A group of trust officers at a mid-sized trust company has assembled in a conference room. Each member of the group has responsibility for an extensive portfolio of trusts, many of which are irrevocable life insurance trusts (ILIT). The group also has responsibility for training colleagues in their department on ILITs, broadly speaking.
The purpose of today’s meeting is three-fold. First, they want to take a fresh look at their standard template for presenting reviews to their ILIT clients. Second, they want to be sure the template addresses some newly expressed “free floating” concerns among upper management about life insurance, apparently based on what they’ve been seeing in the press and hearing at conferences. Third, and somewhat incidental to the first two purposes, the template is a great tool for training colleagues who will one day be responsible for ILITs.
We join the meeting, in a manner of speaking, at the point where the group is focusing on how they address life settlements in the reviews. With so many grantors/insureds aging more gracefully than the insurance policies themselves, life settlements are increasingly common as a means of dealing with policies that are no longer needed, wanted or otherwise worthy of support by any of the parties involved in the ILIT. Much has been written about life settlements, including the fine article by Jon Mendelsohn and Todd Steinberg in the March 2022 edition of Trusts & Estates.
A Trustee’s Concern
Consider that when an individual sells their own policy, it’s case closed. The individual has only themselves to congratulate or blame, as they case may be, unless of course they open a case against an agent or advisor whom they feel misled them or didn’t get them the best price. But when the seller is a trustee, it’s a different story, which may involve a whole different kind of case if they’re not careful.
Just as the group is about to create the bullet points for the life settlement segment of the review template, the head of their department, whom we’ll refer to as “Charlie,” peeks into the conference room and asks if he can sit in for a while. The group says, “Sure.” Charlie sees the term “life settlement” on the whiteboard and asks, “What’s a life settlement? Is that part of a mid-life crisis?” They give Charlie a high-level overview of life settlements, including what they are, when they can be helpful, how they’re done, how they’re stress-tested with a “breakeven” analysis under various assumptions, how they’re taxed and so forth.
Charlie says, “I get it. I can understand why a life settlement can be a powerful tool. But there are some things that bother me, not about the transaction but about our role and our potential exposure. It’s easy for me to imagine a situation in which we do a life settlement, and the client dies of a heart attack two weeks later. The kids, who are out big bucks, come in here with their lawyers and ask why we sold the policy. They might wonder, for example, why we didn’t use income from a funded trust to support the policy or why we didn’t ask them to contribute in some way. I don’t know. On the flip side, it’s just as easy to imagine a situation in which we make an affirmative decision not to sell a policy, it lapses because someone was asleep at the switch or the premiums went through the roof and nobody was willing to pick up the tab. The beneficiaries come in with their lawyers and ask us why we didn’t sell when we had the chance.”
Building the File
Charlie goes on to say, “I’d like you guys to work with our lawyers to figure out what should be in our file to support our decision in either case. Maybe give them the same overview that you gave me. Then, here are some of the things I’d like you to cover with them, but feel free to add to the list:
- That breakeven analysis you talked about. I can absolutely imagine that somebody would challenge our input and assumptions, meaning the life expectancy reports, projected policy performance, projected investment returns and whatever else goes into it. What do we need in the file to be able to defend our analysis against those who would second guess it?
- When we did do a life settlement, how do we show that we checked out all possible sources of cash to keep the policy going before concluding that we had no other options but to sell it?
- How we can show beyond a reasonable doubt that we got the best price for the policy available at the time, that we negotiated commissions, etc.?”
Exit Strategy
The group has more than a few policies that are subject to split-dollar or third-party premium financing arrangements. Many of those arrangements are now living lives of not so quiet desperation. In the usual absence of an exit strategy other than the client/insured’s death, a life settlement might be worth considering if the net proceeds of the sale could repay the premium advances or loans as the case may be. The focus here is on the word “net.”
If the ILIT is a grantor trust for income tax purposes, then the net is the full sales price less the expenses of sale. The tax bill goes to the trust’s grantor, the client, who’s the same individual who’s balking at paying any more out of pocket in the first place. Of course, someone will tell the client that paying the tax on the sale is great estate tax planning because that payment isn’t a gift under current law. As to which the client will reply, “Gimme a break!” But if the trust isn’t a grantor trust, the net is further reduced by the tax on the sale. Will the net, net proceeds still be enough to repay all principal, interest and other fees due on termination of the arrangement? The operative guidance on this point is to trust, but verify.
Certainly, the life settlement could result in a huge sigh of relief from certain parties to the transaction who don’t care about the insurance but do care about the ongoing cost to them of maintaining the arrangement. For example, an employer who advanced premiums on a now vintage split-dollar plan on a now vintage retired employee would probably be among those sighing with relief. A surviving spouse under a survivorship split-dollar plan whose annual economic benefit went bump in the same night that the first spouse died would also be among them. But the beneficiaries who were anticipating the large death benefit from the now departed policy? They’ll sigh too, but not with relief.
A Word of Caution
The tax implications of the life settlement itself may not be the only ones to consider. There may also be questions associated with unwinding the financing arrangement, especially if it is of a certain type and vintage. That’s why the tax advisors should be at the table when this kind of transaction is being considered in this kind of setting.
The group will now move on to policy exchanges, a most unsettling topic for trustees and the subject of an upcoming article.
For more information on ILIT Reviews, see “A Trustee Designs a Template for ILIT Reviews.”