Proper Care and Feeding of Trust-Owned Life Insurance

by Richard M. Flah and Lori W. Denison

Highlighted text not part of the original Florida Bar article or LISI newsletter.

EXECUTIVE SUMMARY:

Trust-owned life insurance (TOLI) is a universally accepted and widely utilized estate planning tool. The tax-preferred, leveraged transfer of wealth is extremely attractive, provided both the trust and policy are properly crafted and administered. And there's the catch!

FACTS AND COMMENT:

THE REAL REASON TRUSTEES AGREE TO SERVE:

Most commonly, those who agree to serve as TOLI trustees do so - not because it generates an attractive revenue stream, but rather as an accommodation to a valued client.

KEY RESPONSIBILITIES TYPICALLY LIE WITH TRUSTEE:

The mechanics of sending Crummey notices and making premium payments are straight forward. The crucial questions are:

Who is:

• systematically confirming carrier and policy suitability?
• measuring the insurance policy's performance in terms of original expectations and in relation to peer-group products?
• benchmarking the policy against peer-group product alternatives and/or alternate investments?
• recommending (and documenting) appropriate changes?

In our experience, these functions are seldom being performed - by anyone! The grantor and trustee might suppose the insurance retailer is providing ongoing monitoring and service. All too often, this is not happening. In fact, it is estimated that between 70% and 95% of TOLI policies are "orphaned", meaning there is no active servicing agent. In most cases the responsibility for policy review and maintenance rests squarely with the trustee, who has a fiduciary duty to ensure that maximum benefit inures to the trust beneficiaries, in keeping with sound investment practices established under state law (e.g. Florida Statute 518.11 (Prudent Investor Rule)).

WHY A PROCESS IS NEEDED:

A documented and well-executed TOLI administration process will help:

• enhance the trustee's relationship with the grantor,
• improve the likelihood of a positive result for the trust beneficiaries, and
• minimize the probability of either a dispute or suit.

WHAT THE PROCESS SHOULD INCLUDE:

• An insurance policy management statement. This document, analogous to an investment policy statement for more traditional investment assets, may be the most important paper a trustee has on file. This statement serves as the trustee's roadmap for policy selection and management, and should document the grantor's:
• Intention for the life insurance
• View of the beneficiaries' needs
• Time horizon. Will insurance be needed for a specified period, only until life expectancy, forever?
• Risk tolerance. How much emphasis should be placed on guarantees? Is variable life a suitable trust investment? If so, what is a reasonable rate-of-return expectation, and who will manage the policy's underlying fund selection and allocation?
• Anticipated funding stream. Will premiums be continuous and predictable? Will the funding source cease to exist at some point? Will the death benefit of a grantor, spouse, or Crummey beneficiary trigger unanticipated gift taxes on future contributions?
• Understanding of what is "guaranteed" and what is based on "hoped for" policy pricing assumptions.
• Preference for restorative action should the policy "under-perform". (Would additional premiums be considered? Should the death benefit be reduced? Reduced whole life? Is a life settlement an option?

Documenting reasonable expectations at the outset should prevent disappointment down the road.

• A review of the trust document. A new trust should anticipate future changes, e.g., provide a mechanism to collapse a small trust, and give the trustee the ability to resign at any time. Wording may be included to memorialize the grantor's intentions. If the trust is already in existence, the trustee should confirm it has been administered according to its terms, that Crummey notices have been handled properly, and gift tax returns have been filed as appropriate.
• An analysis of the proposed or existing carrier. In the current environment (demutualizations, merger & acquisition activity, class action lawsuits and federal investigations), insurance carrier ratings don't necessarily tell the whole story. In fact, top tier ratings were awarded to several carriers in the 1990s, only weeks before their demise! An understanding of carrier financial trends and ratios is more valuable than a quick ratings snapshot.
• An analysis of the proposed or existing policy. At a minimum, two sets of illustrations should be reviewed; one that projects values at the carrier's current "hoped-for" pricing assumptions, and a second based on less optimistic assumptions. It's amazing how few clients realize that the insurance carrier can and often does, at its discretion without notification, modify interest crediting rates, dividends, and even policy charges. These modifications are made based on the carrier's investment performance, expenses, claims experience, and profitability targets.

Because these illustrations of hypothetical future policy values are a comingling of both A) the insurer's representations as to the cost of insurance charges (COIs) and policy expenses they expect to charge and B) some assumed level of performance for invested assets underlying policy cash values, it is also prudent for the trustee to separately A) understand and justify such COI and policy expenses as generally required under Section 7 of the Uniform Prudent Investor Act (UPIA) as adopted by each state, and B) understand and examine the reasonableness of such expected investment performance as generally required under Section 2 of UPIA as adopted by each state (and thus would be imprudent and can potentially be held liable for failing to exercise these fiduciary duties).

As such, THEInsuranceAdvisor.COM (TIA) is an essential ingredient in the TOLI management process according to the endorsement from the New York Bankers Association (NYBA). Only TIA is accepted by the AICPA as an independent source for investigating policy pricing and evaluating policy performance relative to both industry benchmarks and peer-group product alternatives. TIA research reports are also approved by FINRA (the Financial Industry Regulator Authority) for use with all types of permanent life insurance whereas FINRA considers most/many other services/systems that advertise comprehensive policy comparisons, policy reviews, policy audits, or policy analysis reports to be “misleading” (check with any current providers to determine if their policy review offerings meet FINRA standards).

Once the trustee understands what they are being charged and the reasonableness of the expected performance for invested assets underlying TOLI cash values, the trustee and grantor should discern how a change in such underlying pricing representations by the insurer and/or performance expectations can affect the policy's longevity. If the illustrations indicate that the policy is likely to expire before the insured, immediate restorative measures are in order. One option for an existing policy (rarely explored by an agent conducting a "free" review) is to investigate whether the issuing carrier will facilitate a no-commission, "internal exchange" for a more competitive, newer generation policy.The trustee and grantor should discern how a change in assumptions affects the policy's longevity. If the illustrations indicate that the policy is likely to expire before the insured, immediate restorative measures are in order. 

An update on any changes in the insureds' health status. The insured's health status may directly impact how the policy is funded. For example:

• If the insured remains in excellent health, an increase in premiums or a decrease in death benefit may be warranted if the illustration indicates that the policy will lapse somewhere around "average" life expectancy.
• If the insured has quit smoking since the policy was issued, a sizeable rate reduction may be available.
• If the insured is in much less-than-average health, funding a policy to continue to or beyond age 100 may be a waste of premium dollars.
• If the insured is in extremely poor health, paying any premiums may be ill-advised if the policy could be placed on extended term or the policy cash values could be used to pay premiums or if the insured is almost certain to die within the 30 day grace period. A trustee once called to notify us that our client had passed away, and assured us that the annual premium was paid the week before so the insurance wouldn't be in danger of lapsing. Sadly, the trust wasted $120,000; the death benefit would have been identical without the extra premium payment. The insured's current health status also dictates what other options might exist, e.g., a more competitive offering from a different carrier, or a life settlement.

The modest TOLI administration fee a trustee generally charges is insufficient to cover the cost of performing the above duties. Fortunately, some states' laws (e.g. Florida Statute 518.112) allow the trustee to delegate these "investment functions" to the following investment agents:

• Beneficiaries (primary or contingent interest)
• Spouse, ancestor or descendant of said beneficiaries
• Any person or entity nominated by the majority of beneficiaries
• Another investment agent, if the trustee exercises care in the selection, and in establishing the scope and terms of the delegation. Beneficiaries must be notified of the delegation.

While delegating investment authority shifts the burden elsewhere, many trustees are concerned that the trust beneficiaries are not in any better position to perform these functions satisfactorily. The individual who should be best equipped to accept the delegation of investment authority, in most cases, is the insurance retailer who is selling (or sold) the policy. However, since most insurance retailers do not believe it is their responsibility to provide the ongoing maintenance required of a TOLI policy, it is critically important to confirm the retailer's ongoing role before the policy is purchased.

Ask the insurance retailer to confirm that he or she will:

• Accept the delegation of investment functions
• Provide a written servicing agreement to systematically review the insurance policies (as outlined above) and recommend any changes.
• Present a sample of the review deliverable the trustee can expect to receive.

For existing policies, there is little to gain from consulting the original agent if he or she has not been proactive in delivering reviews and insights on a regular basis. The trustee should seek the assistance of an independent insurance specialist who is well regarded by other professional advisors, and whose firm is adequately staffed to skillfully execute these duties… you and the grantor may be leaning on them for the next 20+ years!

CONCLUSION:

Trust litigation is a major growth industry, and TOLI an immense target. To protect your clients, their trustees, and their beneficiaries, ensuring that an administration process is in place will add real value and deepen your client relationships. In the event of a TOLI dispute hearing, it will also insure you are all sitting on the same side of the table.

Use THEInsuranceAdvisor.COM Confidential Policy Evaluator Research Reports to monitor how TOLI holdings relate to both industry averages and peer-group products in support of the trustee’s duty to investigate suitability by justifying TOLI expenses as required under Section 7of the Uniform Prudent Investor Act (UPIA). Using TIA research can also help set reasonable expectations for the risk of and rate of return on invested assets underlying TOLI cash values, as required under Section 2 of UPIA. Click here and get up to 3 Confidential Policy Evaluator (CPE) research reports under our NO-RISK trial subscription.

Special thanks to Richard M. Flah and Lori W. Denison (both principals of Flah & Company, a 28-year-old, independent West Palm Beach Florida firm specializing in the sale, preview, review and rescue of significant life insurance assets) for providing this version of an article published by the Florida Bar Real Property, Probate, and Trust Law Section. To learn more about the "Proper Care & Feeding of TOLI" click here to contact Dick Flah and Lori Denison.   Highlighted text not part of the original Florida Bar article or LISI newsletter.

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