With over $3 trillion in cash values, life insurance ranks second only to the mutual fund industry in magnitude. And though its use has expanded dramatically, particularly in sophisticated planning scenarios, it is rarely evaluated once put into place. Most people consider it a "static asset" that requires little maintenance. Nothing could be farther from the truth.
Life insurance is a significant financial asset, providing valuable protection and planning flexibility. But as with any important asset, policies must be monitored to make sure they continue to meet their intended objectives. With both fixed-interest and investment yields having fallen over time, the performance of existing policies simply has not met the assumptions made at the time of purchase. With lower-than-expected market returns, most life insurance policyholders will face increased premiums, reduced benefits or both. This often comes as a surprise to affected policyholders, who turn back to the life insurance market in search of an updated solution.
The life insurance industry continues to evolve in favorable ways. People live longer as a result of improvements in health, fitness, medical procedures and technology, which has resulted in better pricing of life insurance products. In addition, innovative product design provides greater flexibility while delivering superior, lower-cost guarantees. However, existing policies are not always updated due to the focus on new products, industry consolidation, economics and new regulations. Independent studies have indicated that the majority of policies could be improved by reduced premiums or increased death benefits with newer products.
A NEW KIND OF AUDIT
We developed the forensic life policy audit process to provide clients depth beyond the basic suitability of a life insurance policy and to address whether it meets their specific personal or business planning goals. It is essential to employ a level of sophistication that matches the client's needs and delivers solutions that take into account their overall financial plan. This requires a less linear and more inclusive planning approach than the traditional insurance review, which typically just considers the underlying product's performance and whether the existing policy can be upgraded.
The forensic life policy audit consists of an objective evaluation and comprehensive inventory of the client's life insurance portfolio that considers all aspects of their personal, business and charitable needs and provides specific recommendations on the most secure and effective methods to meet those needs. It is designed to demonstrate exactly where the client stands today, and counsels the adjustments necessary to ensure that product performance and planning goals are aligned.
Here's an example: A 69-year-old business owner, who was in good health, had two variable universal life policies on his life. He and his wife, who was 66, had a net worth just shy of $20 million and reasonable liquidity. He owned one policy with a death benefit of $1.28 million and cash values just over $500,000. No additional premiums were needed and the death benefit would have potentially grown to $1.575 million by age 100. Because it was inside his estate, the proceeds would have been exposed to estate taxes at an effective rate of 45 percent. An irrevocable life insurance trust owned another $1 million policy with $70,000 of cash values and projected premiums required of $49,000 to keep it in force to his age 100. A second ILIT owned a $2 million survivorship variable policy. It had cash values of $60,000 and would require $41,000 of premiums to stay in force to their joint age 100. All projections of premiums and values were based on proposed assumptions and were not guaranteed, and none of the policies were in a taxable gain situation if they were to be surrendered.
After performing the policy review, together with an evaluation of the client's goals and a reworking of his estate plan, all part of the forensic life policy audit process, new insurance was issued to replace the existing coverage. $2 million of no-lapse guaranteed coverage on his life was issued to ILIT No. 1 with an annual premium of $51,200. ILIT No. 2 purchased $3 million of no-lapse guaranteed survivorship coverage with an annual $37,000 premium.
The result was an increase from $3.7 million to $5 million (plus 35 percent) in total net life insurance benefits to the client's family for the same annual premium of approximately $90,000. The cash values available in the trusts from the surrender of the existing policies paid the premium for the entire first year and part of the second year ($130,000), and freed up annual exclusions for the next two years that he then used for other family gifting purposes. Lastly, the surrender of the policy that he owned personally freed up over $500,000 in cash values, which he invested and was able to use for gifts to the trusts in the future.
Trustees and businesses can also benefit from periodic analysis of the life insurance policies they own or administer.
Many people establish irrevocable trusts to hold life insurance because of the estate tax benefits they can provide. The trustee has a fiduciary responsibility to the beneficiaries to ensure that the trust's assets are secure and provide their intended benefit. Having an independent insurance professional review the policies held by the trust is necessary due diligence that may protect the trustee from potential fiduciary liability and provide the beneficiaries with substantially greater benefits. The forensic life policy audit considers not just the performance of the existing insurance coverage, but also takes into consideration how it is structured within the client's estate to determine whether other beneficial changes can be made.
Beyond personal planning scenarios, life insurance is frequently used in a range of business applications. People are often the most valuable assets of a business, and the dynamic nature of business leads to changes that call for a comprehensive policy evaluation. Life insurance is often used to protect a business if a key person dies, and is also used to fund buy/sell agreements between shareholders or partners. Businesses can purchase life insurance to fund benefits for executives or owners as part of a non-qualified benefit plan or as additional bonus compensation.
Generally, life insurance death benefits are income-tax-free to the beneficiary. But since 2000, new regulations have been enacted that affect the tax treatment of certain arrangements, especially in business situations, and may subject the death benefit proceeds to income taxes. The Pension Protection Act of 2006 imposes new rules that a business must follow to preserve income-tax-free benefits.
Businesses also maintain split-dollar plans - common arrangements in which a business and a trust typically share the payment of premiums on the life of a business owner or executive. New regulations affect the way these plans must be accounted for and administered. Frequently clients enter into these types of arrangements with no plan to unwind them. Every situation is unique and certain transactions will trigger undesired consequences.
More often than not, changes in a client's family or business circumstances will dictate the need for a forensic life policy audit. We have to understand a client's specific planning needs before we can make a recommendation regarding their current life insurance portfolio.
A forensic life policy audit represents an opportunity to address a client's more sophisticated issues with solutions that complement their overall financial plan. Fortunately, today's life insurance market offers products that address the range of strategic planning objectives. And all of the insurance-related legislative and tax changes highlight the need to have a qualified life insurance professional, together with the client's tax counsel, review existing arrangements, as well as the policies themselves.
Glen A. Coral, CLU, ChFC, is director of advanced markets planning for CBIZ Wealth Management.
