San Francisco

The life insurance community is under assault, remarks by panelists at the LIMRA International 2005 Advanced Sales Forum, held Aug. 15-17, suggested.

Without concerted action by manufacturers and broker-dealers, long-established principals governing the tax-favored treatment of life insurance, insurable interest laws, policy valuation and federal regulators’ traditionally arms-length approach to industry oversight will continue to erode, they indicated.

This was the overriding theme of the first general session of the annual LIMRA meeting. Between workshops addressing the finer points of tax, technical, practice management and marketing techniques, the trademark format of the 3-day event, advanced market professionals got an earful from the session’s two panelists on the sobering challenges that lay ahead.

Chief among them: what to do about the proliferation of investor-owned life insurance. Typically marketed as charitable- or foundation-owned life insurance (CHOLI or FOLI), the product allows third-party investors in states with liberalized insurable interest laws to buy an interest in a trust that provides a small payment to a charity or educational organization when the insured dies. Most of the death benefit goes to the investors.

“When I say these investor-owned life insurance policies could herald the end of life insurance as we know it, that’s not hyperbole,” said Stephan Leimberg, CEO of Leimberg Information Services, Bryn Mawr, Pa. “If your company hasn’t come out with a strong statement saying, ‘we won’t involve ourselves in these schemes,’ then you’re making a big mistake.”

Without a robust industry effort to contain, if not roll back, the spread of IOLI beyond the handful of states where such policies are now permitted–including Texas, Virginia, Tennessee and North Carolina–Congress might opt to end the tax-favored treatment of life insurance products, he added.

With respect to IOLI policies, that’s already in the offing. Senate bill 993, introduced on May 3rd by Senate Finance Committee Chair Charles Grassley (R-Iowa) and ranking minority member Max Baucus (D-Mont.) would, if enacted, impose a 100% excise tax on the cost of acquiring life insurance policies under IOLI arrangements involving tax-exempt organizations.

Thomas Commito, vice president of business and industry development at Lincoln Financial Distributors, Philadelphia, Pa., said that IOLI policies also invite federal regulation by the Securities and Exchange Commission and National Association of Securities Dealers because of their investor-backing. Pointing to NASD Notice 05-50, released this month, Commito observed that other insurance products, including equity-indexed annuities, are already under heightened federal scrutiny.

The notice calls on insurers to more rigorously supervise the sale of unregistered EIAs by affiliated advisors in their capacity as insurance agents. The notice also warns firms against applying NASD rule 3030 (which concerns “outside business activities”) to an EIA transaction when rule 3040 should govern. The reason: The sale should be interpreted as a “private securities” (as opposed to insurance) transaction.

“More and more, we see federal regulators wanting to oversee the life insurance industry,” said Commito. “With respect to IOLI and other products marketed as investment contracts, I have no qualms about that.”

Commito expressed misgivings, however, about IRS treatment regarding the valuation of life insurance products residing inside qualified pensions or retirement plans. He flagged IRS Revenue Procedure 2005-25, released in April, which provides guidance on how to calculate a policy’s fair market value. Superceding Rev. Proc 2004-167, the new procedure offers two safe harbor formulas for arriving at a determination.

The first of the formulas, dubbed PERC, factors in premiums, earnings and “reasonable charges.” The second formula hinges on the policy’s gift tax value, an amount based on the interpolated, terminal reserve and unearned premium. The IRS instituted the formulas to prevent owners of life insurance policies from transferring the policies from a qualified retirement plan to an ILIT at a tax discount (e.g., by creating an artificial surrender charge that disappears soon after the policy’s withdrawal from the retirement plan).

But while endeavoring to eliminate abuses, the new formulas prompt questions. With respect to PERC, Commito observed that insurers may be at pains to determine what constitutes “reasonable charges.” As to internal reserves, the policy at issue, particularly if it’s a VUL or UL contract, may not have any.

Absent an ironclad standard with which to determine a policy’s value, advisors are left to choose from multiple options. Commito, who informally polled conference attendees on this question, said their companies are largely providing clients with a range of figures, including cash surrender value, account value and reserve value. Then, said Commito, they advise clients to “go consult an attorney.”

Leimberg added, however, that insurers and clients should not have to worry about IRS sanction so long as they observe four “golden rules.” These include creating policies that: (1) are permanent; (2) provide retirement benefits; (3) are available to all employees/participants; and (4) do not discriminate in favor of highly compensated individuals.

“With the [2005-25] rule, the IRS is saying ‘we’ve had it with weasel words and hyper-technical interpretations of fair market value,” said Leimberg. “‘The literal following of the law is not enough when you’re violating its spirit. We’re not going to let you get away with games.’”

Yet another cause of concern to the panelists is the misapplication of insurable interest laws in court proceedings (among them the much publicized case involving Wal-Mart’s purchase of corporate-owned life insurance on rank-and-file employees). Increasingly, noted Commito, judges are erroneously equating assertions of insurable interest–justifiable or otherwise–with fraud, misrepresentation and deceptive practices.

“This interpretation gives us incredible headaches because insurable interest is being twisted in ways that its creators never intended,” said Commito.

Added Leimberg: “When injustices have been done by bad actors with deep pockets, courts will find a way to get what they want, regardless of what the law says.”

“With the [2005-25] rule, the IRS is saying ‘we’ve had it with weasel words and hyper-technical interpretations of fair market value…The literal following of the law is not enough when you’re violating its spirit. We’re not going to let you get away with games.’”

If we can’t get the LIMRA logo–info e-mailed to Don–we can use this infographic

The Golden Rules

To avoid IRS sanction, insurers and clients should follow four “golden rules” when creating policies.

Policies should:

(1) be permanent

(2) provide retirement benefits

(3) be available to all employees/participants

(4) not discriminate in favor of highly compensated individuals