Attention trustees: Are you fulfilling your fiduciary responsibilities and efficiently managing trust owned life insurance?
By Ken Godfrey
Life Insurance Financial Evaluations, LLC
In our current litigious society, it is prudent for trustees to educate themselves on their responsibilities and partner with other professionals as needed.
If a life insurance policy is owned by an irrevocable life insurance trust, the trustee has an important fiduciary responsibility to manage the policy for the benefit of the trust beneficiaries.
Under the Uniform Prudent Investor Act, ILIT trustees must establish and follow a prudent process for determining the suitability of trust owned life insurance (TOLI) policies and manage the life insurance in response to changing market conditions. The Uniform Prudent Investor Act was adopted in 1992 and has been approved by most states.
Compliance with the Uniform Prudent Investor Act is determined by the trustee's conduct in establishing and following a prudent process. The process should focus on monitoring the life insurance, investigating the suitability, and managing the life insurance to minimize and justify the expenses, while simultaneously maximizing the rates of return relative to risk.
The prudent investor standard applies to fiduciaries ranging from the most sophisticated professional investment management firms and corporate fiduciaries (e.g., bank trust departments) to family members with minimal experience.
In 2009, the Cochran vs. KeyBank case highlighted the risks that trustees face when dealing with the prudent management of TOLI. In this case, the beneficiaries of an ILIT sued a trustee for violation of Indiana's Uniform Prudent Investor Act and breach of trust.
Although KeyBank was the trustee and ultimately won the lawsuit, the case brings attention to the appropriate protocols that should be followed when managing TOLI. The March 2, 2009 ruling by the Court of Appeals of Indiana in the Cochran vs. Keybank case highlights the importance of a trustee relying on guidance from "an outside, independent entity with no policy to sell or any other financial stake in the outcome."
A trustee's requirement to determine suitability of a trust owned life insurance policy is only part of their fiduciary responsibility. Management of the policy and ensuring the policy will outlive the insured is of utmost importance. A trustee should consider delegating the policy management to a third party if they aren’t equipped to handle the responsibility on their own. According to a 2006 Time magazine article, 88 percent of universal life insurance policies never pay a death benefit. Policyholders risk wasting the tens of thousands, if not hundreds of thousands or millions, of premium dollars paid into a policy if it does not perform as desired. There are significant risks that an underfunded policy will lapse or expire worthless before the policy reaches maturity (usually age 95 or 100) or before death.
Alternatively, many permanent life insurance policies today can provide coverage to age 120 or later, even though the probability of living this long is very low. To efficiently manage a life insurance policy, the trustee should consider incorporating life expectancy calculations into their analysis. Although it is impossible to know the life expectancy of any one person, it is possible to estimate life expectancy or probability of survival to a given age based on a large number of individuals through actuarial tables.
For flexible premium policies, paying premiums at levels to guarantee the policy to age 120 or later may not be appropriate and the trustee risks overpaying for the policy, particularly if the insured is classified as a non-preferred risk and life expectancy is expected to be significantly lower.
Alternatively, when policies are projected to lapse before the insured’s life expectancy, premiums should be increased to lengthen the policy's duration. When actively managing a policy utilizing life expectancy calculations, premium levels can be modified periodically by responding simultaneously to changing market conditions such as policy performance variations and any significant changes in health that improves or diminishes the insured’s life expectancy.
Although life expectancy calculations continue to be underutilized in the design and ongoing management of life insurance policies, its use in policy management is not a new idea. Life settlement companies use a similar approach to manage life insurance policies to lower the out of pocket premium expenses and enhance the returns for their investors. They continuously monitor the health of the insured and corresponding life expectancy, and manage the policy premiums accordingly.
Incorporating life expectancies into policy management can assist the trustee in managing the policy more accurately and fulfilling their fiduciary obligations under the Uniform Prudent Investor Act. In our current litigious society, it is prudent for trustees to educate themselves on their responsibilities and partner with other professionals as needed.