More than 40% of the trust-owned life insurance policies RIC reviews each year are identified as being inadequately funded—either lapsing prior to maturity or maturing with a significantly reduced death benefit. The causes of these premature lapses are often beyond the control of the trustee or their clients, as insurance companies increase the costs of an insurance policy or reduce its interest crediting. Many of these premature lapses, however, are caused by policies no longer being funded, as clients decide to suspend premium payments.
When faced with the scenario of a client suspending premium, it is an appropriate time to revisit the ongoing needs of the trust and review the suitability of the policy for the trust, which includes assessing the insured’s health, the trust’s risk tolerance level, and the trust’s overall objectives. Even after this review, the trustee must consider a number of options beyond the simple binary decision of keeping the policy or terminating the policy. There are nuances to each policy and/or plan type that will be discussed further below, but to determine the options available to the trust to best manage the policy going forward, the trustee can initially do the following:
Obtain new illustrations from the insurance carrier projecting policy performance with suspended premium. First and foremost, an illustration from the insurance carrier showing the effects of a suspension of premium should be acquired. This will inform the trustee as to how long the policy will persist without any further premium contributions. Depending on the age of the insured and how well the policy was previously funded, the policy may lapse almost immediately or persist for many years without any further premium payments.
Further illustrations to obtain from the insurance carrier will vary depending on policy and/or plan type; however, scenarios showing reduced death benefits to maturity or to a risk tolerable age should be examined. The remaining cash value in the policy after premium suspension occurs will dictate the insurance carrier’s flexibility in providing these additional reduced death benefit scenarios. Reducing the death benefit will typically be an option, but if there is minimal cash value, even reducing the death benefit may not prolong the policy far beyond a projected lapse at its current death benefit.
Investigate replacement of the existing policy. If the duration of coverage at the current death benefit or a reduced death benefit is not satisfactory, replacing the current policy with a newer policy from the insurance carrier or a different insurance carrier should be explored. Depending on the age and health of the insured, utilizing the current policy’s cash surrender value to facilitate a 1035 exchange as a single premium into a new policy could potentially provide the trust with a policy providing superior coverage to the current policy.
Consider surrendering the policy for its cash value or explore the possibility of a life settlement. If death benefit coverage is no longer needed, surrendering the policy for its cash value or selling the policy on the secondary market should be considered. These are ways to get an immediate return on previous premium contributions in lieu of letting the policy lapse without value. EnTrust Settlements (www.entrustsettlements.com), an affiliate of RIC, can provide a preliminary life settlement evaluation to determine if the policy is a good candidate for sale on the secondary market and if the expected sale value would surpass the current cash surrender value. RIC recommends consulting a tax advisor should either of these options be considered to ensure the trustee is aware of the taxation of the proceeds, if any.
Universal Life and Variable Universal Life
As universal life and variable universal life policies are often referred to and marketed as “flexible premium” policies, these are the policy types RIC most often sees with premium fully suspended. In higher interest rate environments, an eventual suspension of premium may have even been planned from policy issue, with the policy projected to persist until maturity. If planned interest or variable earnings have not been achieved, however, premium payments must often continue well beyond the initially planned premium suspension.
Fortunately, the costs of maintaining most universal life and variable universal life policies are fairly transparent and the process of identifying the various options to consider should follow the recommendations above. A notable exception is policies with secondary, or “no lapse,” guarantees. Policies utilizing their secondary guarantees to remain in force can be extremely sensitive to the timing of premium payments. A trustee should take extra care to understand how suspending premium may affect this type of policy.
Contrary to the “flexible premium” of universal life or variable universal life policies, whole life policies require premium to be paid each year unless the policy is explicitly paid-up. There are, however, a number of ways premium can be paid with a whole life policy’s internal values if out-pocket premium contributions are suspended. Most whole life policies owned by trusts earn dividends, which in turn can be utilized to purchase more insurance (paid-up additions) or reduce the premium amount due. If dividends are robust and the policy has been in force for a sufficient amount of time, dividends may be sufficient to pay the premium in full. Alternatively, previously acquired paid-up additions may be surrendered to pay a part, or all, of the premium.
Policy loans can also be used to pay premium. In doing so, a loan is taken out against the cash value of the policy in the amount of the premium. Not only does the loan reduce the amount of cash value available for withdrawal or surrender, it also reduces the policy’s death benefit by the amount of the loan. This method of paying premium can be an effective way to suspend out-of-pocket contributions in later policy years; however, doing so too early and over-leveraging the policy can have a devastating effect on the policy’s death benefit. Unsustainable out-of-pocket contributions may become necessary to prevent the loan balance from exceeding the policy’s cash value and forcing a surrender of the policy. In such cases, there can be taxable consequences of the policy terminating, even though there was no longer any value to the trust.
Most whole life policies can be converted to a paid-up status, albeit with a reduced death benefit. Additionally, some whole life policies contain a term component of insurance that if reduced or eliminated may make full premium payments through dividends more feasible to achieve. With all of the potential moving parts of a whole life policy, it is important for the trustee to work with the insurance carrier to determine what methods are possible to best maintain the policy if no further out-of-pocket contributions will be made.
Typically, term policies will terminate without value if premium ceases to be paid. An option to investigate, however, is if the term policy has a provision to be converted to a permanent plan of insurance. Depending on the age and health of the insured, a permanent policy may have value through a life settlement, once again providing the trust with a monetary alternative to the policy ceasing without value.
The best course for ongoing policy management when a client wishes to suspend premium will depend largely on the needs of the trust and exact options available for that particular policy. It is important, however, to carefully consider all of those available options. While the current death benefit persisting to the insured’s age 90 may seem sufficient, a reduced death benefit guaranteed to maturity would eliminate any risk of the insured outliving coverage. Likewise, surrendering the policy for its current cash value may be a good option if the policy is no longer needed; however, ensuring a life settlement would not yield an even greater cash payout would be a prudent action by a trustee. Working through available options with a client not only fosters a good relationship with them but may also present them alternatives they did not know existed.
RIC provides unparalleled service to trustees and fiduciaries managing unique and hard-to-value assets. We are an independent risk manager and Registered Investment Advisor with the specialized expertise required to manage, analyze, value and administer trust owned life insurance, annuities, variable invested assets, closely held businesses and other unique assets. Since 2001, RIC has been the nation’s leading provider of independent risk management solutions for banks and trust companies.
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