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When do Third Party Administrator (TPA) reports for Trust-Owned Life Insurance (TOLI) create added liability for the ILIT trustee (and opportunity for the "TOLI Manager")?
Case Brief by Craig Loescher ©
A year or so ago I received a phone call from a friend of mine (I’ll call him Henry) who is a member of the senior management team of a well known and highly respected trust company serving clients with ultra high net worths. He had called to ask me a question about the taxation of life insurance dividends. That simple question began a chain of events that exposed the failure of two national third-party administrators (TPAs) to protect the trust company from a very significant liability. Both TPAs advertised comprehensive evaluations of trust owned life insurance (TOLI) policies, yet both failed to measure pricing, performance and suitability of ILIT holdings. As we will see, it is this failure that exposed the trust company to a significant liability.
The Facts
John and Kathy are a married couple who at the time of my introduction were each 69 years old. Fifteen years earlier the trust company, using an ILIT, purchased from a major US insurer a joint survivor whole life policy on their lives having a death benefit of $7,500,000 and an annual premium of $98,500. The premium was in excess of the amount that could be sheltered by their annual gift exclusions.
Henry called me to explore options for reducing the out of pocket trust contributions that John and Kathy were required to make in order to cover the premium. I was happy to help but I was a little curious as to why he had not called the selling agent. The answer was an all too common one; no one had seen nor heard from the agent in years. Other than an annual review by one of the two TPAs, the policy had not seen the light of day in 15 years.
Sounds All Too Familiar
During my 30 year career with three trust companies, I wore the same shoes that Henry wore and I knew as much about life insurance and its management as he did. Notice the use of the past tense in his case. He ended up with a pretty good education. Actually we both became more educated. His education was in the finer points of TOLI management and mine was in the inadequacy of some of the service providers that profess to manage TOLI and/or keep you out of trouble.
Why the Lack of Attention?
There are a number of reasons why trust officers and others responsible for TOLI give insurance less attention than it needs. A few are:
· The mistaken view that life insurance is a long term investment not needing management
· Time is diverted to other seemingly more urgent (meaning profitable?) matters
· Limited realization of the risks inherent in life insurance
· Lack of life insurance product knowledge
· Previous lack of independent research as to the pricing, performance and suitability of a given life insurance product as measured against its peer group.
· A lack of familiarity with the application of the Uniform Prudent Investor Act (UPIA) to life insurance management.
Unfortunately none of these reasons will relieve the negligent trustee of the liability that will come his or her way on the day of reckoning.
Just How Comprehensive is Your “Comprehensive” Policy Review
One of the most comforting provisions of the UPIA is the ability to delegate some of the management and policy analysis functions to third parties. While that authority is quite broad and relieves the TOLI manager of a great deal of liability, it is not a full pardon in advance. But even setting aside the issue of liability, any responsible person wants to provide the best representation for his client. It is essential that life insurance policy holdings be adequately reviewed in a manner that satisfies not only liability issues, but also client concern and service.
During the period of time that the trust company was responsible for the management of John and Kathy’s policy, it had used two different third-party administrators (TPAs). Both are still quite active today and both have what some might consider to be impressive web sites and descriptions of their services.
I learned of the past policy reviews provided to the trust company only after the fact. I found it interesting that these policy evaluations were regularly prepared by the TPAs and routinely relied upon by the trust company, yet the trust company continued to have an extraordinary liability exposure. To see just how extraordinary, continue reading.
In their marketing material, the first TPA advertised that it would provide data on policy and portfolio performance as well as financial and third‑party rating information regarding the insurance carrier. All of this, they say, is designed to provide essential information to satisfy regulators and provide information to facilitate communication with the client and other advisors.
The actual report included the insurer’s financial strength and claims-paying ability ratings from the five rating services and the most basic information about the policy such as the death benefit, cash value, premium, owner, issue date and the like. Attached to the report is an inforce ledger page showing if and when the policy was projected to lapse without value and without paying a claim. The second TPA’s review was more thorough but still provided basically the same kind of information.
Importantly, both specifically excluded product suitability from their review. Also, the only “portfolio performance” information was limited to current projected policy performance as it compared to originally projected policy performance. Neither included any performance data relative to either peer-group or industry benchmark averages (e.g., www.PolicyPricingCalculator.com).
In the end, the report stated that the product was “competitive” (which should translate to little or no liability exposure), but recommended that the trust company give the policy added, but unspecified attention. (I asked Henry what added attention he gave the policy. He stated that he filed the report and did nothing. Well, I guess we can’t blame the evaluation firms for everything.)
These two reports piqued my curiosity so I did a little web surfing on the subject. I found a few other services that provided the same types of data, but they all specifically excluded by disclaimer what TOLI managers need most – independent research as to the pricing, performance and suitability of a given TOLI holding as it relates to its peer group and trust objectives.
While the TPAs did a good job of supplying information on the current policy, they fail to provide the trustee with support for their duty to investigate the suitability of their TOLI holdings. I would submit that this is where the greatest exposure lies. In addition, those that I have reviewed specifically exclude any evaluation of either policy expenses (as required under Section 7 of the Act) and/or the expected performance of the invested assets underlying the policy cash value (as required under Section 2 of the Act). A review of each of these is required by any TOLI manager wishing to comply with UPIA and serve the client’s best interests.
Potential Liability in Spite of the Policy Reviews
The inforce ledger attached to the review of John and Kathy’s policy showed that if they reached their 90’s, the death benefit would drop from $7,500,000 to a little over $3,500,000. No further years were shown and thus I had to wonder if the policy would then lapse without value and without paying a claim if John and/or Kathy were to live that long.
It was obvious that the policy needed attention, but the available solutions were limited by the fact that John had become uninsurable and Kathy would be charged an extra-risk charge also due to changes in health. A direct exchange of the current policy to a more suitable holding was thus out of the question. If we could not find a solution, the trustee’s liability would be sealed.
Two facts came together to provide a workable option. The sole purpose of the original policy was to provide a specific amount of money to their children and it didn’t matter whether they received the funds at the survivor’s death or the death of the first parent to die. Fortunately, they also had sufficient wealth that they would never need to access the policy’s cash value.
That allowed us to utilize the cash value in the existing policy to purchase a fully-guaranteed no-lapse policy on Kathy’s life with a major carrier that offered Kathy standard-health rates even given her adverse changes in health. We were thus able to identify a policy with lower costs and thus lower premiums while actually strengthening guarantees (subject to the claims paying ability of the issuing insurance company).
The Choice and the Measure of Liability
Having identified these cost savings, John and Kathy had two choices. They could use these cost savings to purchase additional insurance and increase death benefits to $10,000,000 for the same $98,500 premium they were paying. Or, they could keep these savings “in their pocket” maintaining the original $7,500,000 death benefit but reducing the annual premium to only $55,000 – a savings of $43,500 annually. Holding true to their original goal, they chose the latter and transferred cash values from the original policy to a new holding with the same death benefit but with better rates and terms. An added bonus was that the new premium was also now within their annual gift tax exclusions.
Had we not been able to exchange the existing policy to a more suitable one, it can be creditably argued that the trustee’s liability would have been at least the $2,500,000 death benefit differential between the $7,500,000 they were getting for the $98,500 premium they were paying and the $10,000,000 death benefit they could have had for that same premium. If the clients, though, had lived to see the original death benefit drop by another $3,500,000, the liability may have been closer to $6,500,000.
The Lesson Learned
There are probably a lot of lessons to learn here but two huge ones are: (1) a TOLI manager’s liability may be exponential when compared to the fees that are charged and (2) the ILIT trustee cannot blindly rely on a third-party administrator’s analysis. Any analysis that does not comport with all of the provisions of a state’s version of the UPIA and that does not include independent research as to the pricing, performance and suitability of the various TOLI holdings is a shield full of holes. It is imperative to have regular third party analyses, but carefully scrutinize the vendor. They are not all alike.
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