The Insurance Design Center, LLC 847 943 0800 · Planning strategies Current asset allocation Personal desires for family The Insurance Design Center, LLC 847 943 0800 Transformation:

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The Insurance Design Center, LLC 847 943 0800 www.idc-llc.com

Presentation for use By IDC Representative Only – Not for Distribution or Use as Independent Source Document

This material is for informational purposes only. Although many of the topics presented may also involve tax, legal, accounting or other issues, neither The Insurance Design Center LLC, nor any of its consultants, advisors, employees or insurance affiliates are in the business of offering such advice. Individuals interested in these topics should consult with their own professional advisors to examine tax, legal, accounting, or financial planning aspects ofthese topics.The Insurance Design Center LLC is licensed and regulated by the State of Illinois Division of Insurance and provides services in the capacity of an Insurance Consultant only. The information is not intended to constitute an offer to sell or a solicitation inconnection with any product or strategy. Trademark & Copyright © 2007 Insurance Design Center, LLC


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Life Insurance Today

There’s More at Risk and Much More to Gain…

Neither the insurance industry, nor the regulators governing it, require full disclosure of the risks in implementing strategies or products.Opportunities and risks are great, but too much of the industry still operates inside a black box.Most changes occurring in the world of insurance are for the benefit of the industry, not your clients.

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The Changing Landscape

What stops insurance owners and advisors from looking into the efficiencies of their portfolios?

Misinformation and leftover beliefsLack of industry and product knowledge Lack of trust in their insurance advisorFear of looking incompetentNo understanding of insurance policy performance issues


Fixed Instruments: Returns on Long Term Bonds

Why do interest rates matter?Early 80’s: In 1981 the long term rate peaked at 15.32%Ten Years Later: rate was 7.65%Bonds (and other fixed instruments) make up 70% or more of the General Investment Portfolio of the average life insurance company


AIG Life Insurance Company

90.6%

0.3%

5.6%

0.2%

2.2%

0.9%0.2%

1

2

3

4

5

6

7

Fixed Instruments:A sample Portfolio

0.9%Other Invested Assets

0.2%Cash and Short Term

2.2%Policy Loans

0.2%Real Estate

5.6%Mortgages

0.3%Stocks

90.6%Bonds

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Source: National Underwriter Life & Health | August 21/28, 2006; pg 12 Fitch Ratings Life & Health Statistical Report / National Underwriter Insurance Data Services

The Changing Landscape: Demutualization of the Industry

93% of life insurance companies are now beholden to stockholders, not policyholders


Demutualization of The Life Insurance Industry

***** As of July 2004, AXA Financial merged with MONY **** As of 2004, Manufacturers Life Insurance Company merged with John Hancock Financial Services, Inc. *** As of July 10, 2003 Great-West Lifeco Inc. acquired 100% of the common shares of Canada Life Financial Corporation. ** As of November 15, 2006 Aviva acquired 100% of the common shares of AmerUs Group * Close price adjusted for dividends and splits.

429%AVERAGE

690%53.187.71March-00SLFSun Life Assurance Company of Canada

472%52.0911.03April-99SFGStandard Insurance Company

342%94.1427.55December-01PRUPrudential Insurance Company of America

337%65.4919.44October-01PFGPrincipal Life Insurance Company

-23%12.0215.51June-01PNXPhoenix Life Insurance Company

November-98MONY Life Insurance Company*****

366%65.5917.93June-00METMetropolitan Life Insurance Company

818%41.785.11September-99MFCManufacturers Life Insurance Company

January-00John Hancock Life Insurance Company****

December-01Canada Life Assurance Company***

January-97AmerUS Life Insurance Company**

% Change in

Stock Price

Adjusted Stock Price Today

(11-30-2007)*

Adjusted Stock Price at

Demutualization*

Month and Year of

Demutualization

Ticker Symbol

Company Name


The Changing Landscape

Source: National Underwriter Life & Health | August 21/28, 2006;pg 12 Fitch Ratings Life & Health Statistical Report / National Underwriter Insurance Data Services

The Changing landscape

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The Changing Landscape: Demutualization of the Life Insurance Industry

Manulife, MetLife and Prudential Versus the S & P and the Dow


Universal Life

$1.0 million Universal Life purchased in 1985 on a male, age 33 reassessed in 1995. Preferred underwriting:

Interest rate 12% 10% 8% 6%Initial Premium 2,543 3,028 3,870 5,380Illustrated Cash yr 10 15,429 21,135 30,500 46,121Actual Cash yr 10 11,816 17,509 28,732 46,121Revised premium 6% 8,160 7,759 6,969 5,380

Source: Southeast Health Management Business, Nov., 2007, Richard M. Weber, MBA, CLU


Whole Life

Whole Life has its own issues…Current dividend crediting rates do not always reflect actual earnings on cash valueProjections (illustrations on in-force policies) should be carefully requested and reviewed if you want to get close to an accurate picture of future performance

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Whole Life

Historical Dividend Crediting Rates


Whole Life

Manulife 7.75% 6.34% 1.41%Sun Life 7.55% 7.26% .29% Northwestern 7.50% 6.10% 1.40%Phoenix 5.99% 6.29% -.30%Mass Mutual 7.40% 6.31% 1.09%New York Life 6.79% 5.82% .97%Guardian 6.50% 5.75% .75%John Hancock 6.25% 6.72% .47%MetLife 6.25% 4.22% 2.03%New England 6.00% 5.41% .59%General American 6.05% 4.07% 1.98%

Insurance Company

Net Yield on Mean Invested Assets - 2006

Dividend Rate for

2006 Difference


Transformation: What can and should be done, and why?

As mentioned previously, 85% of existing trusts could obtain 40%reduction in premium or 40% increase in benefit for the same premium.*The Restatement of the Third law of Trusts (1990) and The Uniform Prudent Investors Act both identify these principles of prudent investing:

DiversifyAvoid unnecessary costsWeigh risksSeek advice when necessary

* Source: Mayer, Fiduciary Duties for Trust Owned Life Insurance un UPIA, “Michigan Lawyer Weekly (July 2, 2001)

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Transformation: The Process

Discovery interview with client and advisorCurrent goals of estate and financial planPlanning strategiesCurrent asset allocation Personal desires for family



Client Planning GoalsSuccession issuesEqualization issuesNew children or grandchildrenCharitable intentCapacity issues



Secure information from each in-force carrierCash Values (accumulation and surrender)Surrender Charges: how much and for how long?Policy loan balancesCost basis for each contractOwners and beneficiaries Current premium: amount and how often paidPremium paid-to dateUnderwriting class at issueRiders or waivers on the contractsFinancial information on the insurance company

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Secure new in-force illustrations from each carrier

Project values and benefits at current premium and current interest or dividend* crediting rate and current mortality Project the policy to last to insured’s age 100 with cash values or to endow at current, and reduced, interest or dividend crediting rates and mortality Any other variation that suits client or advisor funding goals

* If whole life, premiums should (1) run for life and (2) stop once annual dividends along with surrender of dividend accumulations are enough to pay future premiums. The reduced crediting rate for whole life should reflect current investment return.



Medical InformationSecure authorization from insured that will allow attending physicians and medical facilities to copy and send medical files.Forward requests to all physicians, hospitals, etc. Likely that payments will need to be included with requests



Review Funding Alternatives1035 exchangeLife Settlement – are in-force policies candidates?Premium financing – does family or outside financing enhance the value of the program? Discount and Transfer Techniques: LLC’s, LLP’s, GRATS, Sales – what’s being done now to transfer capital that can be used later to fund insurance? Should new steps be taken?

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Unwinding Split Dollar –A case study

Mr. Johnson is 75. He has $18 million of total coverage.

His corporation requests a portfolio review of seven universal and one whole life, split dollar policies issued by MetLife.The client wants the maximum death benefit available for the annual premium of roughly $625,000 currently being paid.The outstanding split dollar obligation is $4,000,000.

Case Open: Dec x, xxxx

Case Compl: Jan x, xxxx

Referral: Mellon Bank


Unwinding Split dollar –A case study

How can the Johnsons continue to fund their life insurance without the split dollar arrangement?

Several years ago, the Johnsons established a trust funded with stock in a new corporation. This trust now had capital to support the premium payments required by the life insurance coverage.The outstanding split dollar obligation of $4,000,000 could be largely met by the cash value of the old policies.

Case Open: Dec x, xxxx

Case Compl: Jan x, xxxx

Referral: Mellon Bank


Life Settlements

Life settlements can provide a welcome source of liquidity. However, determining if this is a prudent course of action for your client and negotiating the terms is fraught with pitfalls.

A life settlement is the sale of an existing life insurance policy to a third-party for an amount greater than the policy’s cash surrender value, and less than the death benefit.

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Life Settlements

Selling a policy for cash is seldom the sole motivation for considering a life settlement.

A settlement can offer a way to reclaim capital that can then be used to rebalance a client’s total portfolio of insurance and investments.A settlement can bring cash back into a trust which can then be diversified to meet the goals of the trust.Policies utilized for business planning are some of the most likely candidates if the business no longer exists or the original purpose of the policies has changed.


Financing Life Insurance

What do clients need to understand when they choose to finance life insurance?

Interest Rate RiskCollateral RequirementsLoss of Insurance CapacityTax RisksRefinancing RiskInsurance Policy PerformanceEconomic Forecasting and ExpectationsInsurable Interest


Ancillary Actions, Options, and Strategies

Life settlementNegotiated underwriting Annuity arbitrage for enhanced funding1035 Exchange

GRATS, sales, QPRTS, etc. Private Split Dollar Premium financing

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What is our responsibility?


Who’s Watching the Store?

Who is responsible for managing, monitoring and maintaining life insurance contracts?

The insured?The settlor?The trustee?The attorney, accountant or financial advisor?The insurance agent?The insurance company?


The Uniform Prudent Investors Act

The UPIA requires advisors and trustees to manage assets as any prudent investor would.

Section 2(c), (Standard of Care, Portfolio Strategy, Risk and Return Objectives) requires the trustee recognize “an asset’s special relationship or special value, if any, to the purposes of the trust”. Life insurance as the sole asset of an ILIT would appear to have such a “special relationship”. John McCabe, National Conference of Commissioners on Uniform State Laws

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Prudent Management

Requires:Review of the policiesReassessment as to actual performance vs. projectedThorough understanding of current alternativesKnowledge of ancillary actions, options, and strategies


In Summary

Life insurance should be looked at in the same light as any capital asset.


An advocate for those with significant amounts of capital entrusted to the life insurance industry.

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IDC – An Objective Resource

The IDC Capital Management Standard™sets a new threshold for the analysis and stewardship of insurance capital.

Growth, security and continuity are only achieved through constant attention to ongoing changes in economic, legislative and regulatory factors. Access the resources needed to create a defensible program that meets today’s regulatory standards.Anticipate change, evaluate impact and recommend prudent responses.


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THE INSURANCE DESIGN CENTER, LLC

500 Lake Cook Rd.Suite 270Deerfield, IL 60015Tel: 847 943 0800Fax: 847 943 0801www.idc-llc.com

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InsuranceDesignCenter.com

Case Study The Johnson Family

Background:

In early 2006, a trust and estate attorney working with a high net worth client required a review of a split dollar arrangement that was implemented prior to the advisor’s engagement.The attorney was concerned with the complexity of the arrangement which included eightseparate underlying policies, the cost and performance of these contracts, and the outstandingobligation for his client in the split dollar arrangement.

The advisor had the following questions:

n How were the underlying policies performing?

n What are the client’s options and risks?

n Was a solution possible given the client’s medical history?

Refinancing Life Insurance to Repay aSplit Dollar Liability

The Situation:

Here is an example of how a proactive attorney’s action provided cash flow for an existing business and improved theoverall liquidity of their client’s estate.

The Johnson FamilyMr. Johnson was 75 years of age. His irrevocable trust owned $18 million of individual life insurance (composed of sevenuniversal life policies and one whole life policy) with MetLife, at a premium cost of approximately $625,000 annually.These policies were originally purchased to fund a split dollar agreement with his company. $3 million of the cash valuewas owed back to the company for funding the split dollar arrangement. All of the universal life contracts were severelyunder-performing the market, and would require significant premium increases to maintain them at their current level ofdeath benefit. The whole life policy was performing well but without the universal contracts, would have been saddledwith the entire split dollar obligation. Underwriting for replacement coverage was complicated due to medical conditionsinvolving cardiovascular surgery eight years prior to this review.

The Solution:

Through negotiated underwriting, Mr. Johnson was insurable at standard rates, and a single $15 million guaranteeduniversal life insurance contract was secured at a cost of $550,000 in annual premium. His trustee then surrenderedthe seven failing universal life policies and, using the resulting cash surrender value, repaid the company $3 million toeliminate the split dollar obligation. The repayment provided the company with a windfall of unanticipated cash flow.

Additionally, the new policy was paid for and owned by a heavily funded irrevocable trust and therefore residesoutside of Mr. Johnson’s estate, exempt from gift taxation and guaranteed for life.

Two years later, IDC went back to underwriters at several insurance carriers and renegotiated preferred rates, whichenhanced the original solution; increasing the death benefit to $17 million for a cost of approximately $540,000. In addition to having the use of a larger death benefit at a lower cost, the client and his family were thrilled with thisaffirmation of his recovery and good health.

Disclosure: This material is for informational purposes only. Although many of the topics presented may also involve tax, legal, accounting or other issues, neitherThe Insurance Design Center LLC, nor any of its consultants, advisors, employees or insurance affiliates are in the business of offering such advice. Individualsinterested in these topics should consult with their own professional advisors to examine tax, legal, accounting, or financial planning aspects of these topics.

The Insurance Design Center LLC is licensed and regulated by the State of Illinois Division of Insurance and provides services in the capacity of an InsuranceConsultant only. The information is not intended to constitute an offer to sell or a solicitation in connection with any product or strategy.

Trademark & Copyright © 2007 The Insurance Design Center, llc. All rights reserved. not for public use or distribution.

500 Lake Cook Rd.Suite 270Deerfield, IL 60015Tel: 866 943 6900 InsuranceDesignCenter.com

Learn more at:

InsuranceDesignCenter.com

Where’s the Risk? Safeguarding Insurance Portfolios – Documenting Active Stewardship The fastest growing division of trust companies is the litigation department due to the groundswell of lawsuits surrounding fiduciary responsibilities. When it comes to life insurance trusts (LITs), litigation is rampant because the interests of the grantor are not typically in concert with the fiduciary responsibilities of the trust company and the trustee, or the interests of the beneficiaries. Whether or not fiduciaries and other advisors wish to deal with the reality of policy failure or poor performance, they must be aware that life insurance is a financial instrument that has evolved into a new asset class. Unfortunately, the fiduciaries and advisors often do not possess the specific expertise now required to serve clients with significant capital entrusted to the life insurance industry. Most are equally wary of the liability they perceive exists in making recommendations. Inaction does not mitigate this

potential liability.

Creating a life insurance portfolio has some similarities to building a house. Even with close oversight and professional review, problems arise. Routine inspections and ongoing maintenance are needed and, over time, you are likely to find problems you didn’t know were there. As with a house, a life insurance portfolio is likely to require modifications as a person’s needs change. Where is the long-term risk? What you don’t know about the “moving parts” within life insurance contracts will increase the risk of a buy and hold philosophy dramatically. Fiduciaries and financial advisors need to understand the potential liability of inertia – Rates of return on death benefits can be surprisingly high Trust cash flow is rarely limited by gifting restrictions

The content covered in this presentation is for informational purposes only. Although many of the topics presented may also involve tax, legal, accounting or other issues, neither The Insurance Design Center LLC, nor any of its consultants, advisors, employees or insurance affiliates are in the business of offering such advice. The Insurance Design Center, LLC is licensed with the State of Illinois Division of Insurance and provides services in the capacity of an Insurance Consultant only. The information contained herein is not intended to constitute an offer to sell or a solicitation in connection with any product or strategy. Trademark & Copyright © 2006 Insurance Design Center, LLC

Capital that is locked up in life insurance contracts is not necessarily illiquid The preconception that people over 70 are locked in to the insurance they own is

a fallacy Cash-value life insurance is likely to fail. Even policies that are heavily funded

have the potential to fail Policies are worth far more than you think Existing plans can often provide opportunities Surrender is rarely the best answer – it is like walking away from the equity in

your house What happens when the contract actually fails? The death benefit is gone forever Why would anyone worth $50 million ever buy life insurance? Because it is a

phenomenal capital management tool.

Identifying Risk To benefit insureds and their beneficiaries and to avoid liability suits, trustees and advisors should develop best practices for managing life insurance assets that put these assets on the same footing as other capital. At the very least, policies should be reviewed annually to identify risk and determine whether they are meeting goals. Fiduciaries who conduct such a review today will find that in many cases, the insurance is not only falling short of targets, but is likely to fail unless significant changes are made. Insurance companies as “manufacturers” are clearly focused on product sales. They provide little incentive to support such vital functions as monitoring ongoing policy performance. A 2004 study estimated that 75% of cash-value policies are not performing as originally illustrated1. This is not a new phenomenon. Studies performed in the early 1990s found that 80% to 90% of cash-value policies would not perform as originally illustrated without “restorative action,” i.e., additional premiums.2 Insureds don’t know it, their trustees don’t know it and their insurance companies aren’t telling them, but drastic steps will need to be taken to restore these insurance policies.


Why are so many life insurance policies on life support? The active climate of mergers, acquisitions, consolidations and demutualizations has had a profound effect on the life insurance industry in recent years. After going public, insurance companies aggressively seek methods to enhance their value on Wall Street, trading policy values for stock values. Remember that insurance companies base their projections on insureds’ anticipated mortality rate and on the expected rate of return from the premiums they charge. Premiums are invested in the general portfolio of the life insurance company, which typically is heavily weighted with fixed-income securities, such as bonds and Treasury bills.

AIG Life Insurance Company

90.6%

0.3%

5.6%

0.2%

2.2%

0.9%0.2%

1

2

3

4

5

6

7

Bonds 90.6%

Stocks 0.3%

Mortgages 5.6%

Real Estate 0.2%

Policy Loans 2.2%

Cash 0.2%

Other 0.9%

Pie Chart for a Traditional Insurance Co. Portfolio Mix


Unfortunately, bond rates have been declining, sometimes precipitously, for 25 years. Rates for 10-year government bonds fell from a peak of 15.32% in September 1981 to 3.33% in June 20033. Insurance purchased at any time during that period was purchased when rates were significantly higher for a fixed portfolio than they are today. The decrease in interest rates has resulted in lower returns than projected. Illustrations used by insurance companies are based on a constant rate of return- this never happens in the real world. The longer the period covered by the illustration, the less accurate it is likely to be. Given that life insurance illustrations project out over a very long term, the likelihood of the projection being accurate is low at best. Other factors also contribute to under-performance. For example, regular payment of premiums is optional for owners of universal life insurance; when premiums aren’t paid, the original projections are no longer accurate. Charging More For Poor Performance Insurance companies have begun using “mortality and expense” charges to compensate for under-performing assets. People are living longer and other expenses are not increasing, so these charges should be decreasing. Yet in some cases, they are rising. Insurers have two sources of income – return on investments and premiums. When companies have lowered their projected rate of return to the minimum contractually guaranteed rate and are still having trouble meeting profit projections, they are limited to raising mortality and expense charges in order to improve the profit picture. The only way insurance companies can make more money is by increasing mortality and expense charges. The limits on mortality and expense charges are set at the state level. Current charges are typically well under the maximum charges. Some insurers are now using the opportunity to pass on the costs of their inaccurate projections. Conseco is just one example of a company that has followed this practice. Among its acquisitions was Massachusetts General, which was selling a large amount of insurance at highly competitive premiums. This under-priced insurance was paying higher interest rates than it should have. Even when dropping rates to the minimum guaranteed rates,


Conseco was not making the necessary profit on the policies, so it raised mortality charges. An argument could perhaps be made that Conseco’s mortality was at stake. Even though bond rates that had trended downward for many years are now heading up, trailing indicators are so deeply entrenched, they have been artificially supporting interest rates in the insurance market for years. Insurance companies, in many cases, continued reporting 7% to 8% rates of return from their underlying portfolio. That can’t go on much longer. Those insurance companies that didn’t ignore the problem have, in some cases, taken actions that made a bad situation worse. Some tried to compensate for declining bond rates by investing in junk bonds. Rather than improving performance, the outcome of these investments was a very negative impact on these insurance companies’ ratings. Put the Policies in the Safe Deposit Box Lawsuits against trustees are increasing, and may result from negligence in maintaining policies, poor or inappropriate investment decisions, or selection of an inappropriate insurance carrier or agent4. Agents who consider themselves representatives of the insured often create friction or even lose clients for trust companies by restricting policy reviews to performance issues, rather than following a holistic review process that considers trust goals as the primary objective. The first responsibility is to the facts, always. Step one must be an objective assessment of policy and company performance, to determine if planning goals are supported. This appraisal will provide the basis necessary for validating objectives and examining alternative solutions. For TOLI, failure to properly manage life insurance assets violates the Uniform Prudent Investors Act (UPIA) and can result in lawsuits against trustees or others with responsibility for managing the life insurance. The UPIA, which in some form has been adopted by 46 states, sets standards for managing trust-owned assets, including life insurance. In spite of the potential liability, recent studies show that trustees are woefully negligent when it comes to managing TOLI. A 2003 survey of nonprofessional trustees, who are


often family members, found that 71.2% had not reviewed the TOLI in the trusts they managed in at least five years5. The same study found that professional trustees are also lax – 83.5% have no guidelines for managing TOLI and 96.3% have no policy statement guiding how life insurance investments should be handled. It shouldn’t be surprising that clients, trustees and sometimes even their advisors fail to take life insurance seriously. It is, after all, “insurance,” which automatically puts it in a category of “things you need,” rather than “things you want.” And who can get excited about a product that reminds us of our mortality? Or that, in the end, pays out a “death benefit?” Yet life insurance may be one of the most useful capital-management tools on the market. If properly constructed, regularly maintained and carefully managed, a life insurance portfolio can have a profound impact on a person’s ability to pass wealth along to heirs, keep a business operating, benefit a charity or supplement retirement income. It also provides a number of tax benefits, as well as liquidity. Policy Review and Portfolio Restructuring Although many trustees have experience managing trust-owned investment capital, few institutional trustees – and almost no private trustees (wives, friends, parents, siblings) – feel qualified to navigate the fiduciary territory of managing all of the “moving parts” at risk when analyzing policy and carrier performance. The trustees in the 2003 study previously referenced also reported that they had no procedures for review and no exit strategy for under performing policies. A reasoned approach to managing life insurance assets provides a defensible framework that benefits trusts, grantors and beneficiaries, as well as trustees and other fiduciaries. Following is a list of the issues an objective review or restructuring should address: 1) What is the logic behind the original insurance acquisition? Should or can the

policies be modified through renegotiation with the insurance companies?


2) What are the current insurance needs? This must be framed in the context of total net worth, current and projected estate requirements, and estimated return on investment.

3) Are the policies appropriate for the risk profile of the grantor or settlor? 4) Should new or additional coverage be considered to meet current objectives and/or to

take advantage of favorable actuarial assumptions and the underwriting environment? 5) Should capital be recovered and reapplied through a life settlement? 6) What structure and funding options are available to most effectively manage the life

insurance capital? In spite of the industry’s problems, insurance policies are generally worth far more than most people would guess. One survey estimates that 85% of policies can be restructured to provide 20% to 40% greater value to the insured1. This restructuring could involve a variety of strategies combined in unique ways to best utilize the available capital. Selling, or arranging for a life settlement of existing policies, though, makes sense only if the coverage is no longer required or if new insurance can be put in place with better benefits, a larger death benefit or a lower premium. Even term insurance has value if it’s convertible to a cash-value contract. If any health changes have occurred for the insured, the policy can be converted to a cash-value contract and then sold. The availability of life settlement options for policies that are surrendered or lapsed can create a fiduciary liability whether or not the fiduciaries are educated in these alternatives. Contrary to popular opinion, life insurance is available even for individuals over 75. We have secured life insurance for people in their mid to late 80’s. If replacement coverage is desired, a broad range of contracts is currently available because of the strong competitive market among companies. Following a bidding or auction process that seeks the best outcome from a life settlement, the resulting funds can be exchanged to buy an immediate annuity. The annual payment from the annuity can then be used to pay for new life insurance


coverage. The immediate annuity provides additional leverage to fund the life insurance contract. The key, though, is to know what’s available and to perform an in-depth competitive analysis. Big, brand name insurance companies aren’t always the best source of life insurance. Just because a company markets aggressively doesn’t mean it has quality products. A piece of the rock or a walk with Snoopy may not be the optimum alternatives for many people. When negotiating a contract, think long term. Most insurance companies have little motivation to keep old policies in the same competitive arena as their new offerings. A select group of companies takes a different approach. When they improve new products, they apply the same adjustments to their existing book of business. Without a broad and educated review process these fine points of carrier quality will be overlooked. The best insurance planning includes gifting strategies that are completely neutral with acceptable levels of risk. In a portfolio where insurance is acquired ad hoc over many years, gifting is obviously not considered strategically. Restructuring with oversight, extensive market analysis and complete integration into the existing and proposed estate and business planning strategies benefits fiduciaries, clients and beneficiaries. What can be done when you have a strategy and know the market is best shown by example. Consider a few real-life cases from The Insurance Design Center, LLC: Case #1 - An $800,000 Windfall: A 78-year-old male client had $12 million in under-performing universal life contracts that were 10 years old. Based on current premiums, we projected that two thirds of the insurance would lapse in nine years and one third would lapse in seven years. We negotiated with three life settlement brokers representing roughly forty different settlement funders. The life insurance policies had a cash value of $700,000, yet we were able to sell them for $1,575,000 – 225% of cash value. The trust used half of the proceeds to buy single-premium annuities and retained the balance. As a result, the trust increased its funds to pay premiums and also has the


money coming out of the single-premium annuity. We used annual payments from the annuity to support the purchase of new coverage with the same $12 million in death benefits, but the new insurance is guaranteed for life – and there’s roughly $800,000 left in the trust. Case #2 - A Bigger Benefit: Two co-owners of a business, aged 50 and 54, each owned 10 different whole life and term insurance policies on each other with a total death benefit of $10 million. After reviewing their insurance portfolio, we found that we could consolidate all of these policies into a single policy at the same premium level and 150% of the death benefit they previously had. Case #3 - A “Home” Run: There are many ways to use life insurance in a trust to circumvent gifting limits. Grantor retained annuity trusts (GRATs), charitable lead trusts and back funding of guaranteed contracts are just a few examples. Another example is the Qualified Personal Residence Trust (QPRT), which was recently used for a woman who was approaching her gifting limits and still wanted to pass on more assets to her children. She owned a lake house worth $3 million. Several years ago, the house had been put in a QPRT, which will now mature in two years. The required premium for the insurance she has in place is greater than her current gifting limits. For a few years she can use her remaining lifetime exemption to augment her gifting program. Once the QPRT matures, in the third year, she will begin paying rent to her children for her use of the lake house. This will more than adequately pay the annual insurance premiums. Should she choose to, she will now be able to make her annual gifts for other purposes. She will also avoid using up her lifetime exemption and will not ultimately be forced to pay gift tax. Insurance policies are put in place in the context of family philosophies, expectations and circumstances. This context shifts continuously, requiring not only a review of the policies relative to the family framework, but also in light of the array of planning options that have become available in the last few years.


Where’s the risk? The risk lies in ignoring the opportunity to discover the structure and funding options that could most effectively manage the life insurance capital. 1Stewardship of Trust-Owned Life Insurance,” The Insurance Design Center, LLC. 2“Managing Trust-Owned Live Insurance Revisited,” Trusts & Estates, April 1994

3E. Randolph Whitelaw and Richard M. Weber, “Trust-Owned Life Insurance: Risk Management Guidance for Fiduciaries,” Estate Planning, September 2005

4Mark A. Teitelbaum, JD, LLM, CLU, ChFC, “Trust-Owned Life Insurance: Issues Trustees Face; Decisions Trustees Need To Make,” Journal of Financial Service Professionals, June 2005.

5Richard L. Harris and Russ Alan Prince, “The Problem with Trusts Owning Life Insurance,” Trusts & Estates, May 2003.


The Journal of Wealth Management for Estate-Planning Professionals—Since 1904

BRIEFING12 Pension Protection Act: three key provisions

• Charitable Disincentives: PPA takes mor-ethan it gives to charites • Tax Law Update: PLR 200626043; ILM 200627023; CCA 200628042; CCA 200628026 • Correction and Update: on Kimberly Clouse’s picture and article

FEATURES18 How to Undo an ILIT, If You Really Have To

Options when an irrevocable life insurancetrust no longer suits your clientBy Charles L. Ratner

24 Sell Your Policy?How to figure when a life settlement is the right choice, and get a good dealBy Allan Goldstein, Leigh Harter and David Holaday

30 How to Fulfill Duties and Promote GoodKnow when socially responsible investing is appropriate—and when it’s notBy Marc J. Lane

COMMITTEE REPORT: RETIREMENT BENEFITS38 IRA Bequests to Charities

Be careful how you leave assets in an individual retirement account to charity By Christopher R. Hoyt

46 Coping With the IRA RaidShould IRA owners’ lives be insured? By Michael J. Jones

50 Court Orders WorkNeed to modify a trust or beneficiary designation? Tell it to the judge By Marcia Chadwick Holt

PERSPECTIVES54 Double Standards

Report reveals big players like the U.S. demand financial info from other nations, but don’t supply it By Richard J. Hay

A Prism Business Media Publication

Nazi-Seized Art Returned—“Adele Bloch-Bauer II” goes to its rightful heirs, p. 6.

Committee Report: Retirement Benefits

September 2006

WWho should consider life settlement as one alternative to managing life insurance capital?

When is a settlement a wise decision? What factors should be considered before selling a life insurance policy? Who will benefit from a settlement? Have most of the possible outcomes been considered?

These are all difficult questions with no right answer.A life settlement1 is defined as the sale of an existing life insur-

ance policy to a third-party for an amount greater than the policy’s cash surrender value and less than the death benefit. This alternative market for life insurance policies began to emerge in the early 1990s as institutional investors (such as hedge funds, banks and pensions) recog-nized that buying and maintaining policies on older insureds could produce returns in excess of 10 percent on capital. Since 1998, the life settlement market has acquired over $13 billion in face amount of policies2 and expe-rienced an approximate 19 percent compound annual growth rate.3

Clearly, while some clients might cringe at the thought of a stranger owning an insurance policy on their lives, others see it as a viable economic option. In fact, life settlements are now an important alternative for trustees, businesses and individuals to turn to for additional leverage.

Yet not everyone need apply. Policies under $250,000 of death benefit, unless part of a larger portfolio, may be too small for the settlement market. Anecdotal information from a number of life settlement insiders indicates an average death benefit per transaction of between $1.5 million and $2 million (transactions typically include more than one policy) and an average multiple offered for cash surrender value of between two and four times cash value. The negotiated value of life settlements varies widely based upon the insured’s life expectancy, projected funding, carrier ratings, type of contract (term, whole life or universal life), cash value, death benefit and interest rates. In most cases, third parties will acquire only policies that are beyond the initial two-year contestable period to avoid the possibility of the insurance company rejecting the death benefit claim. There is some debate now about the insurable interest of third -party purchasers of insurance contracts.

If premiums for the existing insurance are still affordable, surrender for cash value is not the only alternative to settlement. A May 2005 study by Deloitte Consulting LLC of all life settlement sales from 2000 to 20034 estimated that the loss to estate value (that is to say, the percentage of the death benefit that would have been available at the projected life expectancy–adjusted for

INSURANCEINSURANCE

By Allan Goldstein, chief executive officer,

Leigh Harter, managing director and

David Holaday, associate,

The Insurance Design Center, LLC, Deerfield, Ill.

Sell Your Policy?A life settlement provides liquidity. But determining whether it’s the right choice and negotiating the sale are fraught with pitfalls

premiums paid and discounted for time value of money–versus alternative invest-ments for the settlement amount) varied between 52 percent and 81 percent on average, depending on various assumed investment rates and life expectancies. “The potential yield of a life insurance contract when the policyholder’s health has dete-riorated is so great that other creative options to preserve the contract should be explored before making any decision to sell a contract,” Deloitte concluded.5

Understanding how a life settlement transaction proceeds and how to pursue a profitable outcome, as well as when it is more sensible to advise clients not to sell, should be every advisor’s goal when they are reviewing the prospective sale of life insurance coverage.

FIRST THINGS FIRSTThe first question is, of course, what trig-gers a discussion of a life settlement? With individuals and trusts, it generally happens when someone is considering the surrender of coverage; there’s a change of economic circumstances including bank-ruptcy, divorce, or retirement; an estate’s liquidity needs have diminished; or during the restructure of an insurance portfolio when a policy can be sold for greater net cash value than current cash surrender value, with proceeds used to obtain more efficient coverage. With businesses, con-sideration of a life settlement occurs when a company is sold; at the retirement of an individual who’s insured in a buy-sell agreement or key-person plan; and upon termination of a split-dollar agreement.

The three primary administrators of any life settlement transaction are:

• the settlement agent, who should be a licensed life insurance agent in the state in which the policyholder resides, and quali-fied to review the policy regarding its ongo-ing suitability for retention, surrender or settlement;

• the settlement broker, which is a firm that acts as a clearinghouse maintaining contact with 30 or 40 funders or provid-ers; and

• the settlement funder or provider, who’s a third party representing hedge funds, banks and institutional investors that acquire the policy either to hold or to bundle and securitize (simi-

lar to Fannie Mae’s process with mortgages on a much smaller scale). Some examples of funders are Peachtree Financial Partners, Inc. in Atlanta, Coventry First in Fort Washington, Pa., and Life Settlement Solutions, Inc. of San Diego, among others.

With the caveat that each transaction in this market is truly unique, the procedures and timeline resulting in a life settlement generally look like this:

Step One: An advisor, trustee, or agent (let’s just say “agent” from here on) reviews an insurance policy or a group of policies. The insured may have experienced a change in health. The policy or policies could be owned individually or in trust; or it (they) could be owned by a business to fund a buy/sell agreement, a key-person or executive benefit need. For settlement to be an option for a perfectly healthy individual, that per-son typically must be older than 75.

Step Two: The agent collects the neces-sary data to review each policy. This includes policy illustrations, based on stipulated assumptions for interest or dividend6 project-ing the minimum premium (carrying cost) to continue the insurance coverage to certain ages, policy ownership and beneficiary status, policy loans and current policy values. This list of information required (plus all of the medi-cal records and life expectancy numbers dis-cussed below) might seem excessive. But this data does help advisors control the settlement process for the benefit of their clients.

Step Three: The agent obtains a pre-liminary estimate of the market value of

the policy by calling life settlement brokers with a summary of the data collected for the anonymous insured.

BEST PRACTICESLet’s assume selling a life insurance policy makes sense. What’s the best game plan for creating a competitive sale? Estimates of life expectancy provide a guide and should be ordered by the settlement agent to give a basis for benchmarking settlement offers. AVS of Kennesaw, Ga., EMSI in Hewitt, Texas, Fasano Associates of Washington, and 21st Services in Minneapolis are some of the companies that provide life expectancy pro-jections for a fee of about $300 to $500.

Note that if the life expectancy is greater than 12 years, a settlement offer is unlikely.

The agent submits the authorizations, policy information and illustrations, com-plete medical records and cover letters to a minimum of three settlement brokers or funders. The agent also submits prelimi-nary insurance authorizations and medical records to perhaps five insurance companies for informal underwriting to sufficiently can-vas the market for competitive offers.

To select these settlement agents, set-tlement brokers or funders and insurance companies, an advisor should conduct a rigorous due diligence, including check-ing that each not only has the appropriate licenses but also a good track record. Do a background check to determine if any complaints have been registered with the state insurance boards, as well as a simple litigation search.

The agent will send very different cover let-ters to the settlement brokers/funders and to the insurance companies. A “glass half-empty” view of the insured’s health will be stressed for the settlement brokers/funders while the “glass half-full” version will be presented to the insur-ance carriers who may provide preliminary insurance underwriting.

At this point in the process, it makes sense for the agent to have the insured underwritten for an immediate annuity. A rated offer (an annuity offered at a better price than standard for this individual’s age, often referred to as “age rated”) pro-vides independent data on how the insur-ance industry views the life expectancy of this insured.

Policies under

$250,000 of death

benefit, unless part

of a larger portfolio,

may be too small

for the settlement

market.

Example: Assume a 72 year-old client has two policies with a total death benefit of $3.1 million and a cash surrender value of $525,000. Settlement proceeds offered are $1.35 million. His projected life expectancy is eight years. He’ll only break even between years 10 and 11. Conclusion: Unless your client can earn significantly more than 6 percent on a net basis, then he should keep his policy.

The settlement brokers or funders use the insured’s medical records to obtain at least two independent life expectan-cy reports, from the same pool of life expectancy companies, for comparative purposes (unless they accept the reports previously obtained by the advisor). On the basis of those reports and policy illus-trations, the settlement brokers or funders will make preliminary offers to purchase the policies.

Those making the low offers must be apprised that their offers are not competi-tive. They'll either increase their bids or drop out during several rounds of negotiation.

This is what the industry calls “the closed bidding process.” The advisor should hold his cards close to his vest to secure the best possible offers. If players are precisely unaware of what the others are bidding, they may jump way out in front.

This auction generally closes after two to four months, either when only one funder is left or the increase in competing offers becomes

very small. If more than one party is left, how does one decide? Advisors should make an educated assessment of the ease of the transac-tion and the administrative competency of the competing parties. This determination can be made through references from other agents who’ve used this broker’s services or from the personal experience of the agent negotiating the sale.

If replacement insurance is available, the new policy should be in force before the settlement transaction is completed. The risks of both of these transactions include a new contestable period (the two years in which the insurance company can contest payment upon the death of the insured), and the reduced insurance capac-ity that will be available to the client in the future, based on existing coverage still in force and owned by a third party. The new policy will require at least a month or two of premiums paid in advance even if settle-ment money will ultimately be used to buy the new coverage.

With a final offer in place, final calcu-lations can be prepared to help the policy owner decide if it is more beneficial to retain the insurance coverage or to sell the policy.

When the policyholder accepts an offer, the funder prepares legal documents and transmits them to the seller.

Upon acceptance, the funder transfers the funds to an escrow account.

When the policy ownership has changed, the funds in escrow are released to the seller. Following the rescission period,7 the funder pays compensation to the broker and agent.

The whole process normally takes 60 to 120 days, but may take longer depend-ing on the difficulty of collecting medical information from the insured’s doctors and the response time of the policyholder, insured and insurance company.

BENCHMARKSThe margin between the death benefit and the settlement proceeds is often a signifi-

Year Age (1) (2) (3) (4) (5) (6) Annual Death Annual Premium Death Settlement Difference Premium Benefit Accumulated Benefit Proceeds (4-5) at 6 per cent (2-3)

1 72 $71,000 $3,100,000 $75,260 $3,024,740 $1,350,000 $1,674,740 2 73 71,000 3,100,000 155,036 2,944,964 1,261,000 1,683,964 3 74 71,000 3,100,000 239,598 2,860,402 1,336,660 1,523,742 4 75 71,000 3,100,000 329,234 2,770,766 1,416,860 1,353,907 5 76 71,000 3,100,000 424,248 2,675,752 1,501,871 1,173,881 6 77 71,000 3,100,000 524,962 2,575,038 1,591,983 983,054 7 78 71,000 3,100,000 631,720 2,468,280 1,687,502 780,777 8 79 71,000 3,100,000 744,883 2,355,117 1,788,753 566,364 9 80 71,000 3,100,000 864,836 2,235,164 1,896,078 339,086 10 81 71,000 3,100,000 991,987 2,108,013 2,009,842 98,171 11 82 71,000 3,100,000 1,126,766 1,973,234 2,130,433 -157,199 12 83 71,000 3,100,000 1,269,632 1,830,368 2,258,259 -427,891 13 84 71,000 3,100,000 1,421,070 1,678,930 2,393,754 -714,824 14 85 71,000 3,100,000 1,581,594 1,518,406 2,537,380 -1,018,974

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SETTLEMENT PROCEEDS VS. LIFE INSURANCE DEATH BENEFITLook at how long your client must live before he breaks even; then see which avenue makes sense

Source: The Insurance Design Center, LLC, Deerfield, Ill.

cant number. This must be discussed any time a life settlement is considered as a planning strategy. A basis for this discus-sion can be an analysis of how long it will take to reach the death benefit value at some agreed upon interest rate or rates, based on the settlement offer with annual premium funding added in and taxes taken out. A simple projection based on cash flow provides a breakeven year to com-pare to the projected life expectancy.

Let’s consider a sample cash flow with a breakeven between years 10 and 11: Our hypothetical client is a man, age 72, with a history of quadruple bypass and cancer. His projected life expectancy is eight years. He has two life insurance policies with a total death benefit of $3.1 million and current cash surrender value of $525,000. The breakeven year is determined by the outlay of pre-mium, invested for this example at a net rate of 6 percent, subtracted from total death benefit. This is compared to the settlement offer appreciated at 6 percent and adjusted for the impact of income taxes. The final outcome is a breakeven between years 10 and 11. (See “Settlement Proceeds vs. Life Insurance Death Benefit.”)

In a general analysis of settlement transactions, Peter Katt, a life insurance columnist, fee-based advisor, and principal with the Mattawan, Mich.-based Katt & Co, infers that making premium payments based on a level premium schedule over-pays for insurance coverage.8 Although difficult to administer, if one pays the annual current cost of insurance values rather than the level premium, the year in which the death benefit equals the net settlement, plus accrued interest (the crossover year), would occur later.

No advisor is a fortune teller. Some of the possible outcomes of selling life insurance contracts can be weighed by calculating the opportunity cost of premiums spent and death benefit retained versus a cash settle-ment net of taxes. There is the emotional issue of having a third party own insurance coverage on an insured’s life. Financially speaking, the greatest downside to settling a policy is the possibility that the insured could die soon after the settlement transaction is concluded, leaving the heirs shortchanged.

But cash in hand is not usually the primary driver for a life settlement. Often, clients want the life settlement to rebalance their assets, reclaim money held in underperforming poli-cies, or redeploy as premium payments to augment limited gifting capacity. If, as a result of the sale, the premiums on new coverage are reduced or eliminated, some of that money can be redirected elsewhere. With additional cash available, premiums might be reduced, policy guarantees improved or coverage increased.

Generally, policies used in business plan-ning are the most likely candidates for settle-ment once those business needs no longer exist. But before you settle such business-associated life insurance policies, be careful to look at the full picture: Remember, that

a settled policy remains in force and could limit the insured’s access to additional cov-erage based on financial insurability limits. Also, if the insured has serious health issues, more coverage may be difficult or impos-sible to acquire.

The advisors should request that both the agent and broker disclose their com-pensation. Such compensation may be negotiable. Typically, it ranges for a life settlement between 3 percent and 8 per-cent of the face amount of the policy, split between agent and broker. Compensation for life settlements is very flexible and may include bonuses paid by the broker to the agent. These bonuses are consid-ered to be outside the settlement transac-tion negotiated by the agent. If additional

Let’s say your client gets a life settlement of $1.2 million. The cumulative premiums paid ($300,000) are his cost basis—he should recover them tax free. The cash surrender value above the premiums ($150,000) should be treated as ordinary income. And the remainder—$750,000—should be taxed as capital gain.

HOW TO PAY TAXES ON A LIFE SETTLEMENTAlthough the Internal Revenue Service hasn’t weighed in on the tax implications of a life settlement, here’s one approach to satisfying the taxman

$300,000 Tax-free return of principal

$750,000 Long-term capital gain

}}$150,000

Ordinary income

}$300,000

Cost basis

$1.2 million Settlement

proceeds

$450,000 Cash surrender value

Breakdown of Proceeds Tax Bite

Source: The Insurance Design Center, LLC, Deerfield, Ill.

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ESTATE PLANNING & TAXATION

Reprinted with permission from the September 2006 issue of Trusts & Estates® (www.trustsandestates.com)Copyright 2006, Prism Business Media. All rights reserved.

TE-208-CU

life insurance figures into the planning process, the advisor may have more leverage with the agent to negotiate a reduced fee on the life settlement side.

TAXESOf course, whenever a settlement is considered, advisors must look at the tax implications. Internal Revenue Code Section 101(g) provides tax exemption for viatical settlements for the terminally or chronically ill. But most settlements are not viatical. Some tax experts suggest that cumulative premiums paid constitute cost basis and should be recovered tax-free to the insured; the amount, if any, of cash surrender value in excess of the cost basis should be treated as ordinary income; and the amount of settlement proceeds in excess of the cash surrender value should be taxed as capital gain. But the Internal Revenue Service has not weighed in on these issues, and might consider all of the proceeds over basis to be taxable at ordinary income rates. It’s also possible that basis might have to be reduced to account for the benefit of having the insurance coverage. (See “How to Pay Taxes on a Life Settlement.”) Naturally, policyholders should consult their tax advisors and these advisors should review each transaction carefully to ensure proper tax treatment and potential tax liability.

REGULATORY ISSUES It’s also important to be aware that life settlements are not yet federally regulated. About 30 states have some form of regulation, but it’s primarily limited to licensing.

Under state laws, sellers have rights of rescission for a limited period of time. Rescission is based on whether the transaction occurs in a regulated or unregulated state. For example, Florida

and California are regulated and provide 15 days from the date of funding for rescission, whereas Illinois and New York are unregulated; the rescission period is based on the settlement company’s procedure. Practically speaking, Coventry First, for example, provides 10 days from the date of execution of the pur-chase agreement as the rescission period. Generally, state con-sumer laws provide a rescission period of at least three days. ❙

Endnotes1. The definition of life settlements excludes those policies that would

be considered “viaticated.” Viaticated policies are usually policies sold on insureds with projected life expectancies of less than two years.

2. Suneet Kamath and Timothy Sledge, "Life Insurance Long View-Life Settlements Need Not Be Unsettling," Bernstein Research Call, Sanford C. Bernstein & Co., LLC, New York, March 4, 2005, www.idealsettlements.com/downloads/sanford.pdf.

3. Deloitte Consulting LLC and the University of Connecticut Actuarial Center, The Life Settlements Market: An Actuarial Perspective on Consumer Economic Value, May 2005, www.lifesettlementseducation.com/.

4. Ibid.5. Ibid.6. A realistic interest rate based on the current portfolio rate of return for

each insurance company needs to be specified if the current illustrated rate for any company differs significantly from their portfolio rate of return.

7. For the Federal Deposit Insurance Corporation's definition of "rescis-sion period," see www.fdic.gov/regulations/laws/rules.

8. “Assessing Clients’ Life Settlement Offers,” Peter Katt, Journal of Financial Planning (July 2002).

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