Trustee Alert: Don’t Be a Casualty of the Life Insurance Illustration War

In the 1980s when current assumption universal life (CAUL) hit the market, sales illustrations were created showing cash value returns of 10% and more every year – for a product that was invested in fixed instruments.  When equity markets soared and variable universal life (VUL) became the rage, many sales illustrations projected 12% returns – again, every year.

Life insurance illustrations are at best a guide – they do not guarantee the future, they are based on hoped-for returns which do not occur as projected.  All else equal, in a universal life chassis without secondary guarantees, the higher the rate of return assumption, the lower the premium that has to be shown in a sales illustration to carry the policy to maturity (or some other goal).

The premium shown in a sales illustration is not the cost of the policy – costs are shown on the expense page of the illustration.  An unreasonably high return assumption can easily hide higher policy charges.  Why?  Because over the lifetime of the policy, the highest expense is typically the monthly deduction for the cost of insurance – the mortality charges.  Those charges are based not on the death benefit, but on the net amount at risk, which is the difference between the death benefit and the cash value. (For a more detailed explanation of net amount at risk, go to Chapter 6 of the TOLI Handbook, available as a free download here.)  As the cash value climbs, the net amount at risk drops and the actual charges deducted drop.  A high assumed rate of return creates a double-edged cycle – a higher return creates higher cash value which lowers costs which creates higher cash values.  A perfect situation – for a disaster.

The CAUL policies issued in the 80s and into the 90s with unreasonable returns crashed and burned with policy lapses that fueled the rise the rise of secondary death benefit policies, guaranteed universal life (GUL).  The 12% returns of VUL policies did not hold up either and after the market crash of 2007-08, many people fled to equity indexed universal life (EIUL). These were considered more “conservative” because while the returns were tied to an equity index, an interest rate floor – typically 0%, limited the downside – “you could not lose money” with this product. (Note that even though the investment component may not be negative, policy charges still accrue so cash value does drop.)

The policy also has a limit on the upside, called the cap, set by the carrier.  A policy with a cap of 10%, which is typical, means that any returns over 10% will be lost.  This is one reason that the rate of return assumption in EIUL policies is tricky to project.  When we first started seeing these policies, the assumed crediting rate in sales illustrations was well above 7%, often approaching 8%.  Now with regulation AG 49 in force, sales (and in-force) illustrations are limited to a maximum return of around 7%.  One carrier has created an online tool that translates the actual return in an index, like the S&P 500, into the crediting rate applied to the policy.  For example, assuming a 10% cap and 0% floor, to credit a policy with a 7% rate, the actual return in the S&P 500 would have to be between 10 and 11 percent.

However, there is more.  Regulation AG 49 capped the rate of return that could be shown in the policy, but it did not stop the use of various interest bonuses and multipliers that might not be seen or understood in an illustration.  We are in the midst of an illustration war with carriers determined to create products that illustrate better in a sales situation.  According to one life insurance expert, these AG 49 compliant illustrations can take a “6.75% illustrated rate” and “generate a 9% illustrated internal rate of return on cash value.” (1) The industry is turning lead into gold.

Unfortunately for the TOLI trustee taking in a new policy, this creates issues. As a fiduciary, you must make sure that the assumptions on the asset in the trust are reasonable.  As a business person, you must make sure your clients are not disappointed by policy performance – when the policy crashes, it will be your problem.

So what is the answer?  First, have skilled life insurance professionals on staff.  An untrained administrator will not be able to decipher today’s sophisticated products.  If you do not have skilled staff – find them or outsource the service.

Second, do not accept policies with assumptions you deem unreasonable.  Hopefully the current crediting rates on new current assumption policies and dividends on whole life policies are bottoming out, and rates will be rising – a plus.

For variable universal life policies, review the asset allocation and develop a conservative assumption for the expected returns.  If you think 8% is reasonable in an equity-rich allocation, also show the outcome at 5.5% or 6%.  If a more balanced allocation generates an assumed return of 7%, also show 4.5% or 5%. Show the clients the downside funding needs, you will be glad you did.

For equity index UL policies, get an illustration assuming a crediting rate of 5% along with the 6-7% return that is usually shown.  And make sure you (and your grantors) understand the bells and whistles of the policy. (See Chapter 10 of the TOLI Handbook for a thorough discussion of the equity index UL policy.)

Document the higher carrying costs that come with a lower return assumption and have the client sign a document acknowledging those additional costs and make that a part of your trust file.

Generate a report annually that shows the current condition of the policy and any premium changes that should occur to keep the policy on track.

Do not assume the aggressive assumptions made by salespeople to lower the projected premium and increase the chance of a sale will actually occur.  Your job is not to sell a policy – it is to deliver a death benefit.

Be careful out there.

  1. Voya ICAR & The Indexed UL Illustration War, Bobby Samuelson, The Life Product Review, October 11, 2018

 

Saskatchewan Government Squashes Investors Hope For Unlimited Returns Using Life Insurance

On October 29th the government of the Canadian province of Saskatchewan amended regulations dealing with premium deposits into a specially designed universal life policy.  The new rule limits deposits into “side accounts in life insurance policies to an amount equal to premiums required under contract.” (1)

The new regulation comes as a court battle rages between Canadian life insurance carriers and investors who purchased the policies hoping for guaranteed investment returns up to 5%.

The contracts in question were universal life policies issued in the 1990’s when fixed rates were much higher. The policies provide for a death benefit and an investment account – similar to the cash value in a traditional universal life policy.  According to a white paper put out by Muddy Waters Capital, a Canadian investment firm that has shorted Canadian carrier stock (2), one policy issued by Manulife, that is part of the court case, has a tax-exempt account and a separate taxable account. Cash goes into the tax-exempt account to pay the policy premium, and additional funds can be added.  On the policy anniversary date, a test is run, and any cash over a specific amount is moved from the tax-exempt account to the taxable account to preserve the tax status of the policy.  Both accounts have investment options, including an account that guarantees 4%. The tax-exempt account pays an annual bonus of .85 percent on the policy anniversary date. Cash can be contributed at any time.

Universal life policies issued in the United States have contribution limits based on the death benefit provided, but this Canadian policy and others like it can accept unlimited contributions, generating guaranteed returns for investors that are well above market rates.

A Wall Street Journal article recently featured Michael Hawkins, an Ontario businessman who purchased eight life insurance policies and contributed $11 million to them as a method to generate “extra income.” (3)  Hedge funds, investment houses and wealth management firms have purchased policies seeking a limitless cash cow.  Mr. Hawkins is now locked in the court battle that according to the Journal, is being funded in large part by investors, “in exchange for the potential opportunity to earn above-market rates in the side accounts.”

For every winner, there is a loser and if Mr. Hawkins were to win the carriers would be the big losers. The Muddy Waters white paper points out a Manulife expert testified in June of 2017 that a $100 million deposit would cause “an immediate reported loss to the insurer in excess of $45 million.”  However, it appears that the new regulation drastically cut the chances Mr. Hawkins will prevail.  Although some question the governments moves to amend “its insurance regulations in the middle of a judicial process,” the Wall Street Journal article points to one analyst who says the move “should substantially remove” any risk of litigation risk for the insurers in question.

Manulife, who had seen its stock drop 14% as a direct result of the case, saw shares rebound after the new regulation was announced.

(1)   Canadian Province Changes Rules, Benefiting Insurers in Dispute, Jacquie McNish,  Wall Street Journal, October 30, 2018

(2)  Manulife: An Insurance Company on Trial for its Life,  Muddy Waters Capital

(3)  Canadian Insurers Fight Cattle Farmer’s Investment Strategy, Fearing Stampede, Wall Street Journal, October 4, 2018

Finally, a Place for Orphan ILITs!

The last few years have been a tumultuous time in the life insurance trust business.  The prospect base is shrinking after the Tax Cuts and Jobs Act raised the federal estate tax exemption from $5.49M to $11.18M per person.  Today only 1 in 1,000 estates affected by the estate tax (1).  The asset class has become even more cumbersome to manage, as policy performance has suffered and sophisticated policies with more moving parts leave trustees with a greater chance for something to go wrong, just when the society around us seems to have become more litigious – especially in the life insurance space. Many trust-owned life insurance (TOLI) trustees are questioning the viability of their TOLI business model – and perhaps some should.  Especially those whose portfolio includes many orphan accounts – those grantors whose only business with the bank or trust company rests in a trust that generates minimal revenue, but a considerable liability.

The answer?  It’s a three-step process:

  1. Review all the ILITs in your portfolio and determine which represent significant other revenue for your firm. ILITs without additional revenue represent little more than a liability to most banks and trust companies.
  2. For those orphan ILITs with clients that have no other assets at your firm, contact Leon Wessels at Life Insurance Trust Company (LITC) to develop a game plan for removal of those ILITs. While the life insurance asset will be housed at LITC, any other revenue relationships that could be developed would remain with you.
  3. Review your options with the rest of your ILITs. If you are not now utilizing the Managed Solution through ITM TwentyFirst, consider utilizing that service which allows you to still house the ILIT, but outsource the administration of the trust and the tracking and management of the policy.  The Managed Solution option allows you to efficiently and economically raise the level of service to your most profitable clients.

The times have changed dramatically in the bank and trust space, but great reward awaits the business leaders who review their product line and seize growth opportunities while effectively managing or minimizing those areas that bring the least to the bottom line.

Outsourcing has always been a viable option in the right situation and today more than ever in the trust owned life insurance (TOLI) market outsourcing and trimming client lists will cause less liability and greater profits.

For more information on how you can increase profits while limiting your liability, contact Leon Wessels at 605.574.1703 or lwessels@lifeinsurancetrustco.com.

  1. Center on Budget and Policy Priorities

The TOLI Handbook – Chapter 15: Understanding Life Expectancy Reports

In our last blog, we wrote about remediation and the challenges that TOLI trustees have when managing a policy.  Remediation is not just developing the best options for an under performing policy, increasingly it means maximizing the value of a policy that a grantor believes is no longer needed, or one whose expected funding has stopped. These decisions must be well-thought-out and every data point that can be gathered should be utilized in a process that prudently steers the choices made. Often the decisions made are not black and white, they are grey and while the outcome may not be controlled, the process can.

One tool that TOLI trustees need to become aware of is a life expectancy (LE) report.  It grew out of the life settlement market where investors needed to gauge the expected lifespan of an insured and the premium costs until a benefit will be paid to calculate a fair purchase price for a policy that would enable them to make a profit on the investment.

It also provides a great tool for TOLI trustees attempting to make decisions about the management of a policy. The underwriters at ITM TwentyFirst determine the life expectancy calculation based on age, gender, lifestyle, smoking status, family history and medical condition (underwriting factors) to create the LE report. The life expectancy report typically includes the life expectancy estimate and can include the probability of mortality each year based on the insured’s specific underwriting factors.  The best way to show the value of an LE report is through an example.

A trustee of a portfolio of three current assumption universal life (CAUL) policies totaling $10 million in death benefit has been informed by the grantor, a male, age 85, that no more gifting would occur to the trust. The trustee contacted the beneficiaries who informed the trustee they too were not interested in providing additional funding. The trustee was concerned about the possibility of policy lapses but wished to uphold his responsibility to maximize the benefit of the trust to the beneficiaries.

In force illustrations were obtained on all three policies assuming no further premium was going to be paid into the policies. In addition, a life expectancy report was obtained on the insured/grantor and the percentage chance the insured would be alive was plotted.  The information was summarized in the spreadsheet below.

ChartforBlog-8-15-2018

As seen in the spreadsheet, it was projected no premium would have to be paid on any of the policies until the 8th year when Policy #2, the $2 million policy would have to be funded. All the policies would be nominally funded, allowing policy cash value to run to near zero before funding the policies with a minimal amount to keep the policies in force. The last column shows an approximation of the percentage chance the insured would still be alive. The LE report obtained showed that the insured was expected to have passed away by the end of the 9th year. While the LE report is not precise, it can provide guidance, and in this situation, it gave the trustee comfort that, at least for now, nothing should be done to any of the policies in the trust.

Using an LE report adds a data point to a prudent process. The key to mitigating liability is in the process, not the outcome.  A great example of that is shown on page 127 of the TOLI Handbook, a 155-page guide for TOLI trustees and anyone dealing with life insurance.

To download your FREE PDF copy of the TOLI Handbook, go to www.TOLIHandbook.com.

TOLI Trustee Work Load and Liability Climbing as Use of ILITs Diminish

As the federal estate tax laws changed in the last year, the use of new irrevocable life insurance trusts (ILITs) diminished, but the work required to administer existing ILITs went up along with the potential liability attached to the asset class.  There are several reasons for this.

  • As a country, we are aging and the population of the average TOLI portfolio is aging too. For example, 25% of the insureds in policies we manage for TOLI trustees are above age 80, 6% are above age 90.  These demographic realities create decision-making dilemmas with policies, especially those that might be underfunded. Life insurance costs rise with age and problems also increase with age.  Longevity combined with poor policy performance makes policy management decisions more complex and the wrong decision can render a policy funded for a lifetime worthless or near worthless.  For example, there are 72,000 Americans over the age of 100 (1) when most older policies mature.  Unfortunately, the outcome at maturity is often not what you (and your clients) may expect. Many older policies mature for the cash value only, creating two issues.  If the policy contract matures with significant cash value, the proceeds could be subject to taxation. Or worse – the policy matures with minimal cash value leaving the trust with little value. There is an adage with life insurance, “I want to die with a dollar of cash value in my policy.”  Unfortunately, for some who live to maturity, a dollar is about all their beneficiaries get. Try explaining that to a beneficiary that has forgone thousands of dollars over the years by waiving their Crummey rights.
  • Products have not lived up to projections over the years and the problem is growing worse. The use of whole life, with its guarantees, has dropped while the use of universal life (UL) chassis products has increased.  Some UL policies have death benefit guarantees, but most are cash value dependent policies driven by policy performance, which has lagged.  And in the last few years, many carriers have raised the cost of insurance (COI) on policies, exacerbating the performance problem.  Policies with well-known carriers like Transamerica, Lincoln National, AXA, Banner, Genworth and John Hancock, and others, have had carrying costs raised by 200 percent and more, quickly dissipating policy cash value and placing trustees in a precarious situation as policies deteriorate.
  • Even those UL policies with guarantees can have issues. According to an industry expert, (2), a major guaranteed UL carrier performed an audit of policies issued in the 4 years since it started selling the product and found that, in that short timeframe, 31% of the policies already had compromised death benefit guarantees with the major culprit being early payments. Yes, paying early actually damaged policy guarantees putting trustees at risk.
  • The greatest increase in liability and workload for TOLI trustees will accelerate in the coming years as grantors decide they no longer need their policy because of changes in the estate tax law or wish to alter the asset in the trust. The process behind analyzing options besides simply surrendering or lapsing a policy is beyond the capabilities of many trustees and we have come across trustees who have surrendered multi-million-dollar assets with no analysis – a recipe for legal disaster.
  • Policy replacements are flourishing and the number of bad replacements coming into ITM TwentyFirst has increased in the last year. One bad replacement (see Case Study #6, page 146 in the TOLI Handbook) would have robbed the TOLI trust of $900,000 leaving the trustee liable if we had not intervened. Another bad replacement caused a prospect of ours (now a client) to write a 5-figure check to make the client whole because the new policy was inferior to the one it replaced.

It’s a dangerous time out there for TOLI trustees.  And it will not be improving but growing worse.  In the coming weeks, we will be providing some guidance to TOLI trustees.  In the meantime, for guidance now, you can download the free TOLI Handbook, a guide for trustees, regulators and fiduciaries dealing with TOLI policies.  It is available at www.TOLIHandbook.com.

 

  1. Worlds Centenarian Population Expected To Grow Eightfold By 2050, Renee Stepler, Pew Research Center, April 21, 2016, http://www.pewresearch.org/fact-tank/2016/04/21/worlds-centenarian-population-projected-to-grow-eightfold-by-2050/
  2. Bobby Samuelson, The Life Product Review, https://lifeproductreview.com

The Life Insurance Dividend Season (Continued)

In an earlier entry, we reported on the dividend declarations from two of the gold standard mutual insurance companies – Northwestern Mutual and Massachusetts Mutual. Both are very highly rated carriers, and have paid dividends each year for well over 100 years. However, like most insurance companies these days, both are feeling the effects of the historic low interest rate environment, and as a result, have reported lower dividend interest rates (DIR).

MassMutual’s reported DIR for 2018 is 6.40% – a drop from the 2017 rate of 6.70% (which was down from the 2016 DIR rate of 7.10%). Northwestern Mutual declared a 2018 dividend interest rate that dropped to 4.9% from the 2017 DIR rate of 5% (which was down from the 2016 DIR rate of 5.45%).

Since our last post, both New York Life and Guardian Life have reported their dividend interest rates.

New York Life reported a 2018 dividend payout of $1.78 billion, the largest in the history of the company and the 164th consecutive year of dividend payouts. The DIR rate for NY Life was 6.1% (which was down from their 2017 rate of 6.2%). In announcing the DIR drop, their first since 2012, New York Life referenced, “the continued historic low level of interest rates, which constrain our investment returns.”

Guardian Life, who has paid dividends each year since 1868, reported a $911 million dividend payout. The DIR for Guardian remained the same as it was in 2017- 5.85% (which was down from their 2016 rate of 6.05%).

So, for 2018, 3 of the 4 carriers mentioned lowered their DIR. It will take a while for portfolio returns to turn around for insurance carriers. Almost exactly 3 years ago we reported on the dividends for these same four carriers. In that entry, our visual was a battleship and the title referenced the fact that raising dividends is much like turning a battleship around. We featured a quote from the chairman of New York Life at the time, who noted, “The downward pressure on interest rates continues to be challenging for life insurers.”  In announcing the 2018 dividend, Roger Crandall, MassMutual Chairman, President and CEO, referenced the “backdrop of a prolonged low interest rate environment.” Not much has changed.

However, this week the Fed raised rates by a quarter of a percentage point to a range of 1.25 to 1.50 percent, its third rate hike this year, with its forecast of three additional rate increases in 2018 and 2019 unchanged.

Maybe by next year the battleship will really begin to turn around.

Trustee Alert: New Tax Law Changes (Simplifies) Tax Reporting On Life Settlement Sales

Back in May we wrote about the need for trustees to be aware of life settlements. A life settlement can provide a TOLI trust with more value than a policy surrender. The role of a TOLI trustee dictates that all assets are maximized – including “unwanted” life insurance policies.

In the past, tax reporting around a life settlement was onerous, primarily because of an IRS ruling enacted in 2009. IRS Ruling 2009-13 dictated that policy sellers reduce the cost basis in the policy sold by the cumulative cost of insurance charges incurred. The requirement was, at best, burdensome. Often it was impossible to comply with. Most carriers had difficulty providing the information, for some policies it was virtually impossible to compute the amount. The reduction in cost basis also increases the tax burden to the seller, reducing the net amount available to the trust and the beneficiaries.

The new tax bill, The Tax Cut and Jobs Act, in Section 13521, Clarification of Tax Basis of Life Insurance Contracts, reverses the IRS ruling, allowing for “proper adjustment” … for… “mortality, expense or other reasonable charges incurred under an annuity or life insurance contract”.

The taxation of a life settlement is now similar to the taxation of a policy surrender – with a twist since in a sale the policyholder is receiving an amount greater than just the cash surrender value. In a policy surrender, ordinary income tax rates apply to the amount received (cash surrender value) above cost basis. With a life settlement, the policyholder receives more than the cash surrender value and that amount is considered an “investment” taxed at capital gains rates.

Determining the taxation of a life settlement is now an easier three-step process. Let’s look at an example:LSTax.jpg

Assume a policy holder sold a policy and received $375,000. Further assume total premium paid (we will assume this is the cost basis for simplicity, as it usually is) was $100,000 and the policy had cash value of $125,000.

In the first step, you simply subtract the cost basis from the amount received to arrive at the total gain in the sale.

In Step #2, you determine the amount that is attributable to ordinary income tax rates by subtracting the cash value from the cost basis to arrive at the ordinary income received. In Step #3, to compute the capital gains amount you simply subtract the ordinary income amount in the second step from the total gain found in the first step. Note that if there is no cash value (a term policy, for example) the entire amount received would be taxable at capital gains rates.

The change in the tax code will simplify the tax computation of a policy sale and perhaps prompt more policyholders to investigate a life settlement. It will certainly make the transaction more profitable for those that do. In our example above, the policyholder received $375,000, with taxes due on $275,000 ($25,000 at ordinary rates, $250,00 at capital gains rates). If the policy in question had $50,000 in cost of insurance taken out, taxes would be due on $325,000 ($25,000 at ordinary rates, $300,000 at capital gains rates).

One final note…the effective date of the amendment was listed in the new bill for “transactions entered into after August 25, 2009,” which corresponds to the date of IRS Ruling 2009-13. Does this mean that those who may have paid higher taxes in the last eight years are in for a tax rebate? That part is not clear.