The case for the child-owned life insurance policy

For most producers who sell individual life insurance policies to families, the terms “policy owner,” “insured” and “beneficiary” call to mind “parent,” “parent” and (absent a spouse) “child,” in that order. It’s not every day that a child applies to be both policy owner and beneficiary of a contract in which the parent is merely the insured.

There are, however, scenarios in which such a labeling of the contract parties makes good sense. In cases where one or both parents desire to use life insurance to execute traditional estate planning, wealth transfer or long-term care objectives, but are unable to fund the insurance wholly or in part, then making an adult child the policy owner and premium payer could be a solution.

Less commonly, adult children themselves initiate the purchase of a policy on a parent to realize retirement and investment planning goals. But these transactions can raise questions — and red flags — among carriers and regulators. Is the child seeking a policy for legitimate purposes? Does he or she have an insurable interest in the parent?

There are other issues to weigh. Among these are the cost of a policy to the child given a parent’s age and health; the internal rate of return of a policy relative to other investments; the contract exit strategy in the event the insured parent should live longer than expected; siblings contributions’ (or lack thereof) to the premium payments; and whether to elicit the participation of family members in intergenerational planning discussions.

Hanging over all of these questions are two others: the nature of the relationship between parents and adult children; and whether a consensus can be achieved between the parties on goals and objectives.

“Parents may say, ‘Forget about it. Our kids will get plenty of money without a policy after we pass away,’” says Leon Rousso, a principal of Leon Rousso & Associates. “Parents often don’t care whether kids will have to pay the estate tax. Another potential deal-breaker is involving more than one sibling in the planning discussions, which can open up a can of worms,” he adds. “It all depends on the family dynamics.”

Picking up the tab

And, ultimately, on who’s prepared to pick up the premium tab. In some cases, an adult child may be asked to fund an existing policy by parents who no longer have the desire or means to do so on their own. Example: an expensive-to-maintain irrevocable life insurance trust (ILIT) established by parents during their prime earning years for the benefit of their kids. One issue that can arise when children buy a policy is insurable interest: Is the policy being purchased for a reason that would pass muster with a life insurer and the courts? Specifically, would a death benefit be used to compensate beneficiaries for a financial loss (as opposed to providing a speculative gain) resulting from the passing of the insured?

In situations involving conventional estate planning, the answer is clearly yes. A life policy can be used to pay estate taxes that otherwise might prove ruinous to trust beneficiaries forced to liquidate estate assets to cover the tax. And if the policy is owned by an ILIT, beneficiaries are doubly protected, for the policy proceeds are distributed not only income tax-free, but also estate tax-free.

“There’s clearly an insurable interest for things like taking care of the parents’ debts, final expenses and estate tax,” says Ray Benton, a Denver-based advisor for Lincoln Financial Group. “These debts would have to be paid by the children, and so there is a legitimate need for a death benefit. It makes sense in this case for kids to have coverage on parents.”

Assuming there’s an estate tax liability to be paid. Because of recent changes to the tax code, fewer people are funding ILITs to cover estate taxes. The American Taxpayers Relief Act of 2012 set estate taxes at 40 percent of an estate valued above $5 million.

Indexed for inflation, the unified credit (estate and gift tax) exclusion amount rose to $5.3 million in 2014. This figure is well above the $675,000 exemption prevailing at the start of the millennium, before implementation of Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001, which implemented progressively higher estate tax exemptions amounts over the subsequent decade.

“From an estate planning standpoint, [life insurance-funded] tax avoidance strategies were more common when the estate tax exemption amount was much lower,” says Bryan Beatty, a Vienna, Va.-based financial planner. “Today, you run into fewer of these situations. Factoring in a couple’s combined exemption amounts, you’re dealing now with families holding north of $10.6 million in assets.”

Fair enough. But there are reasons apart from tax avoidance objectives for implementing a life insurance-funded estate plan (with or without an ILIT). Parents might, for example, desire to equalize an estate by bequeathing a family business to a market-savvy adult child and providing a life policy equal in value to the business to a sibling. Estate equalization may also be the goal among blended families where, for instance, a spouse by a second marriage is due to inherit the estate. Providing life insurance to adult children by the first marriage — funded, if necessary, by the kids themselves — may be an equitable solution.

In each of above scenarios, child-owned life insurance has a legitimate role to play. Less evident is whether a policy would meet with carrier or court approval in cases where an adult child is buying a policy on parents to fulfill retirement planning objectives. Case in point: using the death benefit to cover a shortfall in savings stemming from the child’s failure to build up an adequate nest egg.

Of course, children applying for a policy on a parent could try to circumvent scrutiny by disclaiming any desire to enrich themselves. This strategy, however, would likely not defeat a rigorous fact-finding. During the underwriting process, a carrier will inquire, among other things, about the applicant’s income and net worth, outstanding debts and other life contracts in force. If a child is seeking a $10 million policy but fails to document matching estate obligations connected with a generational wealth transfer, then the issuing carrier might void the application.

“Policies purchased to fulfill a retirement objective for children usually are a lot more difficult to issue and approve because the insurance companies don’t see a financial need,” says Steve Brown, president of AdvantageOne Insurance. “Carriers don’t want to underwrite policies that might enhance the lives of beneficiaries due to the death of a loved one.”

More likely to meet with a carrier’s approval is a policy purchased by children for dual uses: (1) securing an inheritance; and (2) covering potential long-term care expenses of the insured parent.

Many new linked-benefit products do just that. Integrating a permanent life insurance chassis (typically universal life), the products pay a benefit for the face amount, less any portion thereof needed to cover long-term expenses. Among them: nursing home, assisted living or home attendant costs that, absent a policy, could substantially reduce monies saved by parents to fund retirement needs and/or provide a legacy for children.

Though less expensive than stand-alone long-term policies, linked-benefit products may prove prohibitively costly for parents. Hence the advantage of having a child who is better positioned financially to fund the premiums.

“Parents who have assets to protect may question the value of funding a policy if the premiums paid would reduce cash flow they need to live on,” says Beatty. “Having the kids make the payments can help insure they don’t run out of retirement income.” This strategy might also make moot the insurable interest question in cases where the kids are also looking to fill a gap in their own retirement income planning, he adds.