The coming storm in trust-owned life insurance — and how you can cope

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

1. 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.
2. Clients can now take comfort in the likelihood that anticipated estate taxes may never affect them.
3. 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.