by Attorney Allen Ratcliffe April 25, 2011


Life Insurance owned by an insurance trust is a universally accepted and widely utilized estate planning tool. Life insurance is ideally suited for wealth management planning in that it has a unique utility to transfer wealth in a tax-preferred, leveraged manner, for financing estate taxes, for setting up a fund for preservation of family assets or as a hedge against risks inherent in certain investments, or to balance an estate between family members.

The Baby Boom Generation is now also on the verge of impacting the life insurance business the way it previously and profoundly influenced the investment business. As Boomers move out of the retirement years and into wealth-transfer years, the population over age 65 will likely double between 2010 and 2030 as a percentage of total population, and they are expected to transfer more wealth than ever before. These demographics point toward the continued need for life insurance, insurance trusts, and life insurance management services.


As a practical matter, many individuals who establish life insurance trusts manage their trusts themselves, with the trustee acting as an accommodation to the insured often with minimal participation. The required functions, however, are seldom being performed. Trustees are held to a high fiduciary standard in the exercise of their duties to manage and invest trust assets. A trustee can be held personally responsible for failure to properly administer the trust and for underperformance of trust investments. As a result, trustees should be legitimately concerned with the appropriate management of life insurance policies owned by the trust. And those who establish insurance trusts should be concerned with the exposure that the trustee has invited. Many fiduciaries are under the false assumption that the life insurance agent of record, attorney, or CPA will monitor policy performance. Professional resources, however, have not been up to the job of managing life insurance and the maintenance of insurance trusts. Yet with increased IRS scrutiny, increased litigation and the worse recession since the great depression, the function to be performed by the trustee in monitoring and maintaining the plan has become increasingly important.


In order to enjoy the estate tax saving benefit of a life insurance trust, the trustee must ensure compliance with certain protocols, which include: a validly created insurance trust, contributions to the trust by the insured, payment of insurance proceeds by the trustee, and, of course, all of our favorite … “Crummey” letters. The IRS has recently hired over six new estate tax attorneys, ie auditors, in the San Francisco region and has adopted a more enthusiastic approach to estate and gift reviews. The failure to comply with the required procedures could result in a loss of the ability to make tax free gifts using the annual exclusion which would necessitate the use and therefore reduction of the grantor’s applicable exclusion, or, even worse, could result in the inclusion of the policy proceeds in the estate of the insured upon death.


Trust litigation where a disgruntled beneficiary sues a trustee for violating his or her strict fiduciary duties has become a major growth industry and trust owned life insurance an immense target. Trust litigators often describe TOLI litigation as “low hanging fruit” because trust files are either empty or “papered” with meaningless analysis that is likely to document imprudent decisions. Subsequent trustee depositions can effectively identify the disconnect between well-intended management practices and out-of-date procedures. It is instructive to examine the appropriate steps taken by the trustees and the possible additional actions they could have taken so as to provide a road map for trustees intent on avoiding future lawsuits.


The trustee concerned with the appropriate management of life insurance policies owned by the trust should ask the following questions:

1. Is the insurance policy consistent with trust objectives?

Should the policy or the schedule of premium payments be adjusted or do the circumstances necessitate policy replacement? Recognize that the burden of proof rests solely with the trustee to justify any replacement recommendation. Because all life insurance products are not created equal, and are, in fact, designed very differently for different portfolio objectives, it is important to first determine the objective of the life insurance portfolio. For example, is the policy a minimum-premium plan intended to finance a defined estate tax liability, or is there an investment objective like “wrapping” life insurance around a defined amount of otherwise taxable investments to shelter gains from income taxes. Portfolio objectives can also change, in which case changes to portfolio holdings may be appropriate.

2. Are scheduled premiums adequate to sustain the policy to contract maturity or insured life expectancy, at a minimum?

This question is answered by periodically obtaining an “in force” illustration and by measuring actual portfolio cash values against cash value targets from the original illustration of hypothetical policy values and considering five activities.

a. Change Premiums: When planned premiums and cash values are more than necessary to cover expected future policy expenses, a policy is considered over-funded, and premiums can be reduced or refunded to the extent of such over-funding. Conversely, when a policy is under-funded, the trustee should consider increasing premiums to thereby increase cash values to cover expected future policy expenses.

b. Change Death Benefits: If a client needs more life insurance, death benefits can generally be increased in over-funded policies without additional premiums, and should therefore be considered (this will generally require additional medical and financial underwriting). On the other hand, the trustee should consider reducing policy benefits in under-funded policies in order to reduce policy expenses to amounts supportable by current annual premium and existing cash values.

c. Change Cash Value Investment Allocations: To the extent that changing the asset allocation for a given policy holding is appropriate, the trustee should re-evaluate the allocation of invested assets underlying policy cash values. This may involve a change of the policy itself, such as to or from a variable product. For example, in under-funded policies, the trustee may consider a more aggressive asset allocation among asset classes with greater historical rates of return to make up for under-funding albeit with greater statistical volatility.

d. Sell, Buy or Exchange Policies: In the same way portfolio managers sell investments that are no longer suitable, the trustee may consider exchanging less suitable life insurance policy holdings in favor of more suitable products that offer rates and terms more consistent with planning objectives. Unwarranted replacement is the exchange of one policy for another without compelling need. This unfortunate situation does not benefit the owner but usually results in a windfall commission to the selling agent.

e. Wait-and-See: If policy cash values are slightly above or below targets, or investment performance is within expected ranges and policy expenses are justified, or if cash values and planned premiums are sufficient to support projected expenses for the foreseeable future, then a deliberate “wait and see” approach can be considered so long as policy holdings continue to be monitored and the client/grantor is kept informed as to these options. About-to-lapse policies tend to be ‘minimum funded’, and require premium adequacy evaluation annually and scheduled premium adjustments periodically.

3. Are the legal protocols in place and followed?

If you have created an insurance trust that owns your policy, in order to ensure that your insurance policy is not taxed in your estate, the trustee should check to ensure that the trust documentation is complete, that the trust is the named owner and beneficiary of the policy, and that the trust maintains a bank account to pay the insurance premiums.

At the time the trust was created, it may have been established that “Crummey” letters are to be produced annually to allow annual exclusion gifts to the trust. The IRS looks at these letters with some scrutiny, therefore it is extremely important that the upkeep of the trust is completed each year, and that the Crummey letters are accurate.

4. Have insurance carrier’s ratings deteriorated?

Although life insurance companies have been less severely affected than the banks and brokerages houses by this economic climate, more frequent checks on insurance company ratings with all the rating services is appropriate.

If a company is downgraded and the client is thinking of replacing his policy with a new policy from another carrier, please review carefully the following “replacement” issues:

• is replacement really in the client’s best interests;
• is the old policy favorably priced and already “paid up;”
• are there significant surrender penalties and/or taxes if the old policy is canceled; and
• is the client insurable at favorable rates.

A decline in ratings can result in reduced policy crediting rates and/or increased policy costs, requiring additional premium for these policies to achieve their acceptance benchmark values.


The economics of a life insurance trust are easy to understand – the return (death benefit proceeds) is known from the time of policy issue and will be paid as long as scheduled premiums are made timely and are adequate to sustain the policy for the insured’s lifetime considering the future and generally increasing policy expenses.

The majority of in-force trust owned policies are managed by non-institutional trustees, however, the litigation and tax considerations are generally the same for non-institutional trustees as for institutional trustees. Without a motivated trustee reviewing the life insurance regularly, the insurance may underperform or even lapse. In addition, failure to make prudent inquiry, appropriate adjustments and to carefully document them has resulted in a proliferation of law suits and allegations of breach of fiduciary duty as well as adverse tax consequences. Antiquated custodial care practices must be abandoned.

The expenditure of time and money to properly maintain your investment will ensure its suitability and enhance its benefits to you and your heirs.

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