The Hows & Whys of Reviewing Trust-Owned Life Insurance

Clients rely on many individuals and organizations to help execute long-term plans for themselves and their heirs. Nowhere is this reliance as critical as the relationship between a client and a trustee.

Because a client’s trust may extend for decades beyond his or her life and is frequently used to provide for heirs and descendants, a trustee bears what is commonly referred to as a fiduciary liability. The trustee is required to act, at all times, as the client’s (the trust grantor’s) alter ego and the protector of the beneficiary’s interests. Every state has laws intended to assure that trustees live up to this fiduciary liability.

Where life insurance is owned by a trust, special skills are required. This article will discuss many of the complexities and areas of exposure that trustees must consider when reviewing trust-owned life insurance. It will also explore how building expertise in this area can enhance trustees’ relations with clients.

Trustees need to be able to navigate the many complexities and areas of exposure engendered by trust-owned policies. They also require a certain expertise when reviewing policies.

Although life insurance is sold on the basis of an illustration, few trustees understand that the visual is little more than a “snapshot” in time. Despite the fact that life illustrations display a range of alternative scenarios, including current and guaranteed assumptions, few trustees appreciate all the factors operating behind a life policy. As these factors shift, they affect the underlying policy such that the original illustration on which the policy was sold may become obsolete.

In particular, many policies sold in the 1990s and earlier were sold based on high crediting rates. It was not unusual to see variable life policies (sold to fund estate planning objectives) that assumed gross returns of 10% or 12%. Few policies have seen these levels of return sustained over time. Fixed and whole life policies were based on crediting rates and dividends that, as interest rates dropped in recent years, could not be sustained.

A trust-owned policy may also be at risk if it is inadequately funded. This is often done to keep the costs of gifts to a trust within a client’s annual gifting capacity. It is also done to keep the policy’s purchase price palatable to the client. Regardless, the thin funding may put a policy at risk relative to lower than illustrated rates.

Another concern is the step-type of policy design common in the 1990s. These policies allowed for the purchase of a life insurance policy at a lower than normal rate, with the understanding that at some point, often the 10th or 20th anniversary, the premium cost would jump to a higher than normal level. Often, these policies were sold with high illustrated rates and bought in the belief, based on those rates, that the policy would cover the higher costs internally. Many of these policies are now approaching critical anniversaries and, because of underperformance, owners will see higher than expected costs. This frequently occurs when a client’s gifting capacity is halved due to a spouse’s death.

Other factors may come into play, such as a change in an insurer’s ratings or the client’s situation. Clients may also need a greater or lower death benefit than was originally illustrated. For all these reasons, trustees need to closely track a policy’s performance.

Failure to review a policy will put a trustee at risk. Virtually every state has adopted the Uniform Prudent Investors Act (UPIA). Many states have adopted the act verbatim, while others have folded the act into their unique probate code. Included in all of these state versions is the requirement that a trustee review and monitor trust assets for the benefit of all beneficiaries. The UPIA was written broadly, but the law affects all asset classes, including life insurance. Of the 50 states, only Pennsylvania has carved out an exception for life insurance.