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IRREVOCABLE LIFE INSURANCE TRUSTS

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					FIDUCIARY
ADVISORS
      january 2008, volume 11, issue 1
January 2008                                                                                F I D U C I A RY A D V I S O R S




                                                   IRREVOCABLE LIFE INSURANCE
                                                   TRUSTS: FIDUCIARY DUTIES OF
                                                   INSURANCE AGENTS AND TRUSTEES
                                                   Errold F. Moody Jr., Phd. MSFP, MBA, LLB, BSCE, CFP
                                                   Life and Disability Insurance Analyst
FIDUCIARY ADVISORS
2001 East Grace Street, Suite 416
                                                   The Irrevocable Life Insurance Trust is a mainstay of those seeking to
R i c h m o n d , VA 2 3 2 2 3
                                                   (generally) pay estate taxes upon death. The use of insurance fits per-
w w w. f i d u c i a r y a d v i s o r s . o r g   fectly in most situations since the leverage element of a p olicy allows one
                                                   to pay considerably less in the early years for the perceived ‘benefit’ and
T     804.643.1075                                 yet still reap viable economical coverage if one lives a long time. This is
F     804.643.1075                                 obviously a recap of what everyone knows. The problem arises with the
E     steve.winks@wealth-paths.com                 type of insurance that is used in such trusts.

                                                   The fundamental question is whether the intended purpose of insurance
                                                   is being lost by present industry practices. How do we maintain the in-
                                                   tegrity of policies over time and who is responsible for do ing so? I submit
                                                   that ins urance is simply a tool developed over centuries to reduce the
                                                   risk of potential loss. In the strictest sense, it is not to provide large sums
                                                   of money in excess of value. That is to say that you (supposedly) can-
                                                   not insure a bar n worth $2,000 for $2,000,000. Human life value is more
                                                   esoteric but will still be limited by the facts of the individual. That is the
                                                   essence for most insurance trusts- coverage for current and perceived
                                                   future estate taxes. But this just addressed the concept of ‘insurance’.
                                                   The literal interpretation is coverage for the loss, not for inter nal buildup
                                                   of other value that may provide additional appreciation and/or the ability
                                                   to cease premium payments at some subsequent point in time.

                                                   The use of policies for such purposes entailing extra fees and reliance
                                                   upon extraneous factors (economics, investment manager expertise) can
                                                   cause additional risk to the insurance coverage itself since the policy
                                                   could simply run out of money. Cash value policies of almost all types
C ON TIN UED                                   and any of the variable products can be very costly, far in excess of what
I R REVOCABLE LIFE INSU R A N C E
                                               the consumer bargained for.
T R UST S: F IDUCIARY DUTIE S O F IN -
S UR A N C E AGENTS AND TRU STE E S
Page 2 of 4                                    Pundits will note the vast number of products that have been marketed
                                               and sold to the public to facilitate all sorts of technical objectives—a
                                               supposed choice of the consumer—but there is no corresponding dis-
                                               closure to the consumer as to the long term viability of these insurance
                                               contracts. The ability for such imaginative techniques to switch cash
                                               values in and out to accomplish such objectives such as to cover future
                                               insurance premiums, defeats the real reason for insurance for the typical
                                               and reasonable consumer. It is true that certain elements may possibly
                                               work. But it is also true that the policy may fold before death. If one is
                                               adding risk to a policy via types of cash value buildup and ‘special’ split
                                               dollar- it’s no longer pure insurance coverage which is the primary objec-
                                               tive of 99% of Irrevocable Life Insurance Trusts. There is a clear fiduciary
                                               obligation to explain such risk to the client. If the agent understood the
                                               risk, the wouldn’t have sold the policy. So, then does the trustee of an
                                               Irrevocable Life Insurance Trust have the responsibility to manage the
                                               integrity of a life insurance contract? Certain illustrations with universal
                                               life show part of the problem but are still are relatively unintelligible.
                                               Conversely, illustrations for variable policies do not show underfunding
                                               risk ass ociated with questionable practices undermining the integrity of
                                               life policies.

                                               Readers will be aware of the reduction in interest rates during the mid
                                               1980’s that caused a huge hue and cry among consumers as more and
                                               more company notices were sent out demanding more premiums for uni-
                                               versal policies. The initial illustrations showed high rates that were un-
                                               sustainable. But the issue is that the policy used something other than
                                               static premiums to maintain the policy. The reliance on inter nal retur ns
                                               can work, quite obviously, but the element of risk must be considered—
                                               and rarely is that risk articulated and disclosed. None of such policy eco-
                                               nomics are static. The reliance in a policy that presumes interest rates
                                               will either go up or down is conjecture, a bet, if you will. That therefore
                                               becomes a risk in the policy. Most agents may rationalize the use of such
                                               policy for retirement, college funding et al, but the underlying perfor-
                                               mance cannot be determined with certainty. In fact policy funding may
                                               not even being close to fund the desired objective when one considers
                                               the decades over which assumptions must be achieved. This puts into
                                               question the whole construct of estate planning and the appropriate use
                                               of life insurance.

                                               When one looks to the various variable life policies, the issue d in the
                                               first may well be far, far worse. Further, few (if any) illustrations cover the
                                               volatility of the retur ns through a type of Monte Carlo analysis and hence
                                               such sales almost assuredly violate fiduciary standards via prudent man
                                               rules (identified below). One cannot use a flat rate of retur n in an illustra-
                                               tion with any degree of viability at all.

                                               The point is that in cases where some inter nal type of cash buildup is
                                               required to maintain sustainability, risk has been inserted into the poli-
                                               cies via bility. While this issue may be addressed separately outside of
                                               an Irrevocable Trust, I submit that the absolute reason for insurance to
                                               pay estate taxes should have very little reason of default at any point in
                                               time. The idea that an elderly insured will be notified of the inability of a
                                               major policy to remain in force without a substantial increase in premi-

                                 . . . everything you need to add value                                                  •2•
C ON TIN UED                                   ums and/or lump sum is simply bad planning from inception. The agent
I R REVOCABLE LIFE INSU R A N C E
                                               should recognize that additional monies may no longer be available. If
T R UST S: F IDUCIARY DUTIE S O F IN -
S UR A N C E AGENTS AND TRU STE E S            the insured feels that the policy was misrepresented- and certainly the
Page 3 of 4                                    benefici aries would- then a legal remedy is in order and a suit must be
                                               accordingly be filed. But since the policy has been in force so long, the
                                               agent, estate planning attor ney and the trust officer may no longer be
                                               in business. Yet the trust company and the estate planning attor ney/firm
                                               are still held liable for not recognizing the inherent problem from incep-
                                               tion. The problem may originate from all types of advisors, insurance and
                                               securities agents, with various licenses and credentials but the problem
                                               of default for independent trustees of an irrevocable life insurance trust
                                               cannot be eliminated by focusing on the (faulty) respons ibility of others.
                                               The trustee has a fiduciary duty to not only analyze the initial policy type
                                               and illustration, but must also review any policies on a continual basis
                                               to assure that it will perform for the lifetime of the insured. I submit that
                                               many current policies will be in default over time if not almost from incep-
                                               tion (consider 2000- 2002). That they may separately end up with large
                                               sums of money is extraneous to such risk of default.

                                               Cu rrent Insura nc e Re vie w : A 2004 survey, published in National
                                               Underwriter, found that among professional trustees, fully 83.5% indi-
                                               cated they had no guidelines and procedures for handling trust owned
                                               life insurance. For non-professional trustees, 71.2% indicated they had
                                               not reviewed their trusts’ life insurance policies in the last 5 years. Both
                                               groups did not focus closely on handling the subaccounts for variable
                                               life. Among professional trustees, 95.3%, had no guidelines for handling
                                               the asset allocation components of VL. Among non-professionals, 94.7%
                                               indicated they had no procedures in place for the allocation component
                                               of VL. Clearly an advisor with the requisite skills in investment risk and
                                               reward as well as insurance costs and risk of default is required to opine
                                               as to the economic viability of such arrangements. This is especially true
                                               if an advisor acknowledges fiduciary status.

                                               Another pair of surveys indicated that anywhere from 70%-95% of all
                                               trust owned policies do not have a life insurance agent servicing the con-
                                               tracts.” A trustee may have some legal offset for liability in their reliance
                                               on an agent but it begs the question did the trustee attempt to confirm
                                               the viability of the insurance contract. The trustee and insurance agent
                                               have a responsibility to find an objective third party to act in a fiduciary
                                               capacity and actually do a meaningful analysis. One professional trustee
                                               has indicated that as many as 92% of existing TOLI policies could be
                                               restructured to provide 20% greater value. In fact, that same firm con-
                                               cluded, after a survey of policies, that 74%-87% of these contracts could
                                               be restructured to provide either a 40% increase in death benefit, or 40%
                                               reduction in premium. I concur but would make a different conclusion,
                                               as I am principally concer ned about the ability of the policy to last. Even
                                               if a new policy offered nothing more than certainty rather than risk, all
                                               other issues remaining equal, that element itself demands the change in
                                               the policies by the trustee. The risk in insurance should be minimized for
                                               almost all ILITs. ILITs are designed to last for a lifetime(s). If the advisors
                                               are negligent in the obvious, they will be held liable upon default of the
                                               policy o r a mere indication that more funds are needed. Actually, they are
                                               liable initially where a proper analysis would have showed such risk could
                                               occur. Of course, such liability will be determined in court but I submit
                                               that an initial default rate of over 5%should be met with a claim.


                                 . . . everything you need to add value                                                  •3•
C ON TIN UED                                   There are those that do not accept that position and believe the full
I R REVOCABLE LIFE INSU R A N C E
                                               weight of the Prudent Investor Rule rests on the trustee, and not on the
T R UST S: F IDUCIARY DUTIE S O F IN -
S UR A N C E AGENTS AND TRU STE E S            insurance agent. They maintain the monitoring and reviewing of insur-
Page 4 of 4                                    ance policies within trusts is the responsibility of the trustee. Attor ney
                                               W illiam Riese notes that the types of class-action lawsuits against insur-
                                               ers and agents concer ning so-called vanishing premium policies could
                                               someda y be carried over into trust management. He stressed that life
                                               insurance poses significant risk of liability to a trustee because most pro-
                                               ducers and agents are not held to professional standards of care since
                                               the selling of life insurance is not legally deemed to be a profession. This
                                               fact imposes more duties and responsibilities on a trustee holding life
                                               insurance contracts since insurance producers and their agents have no
                                               duty to advise an insured on the adequacy or suitability of his insurance.
                                               Nor is there a duty on the agent to advise a client on the provisions of
                                               policies previously purchased from another insurer. There also is no duty
                                               to investigate the solvency of an insurer authorized or licensed to do
                                               business in a particular jurisdiction; and after the sale of a life insurance
                                               policy, there is no duty to monitor the continuing solvency of the issuing
                                               carrier. Further, Mr. Ries opined once a policy has been issued, there is
                                               no continuing duty on the part of the agent or insurer to determine that
                                               the cov erage remains appropriate. While insurance producers may be
                                               well served by Mr. Ries opinion, there are reports, that insurance agents
                                               are being sued by banks for non-performance of policies.

                                               It is generally conceded that the duty of an insurance agent is to the
                                               company, not the client. That said, I believe that the essence of a ‘pro-
                                               fessional’ should force a change in the entire process, including the
                                               courts. From all I have read, estate planning attor neys have also suppos-
                                               edly escaped the responsibility for doing some investigation. Or for that
                                               matter having to know anything about insurance to begin with, which is
                                               not good enough. It is patently absurd to remotely infer that any entity
                                               involved in as critical an item as personal life insurance and estate plan-
                                               ning could hide behind a veil of ignorance much less that of the law. One
                                               should not be able to rationalize away the imperative to lear n a financial
                                               product and its uses where so many lives are at risk for it working cor-
                                               rectly.

                                               The knowledge can be lear ned- it’s just requires effort and the desire to
                                               act in the consumers best interest.




                                 . . . everything you need to add value                                                •4•

				
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