Life Insurance: Policy Review and Funding Techniques
Mark W. McGorry and Stephen D. Lassar
2007 - High-net-worth individuals who need large amounts of
life insurance should be aware of the considerable estate
tax advantages of an irrevocable life insurance trust (ILIT).
Within such an estate plan, life insurance can be used to
accomplish the following goals:
of estate taxes;
Estate equalization between heirs;
of state death taxes;
continuity plans and funding of buy-sell agreements; and
life insurance is purchased by an ILIT, the trustees are
the legal owners of the policy and are charged with the
responsibility of carrying out the wishes of the grantor
as specified in the trust instrument. These trustees also
have the responsibility under the “prudent investment
rule,” and associated state statutes where the trust
is located, to create and follow procedures for proper administration
and oversight of the trust’s assets. Although trustees
and their investment advisors are often well versed in what
to do when the trust corpus is composed primarily of bank
accounts, bonds, stocks, and mutual funds, they are usually
at a complete loss as to how to evaluate and monitor the
performance of a life insurance contract owned as an investment
of the trust. There are three major areas with regard to
life insurance policies that trustees should analyze:
Factors to consider when evaluating the financial “health”
of a life insurance policy;
Techniques for paying premiums, especially when annual
exclusions and lifetime exemptions may not be available;
Premium-funding techniques that integrate with other estate
Financial ‘Health’ of a Life Insurance Policy
structure of permanent life insurance contracts.
In the estate planning market, permanent life insurance
policies purchased during the last quarter century have
typically been whole life or universal life policies, or
a blend of either whole or universal with term insurance.
Whole life is a form of contract whose terms provide for
a fixed guaranteed premium, a death benefit, and a cash
surrender value, with the possibility of excess interest
and mortality savings credited in the form of policy dividends.
Dividends can be applied to increase the death and cash
benefits or to reduce the premium outlays. Universal life
policies typically do not carry a fixed premium or a guaranteed
cash value schedule. Instead, they offer the option of a
lower outlay from the time of issue by anticipating the
possibility of interest rates in excess of the guaranteed
rate and mortality expectations lower than those stated
in the policy. As noted above, there is also a blended version
of these policies that combines a base policy (typically,
whole life) with a term insurance rider. Over time, the
paid-up insurance purchased by dividends may replace most
of the term portion, so that eventually the “target
death benefit” consists entirely of the base whole
life policy and the paid-up additions rider.
arrangements for permanent life insurance.
Most policies are purchased for ILITs with the intent that,
regardless of whether the policy was a whole life, universal
life, or blend, the policy would eventually build up sufficient
value such that the internal policy credits would support
itself without further contributions from the policy owner.
the last decade of sharply reduced interest rates, however,
the internal credits to these policies have dropped significantly
below those originally illustrated at the point of sale.
The result is that policies take many more years of annual
premium outlays than originally anticipated before they
become internally self-sustaining, and required annual outlays
increase significantly above the original scheduled premium
levels. In the case of a whole life policy, with its fixed
premium schedule, the premium cannot be increased in excess
of that listed in the policy. Due to the lower dividend,
however, a whole life policy may need to be paid for many
more years than originally illustrated. In the case of universal
life or blend policies that contain term insurance, there
is typically an even greater increase in the number of years
for which premiums must be paid. It is also not unusual
for large increases in annual outlays to be required in
order to avoid a lapse of coverage. These increases might
be 50%, 100%, 200%, 300%, or even more.
internal financial structure of permanent life insurance.
Individuals often ask why the required premium increase
can be so drastic. In part it is due to the lower-interest-rate
environment in recent years and the associated reduction
to internal policy crediting rates. Lower crediting rates
inside the policy ultimately require a greater contribution
from outside the policy in the form of greater premium contributions.
time, however, the greatest negative effect is the internal
“amount at risk” of the policy. Exhibit
1 depicts a financially healthy
policy and an unhealthy policy.
The basic concept behind most permanent insurance policies
is that, over time, the cash value associated with the policy
will increase sufficiently such that the spread between
the promised death benefit and the amount at risk will decrease.
There is an internal charge to the policy for the cost associated
with the amount at risk that increases naturally over time
as the insured grows older, in much the same way as the
cost of a term insurance policy eventually increases as
the insured ages. If the internal interest credits are lower
than originally illustrated, then the amount at risk will
be higher than illustrated, and therefore the annual mortality
charges for the amount at risk will be also be higher. The
result is that in subsequent years the cash values will
be adversely impacted by the higher-than-anticipated internal
mortality charges. This also means that the internal interest
crediting rate will be on a lower than anticipated cash
value, causing further assault on the cash value, a higher
amount at risk, and higher associated mortality costs in
downward cycle can continue such that the cash value, originally
intended to be, in effect, a sinking fund to help support
the insurance policy as the insured ages, will itself sink.
Ultimately this can lead to a policy that operates like
a yearly renewable term policy, with significantly increasing
outlays each year. This can put the policy owner in the
position of needing to make significantly higher outlays
or risk losing the coverage. Worse yet, because these outlays
can continue to grow each year, the owner is put in the
position of a very uncertain cash outlay for an open-ended
period of time until the policy either matures as a death
claim, lapses, or is surrendered. This scenario can also
cause significant gift tax issues.
Problems with Life Insurance Policies
Consider a trust that purchases a second-to-die whole life/term
blended policy with a highly rated mutual life insurance
company in 1991 on a married couple when the husband was
77 and the wife was 64. The policy has a target death benefit
of $610,000, consisting of a base whole life policy of $176,109
and a term rider of $433,891. The policy is intended to
help meet estate-tax liquidity needs and is owned by an
ILIT, with premiums to be funded through gifts to the trust
from the grantors/insureds.
on illustrations prepared in 1991, the couple expect that
the term insurance would mostly be replaced over time with
“paid-up additional insurance” purchased with
the portion of the annual dividend not applied to the term
insurance. In addition, the couple expect that after 10
annual payments of $10,000 per year the policy would be
able to carry itself without further contributions from
the trust. The trust stopped making payments after 10 years,
and for the next five years the insurance company provides
a form to the ILIT’s trustee authorizing the insurance
company to surrender sufficient dividend cash values to
pay the current year’s premiums.
the bill for May 2006 arrived, the couple received an unpleasant
surprise: Instead of a bill for the usual $10,000, this
bill was for almost $40,000. Moreover, when the couple contacted
the insurance company, they learned that there were no additional
dividends available to apply toward the premiums.
went wrong? After some investigation, the
couple’s advisor realized that because the wife received
a “Table C” rating for medical history, the
initial application was amended to increase the term portion
of the policy in order to keep the premium in the $10,000
range. The initial application was for a blend of approximately
60% whole life base and nearly 40% term insurance, a moderately
aggressive mix; however, it was ultimately issued as a blend
of approximately 30% whole life base and 70% term insurance.
For this aggressive mix to work as anticipated, the dividends
from the whole life portion of the policy needed to support
the anticipated offset of the premiums after the 10th year,
as well as pay for the term costs and add sufficient paid-up
additional insurance to replace the term insurance rider.
the years went by and dividends were consistently lower
than originally anticipated, the original 10-year outlay
program should have been adjusted. At the very least, the
$10,000 annual payments should have been continued after
the 10th year, so that the dividends could have continued
to provide a death benefit from paid-up additional insurance.
This would have kept the term insurance portion lower and
helped mitigate the increasing term insurance costs. The
large bill the couple received represented term insurance
costs of approximately $30,000 on top of the $10,000 regular
premium for the whole life portion of the policy. Even worse,
a new illustration shows the anticipated outlay increasing
by approximately $5,000 per year, so that at life expectancy
for the wife, in her late 80s, the annual premium is approaching
$100,000 per year, 10 times the original illustration.
addition, under a fairly common policy contract feature,
the insurance company has the right to increase the term
portion of the premium by almost 50%. Even if the policy
were not already in an untenable position, it certainly
would be if the company exercised its right to increase
the term rate.
responsibility. In this example, the trustee
and the grantor/insureds of the ILIT are in a very difficult
position. The grantors must decide whether to continue funding
this insurance. The trustee had the sole responsibility
for this policy. Typically, the trustee is a family member
or long-term trusted business or professional advisor. The
relationship is usually so close that the trustee is serving
without compensation, because all that has been asked is
merely to maintain an account and then pay premiums.
fact, a trustee’s job is much more involved than that,
a fact that some trustees do not learn until they are sued
by beneficiaries when the primary investment of the insurance
trust, the policy, fails to deliver death benefits as expected.
And the stakes in such a lawsuit can be high; the $610,000
policy in the example here is relatively small for an ILIT,
but a $610,000 lawsuit against an individual trustee would
still be significant. The risk exposure could be very damaging
to a trustee’s personal financial well-being.
policy selection is critical. In every situation,
the purchaser, whether acting in an individual or a fiduciary
capacity, must make a best effort to match the insurance
policy purchased to the needs of the policy owner. It has
been the position of the authors for more than 20 years
that many policies place too much of the long-term risk
on the individual policy owner rather than the insurance
company. This usually occurs when the premium structure
of the contract depends largely on nonguaranteed factors.
These features include the nonguaranteed element of not
only the interest or return assumptions, but an even more
critical element, the costs associated with mortality-related
assumptions and costs. In a term insurance policy or rider,
this refers to the term rates beyond the initial guarantee
period; in universal life, it is the spread between the
currently illustrated and guaranteed annual mortality charges
for the amount at risk; and in a whole life policy, it is
the mortality assumption element of the dividend calculation.
much the same way that an engineer must evaluate how a bridge
will stand up to certain stresses, a purchaser of a financial
investment—be it stock, bond, or life insurance contract—must
consider the effect of various factors on the investments.
Life insurance contracts can be illustrated to allow a purchaser
to see the effect of various scenarios, including those
in which interest rates are the lowest they can be and mortality
charges and other expenses are the highest allowed under
the terms of the contract. These illustrations cannot necessarily
provide absolute assurance to the purchaser that a policy
will not fail. This approach will, however, help the purchaser
more reasonably evaluate the risk involved.
the current marketplace there are universal life policies
that offer what is referred to as a “secondary no-lapse
guarantee” provision. Basically, if a certain predetermined
level of premium is paid for a certain period of time, the
insurance company guarantees that the death benefit will
stay in effect for a set period of time. The guaranteed
coverage period provided by these contract provisions can
even continue to age 100, 110, or 120. These contracts are
popular for the high-net-worth estate planning market. When
choosing a policy, this approach can be illustrated with
different companies in various ways, all of which can provide
a guaranteed death benefit for a selected period.
and continuous review. In addition to carefully
choosing a policy, a policy owner should monitor its performance
on a regular basis. It is generally considered sufficient
to do a thorough review at least every three years. This
may not be frequent enough, however, especially for older
insureds. For example, if an insurance carrier exercised
its contractual right to substantially increase the internal
mortality or term insurance charges for a policy covering
a 70-year-old, the policy might lapse in a couple of years,
unless the payments into the contract are doubled or even
with most problems, early detection is critical. This would
argue for annual reviews to calculate the premium level
required to maintain the policy in force on a guaranteed
basis for the intended period of coverage. If this calculated
premium exceeds a level that the policy owner is willing
to fund, several options are available.
a policy. If an insured is insurable, the
trustee policy owner may want to consider a possible replacement
of the policy with a new one that has a secondary no-lapse
guarantee provision. That policy could possibly be funded
in whole or in part by an IRC section 1035 transfer of surrender
value from the existing policy.
a policy is no longer needed for its original purpose, the
owner could consider terminating the policy in exchange
for its cash surrender value or selling the policy in the
secondary market (e.g., in a senior settlement). Another
possibility would be to see if there is opportunity for
financial arbitrage in the marketplace. The classic example
of this is a life settlement arrangement in which the policy
is sold and the proceeds invested (preferably under a tax-free
IRC section 1035 arrangement) in a deferred annuity, which
provides a guaranteed cash flow that can be matched on a
net after-tax basis to the purchase of a new replacement
policy with a no-lapse guarantee feature. The greatest arbitrage
can be realized when the life settlement and annuity companies
view the insured’s actuarial life expectancy on a
less favorable basis than did the company issuing the new
all other options fail. Under circumstances
in which the possibility of an economically favorable replacement
is not available and the premium to guarantee the full death
benefit is deemed too high, the trustee is faced with a
difficult decision. In these circumstances, a trustee must
consider how long the existing policy is likely to last
on a guaranteed basis, based on the amount of premiums that
will likely be available each year. The trustee will also
need to gather some information on the life expectancy of
the insured, based on actual medical history. When the insured
has a medical history that falls outside the average life-expectancy
tables, the trustee should consider getting a professional
life-expectancy evaluation. The trustee can also consider
reducing the death benefit to a level that will be sustainable
on a guaranteed basis.
matter what course the trustee takes, it should be done
with an eye toward setting a course as close as possible
to meeting the grantor’s goals for the benefit of
the trust’s beneficiaries. Although the trustee may
not be able to plot a course that can guarantee a particular
result, she must demonstrate that she has acted in a manner
consistent with the fiduciary guidelines of the jurisdiction
in which the trust is sited.
Premiums While Minimizing Gift Taxes
corollary concern is how to avoid payment of gift taxes
when premiums can become quite large. One common method
is to apply the annual gift exclusion to each Crummey beneficiary
of a trust. This approach may be inadequate, especially
if the trust has few beneficiaries or if annual gifts are
being used for other purposes. Finally, an insured can apply
a portion of the lifetime exclusion to the gift, but this
may be impracticable for various reasons, particularly if
the exclusion has already been used or is earmarked for
another estate planning technique.
technique, which involves the use of loans by the insured/grantor
to the ILIT (i.e., private financing), can mitigate or even
eliminate gift, income, and estate tax issues involving
the use of life insurance. The authors have used this technique
since the 1990s and have further expanded it since the IRS’s
changes to the split-dollar regulations in September 2003.
The following is a summary of the authors’ approach
and how it can be a part of an effective estate plan:
to pay life insurance premiums will fall into one of two
that bear interest at the applicable federal rate (AFR),
which can take two forms:
that pay interest annually.
that accrue interest and are paid with principal at
the end of the term loan.
that don’t bear interest at the AFR, which can take
three forms. These loans, known as below-market-rate loans,
are governed by IRC section 7872, which imputes interest
at the AFR for both income and gift tax purposes:
demand loans, where the interest is imputed on an annual
basis at the short-term AFR.
Interest-free term loans, where the interest is imputed
at the short-, mid-, or long-term AFR, but all of the
interest over the expected term of the loan is discounted
back to the present value and has tax consequences in
the year of the loan.
Hybrid loans, which have characteristics of both demand
and term loans.
tax considerations. If not properly structured,
a premium loan from the grantor/insured to the ILIT will
constitute a split-dollar arrangement that falls into the
split-dollar loan regime subject to the below-market interest
rules of Treasury Regulations section 1.7872-15. To avoid
gift tax consequences for foregone interest, the appropriate
AFR should be charged. It may be necessary to make sure
the loan is secured via a “bare-bones” assignment,
meaning that the grantor/insured has no other rights in
the policy, in order to avoid estate tax inclusion.
tax considerations. In the case of a grantor
trust, there should be no income tax consequences to either
party, under the nonrecognition rule for transactions between
grantors and their grantor trusts [Revenue Ruling 85-13
(1985-1, C.B. 184)].
tax considerations. Estate tax issues may
arise from a loan from the grantor/insured to the ILIT.
In addition to the IRC section 2042 issue discussed above,
there is also the possibility of estate tax inclusion under
IRC section 2036. Generally, however, this is unlikely to
be an issue and should not result in inclusion of the policy
for estate tax purposes.
considerations. In an era of low interest
rates, it may make sense to lend the trust more than needed
to pay current premiums as well as lock in low rates over
the long term to help pay premiums in future years.
the interest is accrued, there will be both a smaller death
benefit (assuming a level death benefit policy is issued)
and a higher amount includible in the insured’s estate.
To mitigate this effect, it is worth considering applying
for a policy that pays the initial death benefit plus cumulative
premium payments. These policies, which are available as
either single or survivor life, will require a higher premium
than a level death benefit contract.
it may be cost-effective for the grantor/insured to make
the loans to the ILIT using funds obtained from a third-party
lender at market rates.
Exit Strategies: Combining Premium Loan Arrangements with
is generally best to include within an estate plan a method
for paying off the loans used by the trust for premium payments.
The ultimate loan repayment would come when the policy matures
as a result of the death of the insured. At that point,
the death benefits can be available to repay the loan. If,
however, the loans become quite large relative to the death
benefit, this will reduce the death benefit that the trust
can ultimately pay outside of the taxable estate.
potential solution is to take advantage of time-discounted
estate planning techniques, which can ultimately mature
with the ILIT as the remainderman. The techniques include
grantor retained annuity trusts (GRAT), charitable lead
annuity or unitrusts (CLAT or CLUT), and qualified personal
residence trusts (QPRT). The following, shown in Exhibit
2, steps illustrate one such strategy:
The grantor creates an ILIT, which in turn purchases life
insurance on the grantor’s life, with some or all
of the premiums funded by loans from the grantor to the
The grantor also establishes a GRAT that will pass the
assets remaining at the end of the term to the ILIT.
At that time, the ILIT can use the assets received from
the GRAT to either pay down the loan or pay future premiums,
or a combination of both if the ILIT trustee determines
this would be the best approach.
noted above, this strategy can be used with short- or long-term
GRATs, CLATs, or CLUTs, as well as fractional or total interest
QPRTs. Each situation must be individually crafted for the
insurance continues to be a viable economic planning tool
in a variety of estate planning situations. The advice above
represents best-practice approaches to help select and monitor
appropriate life insurance contracts. It also provides several
different alternatives for financing the payment of life
insurance premiums when gift, income, or estate tax constraints
are significant. The selection of the optimum technique
will be dictated by the individual’s goals, objectives,
and personal situation.
W. McGorry, JD, CFP, CPC, CLU, AEP, is a managing
director of Wealth Partners LLC, New York, N.Y. Stephen
D. Lassar, JD, LLM, CPA, is managing director of
the estate, trust, and succession planning division of CBIZ
Business Solutions Inc., and a managing partner at the law
firm of Goldfinger and Lassar, LLP.