LIFE SETTLEMENTS:
A POSSIBLE SOLUTION FOR TOLI
By William Campbell Ries
One of the traditional services offered by financial institutions is serving as trustee under irrevocable life insurance trusts. As a result of the enactment of the new Prudent Investor Rule, favorable changes in mortality and new product offerings by insurance companies, the role of a TOLI trustee has become much more complex and risky. The failure to manage TOLI in a prudent manner may expose the trustee to significant liability to the policy beneficiaries, regulatory sanctions and reputation risks. Life settlements pose an opportunity for TOLI trustees to reduce these risks by providing an alternative for policies that are no longer suitable for the trust.
Life Insurance Trust
Life insurance has always played a significant role in satisfying clients' estate planning needs. Many times, life insurance can be managed more productively when the policy is held in a life insurance trust or when the proceeds are payable to a trust.
In the typical arrangement, the client creates an irrevocable trust for the benefit of the beneficiaries. He or she then makes a contribution to the trust and the trustee uses the contribution to purchase an insurance policy on the client's life, naming the trust as beneficiary. The contribution constitutes a gift and is therefore subject to gift tax. The settlor can either utilize a portion of his or her unified credit and can also take advantage of the annual gift tax exclusion by establishing crummeypowers under the trust. A crummey power enables the beneficiary to withdraw the contribution for a specified period of time. If it is not withdrawn, it remains in the trust and can be used to pay the premium on the life insurance policy. By utilizing an irrevocable trust, the proceeds of the policy escape federal estate tax in the client's estate.
Recent Changes
In recent years, the insurance industry has changed substantially. First, as a result of advances in medicine, life expectancies have increased and are likely to continue to do so in the future. Second, the insurance industry has offered new insurance products which create numerous options for the policy holders. Products such as universal life, variable life, adjustable life, etc., create new opportunities. Third, carrier solvency has become a significant issue. In the past, customers relied on guarantees provided by the carrier to assure the payment of benefits. Now it is important to carefully analyze the financial strength of the carrier before purchasing a policy.
Trustee Duties
Traditionally, the trustee would merely hold the policy as an asset in the trust and pay the premiums from additional contributions to the trust as they come due.
As a result of several factors, the trustee has a greater responsibility in administering TOLI. When held in trust, the settlor gives up all dominion and control over the policy and therefore has no power with respect to the policy. The beneficiaries have no rights in the policy until their interest in the trust vests, usually at the death of the settlor. As a result, the trustee is the only party that can exercise dominion and control over the policies.
As a result of industry changes, it now falls upon the trustee to perform a greater range of responsibilities. For example, if the trustee holds the policy of a carrier that becomes insolvent, the beneficiaries may seek to recover damages from the trustee for its failure to adequately monitor the policy. This could be equivalent to holding a security of a failing company.
As a result of mortality changes and product changes, a beneficiary may seek to recover damages from a trustee if he can show that cheaper or better performing options are available. What if the trustee could obtain a new policy for half the premium and get double the benefits.
The enactment of the new Prudent Investor Rule in most states now treats life insurance the same as any other investment. As a result, the TOLI trustee must exercise appropriate care, skill and caution in managing insurance. This duty has been recognized by the regulators in conducting examinations of financial institutions.
As a result, it is incumbent upon TOLI trustees to manage TOLI in a prudent manner considering the financial strength of the carrier, the life expectancy of the settlor and the various product options available. In certain cases, the trustee may have the duty to replace an existing policy with a new and better policy if one is available. In other cases, it may be prudent to liquidate the policy and reinvest the proceeds in other investments if it is determined that the policy is no longer needed.
Life Settlements
One option available to a TOLI trustee is to utilize what is known as a life settlement when a policy needs to be liquidated. Typically, a whole life policy is liquidated by cashing it in and receiving the cash value. A term policy is terminated by merely stopping the payment of the premiums. Life settlements present a new alternative, i.e., selling the policy to an institutional funder to a life settlement broker.
Typically, institutional funders will purchase the policy from the owner for an amount higher than the cash value but less than the death benefit. The institutional funder then takes over ownership of the policy and pays the premium during the settlor's lifetime. Upon the settlor's death, the proceeds are then paid to the institutional funder. Life settlements are usually only available when the settlor's life expectancy is more than five years and less than fifteen years remaining. Unlike viatical settlements which involve purchasing policies from people who are severely ill, life settlements are directed to persons with normal life expectancies.
Life settlements are regulated by the state insurance commissioners of the states where the life settlement is offered. Currently, thirty-seven states have specific regulations governing life settlements. There is also a series of guidelines issued by the National Association of Insurance Commissioners governing such transactions. As a result of the enactment of the new Prudent Investor Rule and the changes in the insurance industry, the duties of TOLI trustees have become more expensive. As a result, TOLI trustees must act prudently when administering life insurance policies just as they would with any other investment. Life settlements provide an alternative to which the trustee can obtain additional proceeds for the trust when a policy has to be liquidated. The failure to do so could lead to significant liability. It is important that financial institutions review their policies and procedures governing TOLI to avoid liability and regulatory sanctions.
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