Life insurance is an essential estate planning tool that many people use to protect their family’s future. However, the majority of policy owners and their advisors treat life insurance as a buy-and-hold asset rather than as an investment with critical tax advantages. Sophisticated individuals may diligently manage their stock portfolio or real estate holdings but ignore their life insurance policies. Life insurance can be regarded as “biological” real estate, and just like real estate, needs to be managed effectively in order for it to hold its long-term value.
Policy owners who wish to keep their policies to protect their beneficiaries should not surrender their policies or sell them in a transaction called a “life settlement.” Many sellers are unaware that their sales may be double taxed, and that they would be trading in valuable assets with tax-free proceeds for a miniscule profit tempered by taxes and intermediaries’ fees. In contrast, properly managing life insurance allows policy owners to keep their policies despite potential liquidity needs.
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Risks of Life Insurance
Life insurance policies are not as “guaranteed” or “permanent” as many policy owners believe. Different types of policies carry varying amounts of risk. The greatest risk is the longevity risk—the risk of overpaying for life insurance or of outliving the policy’s termination risk. Due to scientific advances and lifestyle changes, many policy owners are living longer than insurance companies’ original predictions decades ago. Longer life expectancies lead policy owners to pay more in premiums than previously expected, with the premium totals often surpassing that of the actual death benefit. Some policy owners are unaware that their policies have termination dates and let their policies lapse when they pass a certain age. Both individual policy owners and sophisticated insurance investors face the longevity risk, but only the latter know how to manage it and reduce it.
Life insurance is also subject to changes in inflation and interest rates. Insurance premium illustrations that were created in the 1980s and 1990s were predicated on interest rates maintaining levels that are now detached from reality. Subsequent events proved that these illustrations were based on unrealistic variables and, therefore, did not accurately predict length of coverage and relevant costs. When interest rates began to decline, most policy owners were not aware that they had to increase the amount of premiums they were paying. As a result, many policies either lapsed or became too expensive to maintain.
It is not the insurance carrier’s duty to notify policy owners to increase their payments, but rather it is the policy owner’s responsibility to increase their payments proactively or risk their policy’s cash value being depleted, which exacerbates the risk of the policy lapsing. The insurance company typically is only obligated to provide the death benefit coverage and send the policy owner an annual statement. Without a proper monitoring system in place, policy owners might be unaware of cost increases and inadvertently let their policy lapse.
While many variables determine the cost to maintain an insurance policy, a key variable that is often misunderstood and subject to change is the cost of insurance (COI). COI is effectively a subjective rate of return that insurance carriers charge to facilitate their target returns. The insurance industry increased the internal COI for the first time in 2016. Regulators and policy owners alike were surprised at how fast these increases took place, and several class actions ensued.
Carriers such as Transamerica Life Insurance Company settled class action lawsuits brought on behalf of policyholders alleging that Transamerica improperly increased monthly charges for universal life policies. However, carriers may still be able to increase the COI at any time with only a 30-days notice to the policy owner. Depending on the policy type, carriers also have the ability to increase premiums, as well as change other factors.
Negative Tax Implications of Selling Your Life Insurance in Life Settlement Market
Life insurance can be an excellent tax planning tool when employed correctly. The proceeds of a policy’s death benefit are not subject to income taxes. If placed in an irrevocable life insurance trust (ILIT), the death benefit is also excluded from the decedent’s gross estate when calculating estate taxes. Upon the sale of a life insurance policy, these tax advantages disappear. Moreover, sellers often have to pay both ordinary income tax and capital gains tax on the sale of their life insurance. A policy owner who sells a policy for more than its cost basis must pay capital gains on the difference between the sale price and the cost basis. The cost basis of a policy is typically the amount of premiums paid into the policy. A policy owner who sells a policy with a cash surrender value (CSV) greater than its cost basis has to pay ordinary income tax on the difference between the CSV and the cost basis.
For example, a policy owner who sells a $1 million policy with a $200,000 CSV and $100,000 cost basis must pay capital gains on the difference between the sale price and the cost basis and ordinary income tax on the difference between the CSV and the cost basis. These taxes, combined with the multiple intermediaries’ fees involved in a life settlement transaction, result in a modest outcome for the seller. Policy owners who sell their policies to fulfill immediate liquidity needs should look for a more creative solution that allows them to benefit from the tax advantages of life insurance.
The best way to mitigate the risks of owning life insurance is to manage life insurance like a liquid asset, and to monitor it continuously. Just like investors in real estate often transfer risks to outside parties and to lenders, policy owners should transfer the longevity risk to a third party. Policy owners can receive credit secured against the future death benefit of their policy to pay premiums and other expenses. This reduces their out-of-pocket premium payments while still maintaining their policies for their beneficiaries and estate planning needs.
Policy owners should not sell their policies because of their inability to pay increasing premiums. Rather, it is far more beneficial to keep life insurance and monetize the future death benefit by treating it like a liquid asset. More specifically, a policy owner can obtain non-recourse loans for existing in-force policies without any additional external collateral. Expert third party management and non-recourse financing enables policy owners to treat life insurance like real estate investments and maximize its profitability.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Grace Bronstein is the CEO of TrustLife Insurance Management (TLIM), an advisory firm that supports CPAs, trustees, financial advisors, and estate planning attorneys in properly managing trust-owned life insurance. Grace is also the COO of AllFinancial Group, an affiliate of TLIM, an asset management firm that provides non-recourse financing for life insurance policies. Previously, Grace was a litigation associate at Schulte Roth & Zabel. Grace is a graduate of Columbia University and Columbia Law School.
Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.