The coming storm in trust-owned life insurance

Several developments have recently combined to create what could be a perfect storm for trust-owned life insurance. Consider the following:

Income on clients' invested assets has fallen to 50-year lows. When they purchased their insurance, conservatively invested principal (think CDs and Treasuries) was generating between 4 percent and 7 percent. Now these assets are generating 1 percent to 2 percent. The reduced income, while health care and other costs have escalated, has forced spending reductions.
Clients can now take comfort in the likelihood that anticipated estate taxes may never affect them.
Simultaneously, low interest rates have affected many popular kinds of life insurance, such as universal life. Keeping many of these policies in force to expected mortality will call for substantial increases in premium to avoid lapsing. Low interest rates have also affected traditional participating policies, too, in that originally projected dividends are failing to materialize.

Given all of this (along with the emergence of the viatical settlement industry), individuals who are no longer comfortably generating enough excess income to continue premiums and who are below estate tax thresholds are seriously reevaluating their life insurance trust programs. At least our clients are.

Obviously, clients with high morbidity could be in a position to very profitably sell their policies or have adult children take them over, as they appear to have become excellent investments.

The healthy insureds can re-deploy their cash values to increase their incomes (depending on the trust structure) or help their trust beneficiaries out in other ways, such as using the cash to assist in education funding for grandchildren or simply making distributions to them. At any rate, no longer continuing their insurance means an immediate reduction in expenses and an increase in available income.

The upshot of this situation will be adverse selection against the life insurers. While healthy people will have trustees surrender and re-deploy cash values, unhealthy ones will either stay with their policies or transfer them to others, such as viators or children, who will continue them.

Elevating lapse rates from healthy individuals, while unhealthy individuals continue their policies, would taint an insurer's book of business, justifying an increase in mortality charges. These increases would be legitimate and mostly accepted by the various state insurance departments.

Indeed, potential increases in mortality charges are fully disclosed on the illustrations that accompanied the sales process, which were signed off on by the trustees who own the policy. Of course, the dividends in participating policies were never guaranteed either, and dividend decreases from original projections were also signed off on at policy delivery.

Many life insurance agents have never considered the possibility of life insurers going to the "guaranteed interest, guaranteed mortality" column on the illustrations used to sell the original policy. They can logically reason that, in general, people are living longer. But this may miss the point: those individuals left comprising an insurer's actual block of business may actually be a sicker population, forcing this dreadful possibility to come true.

So what are the best solutions a life insurance agent can bring to these trustees?

Start a policy review

It is necessary to thoroughly review the contract terms for each trust-owned policy. What are the rights of the insurer to raise the internal mortality rates and/or decrease or end dividends? For universal policies, what is the maximum mortality rate allowed under the contract, and what is the minimum crediting interest rate?

Make the assumption that the client wishes to keep the policy in force over a projected long period. Some of the older participating policies may actually mature or endow at ages 95 or 100 — what happens then? Remember that these events will subject the trust to ordinary income taxes (on the full face amount, less adjusted cost basis), and as mentioned earlier, people are living longer. So there is a risk on both sides: the policy may not last long enough at affordable premiums, or the client could outlive the policy. Either result would be devastating.

You will almost always find that most existing life insurance policies (even those not mentioned, such as variable life or indexed life) are quite vulnerable to unanticipated risks. That is they are subject to stock and bond market risk, high mortality and low interest rate, or diminishing dividend risk. And we all thought we were transferring risk to the insurance companies!

We always recommend doing an informal underwriting on the insured. There are newer insurance policies, which if the applicant can qualify, can mitigate a great deal of the existing risk. An informal underwriting is a cost-free (if often time-consuming) method of completing our preliminary analysis.

For example, we all know of policies that have guaranteed premiums and a guaranteed death benefit for a reasonably long period, such as age 105 or even age 110. Is it possible for the insured to do a 1035 exchange for a policy with these stronger guarantees? Is it possible that the premiums can actually be lowered, even with the stronger guarantees? Would the insured or trustee want to give up some of the cash surrender values now in the current policy, in exchange for a policy with these guarantees? In many circumstances, trustees will find it a worthwhile idea, if the informal underwriting suggests it is possible.

Consider a long-term care rider

Even better, what if a new and attainable policy can pay out prior to death because of a long-term care rider? What if a tax-free liquidity event is possible prior to the insured dying? The desirability is natural because if the premium is now a burden, surely the cost for home or custodial care will be much more so. If a new policy can lower the premium, or even just guarantee the premium, and if that policy could pay out its benefit prior to death, at a time when funds are most needed (that is, for long-term home or custodial care), how desirable would that be to a trustee?

So the newest iteration of guaranteed universal policies are ones with a long-term care rider that can pay out the full death benefit (under various fairly straightforward terms) and do so tax free, when and if the insured requires such care prior to death.

These are not long-term care policies. In some ways they are better and, in some ways, worse. The worse is that eligibility for the living death benefit often entails a disability description requiring that the insured is not likely to recover. On the plus side, some of these policies (not all) use an indemnity structure. That is, once the insured is deemed eligible, they get paid without the burden of submitting bills, care reviews, etc. The money can be used for any purpose.

Typically the death benefit effectively gets paid over a period of years at, say, a rate of 2 percent per month. And the amount of potential payments is currently capped to around $10,000 per month, based on federal tax formulas and constraints, all beyond the scope of this article. Should the client die prior to using up the full death benefit, the unpaid balance of the death benefit is paid, subject to some minor adjustment. And unlike most conventionally available long-term care policies, the premium, as mentioned before, is always guaranteed.

Deal with pushback

The agent will find the client's advisors making some reasonable objections and often without considering the previously mentioned possibility of the current trust insurance faltering or failing. One common objection is, "The client can afford long-term care on his own, and we want the full insurance proceeds to go to the trust beneficiaries."

We suggest advisors consider the following points. Often the insured can be illiquid. Or the expense of long-term care forces the sale of income-producing assets. Or he is forced to sell assets at a loss or incur capital gains taxes — giving up step-up in basis opportunities. Or he might be forced to over-distribute a retirement account or IRA (thereby diminishing the possibility for a preferential stretch IRA result). Getting spendable funds in these manners can be disruptive and stressful for both the insureds and the trustees. In any case, what is the difference if the trust assets, rather than the insured's own assets, are used to pay for long-term care if the net amount passed down to heirs at death is roughly the same?

The real role of the clients' other advisors, such as his estate attorney, is to help model a plan where the trust can distribute funds prior to death (while not jeopardizing the estate-tax-free nature of the trust assets), funds which will be ultimately used, possibly for the care of the insured. And this is where an attorney can be creative. The trust can be decanted (subject for another article). The trust can purchase assets from the insured (arms-length, proper valuations, of course), which it would do anyway, to some extent, upon the insured's demise. The trust can probably lend funds to the insured, though not at bargain basement interest rates. And finally, and probably most important, even if the trust was included in the estate, it would not be a problem for couples under the $10 million ceiling. Most of our clients, needing this approach, are not in this realm.

Finally, if and when you successfully assist your client through the process of a successful transaction, you will enjoy the glint in their eye. In a recent policy delivery, the client literally snatched the policy from my hands.

For more on estate planning, see:

Court: Does ex- or current wife get money?

How to use an IRA as a wealth transfer tool

Protection SLATs offer estate planning flexibility