Is Your Life Insurance Policy Healthy?

The past year and a half to two years has had a dramatic impact on the stock market and the declining interest rates in your overall portfolios.  Hidden in this unwelcome news is a potentially more menacing after effect on your life insurance, primarily universal and variable life policies.  Many of these policies are held in trusts, and if you are the acting trustee, you are not only subjecting yourself and/or the intended beneficiaries to unexpected costs, but you also may be exposing yourself to a fiduciary liability.

If you are currently acting as a trustee or expect to act as a trustee in the future of an irrevocable trust holding insurance on someone else’s life, the insurance policy should be regularly examined.  It is now clear in most states that a trustee of an irrevocable life insurance trust (ILIT) has the same fiduciary responsibilities as a trustee of a trust holding other assets.  In other words, acting as a trustee, you have a duty to manage the life insurance policy to insure that the maximum benefit inures to the beneficiaries.

In a recent court case, In re Stuart Cochran Irrevocable Trust, 901 N.E.2d 1128 (Ind. Ct. App. Mar. 2, 2009), the beneficiaries of an insurance trust sued the trustee for breach of trust for exchanging existing policies the trust held for other policies.  The trustee, KeyBank, owned insurance policies with a total death benefit of just under $5,000,000.  The insured’s insurance advisor recommended KeyBank exchange the policies for variable universal life (VUL) and increase the total benefit to $8,000,000.  Due to market losses in 2001 and 2002, the trustee obtained an independent insurance consultant to review the newly acquired VUL policies.  The independent insurance consultant audited the policies and indicated they would lapse before the insured reached life expectancy.  The insured’s insurance advisor and the independent insurance consultant advised that the VUL policies be replaced with a policy with a face value of just under $3,000,000 and guaranteed to the insured’s age 100.  The insured died unexpectedly soon after the purchase of the new policy.  The trust beneficiaries sued KeyBank for breach of fiduciary duty.

Fortunately for KeyBank, the trial court found in favor of the trustee.  The court focused on the prudence of replacing the old policies in general rather than the prudence of choosing the new policies specifically, and determined the change in policies was prudent.  The appellate court agreed.  However, while the trustee prevailed in this case, the appellate court noted that “the cautious trustee will recognize that actions of KeyBank were considered by the court to be less than ideal,” and that, “this case could have easily gone the other way on the issues of prudent process.”

Recognizing the potential for serious trustee liability with respect to ILITs, legislation has been passed in a few states reducing the trustee’s fiduciary responsibility for life insurance as an investment.  As an example, in Florida, after written notice to the beneficiaries a trustee may delegate investment management of the life insurance to others, including the grantor or the trust beneficiary.  This delegation authority can be a very powerful tool to remove liability from the trustee while imposing a fiduciary duty on the agent.

Unfortunately, not all states have enacted such protective statutes.  Thus, it is crucial that a trustee of an ILIT document the review process when managing life insurance held in the trust.  In addition, the trustee should enlist the help of an appropriate expert to make sure the review process is effective.  In the previously noted case, it was the partially due to the assistance of the independent consultant in reviewing and recommending the changes to KeyBank that the trial court ruled in favor of the trustees.

While it is important to review every type of insurance on one’s life, be it term or permanent, certain types of policies require additional oversight.  It is crucial to examine any permanent cash-value policy on which you are either the insured or the trustee to make sure it is functioning as originally anticipated.

When a life insurance policy is purchased, a print out of projections, or illustration, is issued by the insurance company and/or agent offering the policy to summarize the policy premiums expected to be due and the death benefit intended to be paid under the policy.  However, this information is predicated on any number of assumptions that may no longer be true over time.

As an example, many years ago when interest rates and investment returns were much higher than today, the universal and variable life type policies were sold with assumed rates of interest and projected investment returns as high as 12%.  As we all know, these assumptions are only wishful thinking in the current market.  However, if a policy was issued when interest rates or assumed rates of return were high, it may have been illustrated in this manner.  As a result, the policy may no longer be earning the necessary returns in order to sustain the policy with the premium amounts once projected.  Thus, a short fall will result in unintended costs to you and/or your beneficiaries.

By way of example, a universal life policy issued with a large, well-rated carrier in 2001 with a death benefit of $1,750,000 and an annual premium of $27,556, assuming an interest rate of 6.35%, projected the death benefit would last until the insured’s age 100.  The same projection run today, assuming a current interest rate of 4.15%, illustrates that the policy will lapse at the insured’s age 86.  In order to keep the policy in force until the insured’s age 100, the necessary premium would need to be increased immediately to $54,000, an increase of 96%.  If the insured or trustee chose to do nothing until age 86, at that time the policy premiums would have to be increased to $116,100 annually in order to maintain the policy through the insured’s age 100, an increase of over 321% from the original projected annual premium.

The foregoing illustrates that your life insurance policy should not be on auto pilot, and it is critical that you and your trustee continually monitor it.  A regular review of your policy will give you advanced warning on whether it will meet projections or whether appropriate action must be taken.