Inadequately funded policies—that is, policies lapsing before maturity or maturing with a significantly reduced death benefit—can compose a significant portion of a trustee’s life insurance portfolio. Clients are often content to “stay the course” with their policies, not wanting to or believing they can make any changes to a policy. As the time horizon to lapse shortens, however, the need to explore options to remediate the funding issues becomes more urgent.
It is natural to wait and focus on remediation options when there is more urgency, but it is prudent to consider these even when the time horizon is much longer, as options may become less attractive or not available as time passes. Not all will be suitable or attractive to your client, but discussing these options with a client may introduce them to possibilities with their policy they did not even know existed. Pursuing any one of the below options may “solve” the funding issue, however, a more comprehensive exploration may identify that some options provide more value than others for your client’s particular situation.
While not all-encompassing or applicable to every policy or situation, the following strategies are a good place to begin a conversation with a client whose policy in inadequately funded:
Increase the funding
Many inadequately funded policies are simply a result of no longer funding a policy. Others have been funded more robustly but maybe inconsistently so, or they have been affected by reduced interest crediting or increased charges by the insurance carrier. Because of changes in crediting and charges, perhaps the “planned premium” that has been paid for many years is just no longer sufficient.
An insurance carrier can typically produce illustrations projecting the premium necessary to maintain the policy to maturity or another target year. Of all the options to consider when remediating an inadequately funded policy, increasing the funding to the necessary degree is perhaps the most straightforward. If the means and desire to pay the increased premium amount are available and the current death benefit of the policy is still needed, the funding issue can be resolved with relative ease this way.
Reduce the death benefit
Paying substantially greater premiums, however, is often not financially feasible or attractive to the client. Adjusting the death benefit downward, whether via a face amount reduction or changing the death benefit option from increasing (face amount plus cash value) to level (face amount only) would yield lesser premium requirements. The current level of funding may even be sufficient to maintain the policy to maturity or other target year with a reduced death benefit. Depending on the amount of premium that has already been applied to the policy, there may be limitations as to how much a policy’s death benefit can be reduced. Similarly, the composition of the policy’s death benefit—such as various riders or additional insurance beyond the face amount of the policy—may limit the amount to which it can be reduced.
A combination of the above
The client may be willing to increase funding of the policy but finds that the insurance carrier’s projection of the premium necessary to mature the policy is still too steep. The insurance carrier should be able to provide an illustrated scenario whereby the policy’s death benefit is reduced to the extent at which an increased level of funding would enable the policy to mature. The same caveats apply here in regards to reducing the death benefit: there may be premium or structural constraints that limit allowable funding or the reduction amount.
Replace the policy
If exploring different payment or death benefit scenarios with the current policy is not producing satisfactory options, there could be advantages to policy replacement A newer policy from the same or different insurance carrier may be able to provide more favorable insurance charges, offer higher interest crediting, or be more easily re-structured. If the insured is still healthy and willing to go through medical underwriting, policy replacement may produce a better performing policy.
In considering policy replacement, it is prudent to assess the likelihood or sustainability of any scenario that is projected for the proposed replacement policy. While less than optimal future charges and crediting are also a concern for an existing policy, most new policies have surrender charges that give clients less flexibility for many years if liquidity is needed.
For more information on policy replacement, see Should You Replace a Life Insurance Policy in an ILIT – What Trustees Need to Know.
Surrender the policy for cash
Conditions change. The life insurance policy that fit neatly into your client’s financial plan many years ago may no longer be needed. This is often a driving factor for clients no longer wanting to fund their policy. But there could be a substantial reservoir of cash value within that policy. Surrendering the policy for its cash value now or before insurance charges begin to rapidly deplete the cash value may be an appropriate action if the policy’s death benefit is no longer needed. A taxable gain may be applicable upon policy surrender should the cash value be in excess of the cost basis (typically premiums paid) of the policy.
Investigate the feasibility of a life settlement
If surrendering the policy for cash is considered, investigating the possibility of a life settlement should also be explored. A life settlement buyer may offer more cash to the owner of the policy than a cash surrender of the policy would yield. Unless serious health issues are present, the insured typically needs to be over the age of 75 for a life settlement to potentially be feasible. Additionally, the policy must be transferable, and its face amount should be $100,000 or more.
For more information on life settlements, see Life Settlements Within the Fiduciary World.
Of course, more complex scenarios arise that require further analysis. For example, it is common for trustees to have clients with multiple inadequately funded—or otherwise problematic—policies. At other times, it is necessary to try to meet the needs or goals of several interested parties, keeping in mind the best solutions for each party may compete against each other. Uncertainty regarding the timing of a potential death benefit further complicates any policy management decisions.
With everything to consider, it can seem overwhelming in knowing how to best manage and remediate an inadequately funded policy. RIC can partner with trustees through the process by facilitating arrangements with insurance carriers, providing in-depth analysis of options with actuarially-driven data, or helping to communicate the different options to trustees’ clients. Regardless of the situation, RIC can identify several options and actionable steps to remediate an inadequately funded policy that may be presented to clients. This allows for further discussions with the client as to how the different options might fit into their current financial plan.
RIC is a nation-leading independent risk manager partnering with over 200 corporate trustees. We provide independent policy reviews, ILIT administration software, and remediation services for Trust Owned Life Insurance. As we do not market or sell insurance of any kind, our entire focus is on reducing fiduciary risk and helping trustees meet regulatory oversight requirements.
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