Life Insurance- Its Time to Take a Second Look at Your Policy

Caution: This summary is pretty technical, but important for ILIT trustees.

Take-Away: Due to a recent change in the tax law, newly issued cash value life insurance policies will probably have higher premiums, but that might ultimately result in fewer life insurance policies lapsing prior to the insured’s death. This recent change also is yet another reason for the trustees of irrevocable life insurance trusts (ILITs) to have existing policies annually evaluated.

Background: The Consolidated Appropriations Act of 2021 ( the Act) changed outdated interest rates that are used to determine what is life insurance. This recent change applies to general account and variable life insurance policies that are issued after January 1, 2021. The Act alters the fixed interest rates prescribed by the Tax Code [IRC 7702] with capped indexed floating rates used to determine whether a contract qualifies as a life insurance policy for income tax purposes.

You will recall that with life insurance, dividends are not subject to immediate taxation, distributions from a cash surrender policy are a return of principal first (nontaxable) [IRC 72(e)], and the death benefit paid under a life insurance policy is normally income tax-free. [IRC 101(a)(1).] These tax attributes all derive from the contract being classified as life insurance. Stated another way, Congress does not want too much invested in a cash value life insurance policy in light of the unique tax attributes assigned to life insurance.

Life Insurance Policies: There are many erroneous assumptions about life insurance, and more accurately the responsibilities of a life insurance company. Life insurance policies are designed to deliver a certain rate of return to the insurance company. This return is affected by interest rates, premiums, the projected future death benefit, and other insurance company costs. There is a direct correlation between interest rates and the cost-of-insurance under the life insurance policy. Insurance companies effectively pass interest rate risk onto the policy owner. As interest rates drop, that places a strain on the life insurance policy and its promised death benefit. The insurance company has no duty to tell the policy owner to increase his or her premiums; it is the owner’s responsibility to increase their policy premiums or run the risk of the policy’s cash value being depleted. The life insurance company only has the duty to pay the death benefit coverage and send the owner an annual policy statement. Life insurance companies can also increase their cost-of-insurance charges, or other policy charges, at any time with only a 30-day notice to the owner. In short, there are a lot of ‘moving parts’ to a life insurance policy and its performance, and the onus falls on the policy owner, not the insurance company, to monitor the policy’s performance.

Act: The presumed interest rates used to determine life insurance were changed in part because as current commercial interest and policy crediting rates fell below these previous specified interest rate levels, policy owners could not adequately fund their policies, which caused some policies to be underfunded, in turn leading in some cases to the lapse of the life insurance policy and the loss of the death benefit. Simply paying the annual insurance premium does not automatically lead to the death benefit that was promised, if other ‘hidden’ costs and interest rates do not prevail as assumed in the initial policy illustration provided when the policy was first purchased.

Premiums are ‘Recommendations:’ As a surprise to many, what the insurance company sends to the policy owner as an annual premium statement is only a recommendation. The policy owner could pay more to help sustain the policy, to reduce the owner’s risk of a subsequent policy lapse. But that ‘could’ was limited by the Tax Code and its assumptions.
Change in Interest Rates: The previous interest rates used to determine policy premiums, prior to the Act, effectively limited the amount of cash value required to fully fund the life insurance policy to the insured’s age 95. IRC 7702 fixed statutory interest rates at 4% or 6% to calculate conservatively interest credits to the policy. Those rates were replaced by the Act with interim (more realistic) rates of 2% and 4%, later to be indexed to reflect inflation.
What’s Really Going On: IRC 7702 (c), (d) and (f) are designed to address the life insurance policy’s cash surrender value when it gets too close to the death benefit, too early in time. Recall that this is supposed to be life insurance with a shifting of risk to the insurance company, not an owner’s investment portfolio wrapped in a life insurance contract. The life insurance policy is generally designed to increase the death benefit in a specific ratio to its cash value. This is intended to preserve the amount at risk and allows the policy to continue to be taxed as life insurance for income tax purposes. Generally, the death benefit must be at least 250% of the cash value for insureds ages 0 to 40. This ratio decreases over time to allow the death benefit to equal the cash value at the insured’s age 95. In fact, in cases where there is too much cash value under this specified statutory ratio, there is a return of the overpaid premiums to the policy owner that otherwise would have caused the life insurance policy to violate the guideline premium limit, a fail-safe mechanism so to speak, that allows the policy owner to receive back from the insurance company any excess premiums, thus maintaining the life insurance (risk shifting) nature of the contract.
Effective Change: As noted earlier, this change affects only new life insurance policies that are issued after the first of this year. However, life insurance policies are subject to like-kind exchanges under IRC 2035, and old policies might quickly become new policies. Were a policy owner, or the trustee of an ILIT, to exchange an underperforming life insurance policy for a new policy, that new policy would be subject to the Act’s change in interest rates.
Context: Is the concern over ‘underperforming’ life insurance policy lapses real? It is estimated that Americans age 65 and older let $112 billion in death benefits lapse each year. 34% of all ILIT policies are rated as ‘high risk’, which means that the policy is projected to lapse prior to maturity, or the policy’s no-lapse guarantees have been compromised.

Consequences: Some of the consequences of the Act’s reduced interest rates required to be implemented by life insurance companies in future life insurance policy underwriting will include:

Insurance Companies that have had to keep policy guarantees high to comply with IRC 7702 will now have the freedom to decrease their guaranteed rates.
Insurance Companies will now be able to charge more sustainable (higher) premiums, which sounds like a bad thing, but may be necessary if the goal is for the policy to not lapse before the insured dies.
Policy owners will be able to maximum fund their policies (where they were restricted in the past with regard to adding more cash to their cash surrender values) by prefunding the premiums.
Higher funding for life insurance policies may allow the policy to perform even in adverse economic conditions, or when the insurance company increases mortality charges or reduces credit ratings.
Younger insureds who may now pay more insurance premiums may benefit from longer time horizons.
Those policy owners who need to pay sustainable premiums for their policies will not be forced by the tax laws into buying more death benefit than they want or need.
Rated insureds may have an enhanced ability to accumulate cash values in their life insurance policies.
Those policy owners who participate in split-dollar policy funding arrangements may now be able to acquire a lower death benefit, which may lead to an easier path to unwind the split-dollar arrangement more efficiently.

ILITs: These changes to life insurance should give the trustees of an ILIT pause to think about how the policy held in the ILIT is currently performing and whether the trustee should consider a policy exchange under IRC 1035. All too often the trustee of an ILIT adopts a set-it-and-forget-attitude with regard to the policy. There is much more to administering an ILIT than simply looking at the annual policy statement issued by the insurance company and comparing its information with the policy illustration when the policy was initially issued, and making sure that crummey withdrawal notices are send to the ILIT beneficiaries. It is strongly suggested that the ILIT trustee engage a qualified independent consultant to ‘stress test’ the life insurance policy to confirm that it will perform as intended and not in risk of lapse. This would fulfill the ILIT trustee’s fiduciary duties under the Prudent Investor Rule with regard to the policy held in the trust. An independent consultant (not the agent who sold the policy) will normally look at the following and advise the ILIT trustee. They will-

Determine the monthly cost-of-insurance and all additional charges, which may not be the same as the projected premiums illustrated in past illustrations;
Review and validate the relevance and continuation of any policy riders;
Review in-force policy illustrations and annual statements;
Determine the insurance company’s rating;
Evaluate policy performance;
Look at actual life expectancy reports obtained from a third party (not the insurance company);
Review policy features, including policy guarantees, to evaluate the risks that they present to the ILIT;
Confirm the net death benefit amount from the insurance company;
Confirm the policy’s cash surrender value from the insurance company; and
Analyze the policy’s previous premium payment history, including actual dates of payment.

Conclusion: There is obviously a lot going on with the life insurance industry, and with the recent change in the Tax Code on what constitutes a life insurance policy. The owners of such policies, especially the trustees of ILITs, need to be aware of these changes and the ability to shift from old policies to new policies using IRC 1035 if an exchange is warranted. While most ILITs contain exculpation provisions with regard to the trustee’s administration of the life insurance policy held in the ILIT, those provisions may not provide a complete exoneration. Consider Rafert v. Meyer, 859 N.W. 2d 332 (Neb. 2015) which found an ILIT trustee liable in his management of the ILIT, despite the presence of exculpatory provisions in the trust. The court found that the trustee had an non-waivable duty to keep beneficiaries informed about the status of the insurance policies held in the trust. Stress-testing the policy annually is the best way for the ILIT trustee to fulfill its fiduciary duties to the ILIT’s beneficiaries.