Unique and Hard-to-Value Assets Comptroller’s Handbook
August 2012 Updates:
Life insurance may be placed in a trust as part of an estate planning tool. Life insurance policies may be put into a trust to remove the policy from a grantor’s estate for inheritance or estate transfer tax purposes. A life insurance policy frequently provides the surviving beneficiaries with a liquid asset to pay estate taxes and other final expenses, while enabling them to retain other less liquid assets in the estate. Bank fiduciaries are responsible for protecting and managing the life insurance policy for the benefit of the beneficiaries for the life of the grantor. A bank fiduciary must understand each life insurance policy that the trust accepts or purchases, or the bank fiduciary must employ an advisor who is qualified, independent, objective, and not affiliated with an insurance company to prudently manage these assets. In addition, the bank fiduciary must periodically review the financial condition and rating of the insurance company. The majority of these policies are deposited into the trust by the grantor. Many states have recently passed legislation to limit the liability of bank fiduciaries, in certain situations, by rescinding requirements under state law to perform due diligence on insurance companies as a directed bank fiduciary. The OCC, however, continues to require bank fiduciaries to follow 12 CFR 9.6(c) and 12 CFR 150.220 and to conduct annual investment reviews of all assets of each fiduciary account for which the bank has investment discretion. This review should evaluate the financial health of the issuing insurance company as well as whether the policy is performing as illustrated or whether replacement should be considered. Life insurance trusts are frequently used as estate planning tools. These trusts involve ownership of a life insurance policy that is transferred to a trust by the grantor, and the trust is then identified as the designated beneficiary of the policy. If certain conditions are met, the policy proceeds may pass outside of the grantor’s estate thus escaping estate transfer taxes. There are numerous scenarios, however, where IRS rules could result in a clawback of these policies to the grantor’s estate preventing individuals, for example, from gifting assets to their descendants or other parties once death is imminent in an attempt to avoid estate taxes. These rules primarily focus on insurance policies or assets in which the deceased retains an interest. Absent an irrevocable life insurance trust (ILIT) or some other tax avoidance arrangement, the proceeds of the life insurance policy would otherwise be taxable. Using an ILIT can result in a significant portion of an estate passing untaxed to the beneficiaries by avoiding federal estate taxes on the proceeds. In addition to transferring an existing policy to this type of trust, it is possible to create the trust and then have the trust apply for a life insurance policy. In this situation, the current federal tax code provides that there is no three-year waiting period before the tax advantages are achieved. The possible tax savings of an ILIT are its major advantage. There are, however, some specific requirements that must be considered before a bank trust department accepts and manages such assets:
- The trust must be irrevocable. Once the policy is transferred to the trust, the trust cannot be amended or revoked by the person setting up the trust (the insured).
- Allowing the policy to lapse can present a substantial problem. The fiduciary may be unable to obtain replacement insurance because the insured party has become uninsurable, or may only be able to obtain insurance coverage at a significantly higher cost because the insured party has moved into a different risk category.
- An ILIT typically includes provisions (called “Crummey Provisions” after an IRS case) that allow a beneficiary to withdraw any contribution made to the trust, e.g. contributions to cover premium payments. These special withdrawal powers must be very carefully drafted to avoid creating tax problems for the trust. See the “Personal Fiduciary Services” booklet of the Comptroller’s Handbook for details on these types of trusts (appendix A, pages 72-73).
Adequacy of Insurance Assets
Bank fiduciaries need to have well-developed risk management practices to evaluate and administer accounts with insurance policy holdings. A bank fiduciary with discretion over the account must complete formal preacceptance, initial post-acceptance and annual reviews of the insurance policy. Independent of these reviews, a fiduciary bank must have risk management systems and reviews that address the following:
- Sufficiency of premiums: The bank fiduciary must determine whether current premiums are sufficient to maintain the policy to maturity or to meet the insured’s life expectancy.
- Suitability of the insurance policy: Consider replacing an insurance policy if the bank fiduciary identifies concerns with the condition of the insurance provider or if that provider does not meet the needs of the grantor or beneficiaries. Also assess any tax changes that could affect the suitability of the policy.
- Carrier selection: The bank fiduciary needs to evaluate the carrier’s financial condition. To the extent insurance carrier ratings are available, they generally lag corporate and market events, and should be used principally as indicators of a firm’s creditworthiness.
- Appropriateness of investment strategy: The bank fiduciary must evaluate the appropriateness of investments of any segregated account to support the cash value.
For policies with flexible premiums and non-guaranteed benefits, the trustee should obtain the original policy illustration, which shows planned premium strategies. This policy illustration is subject to a high degree of fluctuation. Periodically, the trustee should obtain an in-force illustration. This provides a measure of performance of a life insurance policy against what was initially illustrated. By obtaining an in-force illustration, the trustee can monitor the effectiveness of the policy to date and project how the policy may perform in the future and plan for any potential shortfall in premiums. This process assists the trustee in monitoring the economics of the policy. Generally, while insurance companies are regulated by the state and maintain a mandatory level of reserves, specific assets are not identified to support an insurer’s promise to pay on a policy. Policyholders are subject to the creditworthiness and liquidity constraints of the company. It is important that a bank fiduciary perform due diligence on an insurance company issuing a policy to ensure that it is sound, viable and able to meet future obligations. Cash value on permanent life insurance policies may be included as part of the account’s assets if the bank has done a thorough review of the insurance company’s financial condition and is satisfied with its soundness. The cash values for variable life and variable universal life policies, however, are supported by separate accounts and comprise assets selected by the policyholder and should be included as account assets. Other term type policies should be held at a nominal value because the payment and value of those policies is based on the payment ability of the insurance company at a future date. Insurance policies should never be reported at the face value of the policy. In some instances, the bank may just hold a policy for safekeeping, see further discussion of different types of insurance products in appendix E of this booklet.
Appendix E: Types of Life Insurance
The function of life insurance is to create a principal sum or estate, either upon the death of the insured or through the accumulation of funds set aside for investment purposes. Life insurance is most commonly used to protect a person’s dependents against the undesirable financial consequences of the insured’s premature death or to provide liquid assets to a person’s estate. Life insurance can be categorized into two broad types, temporary (term) and permanent insurance. While there are numerous variations of these products, most life insurance policies generally fall within either one, or a combination, of the following categories.
Term Life Insurance
Term life insurance is a contract that obligates the insurer to pay the policy’s face value if the insured dies within a specified period. Term life insurance offers death benefits only and generally has no cash value or savings element. Because term life insurance provides only mortality protection, in most situations it provides the most coverage per premium dollar. While term life insurance can be relatively inexpensive for younger policyholders, term life insurance premiums generally increase with the age of the policyholder. Most term life insurance policies are renewable for certain periods or until the policyholder attains a specified age. Additionally, many term life insurance policies are convertible to permanent life insurance without the insured having to show evidence of insurability. Term life insurance is commonly used by a trust in conjunction with a home mortgage. At the death of the policyholder, the proceeds of these term life insurance policies usually are paid to a family member, rather than to the lien holder.
Permanent Life Insurance
Whole Life The cash value of a whole life insurance policy accrues according to a guaranteed, predetermined rate of return determined by the insurance company. These policies are also referred to as “general account” products because the life insurance company’s general assets support the cash value. Most policies provide lifetime protection to age 100. If the insured is still living at that age, the policy “endows,” and the guaranteed cash value equals the face amount of the policy. Premiums and death benefits are guaranteed for the duration of the policy. Because premiums are constant, the cost is much higher in the early years than comparable coverage provided under a term life insurance policy. Typically, however, the cost relationship reverses in later years as the cost of term life insurance rises with the age of the insured. Combination policies usually combine term insurance with a base whole life policy by using an attachment or rider. This combination provides for additional death benefits without a significant increase in premium cost. Please refer to the “Insurance Activities” booklet of the Comptroller’s Handbook for further details on this and other insurance products.
Universal Life Another permanent form of life insurance, universal life is an interest-sensitive form of life insurance, designed to provide flexibility in premium payments and death benefit protection. Policyholders can adjust the premiums, cash values, and level of protection, subject to certain limitations, over the life of the contract. Additionally, unlike whole life, the interest credited to the cash value of universal life policies is based on current interest rates, subject to an interest rate floor. Universal life has a pure insurance component (mortality protection) and a professionally managed investment component. The policyholder can pay higher premiums and maintain a high cash value. Alternatively, the policyholder can make minimal premium payments in an amount large enough to only cover mortality and other expense charges, thus not accumulating as much cash value.
Variable Life Variable life is a form of whole life insurance. A difference between variable and traditional whole life is that the policy’s cash value is invested in segregated accounts comprised of equities and other securities. Premiums may be placed in the insured’s choice of stock, bond, or money market funds offered through the insurance company. The policy’s death benefit and cash value of the policy depend on the underlying investment portfolio’s performance, thereby shifting the investment risk to the policyholder. Generally, there is a minimum guaranteed death benefit. The policy allows for tax-deferred appreciation of the accumulated assets. Because variable life policies are classified as securities, life insurance agents selling these policies must also be registered representatives of a broker-dealer licensed by the Financial Industry Regulatory Authority (FINRA) and must be registered with the SEC.
Variable Universal Life Variable universal life combines the flexible premium features of universal life with the investment component of variable life. These products also are classified as securities and are subject to FINRA and SEC requirements.