Insurance Policy Selection For
Irrevocable Life Insurance Trusts:
New Challenges For Trustees
And Advisors
By Lawrence J. Rybka ValMark Securities, Beachwood, OH.
F
or many years the insurance profession has debated the criteria for selecting and struc-turing the proper life insurance policies for irrevocable life insur-ance trusts. A new body of law governing the duties and standards that trustees must apply to thisprocess will result in a watershed change for insurance profession-als, trustees, and estate planning attorneys.
Background
The irrevocable trust is one of the fundamental tools for estate
plan-ning in the United States. Among its many benefits is the ability for the grantor to make lifetime gifts to the trust for the benefit of others while avoiding inclusion of the proceeds in the grantor’s estate1. If properly
structured, the trust’s principal and its appreciation can pass to the grantor’s family without incurring estate tax2.
Life insurance on the life of the grantor or on the lives of the grant-or and his grant-or her spouse is one of the most popular assets for an ir-revocable trust to own. Inside the trust, the death benefit can pass to the heirs without incurring es-tate or income taxes if the policy qualifies as life insurance under IRS
THE IRREVOCABLE TRUST IS one of the fundamental tools for estate planning. Life insurance on the life of the grant-or grant-or on the lives of the grantgrant-or and his grant-or her spouse is one of the most popular assets for an irrevocable trust to own. Insurance professionals and investment advisors will be able to demonstrate expertise and bring new value to clients by facilitating the process of creating an Investment Policy Statement for their clients’ irrevocable trusts as standard procedure.
TRUSTS & ESTATES / trustsandestates.com / FEBRUARY 2002 45 Code Sec. 7702 and the grantor
has no incidents of ownership un-der IRS Code Secs. 2036 or 2042.
Duties of the Trustee
In order to avoid inclusion in the estate, the irrevocable trust must be separate from the control of the grantor and the grantor must have no incidents of owner-ship under IRC Sec. 2042. There is a long line of established case law that holds that the grantor cannot serve as trustee where he or she is also the insured3. There is also
the practical issue of management of a life insurance policy and its proceeds at the grantor’s death. Thus, in most cases, a corporate trustee, friend or relative of the grantor serves as trustee.
The trustee of an irrevocable trust is under the same obligations and duties of any trustee4. The
trustee serves to protect the in-terests of the beneficiaries of the trust and manages the assets of the trust for their benefit. Dating back to the common law in Eng-land, case law has held that the trustee is bound to a very high standard of care in the selection and management of these assets.5
The legal standard of this duty is that of a fiduciary.6 That is, the
trustee must exercise his or her duties for the benefit of the trust beneficiaries in all areas involving the selection and management of all trust assets, including all life insurance policies.
Under question: the life in-surance selection process In ac-tual practice, the process of select-ing, structuring and servicing life insurance policies for the trust is not often performed in a manner consistent with trust law and in coordination with the actual du-ties required of a trustee. Often, the grantor prematurely initiates the process of selecting the life in-surance policy and may also have begun the underwriting of a par-ticular policy while the irrevocable trust is being created. Of course, when the policy is approved, the trustee formally submits a new ap-plication as owner. Technically, it is the trustee who must make the decision to buy insurance and determine the type of insurance to
be purchased.
While most practitioners feel that this formal application pro-cess by the trustee cleanses any taint of ownership and control of the policy under IRC Secs. 2036 or 2042, it almost certainly does not establish that the trustee has met his or her duty as a fiduciary in the selection and structuring of the life insurance policy. In fact, it may demonstrate precisely the oppo-site conclusion.
If, in these circumstances, the policy has already been selected and all key decisions have been made with regard to the policy’s configuration, how could the trust-ee demonstrate that his or her in-dependent duty has been met as a fiduciary in selecting this asset?
The convergence of two signifi-cant developments in this area has made this problem all the more complex.
#1: The development of vari-able life products. Up until 25 years ago, all insurance compa-nies offered what was known as “General Account” Life Insurance Products (whole life and univer-sal life)7. These relatively simple
products are based on contractual guarantees made by the insur-ance companies are filed with the state insurance commissioner. In-surance companies, at their dis-cretion, can pass along to policy-holders credits in excess of these conservative guarantees. These credits are known as dividends in a whole life policy and interest credits for UL.While companies today spend billions of dollars trying to convince consumers of the superiority of their UL and WL products, the fact remains that these products are very simi-lar to the simple general account products which have been avail-able for decades. This similarity is due to the nature of state insur-ance regulation, which tends to encourage conformity to certain standards.
The role of state insurance reg-ulation. The primary duty of the state insurance commissioner is to make certain that insurance com-panies remain solvent to meet the guarantees made to policyholders, and that the companies’ underlying
assets are sufficient to meet these contractual promises. This form of regulation actually is meant to in-hibit companies from making guar-antees that they may not be able to meet. Thus, if a company wishes to guarantee anything more than a 4 percent interest rate, it has to set aside significant additional reserves to back this promise.8 Likewise,
companies offering a general ac-count product are greatly con-strained in the assets they must hold in their portfolios to back these promises. This is why one rarely sees any significant amount of com-mon stock in the general account of an insurance company.
State insurance regulations seek to protect policyholders from disin-termediation that may occur if the underlying assets are negatively im-pacted by market conditions. For ex-ample, equities have been deemed as being too risky by long-estab-lished state regulation. Therefore, reserving requirements imposed by the states greatly limit which invest-ments companies can hold for their general account portfolio assets.9
The result is that typically 90 percent of general account assets are held in government and high-grade cor-porate bonds, mortgages and high-grade commercial paper.
Two other recent develop-ments have further constrained the investment options for general accounts: risk-based capital ratios and pressure from ratings agen-cies to limit the duration and qual-ity of these underlying debt instru-ments10. The net effect of these
two factors, along with the drop in bond rates, has been to drasti-cally decrease interest credits in general account products.11
The emergence of separate ac-count products. The position of the life insurance industry changed dramatically in the late 70s when the first “Separate Account” life in-surance product was developed12.
General account products and sep-arate account products are regulat-ed in a completely different man-ner. Separate account products are regulated first as a security by the SEC and secondly by the state in-surance commissioner.
With a separate account prod-uct, the company is not required
to set up a reserve for policyhold-er values because the company is not guaranteeing a minimum cash value. Instead, the company cre-ates separate accounts that track the underlying policyholder in-vestments. The cash value is then determined by market value of these underlying investments. This allows policyowners to invest all or a part of their cash value in separate accounts. These separate accounts are similar to mutual funds in that they may hold equi-ties, bonds, international securi-ties or virtually any type of finan-cial instrument. The selection var-ies by insurance company. Instead of the company passing on a dis-cretionary interest credit or divi-dend on to the policyholder,13 the
performance of the product de-pends largely on the performance of the investment accounts select-ed by the policy-owner. The com-pany charges a fee against the per-formance of these sub-accounts that is fixed in the prospectus.
(Separate account products must file a prospectus with the SEC in addition to the state insurance commissioner.)
A separate account product has a floating (versus guaranteed) cash value and allows daily market val-ue adjustments (up and down) to be passed directly to the policy-holder. In the U.S., these policies are known as Variable Universal Life or Variable Adjustable Life con-tracts. In these policies, the poli-cyholder has the right to select or change the allocation of cash val-ues inside the policy. With trust-owned variable life insurance poli-cies it is clear that the trustee must designate which sub-accounts are selected.
General account versus sepa-rate account products. The choice between a general account uct and a separate account prod-uct is a profound one. Because life insurance is often the only as-set contained in irrevocable trusts, it is the fiduciary responsibility of the trustee to make the choice of either a general account or sepa-rate account product. In the past, some trustees may have preferred the simplicity of general account products. However, failure to
dem-onstrate consideration of both of these most basic alternatives would not be consistent with the fiduciary duties of a trustee. Trust-ees must realize that in today’s world, the choice of a general ac-count product is, in effect, a de-fault choice to invest 90 percent of the trust’s assets in bonds and mortgages. On the other hand, the choice of a variable product leads to considerations involving the as-set allocation of sub-accounts and how this allocation will be estab-lished.
#2: Change in standards for trustees. At about the same time the insurance industry be-gan to offer variable life prod-ucts, a profound change oc-curred in U.S. trust law. Just as the insurance industry had be-come entrenched in the exclu-sive use of general account life insurance for 150 years, there was a long established standard for judging whether trustees had properly exercised their fidu-ciary duty in the selection and management of trust assets, in-cluding life insurance. This stan-dard was known as the “Prudent Man Rule”14. Its basic tenet was
preservation of principal. The fo-cus of the test was the avoidance of risk. A trustee would be deemed to have met his or her duty if he or she selected “safe assets” with low volatility and preservation of principal. This standard was consistent with the product characteristics of general
account insurance.
Drawbacks of the Prudent Man Rule. While the Prudent Man Rule promoted the preservation of principal, it ignored two sig-nificant risks to trust assets. First, the focus on preservation of prin-cipal ignored the risk of inflation. A trust established in 1950 with a $50,000 principal represented the equivalent of $368,744 in today’s dollars. So, a trustee who focused on preservation of principal of this amount for 50 years without appreciation would significantly harm the beneficiaries.
The second significant drawback of the Prudent Man Rule was that the focus on principal eliminated assets that offered the best potential for long-term potential. Beneficia-ries were harmed under this stan-dard because it caused the trustee to focus on short-term value, not long-term results. Principal was al-ways preserved, but the trade-off was the significantly lower value of the portfolio over the lifetime of the beneficiaries15. Thus, if a
$50,000 portfolio was invested in money market instruments like CDs, or short-term treasuries, the trustee could, at every point, dem-onstrate maintenance of principal. However, if the same portfolio was invested in the S&P 500, the amount would have grown to $26,782,56916
instead of $1,018,03817 (U.S. 1 Year
Government Treasury).
Against this background and es-pecially in light of the high infla-tion with the concurrent increase in the value of stocks of the 1970s and 80s, judges and legislators completely refashioned trust law. In 1992, The American Law Insti-tute published the “Restatement (Third) of Trusts” and completely altered the standards by which trustees are judged.18 This new
standard (now known as the “Pru-dent Investor Rule”) was also ad-opted by The National Conference of Commissioners on State Laws and has now been adopted into law by approximately 40 states.19
Standards For Trustees Under UPI
The Uniform Prudent Investor Rule (UPI) requires that a trustee acting in a fiduciary capacity
dem-A
separate account product has a floating (versus guaranteed) cash value and allows daily market value adjustments (up and down) to be passed directly to the policyholder.48 TRUSTS & ESTATES / trustsandestates.com / FEBRUARY 2002
onstrate a process for selecting and managing all assets held in the trust. Under UPI, the trustee can no longer exonerate him or herself by demonstrating main-tenance of principal. Rather, the trustee must not only follow the dictates of the trust instrument it-self, but also exercise these pow-ers by balancing the need to pre-serve principal with appreciation and income.
In keeping with the work of noted economist Harry Markow-itz20, the UPI recognized the
di-rect trade-off between short-term preservation of principal and long-term returns. Academic re-search has consistently demon-strated that a conservative bond portfolio would give up 500 basis points to an equity based portfo-lio over longer periods.21 Thus,
courts in UPI jurisdictions have consistently found that trustees can be liable for failing to ob-serve the standards of UPI, even though they maintained princi-pal22 .They recognize the
dra-matic difference between the old Prudent Man Rule and the Pru-dent Investor Rule.
Damages Assessed Against Trustees Under UPI
At the 2001 University of Miami Heckerling Estate Tax Conference, Dom Campisi, one of the county’s foremost trust litigators, presented recent case law that demonstrated a series of explosive multi-million dollar verdicts delivered against trustees who failed to consider eq-uities as required under UPI, or who failed to otherwise diversify the trust portfolio according to UPI standards. Noteworthy precedents established at the appellate level include:
Baker Boyer Nat. Baond v. Garver (Wash. App. 1986) 719 P. 2nd 583, 591 — Corporate Fidu-ciary was found liable for not con-sidering equity investments and in-vesting exclusively in bonds and real estate. Damages were assessed based on the premise that a mini-mum of 40 percent of trust assets should be invested in equities.
Noggel v. Bank of America
(Cal. App. 1999) 70 CA 4th 853 — Awarded a significant
judge-ment against the trustee for in-vesting primarily in bonds. The only question on appeal was whether the S&P 500 or the bank’s proprietary equity fund would serve as the appropriate measure of damages.
Matter of Estate of Janes
(1997) 90 N.Y. 41 659 N.Y. S. 2nd 165 — The first of many cases where courts have awarded multi-million dollar verdicts against trust-ees for being too concentrated in a small number of equities. In this case, 71 percent of the trust was invested in one stock.
With the third “Restatement of Trusts” (Prudent Investor Rule), it is now certain that a trustee who is considering the appropriate asset al-location for trust beneficiaries with a long time horizon, must demonstrate consideration of both an appropriate investment in equities as well as suf-ficient portfolio diversification.
Application of UPI to Irrevocable Trusts Holding Life Insurance Policies
The convergence of separate ac-count life insurance products and the Uniform Prudent Investor Rule as a standard by which trustees must execute their fiduciary duties is profound. It is easy to imagine beneficiaries of a trust owning gen-eral account life insurance products purchased in the 80s suing a trustee for breach of duty.
In a scenario that is all too probable, the trustee may have been directed by the grantor to
purchase a policy for a need 30 or 40 years in the future, without consideration of the appropriate-ness of an equity-based product. For example, if a whole life policy (general account product) earned an average of 8 percent over the last 20 years and the equity ac-count earned an average of 13 percent, that 500 basis points compounded over 20 years would result in a policy with consider-ably higher cash value and death benefit23. Thus, the choice of a
general account product or a vari-able product with bond ac-counts would have produced sub-stantial loss to the beneficiaries. It stands to reason then, that the standards of the UPI which clearly allow beneficiaries to hold trust-ees liable for investing only in bonds should also apply to the choice of underlying investments in a financial product like life in-surance.
Until the development of sepa-rate account products, the trustee did not have the ability to choose a policy that offered equity re-turns. Indeed, the insurance com-missioner leveled the playing field between companies by lim-iting both the guarantees to the policyholder and the underlying investments that companies could purchase for their general ac-count. It could be argued that there were relatively small differ-ences between these policies. Thus, if the trustee checked the credit worthiness of the insurance carrier, he or she may have ful-filled his or her duty under the former Prudent Man Standard24.
Today, however, the failure to demonstrate consideration of separate account products and the ability to participate in equity returns demonstrates a default choice that will, in most cases, result in an allocation of 90 per-cent of the trust’s assets in bonds and mortgages.
Putting UPI Into Practice
It is incumbent upon the insur-ance professional, the attorney, the trustee and the client to change the process by which life insur-ance is procured by the trust, es-pecially an irrevocable trust.
Keep-T
he convergence of separate account life insurance products and the Uniform Prudent Investor Rule as a standard by which trustees must execute their fiduciary duties is profound.ing in mind that the grantor, ben-eficiaries and trustees are all sepa-rate entities, the UPI requires that it is the responsibility of the trust-ee to demonstrate a process for weighing principal preservation with asset appreciation. The fol-lowing steps should therefore be considered in selecting the type and configuration of a trust-owned life insurance policy:
Carefully examine trust docu-ments for existing trusts. In the absence of specific instructions by the grantor, the trustee must at least consider both types of insurance and document a process of com-pliance with the UPI standard.
If a new trust is being estab-lished, the grantor and attor-ney may wish to include lan-guage that appoints a special trustee for policy selection or maintenance. These instructions should carefully define the expec-tations of the grantor with regard to insurance and provide clear guidance for the trustee. If these instructions are not incorporated into the trust document itself, a separate investment policy state-ment for the policy may be incor-porated by reference.
The grantor, trustee and insur-ance professional should clearly qualify the results expected by the grantor25 through the use of
life insurance. Expectations should be specific in regard to:
•
Time horizon for the pol-icy.•
Whether the policy is to produce optimum short-term or long-short-term results.(Short-term protection may best be accomplished by term insurance.)
•
Budget considerations.•
The tradeoff between low premium funding ver-sus stable plans of insur-ance with enhinsur-anced inter-nal rates of return on vari-able life policies26.•
The historical returns and volatility for different asset allocations.•
The duties of policy re-porting and management. Note: if the insurance profession-al is not licensed for the sprofession-ale of variable products, his or herinabil-ity to offer these products as an al-ternative may result in advice that prevents the trustee from demon-strating compliance with his or her duties under the UPI standard.
Create an investment policy statement for the trust. Armed with a thorough discussion of the options, the trustee should arrange for the trust to adopt its own in-vestment policy statement. The statement should include27:
•
A restatement of the ex-pected time horizon for as-sets held in the trust.•
If the grantor has a clear bias toward guarantees and conservatism, there may need to be exculpatory lan-guage for the trustee to make sure that the policy is not in conflict with the du-ties of the UPI standard.•
An original asset allo-cation for the policy and guidelines for changes to this allocation.•
Itemization of specific duties of the trustee, the insurance professional and the investment advisor.•
Clarification of how often the policies should be re-viewed and by whom. This should includeprovi-sions for rebalancing sub-accounts and reviews of sub-account performance and new options in the pol-icy. A written report should be a requirement.
Other Considerations. Because this is a rapidly developing area of the law, practitioners should exam-ine or be cautious of the additional considerations for IRLITs:
•
If an existing trust re-ceives stock through a life insurance company de-mutualization, the trustee should make sure that the stock is sold and diversi-fied. Under the standards of UPI, trustees who con-tinue to hold a single domi-nant stock will be liable for damages if this failure to di-versify does not meet gen-eral market returns•
The UPI standard of di-versification might also be applied to insurance poli-cies. If there isn’t a sig-nificant difference in price or the favorableness of an underwriting offer, why wouldn’t a trustee consider several policies? This is es-pecially true for general ac-count products because of the solvency risk. In short, a portfolio of several pol-icies might well be pre-ferred to a single larger policy.The unique nature of insurance policies requires oversight and management. There are many well-documented consequences of un-managed and underfunded poli-cies resulting in policy lapse and multi-million dollar settlements by insurance companies, agents and trustees. Therefore, the ongoing review of the policy is every bit as important as the original policy selection. Trustees should there-fore make certain that there is a regular documented process to monitor the policies.
If significant events occur (e.g., the death of one of the insureds, a change in tax law, significant market corrections, change in com-pany ratings, et. al.), the trustee should take extra care to ascertain the impact of these changes on
T
here are many well-documented consequences of unmanaged andunderfunded policies resulting in policy lapse and multi-million dollar settlements by insurance companies, agents and trustees. Therefore, the ongoing review of the policy is every bit as important as the original policy selection.
the trust and its beneficiaries.
Conclusion
The advent of variable life products and the UPI has created new standards for trusts holding or contemplating the purchase of life insurance policies. Trustees and advisors need to adopt the process of selecting and manag-ing trust-owned life insurance to fit the new products and stan-dards. A properly implemented Investment Policy Statement for the irrevocable trust will protect beneficiaries and trustees by giv-ing enhanced guidance to trust-ees in selecting and managing life insurance policies. Grantors and beneficiaries will benefit by a more thoughtful process for se-lecting and purchasing life ance. By the same token, insur-ance professionals and invest-ment advisors will be able to demonstrate expertise and bring new value to all parties by facili-tating the process of creating an Investment Policy Statement for their clients’ irrevocable trusts as
standard procedure.
Lawrence J. Rybka, JD, CFP is president of ValMark Securities, a national independent broker-dealer that specializes in providing analytical tools and insurance products for some of the country’s leading independent insurance
professionals. He holds a B.S. in Finance as a University Scholar from the University of Akron, and a law degree from Wake Forest University. He was the insurance content expert for the CFP Board of Examiners from 1994 to 1998. He is on the adjunct faculty of Michigan State University’s Estate and Wealth Strategies Institute.
ENDNOTES
1. Hoops, Frederick K. Family Estate Plan-ning Guide. 3rd ed. vol. II. Deerfield, IL: Clark Boardmand Publishing, 1982. 231. 2. Hoops, 232.
3. Rose v. U.S., 511 F. 2nd 259 (5th Cir. 1975); Terriberry. U.S., 517 F. 2nd 286 (5th Cir. 1975); Hoops, 232.
4. Gurnett v. Mutual Life Ins. Co., 356 Ill 612, 191 NE 350 (1934).
5. Scott, 1967. The Law of Trusts. 3rd ed. 228 at 1855.
6. Scott, 228 at 1855
7. Graves. McGill’s Life Insurance. Bryn Mawr: The American College, 1994. 62. 8. Hanson. Regulation of the Life Insurance
Business. Bryn Mawr: The American Col-lege, 1996. 61-62.
9. Hanson, 45. 10. Hanson, 65.
11. Treaster, Joseph B. “A Tale of Unraveled Fortune.” The New York Times. May 25, 1997.
12. Hanson, 61-62. 13. Graves, 67.
14. Maloney, Eugene F. “The Investment Pro-cess Required by the Uniform Prudent Investor Act.” The Journal of Financial Planning. (November 1999) 78-82. 15. Maloney, 80.
16. Ibbotson & Associates Software histori-cal returns for S&P 500 from 1950- 2000. 17. Ibbotson & Associates Software histori-cal returns for U.S. One Year Government Treasury from 1950-2000
18. Maloney, 78. 19. Maloney, 78
20. Markowitz, Harold. “Portfolio Selection.”
Journal of Finance (March 1952) 77-91 21. Ibbotson, R. and Sinquefield, R. Stocks,
Bonds, Bills And Inflation: The Past And The Future. Charlotesville, VA Financial Analysts Research Foundation , 1982. 22. Campisi, Dominic J. “The Perils of
Pros-perity: What Goes Up Will Likely Result In A Surcharge.” Diss. Heckerling Institute. 2001.
23. Rybka, Lawrence J. “A Case For Variable Life.” Journal of Financial Service Pro-fessionals. (November 1997)
24. Whitelaw, Mark “Managing Trust-Owned Life Insurance Revisited.” Trusts & Estates
Magazine. (April 1994) 25. Maloney, 80.
26. Rybka. Brennan, Michael “Helping Clients Understand Behavior of Variable Life.” Na-tional Underwriter. (September 1996) 27. Maloney, 80.
