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A group of experienced trust officers at a mid-sized trust company has assembled in a conference room. Each member of the group has responsibility for an extensive portfolio of trusts, many of which are irrevocable life insurance trusts (ILITs). The group also has responsibility for training colleagues in their department on ILITs, broadly speaking.
They and their colleagues are about to schedule meetings with clients for annual reviews. The meetings are a great opportunity to hear what’s new with the clients and their families, confirm or revise objectives, talk about the year ahead and so forth. The conversations also help them get out in front of any problems that might be ready to surface with the policies held in clients’ ILITs, the arrangement for paying premiums or both.
The purpose of today’s meeting is three-fold. First, they want to take a fresh look at their standard template for presenting reviews to their ILIT clients. Second, they want to be sure the template addresses some newly expressed free-floating concerns among upper management about life insurance, apparently based on what they’ve been seeing in the press and hearing at conferences. Third, and somewhat incidental to the first two purposes, the template is a great tool for training colleagues who will one day be responsible for ILITs. So the group would like to reassess the template’s value as an educational tool.
Changing Circumstances
Some time ago, the group worked with a consultant to create a standard template for these presentations. The group looks back almost whimsically at how basic their template was when first introduced. Back then, they thought that it was relatively easy to cover three things, namely, what the ILIT owns, how it’s doing and then, depending on what they learned, what they should communicate to the client. Then, things began to change:
More and more of the policies acquired by purchase or transfer were more complex than preceding generations of policies. They had more working parts and took much more time to understand, even at a high level.
Some of the policies in their “book” began to experience difficulty, generally attributable to a decline in interest rates. The agents described this phenomenon as “underperforming.”
Some clients or their advisors began to express concern about the financing arrangements. The concern apparently stemmed from a growing unease that because the policies were underperforming, the arrangements were also underperforming and, best case, would have to remain in place longer than planned or anticipated, assuming of course that the parties advancing the premiums wouldn’t demand payment at their earliest opportunity to do so. That’s about when the group began to hear the term “exit strategy” or, more accurately, “lack of exit strategy.” Apparently, the economic and tax implications of these arrangements didn’t get better with age.
An increasing number of clients began to express doubts about their need for the insurance, their willingness to keep supporting it with those cash gifts or both. Those doubts stemmed from increased estate tax exemptions, decreased cash flow from investments, issues with family or all of the above.
A lot of the agents who sold and serviced the policies had retired or left the business without having a successor in place. In some cases, the successor had also moved on. This development made it considerably more difficult to get current information on policies and the financing arrangements that support them. In other cases, the group had to engage new agents or consultants to re-create a structure for policy information and service. However, for purposes of this article and regardless of the actual situation, we’ll refer to the individual that the group is working with on a policy as the “agent.”
It’s become more difficult and time consuming for agents to get illustrations and other information from carriers.
After a lull of several years in replacement activity, there had been a noticeable uptick in proposals from agents to exchange underperforming policies for new products that are somehow “better” than the current policies. Most of these proposals show no noticeable benefit for the client and, in fact, could be serious mistakes.
A veritable chorus of consultants and vendors were telling the group that, with the layers of fiduciary obligation they had to clients and beneficiaries, the trust company couldn’t possibly carry on without them.
Two Fact Patterns
The group decides that they’ll have an easier time of it if they segment their work into two broad fact patterns: unfunded ILITs and funded ILITs. They’ll then break each category into two segments, those supported by cash gifts from the client and those supported by a financing arrangement such as split-dollar or third-party premium financing. While that seems workable, they check quickly to make sure they’re using an erasable marker on the whiteboard.
They begin to fill in the template. For now, they’ll develop one, single purpose template. Once completed, they can create discrete templates for each fact pattern. So, for example, they’ll have a separate template for an unfunded ILIT supported by cash gifts and one for an unfunded ILIT supported by a financing arrangement.
Template Segments
Opening statement. The first segment of the template calls for an opening statement about the policy. This used to be easy, sort of. No longer. Now, they’ll insert a bullet point description of the features, functionality, benefits, risks and general application of the product as well as an attached diagram that completes the picture. They have a set of bullet points and a diagram for every type of product. They’ll also note the carrier and its ratings from the major services. They’ll supplement their description with information from the carrier’s most recent statement. If the policy offers investment flexibility, they’ll note how the cash value is invested. Finally, they’ll note the name and company affiliation of the agent who’s servicing the policy.
State of the policy. The next box contains a succinct statement as to how the policy’s doing. Of course, this raises the question, “Compared to what?” The short, but not necessarily satisfactory, answer is, “Compared to what they thought they were expecting when they bought the policy.” So as part of their preparation for the review, they ask the agent for an in-force policy illustration as well as any observations or recommendations that the agent has with respect to the policy. They’ll already (hopefully) have the original “as-sold” illustration in the file. Basically, the as-sold shows how the policy was designed, how much premium would be paid for how many years, the key assumptions such as credited interest rate, return on the funds in the separate account or dividend interest rate and the targeted outcome, meaning for example, to support the original death benefit to the client’s
age 100 at the then-current assumptions about credited interest and costs of insurance. The in-force shows how things have played out, where the policy stands today and where it’s projected to be headed absent any changes. So for example, they might note that at the current premium, the policy is now projected to lapse when the client reaches age 87. They’ve asked their graphics department how to put sentences like that one in flashing yellow. There’s a third illustration that shows the (higher) premium projected to be sufficient to get the policy back on track to the targeted result. A higher premium is by no means the only outcome of the meeting, as we’ll discuss in a moment.
Support for the policy. This box calls for either a statement about the cash flow and tax implications of the client’s cash gifts or a succinct description of the structural, economic and tax implications of the financing arrangement, for example, loan regime split dollar. Realizing that the term “succinct description of the financing arrangement” may be a world-class oxymoron, they’ll still do their best. The succinct description will be supplemented by a diagram, hopefully with an embedded GPS.
Financing arrangement. This is the proverbial second shoe. Again, it’s already been described. The question now is how the plan is faring against the original assumptions and anticipated outcome. If the group is fortunate enough to have them, they’ll show the clients both an as-sold illustration that incorporates the arrangement and the in-force. If the policy was sold in a loan regime split-dollar plan, then the as-sold would depict the arrangement and its critical assumptions as of Year 1. The in-force would pick things up in the current year. If either or both of these illustrations aren’t available, then someone has to customize a spreadsheet or just explain it all with words.
Needless to say, this step has become more difficult as more of the agents who sold the case and could communicate with the carrier are no longer on the scene. Regardless, the point is to show the client how far along the plan is to fruition, often referred to as the “rollout,” and the ongoing economic and tax implications for the client until that can happen. Though launched with great fanfare and, in larger cases, with bottles of champagne smashed against the final illustrations, many of these arrangements have fallen on hard times in the past few years. Again, that’s largely attributable to policy underperformance vis-a-vis the initial assumptions, which may seem questionable in retrospect. The question now is how much longer the client will have to deal with the plan’s economic and tax implications.
Client Feedback
Everything is on the table now except for how the client feels about it. Therefore, the group will proceed on a client, policy, ILIT and financing arrangement-adjusted set of questions to get that feedback. As one can imagine, that feedback could call for anything from a tweak to a tow truck. Just by way of example:
“I’m comfortable with the current situation and content to stay the course, even if the course has been shortened by a couple of holes.” The meeting will move on to other things. They’ll revisit the life insurance next year or earlier if something comes up.
“I’m concerned that the policy won’t stay in force to the originally stated (or maybe even once shortened) age. I still want the insurance, so let’s (perhaps again) increase the premium to sustain the policy to age ‘whatever.’” This is a tweak, unless that increase is so large that it makes sense to see if the policy is a candidate for replacement, as noted below.
“You know, I don’t want to give up the coverage, but I really don’t need this much insurance anymore.” What this kind of feedback usually indicates is that it’s not the principle of the thing, it’s the money. Again, this could just call for a tweak, maybe a reduction in the death benefit with a corresponding reduction in the premium projected to carry the policy to the targeted age. Maybe a change in the death benefit option or the dividend option will do the trick. This should be a minor fix.
“You know, I see that the premium will carry the policy to an age that my doctors and I now know is far in excess of my life expectancy. I don’t want to lose any of the coverage, but can we cut back the premium to carry it to a more realistic age?” That’s a tweak.
“I don’t need it. I don’t want it. I won’t pay for it anymore. If you (meaning the trustee) want to pay for it from investment income or the kids are willing to pick up the tab, fine. But I’m out!” This is the approach shot for a life settlement but, as discussed below, the fact pattern may offer or demand a better alternative.
“So the policy and the financing arrangement are competing to see which is in worse shape. Am I missing something? I obviously must’ve missed something when this thing was pitched to me in the first place. Maybe this was what they meant by ‘intentionally defective.’ OK, what are you going to do about it?” The cast of characters for how this situation will play out can include agents, estate-planning attorneys, tax advisors, consultants, lenders, litigation attorneys and expert witnesses. Aside from some comments on the role of life settlements in these situations, I’ll leave discussion of what to do about these arrangements for another time.1
The Way Forward
If the situation is fine, then they’ll mark their file ahead. If the situation calls for a tweak, then they’ll tinker with the premium or the policy accordingly. But the situation may call for more than a tweak. Let’s consider three conceivable steps:
Life settlements. Much has been written about life settlements.2 I’ll focus on how trustees deal with the topic, something I discussed with trustees as background for this article. Consider that when an individual sells their own policy, it’s case closed, The individual has only themself to congratulate or blame, as the case may be, unless of course they open a case against an agent or advisor whom they feel misled them or didn’t get them the best price. But when the seller is a trustee, it’s a different story, which may involve a whole different kind of case if they’re not careful.
Just as the group is about to create the bullet points for the life settlement, the head of their department, whom we’ll refer to as “Charlie,” peeks into the conference room and asks if he can sit in for a while. The group says, “sure.” Charlie sees the term “life settlement” on the whiteboard and asks, “What’s a life settlement? Is that part of a mid-life crisis?” They give Charlie a high level overview of life settlements, including what they are, when they can be helpful, how they’re done, how they’re stress-tested with a “breakeven” analysis under various assumptions and how they’re taxed.
Charlie says, “I get it. I can understand why a life settlement can be a powerful tool. But there are some things that bother me, not about the transaction but about our role and our potential exposure. It’s easy for me to imagine a situation in which we do a life settlement and the client dies of a heart attack two weeks later. The kids, who are out big bucks, come in here with their lawyers and ask why we sold the policy. They might wonder, for example, why we didn’t use income from a funded trust to support the policy or why we didn’t ask them to contribute in some way. I don’t know. On the flip side, it’s just as easy to imagine a situation in which we make an affirmative decision not to sell a policy, it lapses because someone was asleep at the switch or the premiums went through the roof and nobody was willing to pick up the tab or whatever. The beneficiaries come in with their lawyers and ask us why we didn’t sell when we had the chance. I need you guys to work with our lawyers to figure out what should be in our file to support our decision in either case. Maybe give them the same overview of the transaction that you gave to me. Here are some of the things I’d like you to cover with them, but feel free to add to the list:
That breakeven analysis you talked about. I can imagine that somebody would challenge our input and assumptions, meaning the life expectancy reports, projected policy performance, projected investment returns and whatever else goes into it. What do we need in the file to be able to defend our analysis against those who would second guess it?
When we did do a life settlement, how do we show that we checked out all possible sources of cash to keep the policy going before concluding that we had no other options but to sell it?
How can we show beyond a reasonable doubt that we got the best price for the policy available at the time, that we negotiated commissions, etc.?”
Life settlement as an exit strategy from a troubled financing arrangement. The group has more than a few policies that are subject to split-dollar or third-party premium financing arrangements. Many of those arrangements are now living lives of not-so-quiet desperation. I’ve written about those arrangements on several occasions.3 In the usual absence of an exit strategy other than the client/insured’s death, a life settlement might be worth considering if the net proceeds of the sale could repay the premium advances or loans as the case may be. The focus here is on the word “net.”
If the ILIT is a grantor trust for income tax purposes, then the net is the full sales price less the expenses of sale. The tax bill goes to the trust’s grantor, the client, who’s the same individual who’s balking at paying any more out of pocket in the first place. Of course, someone will tell the client that paying the tax on the sale is great estate tax planning because that payment isn’t a gift under current law. As to which the client will reply, “Gimme a break!” But if the trust isn’t a grantor trust, the net is further reduced by the tax on the sale. Will the net, net proceeds still be enough to repay all principal, interest and other fees due on termination of the arrangement? The operative guidance on this point is to trust, but verify.
Certainly, the life settlement could result in a huge sigh of relief from certain parties to the transaction who don’t care about the insurance but do care about the ongoing cost to them of maintaining the arrangement. For example, an employer who advanced premiums on a now vintage split-dollar plan on a now vintage retired employee would probably be among those sighing with relief. A surviving spouse under a survivorship split-dollar plan whose annual economic benefit went bump in the same night that the first spouse died would also be among them. But the beneficiaries who were anticipating the large death benefit from the now departed policy? They’ll sigh too, but not with relief.
A word of caution.The tax implications of the life settlement itself may not be the only tax implications to consider. There may also be tax implications associated with unwinding the financing arrangement, especially if the arrangement is of a certain type and vintage. That’s why the tax advisors should be at the table when this kind of transaction is being considered in this kind of setting.
Policy exchange. As far as the group is concerned, there are two categories of policy exchange proposals: solicited and unsolicited.
Solicited exchanges typically come about in the course and context of an annual review. If a tweak won’t cut it, the trustee might be well served by asking the agent to look for a better mousetrap. A solicited exchange proposal can also be submitted on an ad hoc basis if the agent happens to find something newly worthy of the trustee’s consideration and brings it to the trustee before involving the client.
Unsolicited exchanges don’t come from a review. They come from out of the blue. If there’s any standard theme to these proposals, it’s an exchange from a participating whole life policy to some form of guaranteed universal life policy. There’s always some rationale for the proposal. Sometimes it’s about the carrier. Sometimes it’s about a reduction in premium outlay or a more predictable duration of remaining premium payments.
It’s funny, they note, how replacement proposals regularly come from the same agents who, not long ago, sold the policies that should now be replaced or from agents who were asked to provide an objective review of the policy. What’s not so funny is that the replacement proposals almost always include a “heads up” that the client has seen the illustrations and would like the trustee to make the exchange as soon as possible. Never mind that the illustrations often reflected an underwriting class that was assumed but not offered.
The group resents these agents, because instead of engaging with them first for a productive dialogue about the proposal, they put the trustee under pressure to deal with something that may or may not be in the client’s best interest and, of course, the beneficiaries’. That’s not to say that some of the proposals don’t make sense and won’t save dollars. But the devil’s in the details, and most of these proposals are devilishly short on detail, meaning risks or downsides.
The group has a protocol for each type of exchange. If it’s solicited, they ask the agent to do a feasibility test that includes informal underwriting and some illustrations based on the indicated classification. They look carefully at the tax implications of the potential exchange itself as well as the legal, tax and economic implications of an exchange on the applicable financing arrangement, consulting with advisors and others as appropriate. If things look promising, meaning that the replacement checks out and will ameliorate the situation, they ask the agent to proceed along well-established due care guidelines.
If it’s unsolicited, they ask the agent to complete a questionnaire that lays out in no uncertain terms how and why the features, benefits and risks of the new product and the financial strength and policyholder support history of the new carrier qualitatively and quantitatively tip the scales in favor of the replacement. The proposals are usually promptly withdrawn. But sometimes they’re not withdrawn, and things get testy. If they do, so be it. The group is pretty sure that their lawyers will tell them that “things might get testy” isn’t a defense against a claim of breach of fiduciary duty to the beneficiaries.
Endnotes
1. In the meantime, see Charles L. Ratner, “Deconstructing a Leveraged Life Insurance Plan That’s on Borrowed Time,” www.wealthmanagement.com/insurance/deconstructing-leveraged-life-insurance-plan-s-borrowed-time.
2. For example, see Jon B. Mendelsohn and Todd I. Steinberg, “The Role of Life Settlements in Estate Planning,” Trusts & Estates (April 2022).
3. See, e.g., www.wealthmanagement.com/insurance/leveraged-life-insurance-plans-and-muted-call-arms.