Professionals who work with older-aged clients face challenges not typically encountered in other markets.
Developments in the secondary life insurance market–also known as the life settlement market–could result in such professionals facing increased liability from a number of heretofore benign transactions. Policy exchanges are a good example.
Every professional worth his or her salt knows that Section 1035 of the Internal Revenue Code protects clients from paying tax on gain in their life policy when they exchange for another policy. Such exchanges make sense for many reasons, including the ability to access new policy features, to reduce or eliminate premium outlays, to purchase additional coverage and/or move to a carrier with stronger ratings. Due diligence is key to effectuating any exchange, however, and every exchange must be tested to determine whether it is suitable and in the client’s best interest.
What is important here is that, because of developments in the life settlement market, the due diligence bar has been raised for producers, advisors and trustees.
Before today’s active settlement market developed, older aged clients would typically have one option if they wanted to change policies. That was a Section 1035 exchange.
Now that the secondary market is active and competitive, however, professionals who think with Section 1035 blinders on do so at their own peril.
If the client is age 65 or older and has experienced a change in health since the policy was originally issued, the efficacy of a life settlement transaction clearly needs to be factored into the 1035 exchange due diligence process.
The following example illustrates the tensions that exist. Assume a life insurance trust owns a $3.8 million face policy on an 80-year-old male. The policy has $475,000 of cash surrender value, and the client needs an additional $500,000 of coverage to fully cover his estate planning needs. Consider the following proposals:
o Producer X, a broker working through her brokerage general agency, negotiated an offer from a new carrier for a $4.3 million policy. Producer X’s BGA also negotiated a $1.2 million life settlement on the old policy and used those proceeds to pay up the new policy on a guaranteed basis.
o Producer Y was prohibited by her broker-dealer from participating in life settlement transactions and never explored the settlement option. Producer Y’s recommendation was to 1035 exchange the $475,000 of cash surrender value into the new policy, but additional premium outlays were required.
Assume for a moment that there was no Producer X. Assume further that after conferring with the advisor team, the trustee went ahead and implemented the Section 1035 exchange. Shortly thereafter, a trust beneficiary was informed by Producer X of the other alternative.
Put yourself in the place of the insured, the trustee, an advisor or a trust beneficiary. What would your reaction be?
State insurance codes require that agents act in the best interest of the client. When a producer is barred from participating in settlement transactions, conflicts of interest can arise. In this regard, ethical cannons of professional associations advise producers who are contractually bound to one carrier to maintain their professional independence.
A common objection to settlements has been that “the insured’s children will object if the policy is sold and an unrelated party receives the death benefit.” It is instructive to know that the children of an insured once instituted a National Association of Securities Dealers Arbitration against a registered representative who counseled their mother not to proceed with a settlement transaction.
Some settlement companies consider Producer X’s transaction to qualify for Section 1035 treatment, and have lengthy opinions from outside counsel buttressing this position. Whether you agree with this position or not, this is another example of how the advisor’s due diligence role ratchets up in the older aged market.
As the foregoing demonstrates, the older-age 1035 exchange is no longer the benign transaction it once was. Similar issues are raised in other, seemingly benign contexts, such as where key person or buy-sell coverage is no longer needed.
Advisors and trustees, in many cases those least likely to know about opportunities presented in the secondary market, need to be briefed by the insurance professional about the full range of options presented by the secondary market.
As the foregoing demonstrates, producers who fail to do so can expose themselves to potential liability.