Life Insurance Traps For The Unwary Chicago Estate

Life Insurance Traps For The Unwary Chicago Estate Planning Council December 17, 2013 Larry Herman, JD, CPA, CLU, Ch. FC Herman Agency, Inc. (c) 2013 - Laurence E. Herman and Herman Agency, Inc. - All Rights Reserved

Policy Valuation Traps

Policy Transfer to ILIT Jane owns a $5, 000 10 -year level term policy on her life. Policy Date is 1/1/10, and annual premium is $5, 000. To get the death benefit out of her taxable estate, Jane’s advisor recommends transferring the policy into an ILIT on 7/1/13. Jane submits an ownership and beneficiary change form to the insurance company, treating the transfer as a gift. The insurance company processes the change and issues Jane a Form 712 reporting the gift tax valuation of the policy.

Issues? • The Obvious: Sections 2035 and 2042 (3 -year rule) triggered if a gift. • Not a big deal until it is! • Liability if could have avoided estate inclusion? • The Not So Obvious: Policy valuation

Policy Valuation – Gift and Estate Tax Purposes • “Fair Market Value” = “price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of the facts. ” (Treas. Regs. 2512 -1 and 20. 2031 -1) • Life Insurance policy (not paid-up) = Interpolated Terminal Reserve + unearned premium (Treas. Regs. 2512 -6 and 20. 2031 -8)

Form 712

Interpolated Terminal Reserve (“ITR”) • Insurance Company reserve to meet contractual obligations • Original IRS ITR regulatory guidance from days of Whole Life and Annually Renewable Term (“ART”) • ART has no reserve value (matures each year) • Whole Life ITR tracks cash value • What about today’s level term and guaranteed death benefit Universal Life Policies?

Reserve Methods Vary By Carrier and Product • • Tax Reserve Statutory reserve AG 38 Reserve Deficiency Reserve

What Will The Form 712 Show? Summary of Values at the End of Year 5 Carrier Policy Type Face Amount Cumulative Premium Cash Surrender Value Reported by Carrier A GUL $10, 000 $1, 965, 000 $475, 861 UL $10, 000 $1, 965, 000 $749, 100 B GUL $10, 000 $1, 825, 000 $340, 827 $1, 024, 778 UL $10, 000 $1, 825, 000 $780, 106 $948, 106 C GUL $10, 000 $1, 733, 900 $0 $1, 883, 607 UL $10, 000 $1, 733, 900 $570, 023 $855, 241 Used with permission of AALU

What About Level Term Insurance? • At least two major carriers use “unearned premium” • Most carriers report reserve values that are exponentially higher than “unearned premium”

Isn’t This Crazy? Inadequate guidance = inconsistent interpretations Recognized problem but no clarity yet ABA Task Force on Policy Valuation “Unringing the bell” - Taking a position contrary to the Form 712? • Suggested starting point: Informal request to carrier for Form 712 valuation – Don’t trigger issuance of Form 712 • •

Sale vs. Gift – A Better Approach? • Sale valuation – “FMV” – ITR language of Treas. Reg. § 25. 2512 -6 and Form 712 doesn’t apply because not a gift • Common notion of “willing buyer/willing seller” • What would you pay for a term policy? A cash value policy? • When might you pay $200, 000 for a policy with $100, 000 of surrender value? • Pricing anomaly? • “Springing Cash Value”? • Adverse change in health (shortened mortality)?

Secondary (“Life Settlement”) Market for Life Insurance • True “willing buyer/willing seller” environment? • When might policy be worth more than cash value in the secondary market? • Older ages • Material deterioration in health from time of policy issue • Life expectancy less than about 12 years • Relatively low policy cash value

Professional Valuation? Should you get a professional valuation of a policy? Reportable gift (contradicting Form 712) vs. a sale If a sale: prudence vs. exposure Firms that specialize or have expertise in policy valuation (e. g. , using mortality tables, discounted cash flow, etc. ) • Ashar Group, LLC development of secondary market valuation services with extensive database of comparables and bidders (“willing buyer/willing seller”) • •

What If IRS Successfully Challenges Sale Valuation? • • Part sale/part gift? Section 2035 – 3 -Year Rule Applies Gift and GST tax or exemption Any worse off than if initially reported as a gift?

Policy Sale Mechanics • Grantor trust to avoid gain recognition • Avoids transfer for value issue under Sec. 101(a)(2)(A) – transfer to insured (Rev. Rul. 2007 -13; PLR 201332001 and PLR 201235006) • ILIT is grantor trust if allows for premiums to be paid from trust income [Sec. 677(a)(3)] • Belt and suspenders – include other grantor trust powers • If primary asset of trust is life insurance, then no material ongoing income tax consequences to grantor • Simple sale agreement, plus insurance carrier owner/beneficiary change forms

What About Jane? • Assuming no adverse change in health, consider selling policy to grantor trust for $2, 500 (unearned premium). • What if policy was a larger permanent policy with substantial value? Gift money to trust, then sell? Promissory Note? Step transaction – actually a gift of policy? Transfer for value upon termination of grantor trust status of note outstanding? (see “Sidestepping 2035”, Lawrence Richman, Trusts & Estates, April, 2007). • Trust to trust policy sales • Fiduciary acceptance of approach?

More Confusion: Other Policy Valuation Situations (Rev. Proc. 2005 -25 “PERC” Safe Harbor for Income Tax Valuation) • “PERC” = Premiums plus Earnings less Reasonable Charges • Employer to employer (or employee’s ILIT) – sale or compensation (Section 83) • Transfer from qualified plan (Section 402) • Cost of permanent benefits provided under a group life plan (Section 79)

Traps (and Opportunities) With Permanent Insurance

Appropriate Product Type? Joe (age 60) and Jane’s (age 55) ILIT owns a $15, 000 “No-Lapse” Guaranteed Death Benefit Survivorship Universal Life policy with a $114, 558 annual premium. They are told as long as that premium is paid every year, coverage is guaranteed until age 121 even though it is projected to run out of cash value by their age 85. They and their advisors believe the policy is particularly appropriate for their estate planning purpose.

The Different Flavors of Permanent Insurance • • • “No-Lapse” or “Guaranteed Death Benefit” Universal Life Current Assumption Universal Life Equity Indexed Universal Life Variable Universal Life Whole Life

Which Type is Best? • Ask 2 different insurance professionals, get at least 3 different answers • No one type is better – depends on circumstances • Consider a portfolio of different types/carriers – diversification of interest rate and carrier risk

Relevant Considerations • Purpose (e. g. , estate liquidity in ILIT vs. retirement income) • Downside protection - guarantees • Upside opportunity with rising interest rates or equity markets

Why is the “No-Lapse” Policy Appropriate (and Popular) in Estate Planning? • Premium is often lower than many other insurance types – ideal for limited gift tax exemption • Guarantees = predictability and manageability with gift tax exemptions (policy dividend and interest rates not a factor) • Overriding purpose is estate liquidity – cash value not accessible or important • Simple as it seems? No worries?

How Does The Guarantee Work? – “Only The Shadow Knows” • “Shadow account” completely different from actual cash value account • Shadow account mechanics in the policy contract • Shadow accounts “gamed” by insurance carriers to satisfy “redundant” regulatory reserve requirements • Completely obtuse and counterintuitive (e. g. , paying early can be a problem) • Extreme sensitivity to deviations from scheduled payment patterns

Universal Life – No Lapse Guarantee Missed Premium Sensitivity Analysis, $1, 000 Death Benefit Male, Age 55, Standard Risk Pay the lifetime level pay premium, Solve for guarantee age if one premium is missed Company Ann’l Premium to Guar. To Age 121 Miss Yr 3 Guar Age Miss Yr 6 Guar Age Miss Yr 11 Guar Age A $16, 228 58 66 101 B $15, 211 57 61 71 C $15, 282 107 109 112

The Audit • 24 policies sold over last 5 years • About 35% “off track” • Drill down: • • Premium skipped or varied (intentionally? ) 1035 loan not booked by insurance company Early payment of premiums “Can’t Explain” • After “clean-up” only a few policies off track because deliberately not paying premiums as originally scheduled. • So is the “No-Lapse” policy still appropriate? Opportunity knocks!

The Little Known Flexible Side of “No-Lapse” Policies: “Off-Ramps” • What if today’s no-lapse policy is not attractive in future (e. g. , interest rates increase)? • What if future cash flow or gifting problems preclude planned funding? • Traditional thinking → Little or no cash value = S. O. L.

“Off Ramp” Menu • Cash value (Non-guaranteed & guaranteed) • Contractual ROP • Reduced Paid-Up • Stop premiums with future “catch-up” • Shhh! Let’s keep this to ourselves.

Premium vs. Liquidity ($15, 000 SUL Policy) Carrier Comdex ALIRT Full Pay Premium CV Year 20 CV Year 30 IRR Year 40 Company A 89 71 114, 558 998, 960 Non -Guaranteed 662, 351 Non -Guaranteed 8. 35% 5. 13% Company B 93 53 118, 742 0 0 8. 17% 4. 98% Company C 89 56 119, 479 0 0 8. 13% 4. 96% Company D 83 68 122, 221 719, 819 Guaranteed 3, 151, 713 Guaranteed 8. 02% 4. 87% Company E 91 43 121, 289 0 0 8. 06% 4. 90%

“Reduced Paid-Up” ($15, 000 Initial Death Benefit) Carrier Full Pay Premium Reduced Paid-Up Death Benefit Year 21 CV Year 30 IRR Year 40 Company A 114, 558 8, 000 294, 922 Non. Guaranteed 6. 15% 4. 19% Company B 118, 742 10, 500, 000 0 7. 12% 4. 87% Company C 119, 479 3, 000 0 1. 11% 0. 75% Company D 122, 221 11, 000¹ 2, 311, 256 Guaranteed 7. 15% 4. 88% Company E 121, 289 Not Available

Case Study - Policy Surrender vs. “Reduced Paid-Up” in 5 th Policy Year Policy Annual Premium Original Face Current Surrender Value A 38, 736 5, 000 372, 598 2, 689, 464 B 20, 184 5, 000 470, 551 3, 441, 148 C 34, 016 5, 000 367, 828 2, 898, 075 D 27, 796 5, 000 372, 553 2, 986, 203 E 21, 924 5, 000 192, 420 2, 432, 237 TOTALS 142, 656 25, 000 1, 775, 950 14, 447, 127 Reduced Paid Up IRR – CSV TO Death Benefit at age 91 = 7. 25% (tax-free) (Average current age = 61)

Case Study - Policy Surrender vs. “Reduced Paid-Up” in 5 th Policy Year Policy Annual Premium Original Face Current Surrender Value A 81, 882 5, 000 0 1, 254, 217 B 60, 048 5, 000 0 1, 213, 941 C 67, 780 5, 000 0 1, 233, 968 D 60, 048 5, 000 0 1, 213, 941 E 42, 800 5, 000 0 1, 153, 241 TOTALS 312, 558 25, 000 0 6, 069, 308 Reduced Paid Up

Stop Paying + Future “Catch-Up” ($15, 000 SUL Policy) 20 -Pay Lapse Year/Annual Catch Up for Lifetime Guarantee Carrier Full Pay Premium CV Year 30 IRR Year 40 Company A 114, 558 33 368, 345 0 8. 96% 5. 37% Company B 118, 742 37 752, 030 0 8. 79% 5. 43% Company C 119, 479 24 161, 313 0 8. 34% 5. 00% Company D 122, 221 37 975, 000² 2, 426, 819 Guaranteed 8. 54% 5. 01% Company E 121, 289 37 1, 572, 179 0 8. 69% 4. 58%

“Quick Pay” vs. “Life Pay” • Psychological reasons • Administrative risk • Economics of IRR on DB – If die before age 121, arguably overpaid • Option to “pay-up” guarantee later

Annual Pay With Single Premium To “Pay-Up” Guarantee In Year 21 ($15, 000 SUL Policy) Carrier Full Pay Premium 1 -Pay Premium in year 21 For Paid-Up Lifetime DB Company A 114, 558 1, 813, 561 Company B 118, 742 2, 185, 373 Company C 119, 479 1, 719, 821 Company D 122, 221 1, 550, 000 Company E 121, 289 1, 450, 000

Put It Altogether • Is “cheaper” better? • What really is “cheaper”? • Which would you choose?

Managing Opportunity and Risk • CEO: “We take the interest rate risk, but the policyholder takes the administrative risk” • What happens if/when the insurance company changes strategic direction? Exits the business? (e. g. , Sun Life of Canada, Lincoln Benefit Life) • • Administrative support? Policyholder focused? Quality of notices? Strict adherence to contractual terms?

Best Practices (Trust, But Verify!) • Understand impact of early/late payments. Calendar payment schedules. • File copy of complete policy, especially shadow account pages • File copies of sales illustrations, especially key off ramp scenarios • Obtain “in-force illustrations” every year (or two or three), particularly in the early years • Don’t necessarily accept the first answer you get from an insurance company representative – their systems and capabilities are inconsistent • Work with an insurance advisor who is attentive to ongoing policy administration • Diversification?

The Policy Illustration Trap

Illustrations Are Guaranteed To Be Wrong Interest crediting and dividend rates change Premium funding patterns change Insurance charges may change Variable insurance subaccounts may not be carefully monitored/managed (e. g. , default to money market) • But just because illustration is wrong doesn’t mean policy isn’t right • •

Illustration Regulations • Consumer “Protection” – Illustrations went from 3 pages to 30 pages! • Can’t illustrate higher than current rates • Except for variable and equity indexed products where “backtesting” allowed • The fallacy of assuming linear returns – especially with equity linked policies

Indexed Universal Life Policy Illustration - 8% assumed crediting rate Index UL – 8% “what’s it gonna cost? ” Premium $5, 417 10 8 0% Guaranteed Minimum / 10% Cap / 100% Participation / 1 YR P 2 P S&P 500 Slide reproduced with permission from Richard Weber and The Ethical Edge

Indexed Universal Life Policy Illustration - 8% assumed crediting rate Index UL – 8% Premium $5, 417 Slide reproduced with permission from Richard Weber and The Ethical Edge

Equity Indexed Universal Life • Insurance companies promoting it because it can illustrate well and is more profitable • Actual policy return is driven predominately by insurance carrier’s bond portfolio and not equity returns (fallacy of “backtesting”) • The “Options Budget”

IUL Hedging Transaction ($100, 000 Annual Premium) One Year $4, 762 $95, 238 Residual $100, 000 Discounted Premium Credited Interest 5. 00% Net Premium Slide reproduced with permission from Bobby Samuelson $100, 000 Investment Return

Effect of Options Profit Policy Yield 8. 00% Options Profit $3, 238 68% Yield 4. 76% Options Budget $4, 762 Options Premium $4, 762 Floor = 0% Options Budget Slide reproduced with permission from Bobby Samuelson Illustrated 8% Performance

Reality Bites • Principal protection? • Insurance charges assessed each year • Rule of Thumb – best long-term result is 50 to 100 bps over “portfolio rate” • Will produce wave of missed expectations and litigation

Premium Financing Insult to Injury? • Yesterday’s Trap – premium financing of “stranger owned life insurance” • Today’s Trap – premium financing of equity-indexed universal life (interest rate arbitrage = “free” or low cost insurance) • What’s the exit strategy? Death? Policy loans/withdrawals? • What can go (very) wrong?

Case Study John & Jane Doe Other Agent’s Proposal: $15, 000 Survivor Equity Indexed Policy 7. 5% illustrated rate (“Plus premium” death benefit) $212, 397 10 -pay premium Premium financed • Interest only paid annually out-of-pocket • 5. 35% assumed loan interest rate • After year 10, $115, 211 assumed annual interest • Exit on death with plus premium death benefit • •

Observations • At 7. 5% illustrated rate and 5. 35% loan rate the strategy succeeds • At 5. 5% illustrated rate, policy lapses at age 92 with no value • Consequences of failure: - Collateral calls due to declining cash value - Liable for loan balance ($2, 123, 970 + costs) Almost $4, 000 of interest paid No death benefit Litigation! Reputational (if not economic) risk for the advisors and lender

More Observations • No volatility assumed even in the 5. 5% illustrated rate • $15, 000 no-lapse UL annual premium = about $120, 000 • Assumed loan interest after year 10 was $115, 211 • Why on earth would you use the Equity Indexed UL Policy, especially with this financing strategy? • What do you think client did? • Premium financing (including split dollar), used carefully, can be a powerful estate planning tool

The Cheapest Term Insurance Trap

It’s Not So Obvious Joe just turned age 56, and is overweight with borderline diabetes. He is a successful developer, but illiquid. Lender requires $5, 000 of life insurance to secure loan. Life insurance advisor secures standard underwriting offer from Companies A, B, C, and D all with strong financial ratings. Although Joe has a permanent insurance need, he’s only interested in spending least amount possible on insurance to satisfy his lender. He says he’ll deal with permanent need down the road when he’s more liquid.

Annual Premium for $5, 000 of 10 -year Term at Standard Rates CARRIER ANNUAL PREMIUM A $16, 510 B $18, 575 C $20, 100 D $20, 835 You die, they pay!

Would You Buy the Cheapest Parachute? • • Convertibility – Hedge against future insurability Policy Split Option Face Amount Reduction Option Diversification

The Fine Print $5, 000 10 -Year Term Policy, Male, Age 56, Standard Rates Carrier Annual Premium Max Conversion Period Conversion Currently Allowed to Any Product? Conversion Contractually Allowed to Any Product? Partial Conversion/ Retain Remaining Term? A $16, 510 70 No No B $18, 575 70 Yes C $20, 100 75 Yes D $20, 835 65 Yes Face Reduction? Policy Split? Yes One time only No No Yes Yes, with limitations (including SUL)

What Does The Contract State? • Contractual vs. Company Practice? • Company practice can change • Even strong contractual language is only as good as the company behind it (e. g. , CNA and Lincoln Benefit Life)

Why Do Many Carriers Increasingly Dislike Conversion Privileges? • 74 -year old client with deteriorated health and finances • $2, 500, 000 10 -year term policy at end of 10 th year • Client only needs and could afford to convert $750, 000 of the coverage • Converted and sold the remaining $1, 750, 000 for $120, 000 on the secondary market

Policy Tax Basis Trap (or Opportunity)

Sow’s Ear Into Silk Purse Jane bought a universal life insurance policy in 1980 when the declared interest crediting rate was 15%, and based on the illustration run at that time she has been paying a premium of $5, 000/year that was to have paid up the policy by now. Notwithstanding having paid $165, 000 over the last 33 years, the current policy interest rate is 4%, the cash value is $10, 000, and the policy is projected to lapse without value in 3 years.

1035 Opportunities – Life Policy with Loss § § § To SPIA (with or without new cash) To Deferred Annuity (with or without new cash) $165, 000 of tax basis will shelter next $165, 000 of annuity gains (ordinary income)

1035 Opportunities – Life Policy with Gain § § § To SPIA To Deferred Annuity To Traditional LTCI Policy To Linked Benefit Life/LTC Policy To Optimally Designed Life Policy

The Big Picture

Insurance policy is a legal contract. Understand it.

Diversification • Product types/performance risk • Carriers (financial and administrative risk) • Conversion and other policy features

No Substitute for Periodic Review/Maintenance

Life Insurance is still the best financial product ever invented and should be a critical part of many clients’ planning! Just be thoughtful in your approach.

THANK YOU! Larry Herman, JD, CPA, CLU, Ch. FC Herman Agency, Inc. 715 Enterprise Drive Oak Brook, IL 60523 630 -571 -2217 larry. herman@hermanagency. com