Fixing the Imploding Irrevocable Life Insurance Trust

Last August, a Wall Street Journal article, “Stung by ‘Universal Life,’”¹ described the crisis created by the widespread use and lack of understanding about universal life policies. The article featured retirees receiving notices from their life insurance companies that the annual premiums for the policies had skyrocketed. If this type of policy is held in an irrevocable life insurance trust (ILIT) and the grantor is unwilling or unable to make the significantly increased premium contributions necessary to maintain the policy, the trustee faces serious liability issues. Estimates indicate that flexible premium policies account for 35 percent to 40 percent of the policies held in ILITs.² Attorneys and ILIT trustees should understand the options for fixing trusts holding potentially imploding policies. These options include recourse with the insurance policies, as well as legal alternatives that use the trust agreement or statutory law.   

Traditional Policies

Until the 1980s, individuals most often funded ILITs with guaranteed, whole life policies. This type of traditional policy provides lifetime guarantees to the insured with regard to the death benefit, and the issuing insurance company bears the investment risk. In this context, the fiduciary responsibilities of an ILIT trustee primarily involve reviewing the financial stability of the insurance carrier annually, making timely premium payments and issuing Crummey³ notices. Certainly, legal and tax issues can arise, for example if split-dollar or other loans are used, but generally the policies as a trust investment function in a straightforward manner with minimal liability for the trustee.

Non-guaranteed Policies

In contrast, flexible premium, non-guaranteed policies shift the investment risk to the policy owner, the trustee in the case of an ILIT, and don’t guarantee the length of the policy coverage. Carriers developed these policies in the 1980s, during an economic period of hyperinflation and high interest rates. The newly created product addressed consumer reluctance to invest in more expensive, traditional whole life policies with conservative investment returns. These universal policies retained popularity into the early 2000s.  

With universal life insurance,⁴ the policy owner contributes the premium payment and, after the carrier deducts expenses, the carrier invests the balance of the premium at market rates to cover future costs. Agents prepared illustrations showing the length of coverage using typical interest rates at the time of the sale. When these products were developed, the 10-year Treasury yield exceeded 10 percent.⁵ As long as interest rates stayed the same or increased, the premium payments required to maintain the coverage in force as shown in the illustration, often to age 90 or 95, stayed the same or decreased. The attraction to these policies, as opposed to traditional whole life policies, during periods of rising interest rates is obvious. Under the best circumstances, the universal life policies provided consumers with access to tax-deferred market rate investments and a payment at death.  

Low Interest Rates

During the past decade, interest rates have remained at historically low levels, well below the highs of the 1980s and 1990s, and often far below the illustrations for these policies at the time of sale. In the past three years, the 10-year Treasury has rarely exceeded 3 percent and is less than 2 percent today.⁶ Non-guaranteed policy illustrations that were run when the policy was purchased don’t hold up. The net effect is that to maintain the originally illustrated death benefit and length of coverage, typically until age 90 or 95, premium payments must increase significantly. Alternatively, current illustrations showing lower premium payments result in reduced length of coverage, sometimes less than life expectancy.  

Risk of Lapsing

Today, these policies run the very serious risk of lapsing, creating a nightmare for trustees. As of 2014, as many as 40 percent of in-force flexible premium non-guaranteed policies were carrier illustrated to lapse during the insured’s lifetime or within five years of the insured’s estimated life expectancy.⁷ Adding to the distress, carriers this past year announced increased internal charges associated with the policies.⁸ This increase will further erode the policies.

Unless the ILIT grantor is willing and able to make significantly higher premium payments to maintain the desired length of insurance coverage, these policies may begin to implode. Trustees typically uncover issues with the viability of the insurance policies during the annual trust review process. Corporate fiduciaries have systems in place for these trust reviews, and this allows sufficient time to address problem policies. Inexperienced individual trustees may not become aware of problems until a crisis is reached.  

Possible Solutions

Possible solutions involve both changes to the insurance policies and opportunities pursuant to the trust agreement or applicable state law. Options with regard to the policies include lowering the death benefit to extend the length of coverage to age 90 or 95, using the cash surrender value to purchase a new policy with a reduced death benefit (if the health of the insured allows) or considering the life settlement market. None of these is necessarily a satisfactory resolution because each option results in a reduced payment to the trust beneficiaries. Each option must be considered in light of the trustee’s fiduciary responsibilities and guidance provided by case law.

Duty of Loyalty

First and foremost, the trustee has a fundamental fiduciary duty of loyalty to the trust beneficiaries. In the context of an ILIT, this duty can prove challenging. Because the grantor created the trust and often continues to make decisions about premium payments on the insurance policies, the grantor may overlook the fact that, legally, he no longer has ownership and control over the policies. In truth, the trustee may have a closer relationship with the grantor than the trust beneficiaries. Ultimately, however, the trustee is responsible for ensuring that the beneficiaries receive the maximum benefit from the trust assets, and this fiduciary obligation can strain the relationship with the grantor. Depending on the terms of the trust and state law, if the grantor fails to make sufficient premium payments to sustain the necessary length of policy coverage, the trustee may have a fiduciary obligation to inform the beneficiaries. This may be the case despite the fact that the grantor wishes to keep the information confidential. The grantor may also be willing to take greater risks by shortening the length of policy coverage to a greater extent than the trustee with fiduciary responsibilities to the beneficiaries can justify. 

Uniform Prudent Investor Act

Further, a majority of states have enacted a version of the Uniform Prudent Investor Act,⁹ and pursuant to this statute, the trustee has a duty to invest trust assets according to the prudent investor standard. This duty generally requires the trustee to invest as prudent investors would invest “considering the purposes, terms, distribution requirements, and other circumstances of the trust”¹⁰ and using “reasonable care, skill, and caution.”¹¹ There’s an obligation to diversify investments unless the trustee “reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying.”¹² In the context of ILITs, a few states¹³ have added legislation allowing less strict standards for trustees of ILITs in recognition of the fact that these trusts are designed to hold life insurance policies. However, the majority of states and older trust documents don’t address the unique qualities of an ILIT, and in this context, the trustee is held to traditional standards.  

The Office of the Comptroller of the Currency (OCC), which regulates national banks, issued a handbook in 2012 titled Unique and Hard-to-Value Assets.¹⁴ This handbook provides valuable guidance for all trustees on the documentation necessary for a thorough review of life insurance policies as trust investments. Ideally, the trust file will include the original policy illustrations. These can be compared to current illustrations requested by the trustee on a regular basis. The OCC also outlines factors to consider, such as whether current premiums are sufficient to maintain the policy to the insured’s life expectancy, the condition and suitability of the insurance policy and the carrier’s financial condition and creditworthiness.¹⁵

Although there’s a paucity of case law addressing these fiduciary obligations in the context of ILITs, a 2009 case from Indiana, In Re Stuart Cochran Irrevocable Trust,¹⁶ provides direction. This case suggests that adding independent review of the policies by a qualified, disinterested third party will provide protection for the trustee. In this case, KeyBank served as trustee of an ILIT funded with universal life policies. The grantor created the ILIT in 1987 and funded it with three policies and an annuity. The total death benefit was $4.7 million. In the late 1990s, KeyBank exchanged these policies for two universal life policies with a total death benefit of $8 million. Over the ensuing years, these policies lost significant value, and the length of coverage began declining. In 2003, KeyBank hired an independent, outside consultant to evaluate the policies. The consultant determined that the policies no longer extended to the grantor’s life expectancy. Based on advice from the outside consultant and an insurance agent, KeyBank exchanged the universal life policies for a new policy with a death benefit of $2.8 million guaranteed until age 100. The next year, the grantor died unexpectedly at the age of 53. The beneficiaries of the trust, the grantor’s two daughters, sued KeyBank for breach of fiduciary duty.  

Both the trial court and Court of Appeals held in favor of KeyBank. In doing so, the Court of Appeals noted that KeyBank hired an independent consultant who didn’t benefit financially from the transaction. Further, the court emphasized that KeyBank had to be judged under the facts available at the time it made the decision to exchange the policy and without regard to hindsight. In this case, KeyBank evaluated options at a time when the universal life policies were rapidly deteriorating, the grantor had a life expectancy of 88 years and the independent consultant estimated the universal life policies would likely lapse within five years. Under these circumstances, the court determined that the decision to exchange the universal life policies for a different policy, which was guaranteed to age 100, was prudent.

French v. Wachovia Bank¹⁷ adds a gloss on these issues for corporate trustees. To the extent a corporate fiduciary wishes to exchange an ILIT policy by purchasing a new policy through an affiliate, this case illustrates how a corporate fiduciary can fulfill its fiduciary duty and protect itself against claims of self-dealing. The duty to avoid self-dealing springs from the duty of loyalty to the trust beneficiaries. The trustee must refrain from any behavior that results in a conflict of interest between the trustee and the beneficiaries.  

In French, the grantor executed two life insurance trusts. Wachovia Bank became trustee after the initial funding of the trusts. Wachovia reviewed the policies and, after extensive evaluation and conversations with the grantor, exchanged these policies for new policies sold by Wachovia’s insurance affiliate. These new policies had the same death benefit, but lower premium costs. However, the exchange resulted in significant insurance commissions for the bank’s affiliate, and the trust beneficiaries sued Wachovia for breach of fiduciary duty based on self-dealing.  

The U.S. Court of Appeals for the Seventh Circuit held for Wachovia. In reaching its conclusion, the court evaluated the commissions and found these were reasonable based on industry standards. Further, language in the trust agreement expressly waived self-dealing and lack of diversification. Finally, the court observed that the trustee had kept the family informed throughout the transaction. Thus, if the trust document specifically waives trustee conflicts and the prudent investor rule, so long as the trustee acts in good faith as documented by careful review of the policies and consistency with industry standards, the trustee likely won’t incur liability.¹⁸

Circumstances may arise in which options available with regard to the policies won’t resolve the issues. The grantor may not be insurable so the option of replacing the policy isn’t possible. Also, the family may be willing to take a calculated risk with regard to the policies and the insured’s life expectancy that may be untenable for the trustee. Fortunately, the document itself may offer a solution by providing a back door. For example, the trustee may have discretion to distribute the trust assets outright to the remainder beneficiaries during the life of the grantor. If the trustee exercises this discretion, it allows the beneficiaries to own the policies outright, free of trust, and take whatever risks they wish with regard to the policies, and the proceeds will still remain outside the grantor’s taxable estate. A downside to this option is that the policies will then be subject to the claims of the recipient’s creditors.

Some states, such as New York,¹⁹ have a specific statutory provision allowing a grantor to revoke an irrevocable trust with the consent of the beneficiaries. Under circumstances that fit within the scope of this statute, a trust can be revoked in its entirety or changes can be made to the trust document adding needed flexibility. This flexibility can be especially useful when the trust document doesn’t provide the language necessary for the trustee to use the applicable decanting statute. The grantor’s amendments to an ILIT could include revising the trust provisions so that an individual can act as successor trustee if a corporate trustee wishes to resign, and the language of the trust document doesn’t provide for resignation or the appointment of a successor individual trustee. This type of amendment may be helpful in situations in which the family wishes to retain the policies and is willing to take a risk that a corporate fiduciary wouldn’t take.²⁰ Alternatively, the trust document could be amended to add exculpatory language, allow for a change of trust situs to a jurisdiction, such as Florida, which protects a trustee from liability under prudent investor statutes, or add trustee discretionary authority to distribute the policies outright to the beneficiaries. In New York, however, this statute can’t be used if the ILIT is funded by two grantors with a second-to-die policy and one grantor has already died.²¹Also, its use may be complicated if there are minor or incompetent beneficiaries.

In jurisdictions that have adopted the Uniform Trust Code (UTC), similar options may be available to change the trustee or trust situs or reduce the trustee’s liability for retaining the insurance policies through the use of nonjudicial settlement agreements. Under the UTC, the settlor’s consent isn’t needed for these agreements. This may provide broader applicability and flexibility in the context of second-to-die policies when one grantor has already died. However, a nonjudicial consent modification, rather than a nonjudicial settlement agreement, is necessary under the UTC to terminate the trust and distribute the policy to the remainder beneficiaries. This statutory provision requires the consent of the grantor, so both grantors must be alive to use this provision if the trust holds a second-to-die policy.

Decanting, the statutory authority of a trustee to distribute the trust assets to one or more beneficiaries by transferring the trust assets to a different trust, may also be an option. Twenty-one states have enacted this type of legislation. To have the most flexibility under a decanting statute, the trustee needs authority to distribute the trust assets to the beneficiaries. As a result, decanting to a different trust in the context of an ILIT is useful if there’s a reason that the trust beneficiaries shouldn’t receive the policies outright, such as creditor concerns or generation-skipping transfer tax goals or if another statutory provision isn’t available. Decanting to a new trust will allow amendments to the trust document, and these might include adding provisions for the appointment of an individual trustee or changing the trust situs and governing law to provide for reduced trustee liability if the current document doesn’t provide for these options. In any case, care must be taken to review all possible tax consequences of decanting.

Historically, grantors and trustees viewed life insurance as a “sure thing” from an investment perspective. That’s a dangerous assumption. The crisis with older, flexible premium, non-guaranteed policies drives home the challenges faced by the ILIT trustee and the necessity of reviewing the insurance policy as an investment. An ILIT trustee can only navigate this treacherous terrain through careful deliberation and documentation of options available with the policy or through the trust agreement and state law. 

The solutions for fixing a broken ILIT can also inform conversations when a grantor creates a new ILIT. A grantor guidance letter regarding the purpose of the policy and performance expectations may prove invaluable when circumstances change. Whether to include trustee exculpatory language specific to insurance as a trust investment in the trust agreement is a critical consideration as well. As with any trust, the selection of an appropriate trust situs and flexible back-door provisions to provide for unforeseen circumstances also add value. 

ILITs continue to play an important role in the estate-planning arsenal for high-net-worth clients. In today’s world of increasing fiduciary litigation, communication and documentation are critical, both at the time of trust creation and throughout the trust administration, to reduce risk and ensure that a trustee fulfills its fiduciary duty.                          

Endnotes

1. Leslie Scism, “Stung by ‘Universal Life,’” Wall Street Journal (Aug. 10, 2015).

2. Shari Levitan, Paul Yates and Mike Cohn, “Life Insurance Reviews: What Trustees Should Know (and Do),” Estate Planning Journal, Vol. 39, Number 02, (February 2012).

3. Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968). This case discussed the requirements necessary for the grantor’s contribution to the trust to qualify as a present interest gift by providing the trust beneficiary with a right of withdrawal.

4. The term “universal life” is used throughout the article to describe flexible premium, non-guaranteed life insurance policies. This term includes policies that fit this definition, such as variable universal or adjustable life policies. 

5. www.multpl.com/10-year-treasury-rate/table/by-month.

6. www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/Historic-LongTerm-Rate-Data-Visualization.aspx.

7. E. Randolph Whitelaw, AEP (Distinguished), “How to Relieve the Plight of Unskilled Irrevocable Life Insurance Trust Trustees Unfamiliar with Their Duties,” Journal of Financial Service Professionals (March 2014).

8. Last summer, Aegon NV’s Transamerica unit notified customers that internal charges will be increased, and other insurers are considering similar action. See Scism, supra note 1. 

9. The Uniform Prudent Investor Act (UPIA) is a uniform law created by the Uniform Law Commissioners in 1994. It’s been enacted in 44 states, Washington, D.C. and the U.S. Virgin Islands.

10. Ibid.

11. Ibid.

12. Ibid.

13. These states include Delaware, Florida, North Dakota, Pennsylvania, South Carolina, West Virginia and Wyoming. 

14. Unique and Hard-to-Value Assets, http://www.occ.treas.gov/publications/publications-by-type/comptrollers-handbook/Unique_and_Hard-to-Value_Asset_Booklet.pdf.

15. Ibid.

16. In Re Stuart Cochran Irrevocable Trust, 901 N.E.2d 1128 (Ind. Ct. App. 2009).

17. French v. Wachovia Bank, N.A., Nos. 11-2781, 11-3437 (7th Cir. 2013). 

18. See also Noveletsky v. Metropolitan Life Ins. Co., Inc., 49 F. Supp.3d 123 (2014), which held under Maine law that trust language relaxing the strict self-dealing prohibition allowed the individual trustee to act as insurance agent, sell a policy to the trust and receive a commission without accounting to the trust beneficiaries. Note that exoneration clauses in a trust document won’t overcome bad faith or reckless indifference to the purposes of the trust or interests of the beneficiaries. Rafert v. Meyer, 290 Neb. 219 (2015).

19. N.Y. Estates, Powers, and Trusts Law Section 7-1.9 (McKinneys 2002).

20. Under the UPIA, a corporate fiduciary, because of its special skills and expertise, is held to a higher standard than an individual trustee.

21. Culver v. Title Guarantee & Trust Co., 296 N.Y. 74 (1946).