post-War Contemporary Evening Sale in New York on Nov. 8, 2011 for $43,202,500. From the collection of Emily and Burton Tremaine, this is a new world record sum for a Lichtenstein, eclipsing the previous record of $42.6 million also set at Christie's in 2010.
Easy As Pie
“Sixteen Pies” (20 ⅝ in. by 30 ⅛ in.) by Wayne Thiebaud, sold at Christie's Post-War Contemporary Evening Sale in New York on Nov. 8, 2011 for $1,650,500. Thiebaud is well known for his paintings of production line objects found in diners and cafeterias. In fact, he worked in the food service industry as a young man in Long Beach, Calif. in a cafe called Mile High and Red Hot. “Mile high” refers to ice cream and “red hot” to hot dogs. The experience must have had an impact.