Life insurance is an indispensable estate planning tool that many people use to secure the future of their families. However, the majority of policyholders and their advisors treat life insurance as a buy-and-hold investment rather than an investment with significant tax advantages. Discerning individuals can carefully manage their stock portfolio or real estate holdings but ignore their life insurance policies. Life insurance can be viewed as “biological” real estate and, like real estate, must be managed effectively in order to maintain its value over the long term.
Policyholders who wish to keep their policies to protect their beneficiaries should not return their policies or sell them in a transaction called “Life Settlement”. Many sellers are unaware that their sales could potentially be double taxed and that they would be trading valuable assets with tax-free proceeds for tiny profit mitigated by taxes and fees of intermediaries. In contrast, proper life insurance management enables policyholders to retain their policies despite potential liquidity needs.
Life Insurance Risks
Life insurance is not as “guaranteed” or “permanent” as many policyholders believe. Different types of policies carry different risks. The biggest risk is longevity risk – the risk of overpaying for life insurance or surviving the risk of cancellation of the policy. With advances in science and lifestyle changes, many policyholders are living longer than insurance companies’ original predictions decades ago. The longer life expectancy means that policyholders pay more premiums than previously expected, with the premium sums often exceeding the actual death benefit. Some policyholders are unaware that their policies have a cancellation date and will expire their policies when they reach a certain age. Both individual policyholders and seasoned insurance investors are exposed to longevity risk, but only the latter know how to manage and reduce it.
Life insurance is also subject to changes in inflation and interest rates. Insurance premium maps, which were created in the 1980s and 1990s, were based on the fact that interest rates were holding a level that is now unrelated to reality. Later events proved that these figures were based on unrealistic variables and therefore did not accurately predict the duration of the insurance and the relevant costs. When interest rates started falling, most policyholders were unaware that they needed to increase their premiums. As a result, many policies have either become obsolete or are too expensive to maintain.
It is not the insurance carrier’s duty to notify policyholders that they are increasing their payments, but rather it is the policyholder’s responsibility to proactively increase their payments or risk the present value of their policy, which increases the risk of the policy becoming void. As a rule, the insurance company is only obliged to provide cover for death and to send the policyholder an annual statement. Without a suitable monitoring system, policyholders cannot notice increases in costs and inadvertently let their policies expire.
While many variables determine the cost of maintaining an insurance policy, the cost of insurance (COI) is a key variable that is often misunderstood and can change. COI is effectively a subjective rate of return that insurance carriers calculate in order to achieve their target rates of return. The insurance industry increased the internal COI for the first time in 2016. Regulators and policyholders were surprised at how quickly these increases came, and several class action lawsuits ensued.
Insurance carriers such as Transamerica Life Insurance Company have resolved class action lawsuits on behalf of policyholders alleging that Transamerica inappropriately increased monthly universal life insurance fees. However, freight forwarders can increase the COI at any time with just 30 days’ notice vis-à-vis the policyholder. Depending on the type of policy, the carriers also have the option to increase the premiums and change other factors.
Negative tax effects of selling your life insurance in the life insurance market
Life insurance, when used correctly, can be an excellent tax planning tool. The proceeds of a policy death benefit are not subject to income tax. When contributing to an irrevocable life insurance trust (ILIT), the death benefit is also excluded from the testator’s gross assets when calculating inheritance tax. If you sell a life insurance policy, these tax advantages do not apply. In addition, sellers often have to pay both ordinary income tax and capital gains tax when selling their life insurance. A policyholder selling a policy at a higher price than its cost base must pay capital gains from the difference between the selling price and the cost base. The cost basis of a policy is usually the amount of the premiums paid into the policy. A policyholder selling a policy with a surrender value (CSV) above the cost base must pay ordinary income tax on the difference between the CSV and the cost base.
For example, a policyholder selling a $ 1 million policy with a cost base of $ 200,000 and $ 100,000 must have capital gains on the difference between the sale price and the cost base and ordinary income tax on the difference between the CSV and cost base pay. These taxes, combined with the fees of multiple intermediaries associated with a Life Settlement transaction, result in a modest outcome for the seller. Policyholders selling their policies to meet immediate liquidity needs should look for a more creative solution that will allow them to take advantage of the tax benefits of life insurance.
The best way to mitigate the risks of owning life insurance is to manage and continuously monitor life insurance like a liquid asset. Just as real estate investors often transfer risk to third parties and lenders, policyholders should transfer longevity risk to a third party. Policyholders can get a loan backed against their policy’s future death benefit to pay for premiums and other expenses. This reduces their out-of-pocket premium payments while maintaining their policies for their beneficiaries and estate planning.
Policyholders shouldn’t sell their policies because they are unable to pay rising premiums. Rather, it is far more beneficial to keep life insurance and monetize future death benefit by treating it like a liquid asset. In particular, a policyholder can obtain non-recourse loans for existing policies without additional external collateral. Expert third-party management and non-recourse financing allow policyholders to treat life insurance policies like real estate investments and maximize their profitability.
This column does not necessarily represent the opinion of the Bureau of National Affairs, Inc. or its owners.
Information about the author
Grace Bronstein is the CEO of TrustLife Insurance Management (TLIM), a consultancy that helps accountants, trustees, financial advisors and estate planning attorneys to properly manage fiduciary life insurance. Grace is also the COO of AllFinancial Group, a subsidiary of TLIM, an asset management company that provides non-recourse financing for life insurance. Grace previously worked as a litigation associate at Schulte Roth & Zabel. Grace is a graduate of Columbia University and Columbia Law School.
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