Life Insurance Traps For The Unwary

Chicago Estate Planning CouncilDecember 17, 2013

Larry Herman, JD, CPA, CLU, ChFCHerman Agency, Inc.

(c) 2013 - Laurence E. Herman and Herman Agency, Inc. - All Rights Reserved

PolicyValuation

Traps

Policy Transfer to ILIT

Jane owns a $5,000,000 10-year level term policy on her life. Policy Date is 1/1/10, and annual premium is $5,000. To get the death benefit out of her taxable estate, Jane’s advisor recommends transferring the policy into an ILIT on 7/1/13. Jane submits an ownership and beneficiary change form to the insurance company, treating the transfer as a gift. The insurance company processes the change and issues Jane a Form 712 reporting the gift tax valuation of the policy.

Issues?

• The Obvious: Sections 2035 and 2042 (3-year rule) triggered if a gift.• Not a big deal until it is!• Liability if could have avoided estate inclusion?

• The Not So Obvious: Policy valuation

Policy Valuation – Gift and Estate Tax Purposes

• “Fair Market Value” = “price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of the facts.” (Treas. Regs. 25.2512-1 and 20.2031-1)

• Life Insurance policy (not paid-up) = Interpolated Terminal Reserve + unearned premium (Treas. Regs. 25.2512-6 and 20.2031-8)

Form 712

Interpolated Terminal Reserve (“ITR”)

• Insurance Company reserve to meet contractual obligations

• Original IRS ITR regulatory guidance from days of Whole Life and Annually Renewable Term (“ART”)

• ART has no reserve value (matures each year)• Whole Life ITR tracks cash value• What about today’s level term and guaranteed death

benefit Universal Life Policies?

Reserve Methods Vary By Carrier and Product

• Tax Reserve• Statutory reserve• AG 38 Reserve• Deficiency Reserve

What Will The Form 712 Show?Summary of Values at the End of Year 5

Carrier Policy Type

Face Amount

Cumulative Premium

Cash Surrender

Value

Value Reported by Carrier

AGUL $10,000,000 $1,965,000 $475,861 $475,861

UL $10,000,000 $1,965,000 $749,100 $749,100

BGUL $10,000,000 $1,825,000 $340,827 $1,024,778

UL $10,000,000 $1,825,000 $780,106 $948,106

CGUL $10,000,000 $1,733,900 $0 $1,883,607

UL $10,000,000 $1,733,900 $570,023 $855,241

Used with permission of AALU

What About Level Term Insurance?

• At least two major carriers use “unearned premium”• Most carriers report reserve values that are

exponentially higher than “unearned premium”

Isn’t This Crazy?

• Inadequate guidance = inconsistent interpretations• Recognized problem but no clarity yet• ABA Task Force on Policy Valuation• “Unringing the bell” - Taking a position contrary to

the Form 712?• Suggested starting point: Informal request to carrier

for Form 712 valuation – Don’t trigger issuance of Form 712

Sale vs. Gift – A Better Approach?

• Sale valuation – “FMV” – ITR language of Treas. Reg. §25.2512-6 and Form 712 doesn’t apply because not a gift

• Common notion of “willing buyer/willing seller”• What would you pay for a term policy? A cash value policy?• When might you pay $200,000 for a policy with $100,000 of

surrender value?• Pricing anomaly?• “Springing Cash Value”?• Adverse change in health (shortened mortality)?

Secondary (“Life Settlement”) Market for Life Insurance

• True “willing buyer/willing seller” environment?• When might policy be worth more than cash

value in the secondary market?• Older ages• Material deterioration in health from time of policy

issue• Life expectancy less than about 12 years• Relatively low policy cash value

Professional Valuation?

• Should you get a professional valuation of a policy?• Reportable gift (contradicting Form 712) vs. a sale• If a sale: prudence vs. exposure• Firms that specialize or have expertise in policy valuation

(e.g., using mortality tables, discounted cash flow, etc.)• Ashar Group, LLC development of secondary market

valuation services with extensive database of comparables and bidders (“willing buyer/willing seller”)

What If IRS Successfully Challenges Sale Valuation?

• Part sale/part gift?• Section 2035 – 3-Year Rule Applies• Gift and GST tax or exemption• Any worse off than if initially reported as a

gift?

Policy Sale Mechanics

• Grantor trust to avoid gain recognition• Avoids transfer for value issue under Sec. 101(a)(2)(A) –

transfer to insured (Rev. Rul. 2007-13; PLR 201332001 and PLR 201235006)

• ILIT is grantor trust if allows for premiums to be paid from trust income [Sec. 677(a)(3)]

• Belt and suspenders – include other grantor trust powers• If primary asset of trust is life insurance, then no material

ongoing income tax consequences to grantor• Simple sale agreement, plus insurance carrier

owner/beneficiary change forms

What About Jane?• Assuming no adverse change in health, consider selling policy

to grantor trust for $2,500 (unearned premium).• What if policy was a larger permanent policy with substantial

value? Gift money to trust, then sell? Promissory Note? Step transaction – actually a gift of policy? Transfer for value upon termination of grantor trust status of note outstanding? (see “Sidestepping 2035”, Lawrence Richman, Trusts & Estates, April, 2007).

• Trust to trust policy sales• Fiduciary acceptance of approach?

More Confusion:Other Policy Valuation Situations

(Rev. Proc. 2005-25 “PERC” Safe Harbor for Income Tax Valuation)

• “PERC” = Premiums plus Earnings less Reasonable Charges

• Employer to employer (or employee’s ILIT) – sale or compensation (Section 83)

• Transfer from qualified plan (Section 402)• Cost of permanent benefits provided under a group

life plan (Section 79)

Traps (and Opportunities)

With Permanent Insurance

Appropriate Product Type?

Joe (age 60) and Jane’s (age 55) ILIT owns a $15,000,000 “No-Lapse” Guaranteed Death Benefit Survivorship Universal Life policy with a $114,558 annual premium. They are told as long as that premium is paid every year, coverage is guaranteed until age 121 even though it is projected to run out of cash value by their age 85. They and their advisors believe the policy is particularly appropriate for their estate planning purpose.

The Different Flavors of Permanent Insurance

• “No-Lapse” or “Guaranteed Death Benefit” Universal Life• Current Assumption Universal Life• Equity Indexed Universal Life• Variable Universal Life• Whole Life

Which Type is Best?

• Ask 2 different insurance professionals, get at least 3 different answers

• No one type is better – depends on circumstances• Consider a portfolio of different types/carriers –

diversification of interest rate and carrier risk

Relevant Considerations

• Purpose (e.g., estate liquidity in ILIT vs. retirement income)

• Downside protection - guarantees• Upside opportunity with rising interest rates or

equity markets

Why is the “No-Lapse” Policy Appropriate (and Popular) in

Estate Planning?• Premium is often lower than many other insurance

types – ideal for limited gift tax exemption• Guarantees = predictability and manageability with

gift tax exemptions (policy dividend and interest rates not a factor)

• Overriding purpose is estate liquidity – cash value not accessible or important

• Simple as it seems? No worries?

How Does The Guarantee Work? –“Only The Shadow Knows”

• “Shadow account” completely different from actual cash value account

• Shadow account mechanics in the policy contract• Shadow accounts “gamed” by insurance carriers to

satisfy “redundant” regulatory reserve requirements• Completely obtuse and counterintuitive (e.g., paying

early can be a problem)• Extreme sensitivity to deviations from scheduled

payment patterns

Universal Life – No Lapse GuaranteeMissed Premium Sensitivity Analysis,

$1,000,000 Death BenefitMale, Age 55, Standard Risk

Pay the lifetime level pay premium, Solve for guarantee age if one premium is missed

Company Ann’l Premium to Guar. To

Age 121

Miss Yr 3Guar Age

Miss Yr 6Guar Age

Miss Yr 11Guar Age

A $16,228 58 66 101

B $15,211 57 61 71

C $15,282 107 109 112

The Audit• 24 policies sold over last 5 years• About 35% “off track”• Drill down:

• Premium skipped or varied (intentionally?)• 1035 loan not booked by insurance company• Early payment of premiums• “Can’t Explain”

• After “clean-up” only a few policies off track because deliberately not paying premiums as originally scheduled.

• So is the “No-Lapse” policy still appropriate? Opportunity knocks!

The Little Known Flexible Side of“No-Lapse” Policies: “Off-Ramps”

• What if today’s no-lapse policy is not attractive in future (e.g., interest rates increase)?

• What if future cash flow or gifting problems preclude planned funding?

• Traditional thinking → Little or no cash value = S.O.L.

“Off Ramp” Menu

• Cash value (Non-guaranteed & guaranteed)

• Contractual ROP• Reduced Paid-Up• Stop premiums with future “catch-up”• Shhh! Let’s keep this to ourselves.

Premium vs. Liquidity($15,000,000 SUL Policy)

Carrier Comdex ALIRT Full Pay Premium

CV Year 20 CV Year 30IRR

Year 30IRR

Year 40

Company A 89 71 114,558998,960

Non-Guaranteed

662,351 Non-

Guaranteed8.35% 5.13%

Company B 93 53 118,742 0 0 8.17% 4.98%

Company C 89 56 119,479 0 0 8.13% 4.96%

Company D 83 68 122,221719,819

Guaranteed3,151,713

Guaranteed8.02% 4.87%

Company E 91 43 121,289 0 0 8.06% 4.90%

“Reduced Paid-Up”($15,000,000 Initial Death Benefit)

CarrierFull Pay Premium

Reduced Paid-Up Death Benefit

Year 21CV Year 30 IRR Year 30 IRR Year 40

Company A 114,558 8,000,000294,922 Non-Guaranteed

6.15% 4.19%

Company B 118,742 10,500,000 0 7.12% 4.87%

Company C 119,479 3,000,000 0 1.11% 0.75%

Company D 122,221 11,000,000¹2,311,256

Guaranteed7.15% 4.88%

Company E 121,289 Not Available

Case Study - Policy Surrender vs. “Reduced Paid-Up” in 5th Policy Year

Policy Annual Premium

Original FaceCurrent

Surrender Value

Reduced Paid Up

A 38,736 5,000,000 372,598 2,689,464

B 20,184 5,000,000 470,551 3,441,148

C 34,016 5,000,000 367,828 2,898,075

D 27,796 5,000,000 372,553 2,986,203

E 21,924 5,000,000 192,420 2,432,237

TOTALS 142,656 25,000,000 1,775,950 14,447,127

IRR – CSV TO Death Benefit at age 91 = 7.25% (tax-free) (Average current age = 61)

Case Study - Policy Surrender vs. “Reduced Paid-Up” in 5th Policy

YearPolicy Annual

PremiumOriginal Face

Current Surrender

ValueReduced Paid

Up

A 81,882 5,000,000 0 1,254,217

B 60,048 5,000,000 0 1,213,941

C 67,780 5,000,000 0 1,233,968

D 60,048 5,000,000 0 1,213,941

E 42,800 5,000,000 0 1,153,241

TOTALS 312,558 25,000,000 0 6,069,308

Stop Paying + Future “Catch-Up”($15,000,000 SUL Policy)

CarrierFull Pay Premium

20-PayLapse Year/Annual Catch Up for

Lifetime Guarantee

CV Year 30

IRR Year 30

IRR Year 40

Company A 114,558 33 368,345 0 8.96% 5.37%

Company B 118,742 37 752,030 0 8.79% 5.43%

Company C 119,479 24 161,313 0 8.34% 5.00%

Company D 122,221 37 975,000²2,426,819

Guaranteed8.54% 5.01%

Company E 121,289 37 1,572,179 0 8.69% 4.58%

“Quick Pay” vs. “Life Pay”

• Psychological reasons• Administrative risk• Economics of IRR on DB – If die before age 121,

arguably overpaid• Option to “pay-up” guarantee later

Annual Pay With Single Premium To “Pay-Up” Guarantee In Year 21

($15,000,000 SUL Policy)

Carrier Full Pay Premium1-Pay

Premium in year 21 For Paid-Up Lifetime DB

Company A 114,558 1,813,561

Company B 118,742 2,185,373

Company C 119,479 1,719,821

Company D 122,221 1,550,000

Company E 121,289 1,450,000

Put It Altogether

• Is “cheaper” better?• What really is “cheaper”?• Which would you choose?

Managing Opportunity and Risk

• CEO: “We take the interest rate risk, but the policyholder takes the administrative risk”

• What happens if/when the insurance company changes strategic direction? Exits the business? (e.g., Sun Life of Canada, Lincoln Benefit Life)• Administrative support?• Policyholder focused?• Quality of notices?• Strict adherence to contractual terms?

Best Practices(Trust, But Verify!)

• Understand impact of early/late payments. Calendar payment schedules.

• File copy of complete policy, especially shadow account pages• File copies of sales illustrations, especially key off ramp scenarios• Obtain “in-force illustrations” every year (or two or three),

particularly in the early years• Don’t necessarily accept the first answer you get from an insurance

company representative – their systems and capabilities are inconsistent

• Work with an insurance advisor who is attentive to ongoing policy administration

• Diversification?

The Policy

Illustration Trap

Illustrations Are Guaranteed To Be Wrong

• Interest crediting and dividend rates change• Premium funding patterns change• Insurance charges may change• Variable insurance subaccounts may not be carefully

monitored/managed (e.g., default to money market)• But just because illustration is wrong doesn’t mean

policy isn’t right

Illustration Regulations

• Consumer “Protection” – Illustrations went from 3 pages to 30 pages!

• Can’t illustrate higher than current rates• Except for variable and equity indexed products

where “backtesting” allowed• The fallacy of assuming linear returns – especially

with equity linked policies

Index UL – 8%“what’s it gonna cost?”

Premium $5,417

8

10

0% Guaranteed Minimum / 10% Cap / 100% Participation / 1 YR P2P S&P500

Indexed Universal Life Policy Illustration - 8% assumed crediting rate

Slide reproduced with permission from Richard Weber and The Ethical Edge

Index UL – 8%Premium $5,417

Indexed Universal Life Policy Illustration - 8% assumed crediting rate

Slide reproduced with permission from Richard Weber and The Ethical Edge

Equity Indexed Universal Life

• Insurance companies promoting it because it can illustrate well and is more profitable

• Actual policy return is driven predominately by insurance carrier’s bond portfolio and not equity returns (fallacy of “backtesting”)

• The “Options Budget”

IUL Hedging Transaction($100,000 Annual Premium)

$100,000

Net Premium

$100,000

InvestmentReturn

Residual

CreditedInterest5.00%

$95,238

One Year

$4,762

DiscountedPremium

Slide reproduced with permission from Bobby Samuelson

Options Budget

$4,762

Options Budget

Illustrated8% Performance

OptionsPremium

$4,762

Floor = 0%

4.76%

Options Profit

$3,23868% Yield

8.00%Po

licy

Yiel

dEffect of Options Profit

Slide reproduced with permission from Bobby Samuelson

Reality Bites

• Principal protection?• Insurance charges assessed each year

• Rule of Thumb – best long-term result is 50 to 100 bps over “portfolio rate”

• Will produce wave of missed expectations and litigation

Premium Financing -Insult to Injury?

• Yesterday’s Trap – premium financing of “stranger owned life insurance”

• Today’s Trap – premium financing of equity-indexed universal life (interest rate arbitrage = “free” or low cost insurance)

• What’s the exit strategy? Death? Policy loans/withdrawals?

• What can go (very) wrong?

Case StudyJohn & Jane Doe

Other Agent’s Proposal:• $15,000,000 Survivor Equity Indexed Policy• 7.5% illustrated rate (“Plus premium” death benefit)• $212,397 10-pay premium• Premium financed

• Interest only paid annually out-of-pocket• 5.35% assumed loan interest rate• After year 10, $115,211 assumed annual interest

• Exit on death with plus premium death benefit

Observations• At 7.5% illustrated rate and 5.35% loan rate the

strategy succeeds• At 5.5% illustrated rate, policy lapses at age 92 with

no value• Consequences of failure:

- Collateral calls due to declining cash value- Liable for loan balance ($2,123,970 + costs)- Almost $4,000,000 of interest paid- No death benefit- Litigation!- Reputational (if not economic) risk for the advisors and

lender

More Observations• No volatility assumed even in the 5.5% illustrated

rate• $15,000,000 no-lapse UL annual premium = about

$120,000• Assumed loan interest after year 10 was $115,211• Why on earth would you use the Equity Indexed UL

Policy, especially with this financing strategy?• What do you think client did?• Premium financing (including split dollar), used

carefully, can be a powerful estate planning tool

The CheapestTerm

InsuranceTrap

It’s Not So Obvious

Joe just turned age 56, and is overweight with borderline diabetes. He is a successful developer, but illiquid. Lender requires $5,000,000 of life insurance to secure loan. Life insurance advisor secures standard underwriting offer from Companies A, B, C, and D all with strong financial ratings. Although Joe has a permanent insurance need, he’s only interested in spending least amount possible on insurance to satisfy his lender. He says he’ll deal with permanent need down the road when he’s more liquid.

Annual Premium for $5,000,000 of10-year Term at Standard Rates

CARRIER ANNUAL PREMIUM

A $16,510

B $18,575

C $20,100

D $20,835

You die, they pay!

Would You Buy the CheapestParachute?

• Convertibility – Hedge against future insurability• Policy Split Option• Face Amount Reduction Option• Diversification

The Fine Print$5,000,000 10-Year Term Policy,Male, Age 56, Standard Rates

CarrierAnnual

PremiumMax

ConversionPeriod

Conversion Currently

Allowed to Any Product?

Conversion Contractually

Allowed to Any Product?

Partial Conversion/

Retain Remaining

Term?

Face Reduction?

PolicySplit?

A $16,510 70 No No Yes One time only

No

B $18,575 70 Yes No Yes No No

C $20,100 75 Yes Yes(including SUL)

Yes Yes, with limitations

No

D $20,835 65 Yes Yes Yes Yes Yes, with limitations

What Does The Contract State?

• Contractual vs. Company Practice?• Company practice can change• Even strong contractual language is only as

good as the company behind it (e.g., CNA and Lincoln Benefit Life)

Why Do Many Carriers Increasingly Dislike Conversion Privileges?

• 74-year old client with deteriorated health and finances

• $2,500,000 10-year term policy at end of 10th year• Client only needs and could afford to convert

$750,000 of the coverage• Converted and sold the remaining $1,750,000 for

$120,000 on the secondary market

Policy Tax Basis Trap

(or Opportunity)

Sow’s Ear Into Silk Purse

Jane bought a universal life insurance policy in 1980 when the declared interest crediting rate was 15%, and based on the illustration run at that time she has been paying a premium of $5,000/year that was to have paid up the policy by now. Notwithstanding having paid $165,000 over the last 33 years, the current policy interest rate is 4%, the cash value is $10,000, and the policy is projected to lapse without value in 3 years.

1035 Opportunities – Life Policy with Loss

To SPIA (with or without new cash) To Deferred Annuity (with or without new cash) $165,000 of tax basis will shelter next $165,000 of

annuity gains (ordinary income)

1035 Opportunities – Life Policy with Gain

To SPIA To Deferred Annuity To Traditional LTCI Policy To Linked Benefit Life/LTC Policy To Optimally Designed Life Policy

The BigPicture

Insurance policy is a legal contract. Understand it.

Diversification

• Product types/performance risk• Carriers (financial and administrative risk)• Conversion and other policy features

No Substitute forPeriodic

Review/Maintenance

Life Insurance is still the best financial product ever invented and should be a critical part of

many clients’ planning!

Just be thoughtful in your approach.

THANK YOU!

Larry Herman, JD, CPA, CLU, ChFCHerman Agency, Inc.715 Enterprise DriveOak Brook, IL 60523

630-571-2217larry.herman@hermanagency.com