Trustees Should Monitor Insurance Policies to Prevent Lapses

The major responsibility of an Irrevocable Life Insurance Trust’s (ILIT) trustee, is to make certain that the trust’s assets or individually owned policy proceeds are available to achieve their primary objective, which is to reach their intended beneficiaries at death. Stated simply, to make certain that the policy’s coverage does not expire before the insured. The trustee is not a guarantor of the trust’s investment performance, but their fiduciary responsibility is to do what needs to be done to make certain that the death benefit reaches their beneficiaries. If they, as in many cases, don’t have the experience or knowledge to do what needs to be done, their legal responsibility is to obtain consultive services from a professional that does.

The life insurance industry itself estimates that approximately 40-45% of current in-force flexible premium non-guaranteed death benefit Trust-Owned Life Insurance (TOLI) and individually owned policies are expected to lapse prior to five years of the insured’s life expectancy. There are primarily three reasons responsible for this ever-increasing problem.

1. Prior to 1982, only guaranteed life insurance policies existed in the marketplace. Then in 1981 when interest rates hit a high of 18%, a new type of life insurance policy known as Universal Life Insurance was created by E.F. Hutton, a major investment brokerage firm. Unfortunately, the great majority of the life insurance buying public was not aware that these new policies were not guaranteed to last for the rest of their lives.

2. The life insurance industry did a poor job of informing the insurance buying public that these new policies were not guaranteed, and that they needed to be actively managed based on the annual fluctuations of the stated interest rates declared by the board of directors of the individual insurance company. In 1982, the stated interest rates of universal policies were in the vicinity of 18-20% and have since steadily decreased to the current 3-4%. When interest rates decreased, the owners of individually owned policies, or the trustees of trust owned policies (which in 90% of the cases was usually the insured/grantors eldest sibling acting as an amateur trustee), should have increased the premiums paid to the insurance company.

3. Contrary to popular belief, it was not the insurance companies, nor the agent/brokers’ responsibility, nor was it the duty of the insureds’ attorney or CPA to inform the owner of the policy that they should be increasing their premium in order to maintain their coverage. So, after years of neglect and inaction on the part of uninformed owners, the duration of the coverage period unexpectedly decreased and only when the coverage period was within a year of expiring would the owner receive a written notice from the insurance company notifying them that unless a significantly higher premium was paid the policy’s coverage would expire, often while the insured may have only been in their 80’s. As a result, these non-guaranteed policies would expire before the person they were insuring. It wasn’t until 1983 that insurers began offering more expensive Guaranteed Universal Life insurance policies.

Imagine that you, or your client is the trustee of an Irrevocable Life Insurance Trust (ILIT), or you are the advisor to an unskilled trustee or the CPA or attorney in charge of a Family Office and responsible for the life insurance policies. The amateur trustee is uncertain of their ILIT administration responsibilities and life insurance policy performance duties. You, or they, lack life insurance product and policy evaluation expertise. The grantor or policy owner isn’t aware of the duration of the coverage nor how the policy is performing as no evaluation services have ever been done. The sales agent does not offer annual policy service or is no longer active in the life insurance business. That said, a carrier notice is received that a $2,750,000 death benefit TOLI policy is estimated to lapse in the next 12 months. The insured is 78 and premiums paid to date exceed $500,000. Corrective action is needed. How would you manage that situation in your office?

Because proactive corrective action is needed to prevent the policy from lapsing prior to the insured’s life expectancy, the first thing that needs to be done is to consult with and engage an independent experienced life insurance professional who will order a historic projection which will provide the trustee with information as to how much additional premium would be required to maintain the insured’s policy’s coverage to a more appropriate predetermined age. Depending on the insured/grantor’s age and health, it may make a great deal of sense to order an L.E. (life expectancy) report in order to make a more accurate determination as to what age to have the coverage guaranteed to last. Decisions would then be made based on the grantors available cash flow to determine whether additional premiums can be paid, or whether the death benefit should be reduced. As a last resort, they would explore the possibility as to whether the policy could be sold as a life settlement to an institutional investor. If neither of those options are possible due to the insured’s good health (investors have no interest in purchasing a policy of an insured under age 70 and in good health), or the insured/grantors’ inability to pay a higher premium, then the policy should be surrendered back to the insurer to prevent any further erosion of any accumulated cash value that may still be available.

However, before any policy is surrendered back to the insurance company for its cash value, two things must be taken into consideration:

1. Are there any outstanding loans taken by the insured/grantor that have not been repaid?

2. Is there a gain in the policy? This is calculated by adding the accumulated dividends and cash value, and subtracting all premiums paid.

If there is a gain in the policy and the policy expires while the insured is alive, the gain is taxable. This is a very costly mistake that cannot be fixed after the policy has expired. However, if the policy is in-force at the insured’s passing, the gain is not taxable. And the loan does not have to be paid back as it is deducted from the death benefit.

To prevent this financial disaster from occurring in the first place, a preventative action plan should be in place and include a historic projection listing all of the premiums previously paid as well as the annual stated interest rates declared by the insurance company. This would then allow an accurate evaluation of a client’s individually owned as well as trust owned life insurance policy to take place every 2 to 3 years. The plan would:

1. obtain a history of previous increases in COI’s (Cost of Insurance) and the insurer’s financial ratings.

2. provide guidance to the amateur trustee regarding their fiduciary duties and liabilities.

3. clarify the policy owner’s current trust objectives, making certain the policy is still suitable for the insured and that all beneficiary designations are up to date; and

4. make certain that the CPA or attorney has prepared and delivered the annual Crummey letters to the trust’s beneficiary which ensure that the death benefit when received, is not taxable.

It’s important to note that the earlier an evaluation of a life insurance portfolio is completed, the more options are available, and the less costly it will be to find the best solution to fix any potential problems from occurring.

So why isn’t the CPA or attorney, the client’s closest advisors, focused on this insidious growing problem? Why do accountants all too often say “I don’t get involved with my client’s life insurance”? How can a firm that is otherwise dedicated to working with and protecting a client’s financial matters choose to absolve themselves from providing their guidance and advice regarding a client’s life insurance portfolio, a tax-free portfolio that can at times make up 40-50% of the client’s net estate.

Perhaps it’s because many accountants are not familiar with the internal workings of a life insurance policy’s coverage. Or because they are under the misimpression that the agent or broker that sold their client a life insurance policy, or surely the insurance company, was monitoring their client’s policy to make certain that their coverage would continue to remain in force. However, the agent is contracted with and obligated to the insurance company, not to the insured. It’s the agent’s/broker’s job to merely market and deliver the insurance policy to their customers. It’s the insurance company’s responsibility to merely provide coverage and send the owner of the policy an annual statement, not manage it. That aside, life insurers certainly don’t mind when a client’s life insurance policies expire prematurely as they get to keep all of the previous years’ paid premiums and never have to pay out a death benefit.

Whatever the case may be, it’s solely the insureds’ owner / trustee’s’ fiduciary responsibility to manage the life insurance policy. If the owner/trustee doesn’t have the expertise to determine if a ‘sufficient premium’ is being paid to keep the insurance coverage in force until at least the insured’s life expectancy, it would be an extremely useful ad-on for a client’s accountant to suggest that they obtain an independent policy performance evaluation from a fee-based planner to determine whether their current policy(ies) are adequately funded to remain in force for at least 5 years beyond the insured’s current life expectancy. I say ‘current’ because if the insured has a significant illness, it wouldn’t be necessary to continue to pay a premium to keep their policies coverage in force to their normal life expectancy.

To review, there are 3 variables to deal with:

1. death benefit;

2. premium; and

3. duration.

These are the five options available to fix a client’s potential problem or shortfall.

1. the insured can pay a higher premium in order to keep the same death benefit in force to their current life expectancy.

2. the insured can reduce the death benefit in order to maintain the same premium to keep the reduced coverage in force until the client’s mid 90’s.

3. the insured may, depending on their health, purchase a new policy with the ability to pay for long-term care costs and extend their guarantees to their current life expectancy.

4. If over age 70, the insured may be able to sell their life insurance policy as a life settlement where they may receive more than if the policy was surrendered.

5. A strategy where all or part of an existing life policy is sold in conjunction with the purchase of a new life policy with additional benefits such as long-term care coverage.

The means to fix a prematurely expiring life insurance problem are available. The owner or trustee must be made aware that the majority of universal life insurance coverage is not guaranteed to last for the rest of an insured’s life, and that steps must be taken by the trustee or owner of an individually owned policy to get help to identify problems and use the various alternatives mentioned above to prevent an unexpected financial loss from occurring.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Henry Montag, CFP, Managing Partner of The TOLI Center East, in practice since 1984 with offices in Long Island, NY, has authored articles and acted as a source for NYSBA, NYSSCPA, Bloomberg’s EG&T Journal, Trusts & Estate, Accounting Today, and The Wall Street Journal. He has appeared on Wall Street Week and Fox Business, and co-authored an ABA flagship book, The Advisors’ & Trustees’ Guide to Managing Risk.

Write for Us: Author Guidelines