Understanding The Hidden Risks Of Life Insurance: Due Diligence For Policy Holders And Fiduciaries

Monday, December 16, 2013 - 15:47

Immediate cash needs at death range from general living expenses to buying out a business partner or providing funds to pay estate taxes. But imagine opening a letter one day from your insurance company to find that your equity-based life insurance policy may lapse due to lack of funding. Despite thousands of dollars in premiums dutifully paid over many years, market conditions may have quietly eroded the equity value of your policy. Over the past few years, universal and equity-based life insurance policy owners have found themselves asking, “How did this happen?” and “How could I have avoided this?”

The answer to the first question is fairly straightforward. Universal life insurance is still a relatively young product. It arrived in the marketplace in the late 1970s and saw explosive growth in popularity throughout the high-interest-rate era of the 1980s. Three decades and two recessions later, we find that the projections and assumptions originally used to illustrate the economics of the policy were not borne out in reality.

The low-interest, low-return environment that we have experienced over the past decade has resulted in the owners of universal life policies receiving considerably less interest on the cash portion of their policy as compared to the higher interest rates that were available at the time of purchase and were used in projections and illustrations. Meanwhile, the policy charges that were easily handled at the higher projected interest rates are now adversely impacting the originally projected policy cash values. This will result in less-than-expected cash values down the road, potentially reduced death benefits and/or in the worst case, policies lapsing years earlier than originally projected. The owners face the difficult decision of anteing up additional money to save the policy or losing their coverage and the years of premiums they have already paid. Even more problematic are the policies that have eroded to near worthlessness under the care of a well-meaning but uninformed trustee.

With regard to the second question, determining whether there might be a looming problem or opportunity requires some work, but may well be worthwhile for owners and trustees alike. Here are some suggested steps to getting at the issue.

First, locate the most recent premium statement, the original contract, and the illustration provided when the policy was purchased. You’ll want to review the contract for the death benefit, premium amount, duration, and type of policy, such as term, universal or whole life. Next, ask your broker or agent for an "in-force ledger" that will help you determine how long the policy will last and what future premiums might be required to maintain the policy. And, of course, reevaluate the purpose of the life insurance to determine if there is still a need for the coverage – even if the need has changed since the time of purchase.

If you are in good health, you may actually find new policies charging lower premiums for the same coverage. This is because most insurance carriers have been able to improve the prices of their newer policies by reducing the cost of insurance charges due to better-than-projected mortality experience (insureds living longer than expected). On the other hand, if your health has declined, you may be able to reduce or skip the next premium. Why? Most universal life policies are sold with a life expectancy past age 100 even though most people will never live that long. There may be enough built-up equity value in your portfolio to carry the policy without fulfilling all of the originally scheduled premium payments. A recent review on a 78-year-old man who had $9 million of coverage between three universal life policies (that his family thought were no longer affordable at the projected higher premium due to low interest rates) resulted in a savings of over $100,000 per year simply by focusing on his life expectancy and not the impact of low-interest crediting rate!

Finally, if you are the trustee of a life insurance trust, you have a fiduciary responsibility to monitor the policy, even if you are an unsuspecting family member who is not a financial professional. Just paying the premiums and issuing the Crummey notices is only part of the trustee’s responsibility. Protecting the assets of the trust and protecting the beneficiaries needs to be addressed by performing periodic due diligence ranging from reviewing the company’s current credit worthiness to following the steps above.

So perhaps consider a life insurance "physical" as part of your year-end tax and financial planning or add it to the long list of New Year’s resolutions! Your insurance advisor should be able to help you understand the financial "fitness" of your policy, or your WTAS advisor can help coordinate a review with a qualified insurance professional.

Gerald DesRoches is a Managing Director of WTAS LLC. Neal McFarland is an Associate in the New York office.

Please email the author at gerald.desroches@wtas.com with questions about this article.