Danger: Fiduciary liability ahead

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Trustees of irrevocable life insurance trusts and other fiduciaries have a duty to act in the best interests of beneficiaries. Lawsuits are waiting to happen, because the benefits and risks of life insurance policies are often poorly understood.

The Restatement of the Law Third of Trusts (1990) and the Uniform Prudent Investor Act identify these principles of prudent investing:

  • Duty to diversify. If you decide to forgo the benefits of diversification, you need to have a good reason.
  • Duty to invest according to a suitable level of risk. You need to weigh risk and return in the context of the trust's objectives.
  • Duty to avoid unnecessary expenses. If you decide to pay higher costs than necessary, you need to have a good reason.
  • Duty to seek advice when necessary. You should recognize when you need help, and you must choose an adviser carefully and monitor the adviser's actions.

In some cases, trust documents can be drafted to override some of these duties, but why would you want to override sound principles?

Life insurance is an asset that must be purchased and monitored with care. The following questions cover areas where attention to detail can add value for the beneficiaries and prevent trouble years from now. The focus is on existing policies, but many of these items also apply to new policies.

  1. Is the policy information correct?
  2. Does the case design match the objectives?
  3. Is the policy providing good value?
  4. Can the policy be modified to provide better value?
  5. Can you obtain additional benefits through litigation?
  6. Has the company announced a plan to demutualize?
  7. Are the planned premiums adequate?
  8. Has the agent complied with the service contract?

1. Is the policy information correct?

It's worth spending a few minutes to make sure that you actually have what you think you have. Look at the contract. Are the type of policy, face amount, planned premium, riders, underwriting class, insured, and ownership and beneficiary designations correct?

Look at the original illustration, annual statements, and additional correspondence in your file. Are there any surprises, such as unexpected policy loans, required premiums, or a change in modified endowment contract (MEC) status? Have there been any changes in ownership and beneficiary designations that could lead to tax problems, such as a transfer for value?

Do you know the policy's cost basis (also called the "investment in the contract")? If not, you can obtain that information from the agent or the company. It may be useful for making decisions later.

Do you have a recent in-force illustration, showing the future policy values based on current or other specified assumptions? You will need this to evaluate the policy.

Do you have any notices regarding class action settlements or demutualization plans? You will need to review these documents to see if you are eligible for additional benefits.

Is the application, including medical information, attached to the contract? Do you have reason to believe that the insured did not provide accurate information about his health? If so, there may be a risk that the insurer will contest a death claim. The contract's incontestable clause may work in your favor if the claim occurs after the contestable period (usually two years), but insurers may try to challenge the traditional protections of this clause in the future. This is obviously a delicate matter, and you will have to look at the facts of the situation.

Has the insured's health changed since the policy was issued? You'll probably have to ask the insured for that information. You're looking for any negative or positive developments. An adverse change will increase the chances that the policy should be kept. A favorable change, such as stopping tobacco use, signals that you should consider replacing the policy or asking the insurer to modify it.

Take note of three types of special circumstances that you may encounter:

(1) Favorable underwriting. Skillful agents can sometimes help people with health problems get a good deal from a particular company. This occurs less often than agents would like everyone to believe, but it does happen.

(2) Negotiated endorsements at the time of issue. It's possible in some cases to obtain a special endorsement to the policy to provide a desired benefit, such as waiving evidence of insurability for a paid-up additions rider. These endorsements are unusual, but they do exist.

(3) Voluntary waiver of contractual provisions after issue. The company may voluntarily waive minor contractual provisions for all policyholders after issue. For example, it might waive restrictions on transfers from the general account to the variable subaccounts for variable life policies, or it might waive partial surrender charges when universal life face amounts are reduced. These waivers may be communicated to policyholders in writing, or you may have to contact the agent or customer service representative to find out about them.

2. Does the case design match the objectives?

Case design refers to the planned premiums, initial death benefit, and future death benefits. You can also call it the policy design or the policy configuration. Whatever you call it, you want to verify that the policy is set up to accomplish the desired financial objectives.

Example: The goal is to use life insurance to increase the future wealth of the beneficiaries. The trust owns a $2 million second-to-die universal life policy on a 72-year-old couple, with a planned annual premium of $50,000 for life. The rate of return on death at age 100 is only 2.4%, which is less than the after-tax return on alternative investments. Although living to age 100 seems like a long shot, the probability that at least one person will survive to that age could be over 20%. Setting the policy up with a level death benefit creates a significant risk that the heirs will actually have less money than if premiums had been invested elsewhere. This risk can be reduced or eliminated by paying a higher premium or reducing the current death benefit, in order to produce a rising death benefit later. Be sure to document the reasoning behind this, because if the couple dies early, the beneficiaries may complain that your prudent action actually cost them money.

3. Is the policy providing good value?

Term insurance prices have decreased significantly in recent years, so it may be easy to find a policy that has lower premiums and a longer guarantee period.

To evaluate an existing term policy, you need to compare the schedule of current and guaranteed rates against what is available in today's marketplace. There are many websites that can give you an idea of term prices. You should also consider the guarantee and renewability periods and the convertibility provision. For good advice on how to shop for term insurance, see the July 1998 issue of Consumer Reports.

To evaluate an existing cash value policy, you need to obtain an in-force illustration showing projected cash values and death benefits based on current assumptions. Three methods of analysis are useful to begin to form a judgment about the performance of the policy:

a. Comparison of the projected values with those of low-load policies, funded with the existing cash value and the same premiums. Ameritas (800-552-3553) and USAA (800-531-8000) are useful for this purpose, because they have a record of excellent performance and solid pricing practices. If the existing policy can compete with low-loads, that's a good sign. You can also compare the existing policy with a new universal life policy with a no-lapse guarantee. This type of policy has recently become very popular, although the advantages are more obvious than the disadvantages.

b. Rate of return on the savings component (also called the Linton yield). This is the method of analysis used by the Consumer Federation of America's Life Insurance Rate of Return Service. When the results are interpreted properly, this provides information about performance and also raises questions for further research. A smooth pattern of competitive rates of return is a good sign. (For insured-owned policies, a variation of this analysis lets you compare the existing policy against the alternative of buying term insurance and investing in a Roth IRA.)

Example: I own a $20,000 Mass Mutual whole life policy, issued in 1964. For the 2002-2003 policy year, it's reasonable to say that the policy provided about a 6.1% rate of return, computed as follows:

Cash value at beginning of year: $32,297

Premium: $285
Estimated value of insurance protection: $323 (based on low-cost term insurance)
Cash value at end of year: $336,277

Cash flow diagram:

This 6.1% could be compared to money market or short-term bond fund returns, keeping in mind that cash value life insurance receives favorable tax treatment. Note that Mass Mutual's 2003 dividend interest rate was above 7%, so this demonstrates that you can't use the dividend interest rate as a shortcut.

c. For fixed-premium and flexible-premium universal life and variable life, examination of the load structure of the policy, including premium and other loads, cost-of-insurance rates, surrender charges, and the interest rate. This helps you understand how the policy works, and it can suggest appropriate actions.

You can make bad decisions with all of these methods if you apply them mindlessly. Keep an open mind and look for contrary evidence. Ideally, you would try to understand all of the steps in the company's pricing process, but that is rarely practical. It requires more time and expense than you can probably afford and more cooperation from the insurer than you're going to get. You will often have to make decisions without enough information to feel confident.

There is no simple way to compare or analyze life insurance policies. If there were, fee-only consultants would have written a short article explaining how to do it and then moved on to other occupations. You can certainly find charlatans who claim to have a simple method, but you will find no support for these claims in the voluminous academic literature on this subject. Therefore, fiduciaries who use these methods will have some explaining to do if they are ever invited to appear in court.

Of course, it's not enough to look at numbers in deciding whether or not to replace an existing policy. You also need to look at these features:

d. Financial strength ratings and full reports from rating agencies, such as A.M. Best, Fitch, Moody's, and Standard & Poor's. Financial information may also be available from Conning & Company, Thomson Bankwatch, Townsend & Schupp, Ward Financial Group, and Weiss Ratings.

e. Contractual provisions that might add value, including the incontestable and suicide periods, no-lapse premium provisions, and riders (e.g., policy split option, waiver of monthly deductions at first death, waiver of premium for disability, extended maturity). In a period of sustained low interest rates, a 4% guaranteed minimum interest rate might actually be worth something. Keep in mind, however, that policy guarantees are more complicated than they seem, because an interest rate shortfall can be partially or entirely offset by the mortality and expense components of the dividend (for whole life) or by higher insurance and expense charges (for universal life).

f. Grandfathering under old tax laws.

The Replacement Questionnaire (RQ) created by the Society of Financial Service Professionals is a convenient tool for assembling information. This watch list may also give you some guidance.

Don't forget that the decision to replace an existing policy is not a one-time-only choice. You have the option to wait for more information. If a low-quality policy has a peculiar load structure, such as a rapidly decreasing surrender charge, it may make sense to wait for a few years before replacing it. The obvious risk is that the insured's health will change in the meantime, making it more difficult to obtain a new policy.

4. Can the policy be modified to provide better value?

You may have opportunities to improve the performance of an existing policy. In some cases, this could even make it worthwhile to keep a policy that you would otherwise replace. Some possibilities to consider:

a. Use retroactive blending to reduce commissions and improve values. This may be worth pursuing in cases where the agent failed to adequately explain the alternatives. "The Basics of Blending" (a PDF file) discusses the pros and cons of this technique. To change a blend retroactively, the insurance company will have to re-issue the policy.

As soon as plaintiffs' attorneys understand how blending works, this will become a new frontier of litigation. It clearly relates to the duty to avoid unnecessary expenses. The damages can be significant and are relatively easy to determine.

b. Use dividends to buy paid-up additions (PUAs). You can think of PUAs as low-load, single-premium whole life additions. They usually offer an attractive, tax-deferred rate of return on the cash value, and they provide a small amount of additional insurance.

c. For fixed-premium policies, pay premiums annually. The implicit interest charge for monthly, quarterly, or semi-annual payments varies widely, and it can be surprisingly high. One large company charges an effective interest rate of 27.1% for semi-annual payments and 18.9% for monthly payments.

d. If there is a policy loan, determine its true cost. The pre-tax cost is the policy loan interest rate plus the reduction in interest rate or dividends caused by borrowing. The so-called "net cost of borrowing" may be 2% or less, but the true cost of borrowing is much higher.

e. For participating whole life policies with a fixed policy loan interest rate, find out if you can update the policy to a variable rate (or an equivalent adjustment), in exchange for higher dividends.

f. Cancel riders that you no longer need.

g. For flexible-premium policies (i.e., universal and variable universal life) with a level death benefit, stop paying premiums if the insured is in poor health. You can resume making payments if necessary. For whole life, you can elect the extended term insurance option, but this is irrevocable.

h. For flexible-premium policies, you can improve relative performance by examining the load structure and taking advantage of strengths and weaknesses. For example, if a policy has no premium load, a high interest rate, and high cost-of-insurance rates, it may make sense to increase the premium or reduce the face amount (but watch out for partial surrender charges). In other cases, it may make sense to reduce the premium, but make sure that you won't forfeit any benefits — e.g., no-lapse guarantee, interest rate bonus — by doing so. "Repair or Replace: A Case Study" (a PDF file) shows how to rescue a policy from the scrap heap.

i. Instead of dropping an existing whole life policy, consider electing the reduced paid-up nonforfeiture option.

j. Life insurance policies generally have guaranteed minimum interest rates of 3.5% to 5%. If market interest rates are low, it could make sense to reconfigure a policy to perform as a high-yielding investment.

k. If the policy was issued with higher-than-standard premiums due to a health impairment and the insured's health has since improved, find out if you can get the extra charges reduced or removed.

l. If you have decided to drop the policy, consider three ways to squeeze out additional value:

  1. For dividend-paying whole life policies, wait until the policy anniversary. Most companies do not pay a pro-rata dividend upon surrender. You may have to weigh this against losing a pro-rata refund of premium by waiting.
  2. If the policy's cost basis is greater than its cash value, do a tax-free exchange to a variable annuity. You can then use the excess basis to shelter future investment earnings from income tax.
  3. For large policies (typically, $500,000 or more) with older insureds (typically, age 70 or higher), it may be possible to sell the policy to a third party for more than the cash value. This is called a life settlement (or lifetime settlement, senior settlement, elder settlement, or high net worth transaction). It is similar to a viatical settlement, but it does not require a terminal illness.

5. Can you obtain additional benefits through litigation?

You may already be eligible for benefits as part of a class action settlement. If so, you should have received a notice explaining your options. If you have good documentation to support a claim, you may be offered one of the levels of relief, including honoring the original projected premium schedule or refunding premiums.

If you're not part of a class action, the insurance company may agree to a quiet settlement on a case-by-case basis, to avoid bad publicity and extended litigation.

6. If the policy is issued by a mutual company: Has the company announced a plan to demutualize? If it hasn't already, is it likely to announce a plan?

This is important, because you may be entitled to a valuable distribution of stock or cash in the future. If you drop the policy before the record date, you forfeit your right to this bonus. You can find a discussion of this subject and a table showing the reorganization status of major mutual life insurers at "Mutual company reorganizations."

7. Are the planned premiums adequate to support the desired case design using prudent assumptions?

If you have decided to keep the existing policy and have made appropriate adjustments to improve performance, you need to verify that the planned premiums are adequate. There are several degrees of adequacy, depending on the purpose of the policy. Are the premiums adequate to keep the policy in force for some desired period, such as 20 years? Adequate to endow the policy at maturity? Adequate to create a rising death benefit in later years, in order to provide an acceptable rate of return on death at all ages?

Many companies now pay an interest rate of over 6% on whole life and over 5% on universal life. If market rates remain where they are, insurers will eventually have to reduce their credited rates. You can ask the insurer to provide an in-force illustration with a 1% or 2% reduction in the credited interest rate to see the effect of lower rates. (Caution: The difference in typical interest rates between whole life and universal life tells you nothing about the relative merit of the two types of products, because there are other factors that affect performance.)

It is particularly tricky to determine an adequate funding level for variable life policies, because of the effect of the volatility of returns. Even if you make an accurate guess about the future average annual return on the variable subaccounts, the pattern of annual returns can have a dramatic effect on future policy values.

One way is sidestep the need to determine funding adequacy is to pay the maximum allowable premium each year. For whole life, it's the guaranteed annual premium. For universal and variable universal life, it's usually the guideline annual premium.

You will also have to take account of estate planning constraints, such as limitations on tax-free gifts, and the premium limits related to modified endowment contracts.

8. Has the agent complied with the service contract?

Life insurance contracts do not spell out agents' duties to provide service after the sale, so you need a separate agreement in place to accomplish that. It is clearly a good business practice to ask the agent to disclose all compensation and to specify the services that will be provided. Most policies pay a high first-year commission and lower renewal-year commissions, so you are prepaying for future services. Are you getting what you paid for?

You can tailor this sample service contract to your own situation. If you're not sure what to put in the contract, think of a service as something that you would miss if you didn't have it. What things come to mind?

You can use this one-page form to organize information about your service provider, including commission disclosure.

Disclosure form (10/26/98; 3kb) PDF Download