“Reverse insurance” arrangements are aggressively sold to seniors and packaged for institutional portfolios, but trust advisors are finding that this is a good way to demonstrate value for wealthy clients, too.
With all the dramatic swings in the estate tax over the last few years, many wealthy families are wondering why they’re still paying $30,000 a year in life insurance premiums they may no longer need.
One classic scenario, says Washington State financial consultant Scott Scholtz, is the entrepreneur who bought permanent insurance to pay the cost of winding up his business empire if he died on the job, but now he’s finally retired.
“Here he is now, 73 years old and no longer needs what has become a fairly expensive insurance policy,” Scholtz tells me.
“Does he continue making these payments on a policy he doesn’t need? Does he let it lapse? Or does he sell it off?”
Selling the policy off can entail just taking the cash surrender value that’s built up. In that case, the death benefit evaporates -- nobody gets paid when our hypothetical 73-year-old dies.
Or, increasingly, the policy owner can sell it to a life settlement company that will then package it for sale to endowments and other institutional investors.
In that scenario, the investor eventually collects the death benefit at face value and, Scholtz estimates, may pay 25% to 30% of that amount.
Big questions for ILIT trustees
Hundreds of thousands of Americans created irrevocable life insurance trusts (ILITs) to shield their heirs from the federal estate tax. Life settlements are relevant to their trustees as well.
In an ILIT structure, the trust -- and not the hypothetical 73-year-old retiree -- owns the insurance policy, which was designed to deliver a death benefit big enough to pay the estimated estate tax bills when the grantor dies.
The premiums are then funded by internal cash flows or, as needed, regular gifts to the trust, which then writes the checks to the insurance company.
Last year, when even middle-class families were staring at the prospect that the estate tax exemption would drop back to $1 million, a substantial ILIT probably made sense for many clients in the “mass affluent” market and beyond.
But now that Congress has decided to lift the exemption to $5 million for the next few years at least, even high-end ILITs look like could easily be carrying $4 million more insurance -- costing maybe $30,000 a year in premiums -- than they need.
None of the insurance gurus I talked to recommend simply winding down the ILIT, since anything can happen once the current estate tax rules expire at the end of 2012.
A cheaper ILIT doesn’t necessarily mean lower coverage
A lot of trust companies act as though they’re stuck with the policy that initially goes into an ILIT. After all, they’re not insurance brokers.
However, the only thing that’s really “irrevocable” about these trusts is the gifts that got the whole machine going.
The insurance in every ILIT should be regularly reviewed and, when appropriate, sold for something more appropriate, Atlanta life settlement guru Bryan Freeman routinely tells trust officers.
“Far too many ILITs contain underperforming life policies,” he says.
“In the worst cases, these underperforming policies result in the trustees having to ask the grantor for more premiums.”
In fact, I’ve seen anecdotal numbers that ILITs are the ones selling something like 40% of all the policies that go into life settlements.
They simply sell the old policy to any of the settlement brokers -- Christian Stanley is one of the biggest and best known, but Scott Scholtz tells me there are hundreds out there -- and use the proceeds to buy a new one that’s more appropriate to their grantor’s current needs.
Due diligence is crucial when finding a partner. Christian Stanley, for example, may be paying William Shatner to be its spokesman, but its accountants have raised questions about whether its business can continue as a going concern for a few years now.
Deep discounts are out there
For older ILITs, an audit of the underlying insurance is probably more crucial than ever.
Over and above the shifting estate tax considerations, the current generation of variable universal life products out there can invest in a much wider range of asset classes and theoretically deliver better risk-adjusted returns.
Plus, any policy purchased before 2008 used the old mortality tables, which assumed that the typical person would die at a younger age and so charged seniors 3% to 6% more.
And the recession drove insurance prices down even more. From 2008 to 2010, overall premiums dipped 17%, according to the industry umbrella group LIMRA.
All in all, an ILIT built to shield a $10 million estate from the $1 million estate tax exemption and a 55% tax rate could easily recoup $1.3 million from selling its current policy.
Then, the trustee can turn around and pre-fund a policy tailored to the new tax environment for the foreseeable life of the grantors -- assuming, of course, that they’re still healthy enough to get decent coverage.
Once again, there’s no need to scale coverage all the way back to reflect the $5 million exemption, which everybody I talk to expects to recede again as the federal government grasps for any revenue it can find.
Remember, to be eligible for sale in a life settlement, a policy has to be at least 25 months old.
And one note of warning: Since LIMRA says premiums edged back up 4% at the end of last year, the deep discounts out there are probably not going to be around for long.
Scott Martin, senior editor, The Trust Advisor Blog. Steve Maimes contributed to the editing and research.