LIFE INSURANCE PRODUCT DUE DILIGENCE: A GUIDE FOR ATTORNEYS, ACCOUNTANTS & FINANCIAL ADVISORS

By Robert Adler & Joseph Gentile*

OVERVIEW

Life insurance is unique. It predates the formation of the U.S. and is the only asset that Congress has bestowed with “most favored tax” status. It plays a critical role in protecting families and businesses. For a “few dollars” of premium an insured can obtain thousands of dollars of life insurance coverage. No other investment category provides a similar “payoff.” Pay the first year’s premium, die several months later, and the insured’s beneficiaries receive thousands (possibly millions) of dollars of death benefits, income tax free. And when life insurance is owned by a trust, the death benefit can be received free of estate tax and generation-skipping transfer taxes, and be used to benefit the insured’s loved ones for generations to come.

Because of its unique nature, life insurance is ubiquitous and plays an integral part in many matters for which legal, accounting and financial advice is sought, from taxes to estate planning. It is therefore highly beneficial for attorneys, accountants and financial advisors to be able to speak fluently about a client’s coverage and communicate effectively with the client’s life insurance agents. The more these trusted professionals know about life insurance, the more value they can add to their client relationship.

This paper[1] provides an overview of the general types of life insurance policies a professional may encounter and discusses the major risk factors/elements that affect a life insurance policy. It includes a description of the major types of life insurance policies available – term, whole life, universal life, variable universal life, etc. – as well as a summary of their important features, advantages, and disadvantages. It also discusses the management of certain legal entities whose primary asset is life insurance, such as an irrevocable life insurance trust (“ILIT”), a trust-owned life insurance (“TOLI”) arrangement, or a special needs trust. Finally, this paper provides some suggested “best management practices” when providing legal advice on matters involving life insurance.

The discussion that follows is not, however, a substitute for comprehensive legal or financial advice and obtaining proper and competent advice from a licensed life insurance agent, and, if appropriate, from a fee-only life insurance advisor.[2]

 

1. SELECTING THE RIGHT LIFE INSURANCE POLICY

1(a) Selecting The Correct Policy[3]

Life insurance policies may be divided into two fundamental categories: term and permanent.[4] In reality, all life insurance may be viewed as term insurance, with various forms of permanent insurance combining term insurance protection with a cash value (or investment) account as a means of pre-funding a portion of the cost of the term protection and building equity in the policy. Within each category are numerous variations as a result of product design and/or add-on riders. In reviewing what follows, it is helpful to note how the various moving parts or risk factors (which are discussed in section 4 below), operate in the various types of policies.

1(a)(1) Using Tax-Free Dollars to Pay Life Insurance Premiums

As previously mentioned, all life insurance is term insurance (since all life insurance includes the cost of term insurance, which, from the life insurance company’s perspective is its “net amount at risk,” or the company’s “risk element” under the policy). According to Ben G. Baldwin, CLU, CFP, ChFC, MSFS, and MSM, the question to be asked and answered is not “What type of life insurance should the client purchase?” Rather, the question to be asked and answered is: “What is the best way to pay for the life insurance coverage that the client desires and can afford?” Pure term insurance, which is the “lowest-outlay” form of life insurance coverage, requires premium payments to be made from after-tax dollars. Hence pure term insurance premiums are the most “tax expensive” form of premium payment.

On the other hand, variable universal life insurance, which requires a larger premium payment than pure term insurance, in the early years, can be a less “tax expensive” form of life insurance coverage. This is accomplished by using the variable universal life policy’s annual earnings on its cash value component to pay part of the life insurance premium costs.[5] Generally speaking, the accumulation of earnings in an equity-building life insurance policy’s cash value component is “income tax deferred.” Thus, the use of the “tax-deferred” earnings to pay some or all of the annual premiums is a less “tax expensive” form of premium payment. If the owner of the equity-building life insurance policy holds the policy until his or her death, the investment income earned by the policy’s cash value component escapes income taxation totally, and the life insurance proceeds are received income tax free by the beneficiary. If the policy is owned by an ILIT, the life insurance proceeds can also avoid federal estate taxes—a triple tax benefit.[6] And, if the ILIT has been structured as a generation-skipping trust (“GST”), the life insurance proceeds can be used to benefit future generations of beneficiaries free of the confiscatory GST tax—a fourth benefit.

1(b) Different Life Insurance Companies Offer Different Products

Even though a life insurance company may be highly rated, the quality and pricing of products offered by that life insurance company may vary. For example, one company may offer a very high quality, competitively priced term product, but may not have high quality, competitively priced permanent products. Also, ratings of life insurance companies and their products change over time. This can make shopping for the “right policy with the right company” a challenge.

It is vital to select a knowledgeable, sophisticated life insurance agent or broker, both to design the most desirable policy and also to provide long-term, quality policy service, independent of the life insurance carrier. Life insurance acquired for trust ownership may be a very long-term investment. It may also be appropriate to hire an independent fee-only life insurance advisor to assist in the analysis and make appropriate recommendations. Also, consider reviewing illustrations from more than one life insurance company.

Determine whether it is practical to obtain layers of coverage from more than one company for diversification. Likewise, determine whether the spouses should obtain insurance from different companies.

1(c) Basic Rules Of Thumb In Selecting A Life Insurance Policy

In his book, The Lawyer’s Guide to Insurance (Personal Insurance Coverage for Professionals and Their Clients), Ben G. Baldwin, provides eight basic “rules of thumb” for a prospective insured who is considering life insurance coverage:

  (1) Know the internal costs of the product, especially in the early years of coverage.

  (2) Establish long-term relationships with quality insurance companies and intermediaries, such as a life insurance agent and/or a fee-only life insurance advisor.

  (3) Choose control over the policy over no control.

  (4) Choose flexibility over the policy (such as the death benefit amount, the premium amount, investment decisions, etc.) over inflexibility.

  (5) Choose quality over current or future interest rate promises.

  (6) Choose a survivor among insurance companies and intermediaries, rather than a “here today, gone bankrupt (or become insolvent) tomorrow” insurance company.[7]

  (7) Accept the fact that assets within insurance contracts require management, just like every other asset on a balance sheet does.

  (8) Demand a written disclosure of the intermediary’s compensation before purchasing.[8]

2. LIFE INSURANCE POLICY SELECTION DUE CARE

The due diligence necessary for selecting a life insurance policy[9] should always consist of four interdependent elements: (1) the policy must be suitable, (2) the life insurance company must be strong, (3) the policy must be competitive and well designed, and (4) the whole story must be credible.

Caution: “There is no simple way to compare or analyze life insurance policies. If there were, fee-only consultants would have written a short article explaining how to do it and then moved on to other occupations.”[10]

2(a) Policy Suitability

The policy must be suitable. Much like investments, certain types of insurance products have dominant features and benefits that will align themselves with certain characteristics the policy owner desires for the coverage. The parameters for determining suitability, which are discussed below, include: (i) premium amount, (ii) death benefit amount, (iii) policy flexibility, (iv) ability to select investments and influence the return, (v) tax considerations, (vi) risks, (vii) appropriateness of the arrangement, and (viii) cash value buildup.

It is important to note that while this “suitability” standard is applicable to 49 states, New York imposes a higher “best interest” standard. According to New York Department of Financial Services Regulation 187, 11 NYCRR 224 (“Reg 187”), the sale of life insurance must be conducted “in the best interest of the consumer.”[11] Reg 187 requires advisors to, among others: gather and analyze detailed financial information before making recommendations; consider the client’s overall financial situation, objectives, and risk tolerance; evaluate alternatives and product features carefully; document the reasoning behind their recommendation; and avoid allowing compensation incentives to influence the advice given. As a result, many advisors have abandoned conducting business in New York and many insurers do not sell policies in New York with some having adopted a “49 and 1” corporate structure in which they operate freely in 49 states but conduct business in New York through a separate affiliated entity.

2(a)(1) Premium

The premium is the amount the policy owner will pay for life insurance coverage. Some basic questions worth asking are: Is there a maximum annual premium the policy owner is willing to pay for the coverage? If the underwriters want to charge the policy owner more for the insurance, will the policy owner raise his premium tolerance or compromise on other aspects of the policy design? Does the policy owner want to pay the premium for a particular number of years? Will the premium be financed?

2(a)(2) Death Benefit

The policy owner’s estate plan may call for either a level or increasing death benefit. For example, a growing estate may require an increasing death benefit to pay estate or inheritance taxes. On the other hand, if the policy owner is willing to implement estate tax reduction strategies sooner rather than later, a level death benefit may be adequate. In a compensation-related case, the parties may want the death benefit to track increases in compensation. Or, the death benefit may be entirely incidental to the overall purpose of the insurance, i.e., where the insurance is to be used for asset accumulation and retirement income. In these cases, the death benefit will be minimized vis-à-vis the premium paid.

2(a)(3) Flexibility

The policy owner may want the flexibility to skip or change the premium amount. For example, if the policy owner has varying demands on his or her cash flow or the policy owner’s business is cyclical, the ability to skip or reduce the premium for a year or two may be an important element of policy design. The policy owner may also want to be able to increase the premium without increasing the death benefit. This is an efficient way to use the policy as a tax-deferred (and possibly tax-free) savings or investment vehicle. The policy owner may want to be able to reduce the death benefit from time to time. The flexibility to reduce the death benefit enables the policy owner to modify the policy as the policy owner’s need for life insurance decreases over the years. This flexibility also enables the policy owner to maximize the policy’s cash value or reduce the premium commitment in the policy’s later years.

2(a)(4) Ability To Influence Investment Return

If the policy owner wants to be able to direct the investment of the policy’s cash value component, then a variable or indexed life product may be the appropriate type of policy. If the policy owner does not want to worry about asset allocation decisions with respect to the life insurance policy, and is willing to permanently forgo that potential control, then a variable life product is likely not appropriate.

2(a)(5) Tax Considerations

The level of premium, duration of the premium payments, and policy flexibility may need to be coordinated with income, gift or GST tax considerations. Predictability of policy performance, policy flexibility, and cash value maximization may be desirable in certain tax-oriented designs such as generation-skipping or split dollar.

2(a)(6) Risks[12]

The policy owner may (or may not) want to be certain that the planned premium will always be adequate to support the death benefit. The policy owner may (or may not) need to be certain that he or she will pay premiums for the number of years he or she planned to pay them. The certainty described here is typically (and mistakenly) associated with a particular type of policy, to wit, whole life. Actually, certainty as to outlay or result is more truly associated with the level of funding (premium) than the type of policy. If the policy owner seeks protection from creditor claims against the insurer’s general fund, then a variable life product may be appropriate. In addition to the foregoing, the policy owner’s greatest risk is that the recommended product will not be suitable for the circumstances, the planning strategy, or the premium payment technique. Additionally, there is the risk that the advisors’ risk tolerance or interests may differ from the policy owner’s, and those differences may overshadow the appropriate selection and product design process for the policy owner.

2(a)(7) Appropriateness For The Arrangement

Certain arrangements such as split dollar and premium financing call for careful selection, design, and funding of the life insurance product. Too often, the insurance product and premium level are selected first and then split dollar is recommended as a payment mechanism. The only guarantee in this arrangement is trouble.

Premium financing deserves particular caution because it can transform a life insurance policy from a relatively straightforward protection or estate planning asset into a leveraged financial arrangement dependent on multiple moving assumptions. In a typical premium financing transaction, the policy owner or a trust borrows funds to pay some or all of the premiums, with the expectation that the policy’s cash value, outside collateral, or eventual death benefit will support repayment of the loan. These arrangements may be attractive where a client has substantial net worth but does not want to liquidate assets or make large annual gifts to fund premiums.

However, premium financing introduces risks that are separate from the insurance policy itself, including interest rate risk, collateral call risk, lender renewal risk, and the risk that the client’s estate, trust, or family will be required to contribute additional capital at an inconvenient time. A policy that appears sustainable when illustrated with favorable crediting rates, low borrowing costs, and stable collateral requirements may become uneconomic if interest rates rise, policy values underperform, caps or participation rates are reduced, dividends decline, loan spreads widen, or the lender requires additional collateral. For that reason, premium financing should be evaluated as a combined insurance, credit, tax, and liquidity strategy, not merely as a way to “avoid” paying premiums out of pocket.

At a minimum, the arrangement should be stress-tested under conservative assumptions, including higher loan rates, lower policy crediting rates, reduced policy values, increased collateral requirements, and an earlier-than-expected need to exit the transaction.

Premium financing is often used in connection with indexed universal life (“IUL”) policies (see section 3(d), below) and private placement life insurance (see section 3(h), below).

2(a)(8) Cash Value Buildup

Will the policy be a source of income in the future? If so, when? How much? Could it be important to rely on the policy’s value to sustain the death benefit, with no or reduced ongoing cash premium payments? Anticipated cash surrender values may be one of the most important aspects to consider in life insurance due care.

2(b) The Life Insurance Company Must Be Strong

There is no question that the policy owner will not want to do business with a life insurance company that he or she might outlive. Thus, the financial strength of any life insurance company recommended by the agent must be verified by the major life insurance company rating services.[13]

However, ratings themselves are primarily indicative of the ability of the life insurance company to meet its obligations, i.e., to pay the claim. By no means do high ratings from the major rating services assure the policy owner that: (i) the company is in a position to achieve the projections made in the policy illustration; (ii) the company’s products are competitive and well designed; (iii) the company’s products are appropriate for the policy owner’s needs (as discussed above); and (iv) the company has treated its policyholders well in the past (or will continue to do so in the future). Unfortunately, these four critical points are often overlooked in the rush to limit selection to life insurance companies with the highest ratings.

When an insurance company is highly rated, it is important to find out which agency rated the company and to understand how that agency rates insurance companies. The four major rating agencies that use information beyond what is found in the company’s annual reports are A.M. Best, Standard & Poor’s, Moody’s and Duff and Phelps. Weiss Research, generally a less-used rating source, tends to limit its information to the insurance company’s annual reports. A.M. Best uses a rating range from A++ to D. Standard & Poor’s uses a range from AAA to CCC. Moody’s uses a range from Aaa to DD. Duff and Phelps uses a range from AAA to DD. As a result, a B rating can mean that the company is a second-tier company under Weiss or a fourth-tier company under Duff & Phelps.

Each rating agency looks for different information. A.M. Best rates most insurance companies based on their relative strength. Standard & Poor’s only rates companies that request a rating, and issues a rating based on the insurance company’s claims-paying ability. Moody’s rates insurance companies based on their financial strength, as indicated by the company’s ability to pay senior policyholder obligations. Lastly, Duff and Phelps rates insurance companies on their claims-paying ability. However, Duff and Phelps does so with an analytical and statistical bent based on the insurance company’s liquidity and solvency.

Although financial-strength ratings remain an essential starting point in evaluating a life insurance company, they are not a substitute for a more complete review of the insurer’s business model, ownership structure, investment strategy, reinsurance arrangements, and treatment of policyholders. A highly rated company may nevertheless offer a poorly designed product, maintain aggressive non-guaranteed pricing assumptions, rely heavily on affiliated investment managers, private equity ownership, cede substantial reserves to offshore reinsurers, or invest heavily in illiquid assets whose value may be difficult to assess in stressed market conditions. Conversely, a company with a conservative ownership structure, long operating history, strong policyholder orientation, transparent investment practices, and disciplined pricing may be more attractive for certain planning purposes even if its product illustration is less aggressive.

Ownership structure matters because it may affect the insurer’s incentives. Mutual life insurance companies[14] are owned for the benefit of their policyholders and, in theory, may be more closely aligned with long-term policyholder interests than stock companies whose primary obligation is to shareholders. Fraternal benefit societies[15] likewise have a member-oriented structure, though their financial strength, product quality, governance, and contractual protections must still be evaluated on their own merits. Stock insurers, private-equity-backed insurers, and insurers affiliated with large asset managers may be entirely appropriate carriers, and many are financially strong. But their ownership structures can create different incentives, including greater pressure to generate investment yield, improve capital efficiency, increase return on equity, use affiliated asset managers, or transfer risk through reinsurance. These incentives are not inherently improper, but they should be understood before recommending or retaining a policy intended to last for decades.

In recent years, regulators, rating agencies, and market observers have focused increasing attention on the convergence of life insurance, private equity, private credit, asset management, and offshore reinsurance. Many life insurers have increased allocations to private credit, structured credit, collateralized loan obligations, asset-backed securities, and other less liquid or more complex investments in search of yield. Some insurers also reinsure blocks of annuity or life insurance business to affiliated or offshore reinsurers, often in Bermuda, the Cayman Islands or other jurisdictions, in order to manage capital, reserves, investment strategy, and profitability. These arrangements can provide legitimate business benefits, including diversification, capital efficiency, and potentially stronger product pricing. But they can also make it more difficult for policy owners and advisors to understand where the economic risk resides, who controls the assets supporting policy obligations, whether affiliated transactions are being conducted on arm’s-length terms, and how the insurer would perform in a period of credit stress, rising defaults, illiquidity, or adverse policyholder behavior.[16]

Accordingly, modern carrier diligence should go beyond asking whether the insurer has a high rating from one or more rating agencies. Attorneys, trustees, and advisors should consider whether the insurer is a mutual, fraternal, stock, private-equity-backed, or asset-manager-affiliated company; whether the insurer relies materially on affiliated investment managers or affiliated reinsurance; whether significant liabilities have been ceded offshore; whether the insurer’s general account is heavily exposed to private credit, structured assets, or hard-to-value securities; whether the insurer has a history of reducing non-guaranteed elements, increasing cost-of-insurance charges, or aggressively repricing older blocks of business; whether the insurer’s products are designed to be durable under conservative assumptions; and whether the insurer has demonstrated fair treatment of existing policyholders, not merely competitive pricing for new policyholders.

This diligence is especially important for trust-owned life insurance, private placement life insurance, premium-financed arrangements, no-lapse guarantee policies, indexed universal life, and any policy whose success depends on non-guaranteed crediting rates, dividends, caps, participation rates, expenses, cost-of-insurance charges, or reinsurance support. The relevant question is not simply whether the insurer appears able to pay death claims today. The more precise question is whether the insurer’s product design, investment strategy, ownership incentives, reinsurance structure, and policyholder practices make it a prudent long-term counterparty for the specific policy being purchased or retained. Because life insurance may be intended to remain in force for several decades, carrier selection should be treated as a long-duration counterparty-risk decision, not merely as a comparison of current illustrations.

2(c) Competitive And Well-Designed Policy

The life insurance product must be competitive and well designed. Some products of similar stripe are better packaged for the policy owner’s situation than others. They may be more flexible, for example, or allow more premium to be paid relative to the death benefit. Some products enable the policy owner, rather than the life insurance company, to control the level of risk the policy owner assumes. Some products enable the policy owner to control the level of compensation paid to the agent, thereby increasing the efficiency of the product at the same premium. Some life insurance companies may have significantly more flexible and generous underwriting, which can make a dramatic difference in required policy premiums, death benefit and in cash value, for a particular premium amount. Finally, some products are simply more competitive, meaning legitimately competitive, than others.

2(d) Credibility

The last element is policy/illustration credibility, i.e., how realistic the non-guaranteed elements used in a policy illustration are. This is as crucial an area of modern life insurance practice as there is, and the policy owner should expect valuable insight (and empirical data) from the life insurance agent on these points:

(1) Does a close examination of the non-guaranteed elements of policy performance suggest credibility?

(2) Is the life insurance company well positioned by virtue of current strength and past performance to deliver on the projected illustration? Does the company’s record, in terms of dividend history and results in mortality, interest crediting rate, lapses, and expenses suggest it has delivered in the past and will continue to do so in the future? Does a company with current outstanding pricing give fair pricing treatment to existing policies as well, so that the policy owner will share in the “good times”?

(3) Does the life insurance company support the market in which the policy owner is buying, i.e., if the policy owner is going to buy split dollar insurance, does the company do in-force illustrations (also known as in-force ledgers) for split dollar cases? Has the company been a consistent presence in the particular market? Has the company passed along mortality and expense improvements to all policyholders?

These are the questions that the agent should be prepared to address.

 

3. UNDERSTANDING COMMON LIFE INSURANCE POLICIES[17]

3(a) Term Insurance

Term insurance[18] is the simplest form of life insurance. It provides coverage for a limited duration (e.g., a few years) with only a death benefit and nothing more; at the end of the term, the coverage expires. Since most term policies expire before the insured dies, many term policies never pay a death benefit. Nearly all of the premium for a term policy is for the cost of the insurance (“COI”)[19] or the “net amount at risk” (“NAR”),[20] (i.e., the mortality expense), plus the life insurance company’s load/expense. Collectively the NAR and load/expense charges are often referred to as the mortality and expense charges (“M&E”).[21] See section 4, below. Thus, term insurance is pure life insurance protection without any build-up of cash value, i.e., there is no cash savings or investment component.[22] Because there is no cash value (or investment) component in term insurance, the owner of the policy cannot take out a loan or make a withdrawal from a term policy. Term insurance is the lowest outlay form of insurance, at least in the early years. However, term insurance becomes more expensive with every renewal since it is age-based and as the insured becomes older, the probability of death becomes greater.[23] The higher the actuarial probability of death in a given year, the greater the COI and the higher the premium.

Most term policies are sold based on a current or illustrated rate schedule and a higher guaranteed schedule of maximum premiums that may be charged if the policy is renewed and the illustrated premium is no longer in effect. Since there is no cash value build up in the policy to help offset increased costs upon renewal of the policy, annual renewable term life insurance tends to be most sensitive of all life insurance products to fluctuations in risk factors, such as the interest/investment return and mortality experience of the life insurance company. See section 4, below. The maximum guaranteed premium that the life insurance company may charge on renewal of a term policy is generally substantially higher than the premium illustrated by the insurance company. If the life insurance company’s underwriting practices are poor and the company insures many bad risks (i.e., has a higher than expected mortality experience), or the reinsurance company used by the life insurance company has too many bad risks, there is a substantial risk that premiums for an annual renewable term policy will be increased, up to (but not in excess of) the maximum guaranteed premium. Term insurance is either renewable or nonrenewable. Renewable term is more expensive, but the extra cost is often offset by the increased flexibility and security of being able to maintain coverage if the insured becomes uninsurable for any reason. Many renewable term policies permit the insured to maintain coverage past the age of 65 without evidence of insurability. Most renewable term policies offer a conversion feature permitting the policy to be converted to a permanent policy without evidence of insurability.[24] This is particularly advantageous to an insured who wants permanent coverage and whose health has declined while holding the term policy. Some term policies renew to age 90, but become so expensive that they are impractical for long-term estate planning solutions. As a general rule, term insurance maintained for more than 20 years is not competitive with permanent insurance. However, 30-year level term insurance has become much more competitive.[25]

3(a)(1) Popular Types Of Term Life Insurance

The more popular variations of term insurance are:

  • Annual Renewable Term. Annual renewable term life insurance provides a death benefit for the present year and guarantees the right to renew for the following year at a specified rate. Consequently, the death benefit stays level but the premium increases every year. Annual renewable term is most appropriate for short-term coverage, typically five years or less. If coverage for a longer period is desired, it may be less expensive to purchase level term. Because of the increasing premium costs and lack of cash value, annual renewable term is generally not suitable for an ILIT.

  • Level Term. Level term life insurance is written for a fixed death benefit with a guaranteed level annual premium for a period of years (5, 10, 20, or 30 years). Popular types include 10-year convertible and renewable term, 20-year convertible and renewable term, and term to age 65. At the end of the term, the insured must apply for new insurance if needed, or may be able to continue coverage on a year-to-year basis under the existing policy by paying an annual term rate premium (which can be cost prohibitive depending on the insured’s age).

  • Decreasing Term. Decreasing term life insurance is also known as “declining balance term” and is frequently sold by life insurance companies as “mortgage insurance” to pay off an insured’s mortgage if he or she dies during the term of the loan. Premiums remain constant over the period of coverage, but the amount of life insurance coverage decreases annually. In addition to providing mortgage-payoff protection, these policies are generally used to provide a surviving spouse with a fixed monthly income for a specified period of time and are often used to assure college education for children.

  • Modified Term. Modified term life insurance is usually set up to function as term insurance for five to ten years and then automatically convert to permanent insurance.

3(b) Whole Life Insurance[26]

Whole life insurance is the oldest form of “permanent”[27] (or cash value) insurance and features premiums that are level (rather than increasing with age) and a guaranteed cash value and a guaranteed death benefit. As a general rule, premiums are payable for the “whole life” of the insured or until the policy endows, usually at age 100. Thus, whole life has a much higher initial premium than term insurance; however, as the insured ages, the premiums for term insurance increase and eventually become “prohibitive” if the insured has a long life span. In a traditional whole life policy (also referred to as an “ordinary whole life policy”), the premiums are structured so that the combination of the premium payments and the guaranteed minimum crediting rate will result in the policy reserves equaling the original face amount of the policy at age 100. The assumptions used by life insurance companies in pricing traditional whole life products are generally more conservative than, for example, the (more aggressive) assumptions currently used to price no-lapse/secondary guarantee universal life policies.

The level premium system results in the life insurance company collecting more in a policy’s early years than the company needs to pay claims in those years. In the policy’s later years, increased mortality results in less being collected than needed to pay claims, but the shortfall is covered by the earnings on the excess premiums collected in the early years.

Premium payments are divided between risk protection (mortality charges) and a savings or investment account. The savings or investment account is typically composed of long-term bonds and mortgages selected by the life insurance company, and the investments are part of the life insurance company’s general investment account that is available to its creditors if the life insurance company should experience financial problems. The risk protection (mortality charges) represents pure term insurance and the investment portion acts as a savings account inside the policy, commonly known as cash value.[28] Premium payments also are applied to the life insurance company’s load/expenses. See section 4, below. Each year the policy is in force the amount at risk (the pure term insurance component) decreases and the cash value (investment component) increases. Each year the increase in the policy’s cash value component offsets the amount of pure term insurance coverage that is needed to provide the death benefit. Together, the pure term insurance component and the (increasing) cash value component provide the death benefit. The cash value is a liquid asset available to the owner of the policy through borrowing or surrendering the policy. The year-by-year buildup of cash value through dividends or interest credited to the policy is usually free from current income taxes because of tax-favored treatment. When the policy is surrendered for its cash value, income taxes are due only on the amount that exceeds the total premium paid less tax-free dividends received, if any.

In traditional whole life policies[29] the premiums remain level, and the company cannot increase the premiums to reflect actual mortality experience.[30] See section 4, below. However, the illustrated premium structure which forms the basis on which many whole life policies are sold assumes that the company will credit the cash value of the policy with annual dividends[31] or interest in excess of the guaranteed rate. Such excess dividends or interest may be used to offset the premiums, thereby decreasing the number of years that premiums must be paid by the policy owner before the premiums “vanish.”[32] However, the vanish date is not guaranteed. The company may reduce the amount of dividends or interest credited to the policy to a minimum guaranteed level if it is unable to attain the illustrated investment yield, or if expenses increase, or if it experiences increased mortality. As a result, the number of years that the premium must be paid can increase substantially over that illustrated if the policy is to be kept in force for the insured’s lifetime. Moreover, if the product is a current assumption (interest sensitive) whole life policy, premiums can be adjusted up to a guaranteed maximum.

A whole life policy is well suited for an individual who wants permanent protection, fixed premium payments, and guarantees with respect to the cash value account and the death benefit amount. It is also the simplest form of an interest-earning life insurance policy. Thus, an extremely “conservative” individual will generally find the whole life policy, especially from a mutual insurer, to have little to no risk.

3(b)(1) Popular Types Of Whole Life Insurance

The major variations of whole life insurance are discussed below.

• Limited-Pay Whole Life.[33] Traditional whole life insurance features a level premium payable for the insured’s lifetime or until the policy endows. In limited-pay whole life, the level premium is designed to be payable over a period shorter than the insured’s lifetime. Since the life insurance company must collect the same actuarial amount under either type of policy in order to create the required reserves within a much shorter period of time, the premiums payable for the same protection under a limited-pay whole life policy are greater than those payable under a traditional whole life policy providing the same protection. In a true limited-pay policy, the number of premium payments is guaranteed. This is in contrast to a “vanishing” premium, where the number of premium payments is not guaranteed.

  • Single Premium Whole Life.[34] Single premium whole life insurance is a form of limited-pay whole life insurance that requires only a one-time premium payment. Once that payment is made, no further premium payments are required to keep the policy in force for the insured’s entire life. All single premium life insurance policies purchased on or after June 20, 1988, are likely to be classified as a modified endowment contract (“MEC”) under IRC section 7702A, and are subject to special income tax rules.

  • Current Assumption Whole Life.[35] Current assumption whole life insurance, also known as “interest sensitive whole life insurance,” features a level premium that remains fixed for only a specified period of time, usually three to five years. At the end of the three-to-five-year period, the amount of the premium, and possibly the amount of the death benefit, will be redetermined based on the actual cash value of the policy, which is a function of the crediting rate declared by the insurance company during that fixed period. Since the crediting rate is a function of the investment return of the insurance company on its interest-sensitive block of policies, as well as expenses and mortality experience, an interest-sensitive policy is actually sensitive not only to investment performance but to all risk factors, including expense and mortality experience. See section 4, below. If investment performance, expenses, and mortality experience are poor, the insurance company may increase the premium up to a guaranteed maximum, represented by the minimum interest guarantee and the maximum mortality charges set forth in the policy.

If the insurance company increases the premium, the policy owner has the option to:

(1) Continue paying premiums at the old level and receive a reduced death benefit;

(2) Pay the increased premium and keep the death benefit level; or,

(3) If there is sufficient cash surrender value, pay premiums at the old level and augment those payments through use of the policy’s cash values.

If the life insurance company reduces the premium, the owner has the option to:

(1) Continue paying premiums at the old level and increase the death benefit, subject to proof of insurability;

(2) Continue paying premiums at the old level, keep the death benefit level, and increase the cash value of the policy, effectively creating a “vanishing” premium once cash values increase to the requisite level; or,

(3) Pay a lower premium and keep the death benefit level.

  • Blended Whole Life/Term Insurance.[36] Blended whole life/term insurance is a combination of whole life insurance (often referred to as the “base”) and term insurance. Blending is used to reduce the total premiums required to maintain a desired amount of death benefit, permanently.[37] The whole life portion of the blend offers the guarantees associated with that product. The term element offers low-cost coverage, but the term rates can be subject to marked increases up to a very costly guaranteed maximum under the policy. In a blended policy, the total death benefit is comprised of the guaranteed death benefit from the whole life, paid-up additions, and the term insurance. Thus, the blended product is designed so that dividends or interest paid on the whole life base will be used to buy paid-up additions (additional blocks or units of paid-up whole life insurance) that will ultimately replace the term insurance component.[38] Consequently, dividend/interest performance on the whole life base is extremely important.

It is a common misconception that because of the term element, a blended contract carries more risk than a whole life or “all base” contract. The truth is that a blended contract is in fact subject to less risk of underperformance, at the same premium outlay and face amount, than a non-blended contract. Assuming equal premium outlays and death benefits, a blended policy will have greater cash value than a non-blended contract because blending reduces internal policy loads and commissions, and potential surrender charges. Blending will enhance cash value and minimize surrender charges as quickly as possible.[39] With both a base contract and a blended contract, the policy owner is subject to risks associated with poor mortality or interest/investment experience.

3(c) Universal Life[40]

Universal life (“UL”) policies were developed in the late 1970s in response to rising interest rates in the money market. They classically illustrate the separate term component and cash value component of permanent life insurance by allowing an insured to buy term insurance and invest the rest within the same policy. The hallmark of this is flexibility, i.e., to design a policy to meet a certain immediate objective and remain able to reshape the policy to suit changing circumstances.

The premium payments for a UL policy are not fixed. In all other forms of life insurance, premiums are payable for the insured’s life (or for a shorter fixed period when limited-pay whole life is involved) in fixed amounts and on a fixed schedule. Thus, while the insured is young, the policy owner can pay “less” premium in order to maintain the term insurance component. As the insured ages and the term insurance component costs increase, the policy owner will (presumably) have more income available to pay premiums in excess of the term insurance cost. This flexibility demonstrates one of the key differences between universal life and traditional whole life (which requires a constant level premium).

Another aspect of a UL policy’s flexibility is that the policy owner can raise or lower the death benefit without getting a new policy. However, increases in death benefit coverage usually require new evidence of insurability. Thus, a UL policy owner can adjust the amount of savings and death benefits as he or she determines (within prescribed limits).

Universal life insurance, often referred to as “flexible premium adjustable life,”[41] features premium payments in which both the frequency and amount are flexible, within prescribed limits.[42] As typically structured, the planned universal life premium for a given death benefit is set considerably lower than the traditional whole life premium amount. Universal life, like whole life, may be designed with a blended policy design, combining a term rider and a base amount of coverage. The premium for a universal life policy is first applied to a sales load and then deposited into a “side fund” where it is credited interest at the insurer’s current crediting rate. Monthly charges for administrative expenses and the cost of insurance on the amount at risk are then withdrawn from the side fund. There is a minimum guarantee (floor) on the crediting rate and a maximum guarantee (ceiling) on the cost of insurance.

Because UL premiums are not fixed, the policy owner may skip making one or more premium payments as long as the cash value of the universal policy is sufficient to cover that month’s mortality and expense charges.[43] Under a whole life policy, a skipped premium would be treated as a policy loan which would reduce the death benefit and result in an interest charge. Within certain limitations, the policy owner can also increase the universal life premiums through so-called “dump-ins” at sharply reduced loads, without evidence of insurability.

An unattended UL policy can create problems. For example, if the cash value of a UL policy is allowed to drop to a low level, the future contributions that will be required to keep the policy in effect will be substantially similar to the cost of annually increasing term insurance, and the cost of maintaining the policy may become prohibitive. Moreover, if the cash value is allowed to drop below the level necessary to keep a UL policy in force, the policy will lapse, i.e., terminate, and a new policy will have to be purchased, with the premiums based on the current age and health of the insured. Thus, UL policies do not guarantee any given death benefit beyond the first month or year of the policy unless sufficient premiums are paid to maintain the cash value (known as the “accumulation account”) at an adequate level to pay mortality and expense charges, which are deducted each month and can change over time.

A UL policy owner can usually select between two death benefit payouts: (i) Option A/Option 1 (which is for the policy’s face amount), or (ii) Option B/Option 2 (which is for the policy’s face amount, plus the balance of the policy’s cash value account, thus providing a larger payout amount).[44] Such options do not exist for the traditional whole life policy, which typically pays only the face amount.

The cash value account of a UL policy is invested by the life insurance company, and is part of the company’s general account. The policy owner does not control the investment of the policy’s cash value. The cash value account is typically invested in short term fixed income investments, such as short term bonds (which in the 1980’s were paying very high rates of interest and consequently policy owners were abandoning lower yielding policies, such as traditional whole life, for higher yielding universal life policies). The UL policy owner has access to the policy’s cash value via loans or withdrawals. In traditional whole life, the policy owner only has access to the policy’s cash value via loans.

In some UL products, back end loads result in cash values building more rapidly than in traditional whole life products. Most whole life policies recover initial policy costs (commissions, underwriting, etc.) from the initial premiums, a practice known as front-end loading or “heaped” commission structures. Some UL policies defer recovery of initial policy costs until the later years of the policy (known as “back-end loading”), thereby permitting cash values to increase more rapidly. UL products typically have surrender charges that apply to reduce the policy’s cash value if the policy is terminated within the first ten to fifteen years. As a practical matter, whole life policies have charges essentially equivalent to surrender charges, but they are not separately identified.

A UL policy (the “base”) can also be blended with term insurance. The UL policy’s death benefit may be comprised of a relatively low amount of base and a large amount of term rider. These policy designs can make universal products even more competitive than they otherwise might be.

A unique feature of UL (and of variable UL policies, discussed in section 3(e), below) is the transparency of the policy as a result of unbundled product disclosure. In a traditional whole life policy, the insured sees only the “end result” without a breakdown of what is occurring within the policy. In a UL policy (including variable UL policy), the various “working” elements (or risks, which are discussed in section 4, below) are disclosed and the policy owner sees the interaction of mortality charges/costs, expense loads, crediting rates, premium payments, etc. Transparency helps the policy owner understand how a thinly-funded UL (or variable UL) life policy can fail.

Since a UL policy permits the policy owner to minimize premium payments and to adjust the amount of payments, a UL policy is sensitive to the various risk factors discussed in section 4, below. Thus, the UL policy owner is subject to certain investment risks and mortality risks. Because of these risks and the policy’s flexibility, from an ILIT trustee’s “best practices” perspective, UL insurance typically requires annual TOLI management.[45]

3(c)(1) No-Lapse Guarantee Universal Life

Many life insurance companies offer a no lapse guarantee rider that provides a lifetime (until death or a certain age selected by the insured, such as age 95) benefit even if the “traditional” UL policy has no cash value, so long as a specified premium is paid when due and other conditions are met.[46] The no lapse guarantee rider is typically available up to ages 95 through 120, as selected by the policy owner. Regardless of the policy owner’s cash flow situation, the specified premiums must be paid in “good” times and in “bad” times—there is no flexibility. These no lapse guarantee riders offer relatively inexpensive permanent death benefit guarantees, coupled with significantly lower (or no) cash value increases.[47] A no lapse guarantee UL (“NLGUL”) policy functions like owning term insurance to whatever age the guarantee has been established by the insured (typically between ages 100 – 120). In addition, many life insurance companies are now offering “secondary guarantee”[48] UL products that are pure no lapse UL policies from their inception (i.e., there is no rider concerning the no lapse guarantee) that are similarly designed to maintain the death benefit even if the policy’s cash value is zero so long as premium payment requirements continue to be met, in essence, providing a “term to age 100 or beyond” type of product.[49]

No lapse/secondary guarantee[50] UL policies are attractive to policy owners who: (1) are typically 75 years or older, i.e., they are less likely to be concerned about changes that would affect the desirability of holding on to a policy with a low cash value, (2) have sufficient liquidity and capital outside of the no-lapse guarantee policy, i.e., they are not dependent on the policy’s cash value for their future living expenses, (3) are not overly concerned with the life insurance company’s claims paying ability ratings, i.e., they are risk takers, (4) understand the inflexibility of the policy and the potential losses involved in a lapse of the policy, (5) are committed to funding the policy for its specified duration, (6) expect to die sooner than the expiration of the no lapse guarantee period, which is typically between ages 100 through 120, (7) do not want premium increases, i.e., they want to pay a certain fixed premium amount, (8) are concerned about  low (or decreasing) interest rates in the fixed income market, (9) are concerned about premiums that were/are supposed to “vanish” but have (or will) not, (10) are concerned about  lackluster/underperformance of IUL and VUL products, (11) plan to hold the policy until their death and are (presumably) not concerned with the policy’s cash value amount, i.e., they do not plan to withdraw or borrow from the policy, and (12) are an ILIT trustee who understands the risks inherent in a no-lapse guarantee policy and has received appropriate exculpatory language in the ILIT.[51] Some commentators[52] have recommended caution in purchasing no lapse/secondary guarantee UL policies for several reasons, including: (1) the additional premium cost of the no-lapse or second guarantee rider, (2) the policy’s lower or non-existent cash value (a possible concern if the policy lapses due to the non-payment of premiums, or if the policy owner wants to restructure or exchange the policy for a different type of life insurance policy), (3) the lack of premium payment flexibility (however, the required minimum premium will not increase and is lower than in a non-guaranteed universal life policy), (4) the policy’s low crediting rate will prevent it from sharing in any meaningful increase (upside) if the carrier’s crediting rate or dividend rate increases with regard to its other products, and (5) the possible danger identified by Moody’s in a Special Comment issued in July, 2004, in which the rating service expressed its concern over the effect that “aggressively priced” no lapse guarantees create significant losses that impact the company’s profitability and ability to pay claims. Shortly thereafter, Fitch Ratings downgraded two of Pacific Life Corp’s insurance subsidiaries, citing among other reasons potential risks from being a market leader in universal life policies with no lapse riders.[53] These concerns underscore the importance of buying no lapse/secondary guarantee UL insurance from a strong, highly rated life insurance company. In addition, borrowing from or making late premium payments to a no-lapse/secondary-guarantee UL policy will result in an increase in future premiums, which can far exceed the amount borrowed or paid late.[54]

There is one final note of caution: when no lapse riders first became available, it was not uncommon for the rider to contain very strict requirements for the no lapse guarantee to remain in effect. Paying the rider premium just one day past the due date, but within the policy’s premium payment grace period, would, in some instances, be sufficient for the rider to lapse and cause the policy owner to lose the no lapse/secondary guarantee. A policy loan or withdrawal could also affect the no lapse/secondary guarantee. It is thus important to read the no lapse guarantee rider carefully and understand its requirements, restrictions, and premium payment timeliness requirements. Also, if possible, try to purchase the no-lapse insurance product from the parent life insurance company, rather than from a subsidiary, which may not be as financially secure as the parent company, or obtain a statement from the parent company that it stands behind the subsidiary’s obligations.

There is also a related practice point: an ILIT trustee who owns a no lapse/secondary guarantee UL policy must be careful to make sure premiums are paid on time in order to avoid triggering a “penalty” provision in a no-lapse/secondary guarantee policy. A late premium payment could reduce or terminate the no lapse/secondary guarantee, as well as reduce the death benefit amount. Therefore, the grantor should consider making Crummey contributions well in advance of the policy’s anniversary date in order to provide the ILIT trustee with sufficient time to deposit the gift amount, send out the Crummey notices, and pay the premium prior to its due date. An especially cautious ILIT trustee may want to consider having the grantor gift an extra year of premium into the ILIT. The extra premium would act as a “reserve” fund (or “buffer”) to be used if the grantor is late in making a Crummey contribution in subsequent years. Also, if split dollar funding may be used to reduce the insured’s anticipated gifting (and gift tax consequences), then a policy with low or no cash value will be inflexible. A policy with a no lapse guarantee structure (as opposed to a policy with significant cash value) may therefore become seriously problematic if any change becomes necessary in the split dollar funding plan. If it becomes desirable to temporarily suspend, reduce, or reallocate premium payments between the parties, then having as much policy cash value as possible, becomes critically important to the successful management of the policy and the maintenance of the full death benefit.

3(d) Indexed Universal Life

Indexed universal life (“IUL”) is a form of universal life insurance in which the policy’s cash value is credited, in whole or in part, by reference to the performance of one or more external market indices. IUL is often described as a product that provides some exposure to market upside while limiting downside risk. That shorthand is useful, but incomplete. The policy owner is not actually investing in the index, and the policy’s cash value is not placed directly into the S&P 500®, Nasdaq-100®, a proprietary index, or any other equity or multi-asset benchmark. Rather, as with traditional universal life, the policy’s cash value generally remains in the insurer’s general account. The insurer then uses the selected index only as a reference point for determining the amount of interest, if any, to credit to the policy for a specified measuring period, subject to the contract’s crediting formula.

The insurer typically supports the indexed-crediting feature by allocating a portion of its general-account yield to purchase options or other hedging instruments designed to provide the policy with limited participation in the positive movement of the referenced index. The amount available for that hedging budget is affected by interest rates, the insurer’s investment yield, option costs, market volatility, the policy’s charges, and the insurer’s pricing decisions. For that reason, the most important economic terms in an IUL policy—such as caps, participation rates, spreads, bonuses, multipliers, volatility controls, and loan-crediting provisions—are often non-guaranteed and may be changed by the insurer after issue, subject to the policy’s terms. Thus, while the policy may have a contractual floor that prevents the indexed account from being credited with a negative return for a given segment or policy year, the policy owner can still lose value in a practical sense because mortality charges, expense charges, loan interest, rider charges, and other deductions continue to be assessed even in years when little or no interest is credited.

Traditional IUL products often reference broad, recognizable indices, such as the S&P 500®, usually excluding dividends. The policy may provide that if the index increases during the measuring period, the policy will receive a portion of that increase, subject to a cap, participation rate, or spread. If the index declines, the policy may receive a 0% credit, or in some older designs a small positive guaranteed minimum credit, for that segment.

To understand the crediting function and how the participation rate[55] works, some examples are useful. Assume an IUL policy with a crediting or participation rate of 100% based on the S&P 500® index, with a 9% annual cap and a 0% floor. If the index rises 10%, the policy receives a 9% credit; if the index rises 5%, the policy receives a 5% credit; and if the index falls 5%, the policy receives 0% credit. Now assume that the same IUL has a 200% participation rate and no annual cap and a 0% floor.  If the index rises 10%, the policy receives 20%; if the index rises 5%, the policy receives a 10% credit; and if the index falls 5%, the policy receives 0% credit. The chart below details how these assumptions operate.

Participation Rate

& Performance

Policy A

100% Participation Rate,

9% Cap & 0% Floor

Policy B

200% Participation Rate,

No Cap & 0% Floor

Index Rises 10%

9% credited to policy
(10% × 100% = 10%; limited by 9% cap)

20% credited to policy
(10% × 200% = 20%)

Index Rises 5%

5% credited to policy
(5% × 100% = 5%; cap not reached)

10% credited to policy
(5% × 200% = 10%)

Index Falls 5%

0% credited to policy
(0% floor applies)

0% credited to policy
(0% floor applies)

These examples only show the index segment crediting result. They do not mean that the policy’s total cash value is guaranteed not to decline. The crediting account may be protected from negative index performance, but the policy remains subject to internal charges and the risk that insufficient premiums, disappointing credited interest, policy loans, or rising cost-of-insurance charges will cause the policy to underperform or lapse.

IUL policies can be attractive in appropriate circumstances. They may provide more upside potential than traditional current-assumption universal life, without exposing the policy owner to the direct investment losses associated with variable universal life. They may also appeal to clients who desire flexible premiums, death-benefit flexibility, tax-deferred cash-value accumulation, access to policy values through withdrawals or loans, and some measure of downside protection in the credited-interest formula. Properly designed and adequately funded, an IUL policy may serve as a useful permanent-life-insurance product for a policy owner who understands that the illustrated values are not guaranteed and who is willing to monitor the policy over time.

The principal risk of IUL is that its apparent simplicity can obscure substantial complexity. The policy owner may focus on the floor and conclude that the policy is insulated from market risk, while failing to appreciate that the upside is limited, the crediting terms can change at the carrier’s discretion, the index excludes dividends, and the policy’s internal charges continue and, in the case of COI, increase, regardless of index performance. IUL illustrations are also highly sensitive to assumptions about future index returns, caps, participation rates, loan rates, bonuses, and persistency. A modest reduction in credited interest, a future reduction in the cap or participation rate, an increase in policy charges, or the use of policy loans can materially change the long-term outcome. For this reason, IUL should not be evaluated solely on the basis of the illustrated rate of return or the projected future income stream. It should be stress-tested using lower credited rates, reduced caps or participation rates, higher policy charges where contractually permitted, and conservative assumptions regarding policy loans.

Because many IUL policies are financed with loans, the use of premium financing can complicate their use further. See sections 2(a)(7) and 3(h)(4), below.

3(d)(1) AG-49

Because of the complexity and illustration sensitivity of IUL products, state insurance regulators have adopted special rules governing how IUL policies may be illustrated. Actuarial Guideline XLIX (“AG 49”) and its successor, Actuarial Guideline XLIX-A (“AG 49-A”), were intended to bring greater discipline and consistency to IUL illustrations, particularly with respect to maximum illustrated rates, indexed loan arbitrage, bonuses, multipliers, and volatility-controlled indices. These regulatory limits do not make an illustration a prediction of actual policy performance. They merely impose guardrails, albeit limited ones, on what may be shown in a compliant sales illustration. A prudent policy owner, trustee, attorney, or advisor should therefore treat an IUL illustration as a hypothetical projection, not as an expected result, and should obtain alternative illustrations showing materially less favorable assumptions before concluding that the policy is suitable.

3(d)(2) Synthetic / Proprietary Indices

In addition to traditional indices, many IUL carriers now offer indexed accounts tied to proprietary, custom, or synthetic indices. These indices are often created by investment banks or large financial institutions for exclusive use in life insurance and annuity products. Unlike a familiar market-capitalization-weighted index such as the S&P 500®, a proprietary or synthetic index may be constructed using a rules-based formula that allocates among multiple asset classes, such as domestic equities, international equities, bonds, commodities, currencies, cash, futures, or volatility-control components. The index may use momentum signals, trend following rules, risk control targets, daily rebalancing, or other quantitative methods. Many such indices are designed to maintain a relatively stable level of volatility, often by reducing exposure to risk assets when market volatility rises and increasing exposure when volatility falls.

The purpose of these indices is not necessarily to outperform a broad equity index in a strong bull market. Rather, they are purportedly designed to produce a smoother return pattern and to reduce the cost to the insurer of purchasing the options or hedging instruments needed to support the crediting strategy. Lower volatility generally makes the insurer’s hedge less expensive. That lower hedging cost may allow the insurer to offer features that appear attractive in the illustration, such as higher participation rates, higher caps, uncapped crediting potential, multipliers, bonuses, or lower spreads. Thus, an IUL account tied to a proprietary volatility-controlled index might illustrate a participation rate of 150%, 200%, or more, while an S&P 500® account might illustrate a much lower cap or participation rate. The higher participation rate, however, does not necessarily mean the policy owner is receiving a more favorable economic opportunity. The underlying index itself may be engineered to have lower volatility and therefore lower expected upside.

A significant concern with proprietary and synthetic indices is that many have little or no live performance history. Their historical performance is often shown through hypothetical “back casting,” “back testing,” or “hypothetical historical” returns. Back casting applies the index’s current rules to prior historical market data to show how the index would have performed if it had existed in the past. This information can be useful in understanding how the index formula might have behaved under prior market conditions. But it should not be confused with actual performance. Because the index rules may have been designed after reviewing historical data, the back cast results may reflect the benefit of hindsight. Even where the index methodology is fixed and rules based, there is a risk that the index was optimized to look attractive over a particular historical period. The fact that an index would have performed well in a hypothetical back test does not mean it will perform similarly in the future.

Proprietary and synthetic indices also create transparency and comparability concerns. A policy owner may understand the general nature of the S&P 500®, even if he or she does not understand all of its details. By contrast, a custom multi-asset index may be difficult for a policy owner, trustee, or attorney to evaluate without specialized assistance. The index may have limited public recognition, limited independent commentary, limited live history, and complex rules governing asset allocation, rebalancing, volatility control, excess-return calculations, embedded financing costs, or deductions. Some indices are “excess return” indices, meaning that their return is reduced by a cash, financing, or benchmark rate before the policy crediting formula is applied. Others may include internal index deductions called decrements or volatility-control mechanisms that materially affect performance. These features can make the illustrated rate appear more credible than it is, particularly where the policy illustration emphasizes participation rates or bonuses rather than the index’s actual mechanics.

Proprietary and synthetic indices should be viewed as illustration sensitive crediting mechanisms, not as proven investment strategies. The key question is not whether the hypothetical historical chart looks attractive, but whether the policy remains suitable and adequately funded under conservative, understandable, and stress-tested assumptions. Attorneys and trustees reviewing an IUL policy should be especially cautious where the policy’s long-term success depends on sustained illustrated performance from a relatively new proprietary index, aggressive participation rates, uncapped volatility-controlled crediting, positive loan arbitrage, or bonuses that may not be guaranteed. As with all flexible-premium permanent insurance, the policy should be reviewed regularly through in-force illustrations and, where appropriate, independent analysis.

3(d)(3) Examples of Popular IUL Indices

The following are examples of proprietary, custom, synthetic, excess-return, or volatility-controlled indices that have appeared in IUL products. This list is illustrative, not exhaustive. Index availability changes over time and may vary by carrier, product, policy date, state of issue, and allocation option.

• Bloomberg US Dynamic Balance III ER Index
– Index sponsor/provider: Bloomberg Index Services Limited
– Carrier/product example: Allianz Life Insurance Company of North America; Allianz Life Accumulator® Indexed Universal Life

• PIMCO Tactical Balanced ER Index
– Index sponsor/provider: Pacific Investment Management Company LLC / PIMCO index family
– Carrier/product example: Allianz Life Insurance Company of North America; Allianz Life

Accumulator® Indexed Universal Life

• S&P 500® Futures Index ER
– Index sponsor/provider: S&P Dow Jones Indices
– Carrier/product example: Allianz Life Insurance Company of North America; Allianz Life Accumulator® Indexed Universal Life

• Blended Futures Index
– Index sponsor/provider: Allianz index-allocation option referencing futures-based components
– Carrier/product example: Allianz Life Insurance Company of North America; Allianz Life Accumulator® Indexed Universal Life

• BlackRock iBLD® Endura® VC 5.5 ER Index / BlackRock Endura® Index
– Index sponsor/provider: BlackRock Index Services, LLC
– Carrier/product example: Pacific Life Insurance Company; Pacific Life indexed universal life products using the BlackRock Endura® Index

• J.P. Morgan Mozaic II℠ Index
– Index sponsor/provider: J.P. Morgan Securities LLC / JPMorgan index family
– Carrier/product example: Nationwide Life and Annuity Insurance Company; Nationwide New Heights indexed universal life products

• Goldman Sachs Voyager Index
– Index sponsor/provider: Goldman Sachs & Co. LLC / Goldman Sachs index family
– Carrier/product example: Prudential indexed universal life products, where offered as an indexed account option

• S&P PRISM Index
– Index sponsor/provider: S&P Dow Jones Indices
– Carrier/product example: Minnesota Life Insurance Company / Securian Financial indexed universal life products

• Barclays Trailblazer Sectors 5 Index
– Index sponsor/provider: Barclays Bank PLC / Barclays index family
– Carrier/product example: Fidelity & Guaranty Life Insurance Company indexed universal life products and related indexed products, where offered

The foregoing examples demonstrate the breadth of modern IUL index design. Many of these indices are not simple equity indices. They may be multi-asset, rules-based, volatility-controlled, excess-return, or futures-based indices. Some have substantial hypothetical or back tested histories but comparatively limited live performance histories. Accordingly, a policy owner, attorney, trustee, or advisor should not evaluate an IUL policy merely by looking at the illustrated rate, participation rate, or historical chart. The more important questions are who sponsors the index, how long the index has existed on a live basis, whether the historical results are actual or hypothetical, whether the index is total-return, price-return, or excess-return, whether dividends are included, whether volatility controls or embedded costs reduce returns, whether the carrier can change caps or participation rates, and how the policy performs under conservative assumptions.

3(e) Variable Universal Life Insurance[56]

Whole life and universal life policies are general account policies, i.e., the investment component or cash value of the policies is represented by assets that are part of the life insurance company’s general fund and the investments are controlled by the life insurance company. Variable life insurance, which was first introduced in 1976, is a form of permanent insurance, and is often viewed as a sort of mutual fund that is used to purchase life insurance coverage. The key difference from whole life and variable universal life policies is that the cash value of a variable policy may be allocated to legally separate investment account(s) that are administered by the life insurance company but the investments are selected (and monitored) by the owner of the policy from a group of funds made available within the product design. In other words, a variable life insurance policy uses a fixed premium chassis (as opposed to a variable universal life product) and is conceptually based on a whole life policy where the policy owner invests the cash values in a wide “variable” range of options. The owner may allocate cash value among a guaranteed fixed account (which is not a security) as well as to various mutual fund-like investments (known as “sub-accounts”), such as:

  • Stocks (aggressive, conservative, and blend);

  • Bonds (short-term, mid term, and long-term);

  • Government securities;

  • Total Return Accounts (stocks, bonds, cash, and so on);

  • Money market accounts;

  • International accounts; and

  • Real estate accounts.

As previously noted, the investment accounts underlying variable life insurance are legally separate from the life insurance company’s general account and are not subject to the claims of the life insurance company’s creditors. Except to the extent that cash value is allocated to the guaranteed interest account, the investment risk is shifted entirely to the policy owner, and the life insurance company provides no guarantees with respect to the policy’s cash value account. However, unlike a general account policy where the amount credited to the cash value is determined periodically by the life insurance company, the actual performance of the investment account in a variable policy passes through to the policy owner, less a fixed administrative charge. The typical variable life prospectus illustrates the policy based on hypothetical gross annual rates of investment return of 0%, 6%, and 12%.[57] Good investment performance will result in a larger cash value, while poor investment performance will result in a smaller cash value. Poor investment performance may require the policy owner to pay additional premiums in order to maintain the (full) face amount of coverage. Furthermore, poor investment performance could actually produce a negative rate of investment return which could cause the policy to lapse earlier than illustrated in the 0% illustration.

A variable life insurance policy may be structured with fixed premiums (or with flexible premiums, in the case of a variable universal life policy). Premium payment plans include a single premium payment, payment for a limited number of years, or payment for the life of the insured.

Some variable life insurance policies have higher administrative costs than general account policies. In theory, the extra cost may be offset by the pass-through of the increased earnings of the policy’s investment account.

3(e)(1) Similarities Of Variable Life And Variable Universal Life

The key similarities between variable life (“VL”) and variable universal life (“VUL”) (see section 3(f), below) policies involve investment optionality, as follows: (1) the policy owner can select how the premiums are invested; (2) except to the extent that cash value is allocated to the policy’s fixed or guaranteed interest account, neither policy is guaranteed a minimum interest rate on its cash value account—the policy owner assumes all the risk; (3) each policy’s cash value fluctuates depending on the performance of the investments selected by the policy owner; (4) each policy’s cash value account grows income tax deferred; and (5) both policies are considered securities, and the selling agent must hold a special license.[58]

3(e)(2) Differences Between Variable Life And Variable Universal Life

The key differences between VL and VUL policies involve premium and design flexibility, as follows: (1) the premium amounts in a VUL policy are flexible, but the premium amounts in a VL are not flexible; (2) a VUL policy owner can vary the frequency or amount of premiums, a VL policy owner cannot; (3) a VUL policy owner can increase or decrease the death benefit amount and can select an Option A/Option 1 or Option B/Option 2 payout, a VL policy owner cannot; (4) a VUL policy owner can make withdrawals from the policy’s cash value, a VL policy owner cannot (but a VL owner can, however, access the cash value through policy loans); and (5) a VUL policy owner receives “unbundled product disclosure” from the life insurance company, a VL policy owner does not.[59]

3(e)(3) Appropriateness Of Variable Universal Life

VUL insurance is appropriate only if the owner is able to monitor the investments, has tolerance for substantial investment risk, intends to hold the policy for the long term, and wants assurance that the cash value of the policy is not subject to the claims of the life insurance company’s creditors (assuming the owner of the policy has not chosen to invest in the life insurance company’s own general account). Since the death benefit may be structured to increase proportionately to the increase in the cash value of the policy, variable insurance may also be seen as providing a hedge against inflation.

3(e)(4) Dual License Required To Sell Variable Life Insurance

Because of the sub-account investment options available to the policy owner, a life insurance agent selling variable life insurance must also have a securities license, and all policy illustrations must be accompanied by a current prospectus. Not all life insurance agents are licensed to sell variable insurance, and therefore may be less likely to recommend the product.

3(f) Variable Universal Life[60]

Variable universal life (“VUL”) insurance is a hybrid type of permanent insurance that combines the investment flexibility of variable life with the premium and face amount flexibility of universal life. VUL is sometimes referred to as “flexible premium variable life.” A VUL policy owner has control over the policy’s face amount, investments, premiums, and premium payments. In many VUL policies the policy owner can select the accounts from which the policy’s expenses and mortality charges are deducted. The policy owner can usually select between two death benefit payouts: (i) Option A/Option 1 (which is for the policy’s face amount), or (ii) Option B/Option 2 (which is for the policy’s face amount plus the balance of the policy’s cash value account).

A VUL policy (the “base”) can be blended with term insurance. The term component can make the policy more efficient for the owner because it can have lower COI than the base and/or the premium attributable to the term component will not be part of the life insurance agent’s commission. The term component may also cause other policy charges, such as the M&E charge to be lower. In a well-designed term component that creates savings for the owner, the base should be minimized, the term component should be maximized and the owner should fund the policy aggressively, especially in the early years, with premium outlays being made on an all-base design and on a conservative investment rate of return on the base’s investment sub-account.[61]

3(f)(1) Similarities Of Universal Life And Variable Universal Life Insurance

UL and VUL are similar in the following ways: (1) they both allow “blending,” that is, the insured may buy term insurance and invest the rest within the same policy; (2) they both provide a guaranteed death benefit while the policy is in force; (3) the premium amounts are flexible (however, the policy owner should be careful to not under-fund the policy); (4) the policy owner can vary the frequency and amount of premium payments; (5) the policy owner can decrease or increase (subject to proof of insurability) the amount of the policy’s death benefit; (6) the policy owner can choose the Option A/Option 1 or Option B/Option 2 death benefit; (7) partial withdrawals of cash from the policy are permitted; (8) policy loans are permitted[62]; (9) the cash value account grows income tax deferred; (10) mortality and expense charges are deducted monthly; and (11) the life insurance company provides “unbundled product disclosure.”[63]

3(f)(2) Differences Between Universal Life And Variable Universal Life Insurance

The key differences between UL and VUL are: (1) a VUL policy owner can select how the premiums are invested, such as equity funds, bond funds, money market funds, etc., but a UL owner cannot select how premiums are invested—they are invested in the life insurance company’s general investment account and are subject to minimum and maximum crediting rates, whereas in a VUL policy the premiums are not subject to minimum or maximum crediting rates; (2) the cash value account in a VUL policy will fluctuate based on the performance of the investment portfolio selected by the policy owner, but a UL’s cash value account will not fluctuate in value based on fluctuations in the company’s general portfolio; (3) there are no interest rate guarantees on a VUL’s cash value account that is allocated other than to the guaranteed interest account; but there is a guaranteed interest rate on a UL’s cash value account; (4) the cash value account in a UL is represented by assets that are part of the life insurance company’s general fund that is subject to the claims of the life insurance company’s creditors, whereas the cash value account in a VUL that is allocated other than to the guaranteed interest account is represented by a separate investment account that is not subject to the claims of the life insurance company’s creditors; (5) VUL is a security that requires a special license to be sold, but a UL is not a security; and (6) because VUL is a security, its expense loading is limited by the Investment Company Act of 1940, but a UL’s expense loading is not limited and may be higher than that of a VUL.[64]

3(f)(3) Variable Universal Life Insurance Fees And Expenses

VUL policy fee structures are an important basis of comparison between registered and private placement products and domestic and offshore private placement products. First, there are the charges and fees assessed against the VUL premium before it is deposited into the separate investment account. These include the sales load to cover expenses associated with putting the policy in force, paying commissions, etc. The sales load might range from 4% to 6% of the premium, with a cap of 9% of all premiums paid within the lesser of 20 years or life expectancy. In addition, the life insurance company is reimbursed for the tax it has to pay to the state in which the policy is sold. This charge is usually about 2% of the premium. There is also the “DAC tax”[65] of approximately 1% of the premium, which is to reimburse the life insurance company for the tax it pays to the federal government for putting the business in force. After the deductions for those loads and taxes, the VUL premiums are deposited into the separate investment account and allocated among the funds in accordance with the policy owner’s designated allocation. The policy owner can periodically change the fund account to which the premium is to be allocated. Each month the life insurance company charges the separate account with the cost of the insurance (“COI”) for the amount at risk. The life insurance company can increase the COI up to a contractual maximum. The life insurance company also deducts a mortality and expense (“M&E”) risk charge. The M&E charge is supposed to compensate the life insurance company for certain risks it assumes under variable life insurance policies. The M&E charge is generally limited to 90 basis points (0.9%) of cash value on an annual basis. Life insurance companies differ widely in the way they impose the M&E charge, ranging from the full 90 basis points for the life of the policy, to perhaps 65 basis points for the life of the policy, to a tiered approach of perhaps 30 basis points for 15 years and 10 basis points thereafter. Another approach to tiering is to charge a certain M&E risk for the first $X million of cash value and a lower charge for additional cash value. There are additional expenses for the management and administration of the separate account investments. Any investment returns are earned net of these expenses. Finally, surrender charges help a life insurance company recoup un-recovered sales commissions and other expenses. These charges are generally imposed during the first 10, 15, or 20 policy years. The charges decline over the years the policy is in force.

Unfortunately, VUL illustrations usually show a constant return on the cash value, rather than the fluctuating returns that are much more likely to occur. The danger here is that in prolonged bear markets, as the cash value dips, the amount at risk increases. It is possible for the investment sub-accounts to experience a negative return (i.e., below 0% return), which could affect the policy’s viability. Unless internal charges are taken from a guaranteed interest account, the policy will have to sell fund investment units at depressed values to cover COI deductions. These kinds of fluctuations can wreak havoc on a VUL policy that is not sufficiently funded to weather a down or bear market. Thus, it is fair to say that the keys to success with VUL are: (1) adequate funding, (2) sound investment management, and (3) where permitted, managing the policy in a way that minimizes the impact of market downturns on policy performance. One such technique is paying the COI from the guaranteed interest account or a money market fund, and heavily funding the policy (i.e., paying more than the annual minimum premium).

A VUL policy that is heavily funded in the early years and whose policy owner has the cash flow to sustain the policy in a bear market, can produce tremendous income tax benefits to the policy owner or greatly reduce the aggregate long-term cash premium outlays necessary to sustain the death benefit. This is because the earnings on the subaccounts accumulate income tax free and are used to pay for the cost of the net amount at risk (i.e., the tax free earnings are used to pay for the term insurance component of the VUL policy), and if the policy owner has selected an Option B/Option 2 payout, all of the accumulated earnings (which were never taxed) are received income tax free by the beneficiaries. When held in an ILIT, the insured’s beneficiaries can also receive the death benefits free of estate taxes.

As a general rule, policy loans on universal, variable, and variable universal life insurance are not subject to income taxation.[66] However, if an insurance policy is allowed to lapse prior to death and the owner has borrowed against the policy in an amount in excess of his or her basis in the policy, the amount of such excess will be taxable income.

To help explain the foregoing, the following example may be helpful. A 35-year-old male purchases a VUL policy with a death benefit of $300,000 and a $4,000 annual premium. The policy produces a gross annual rate of investment return of 9%. The policyholder pays premiums until age 65 or a total of $120,000. Starting at age 65 the policyholder begins to borrow $40,000 a year from the policy at a 5% loan interest rate. At age 72, the cash value will be $360,000 and the loan account will be $342,000. If the policy is then surrendered and the cash value is used to pay off the loan, the policyholder will have taxable income of $240,000, which is the amount by which the cash value exceeds total premium payments ($360,000 – $120,000 = $240,000). If the policyholder did not wish to incur such phantom income, it would then be necessary to begin to pay premiums again in an amount necessary to keep the policy in force (i.e., not surrender the policy), as well as forgoing further borrowing. It is possible for the policyholder to find himself or herself in what Joseph M. Belth refers to as a “surrender squeeze” in which it is expensive to either keep the policy in effect or surrender it.

3(g) Joint Lives Life Insurance[67]

Joint lives insurance provides “second-to-die” or “first-to-die” coverage. For ease of understanding, a “second-to-die” policy is discussed first.

A second-to-die policy is intended to pay a death benefit only when the last insured dies. Thus, second-to-die policies are frequently used by spouses to pay estate and inheritance taxes upon the death of the second spouse (especially where estate taxes have been deferred because of the use of the unlimited marital deduction, which was enacted in 1981). Second-to-die policies are also used to fund special needs trusts. Some life insurance companies will issue policies up to the combined insureds’ net worth to accommodate the funding of the ILIT or wealth replacement trust.

A second-to-die policy is usually less expensive than two separate policies and is appropriate when the insureds want to receive the proceeds at the survivor’s death, such as when the surviving spouse dies and there is a need to pay estate taxes and administration expenses. Second-to-die life insurance is not appropriate when insurance proceeds are needed for income replacement, such as to provide funds for the proper care and support of the insured’s surviving spouse and/or children.

Many second-to-die life insurance policies involve a combination of permanent (base) and term insurance in order to lower the premium. The policies can be paid up at the first death or premiums can continue until the second death. Premiums can be paid for life or can be structured to “vanish.” Most joint life policies are traditional whole life or universal life. Some life insurance companies offer the second-to-die feature as a rider to a primary single insured.

Because second-to-die life insurance does not pay a death benefit until the last of the two insureds dies, a life insurance company may be willing to insure a person who is in poor health and would not otherwise be able to obtain life insurance coverage provided that the other insured is in “good” health.

Since a second-to-die life insurance policy insures two lives, the obligation to pay premiums continues after the death of the first insured. After the death of the first insured, the probability of the surviving insured’s death is greater and, in some policy structures, the premiums increase. Riders can reduce or eliminate the payment of premiums after the death of the first insured.

In the absence of a rider, it may be prudent for a surviving spouse to be left enough money (either outright or through trust distributions) to be able to pay the continuing premiums on the second-to-die policy. Because the life insurance company will receive the use of the premiums for a longer period of time (for two lives instead of one), the premiums on a second-to-die policy are usually relatively low (but are paid over a longer period of time).

First-to-die contracts also insure joint lives but proceeds are payable at the first death. As a result, the total premium cost is higher than the premium for a second-to-die policy but substantially less than separate policies on both lives since only one death benefit is payable.

3(h) Private Placement Life Insurance

Private placement life insurance (“PPLI”) is a custom-designed, institutionally priced life insurance policy that is offered only to qualified persons.[68] PPLI policies are always structured as separate account variable universal life (“VUL”) policies and offer the broadest range of investment alternatives of any life insurance product. Because they are offered only to a sophisticated, high-net-worth market, marketing costs and agent commissions are significantly lower than those of a comparable “off-the-shelf” VUL policy,which in turn improves net investment performance inside the policy. (Some carriers have begun offering standardized shelf PPLI products that compete with traditional custom-designed structures.[69])

A PPLI policy owner may direct that policy assets be invested in a wide array of investments, including mutual funds, equities, bonds, derivatives, real estate investment trusts, and hedge funds.[70] Because PPLI is primarily a vehicle for income tax-free growth of otherwise tax-inefficient investments, it is more accurately described as a tax-driven investment product than a life insurance protection product.[71] Minimum premium commitments typically range from $1 million to $10 million or more, and a commitment of at least $5 million over the first five years is generally required to access certain asset classes such as hedge funds or discretionary managed accounts.[72] Many investors structure the policy as a modified endowment contract (“MEC”) in order to maximize the benefit of tax-free compounding through greater initial funding.[73]

PPLI is a highly specialized structure that sits well beyond the day-to-day practice of a general estate planning attorney. Attorneys whose clients hold or are considering PPLI policies should ensure that qualified PPLI counsel, an experienced insurance actuary, and a dedicated compliance professional are engaged. The stakes—tax, regulatory, and financial—are substantial, as described below.

 

3(h)(1) Domestic v. Offshore PPLI

PPLI policies may be purchased domestically or through offshore carriers.[74] Offshore PPLI can offer cost advantages: state premium taxes (which typically range from 0.08% to 3% of premiums) generally do not apply to offshore-issued policies,[75] and the federal deferred acquisition cost (“DAC”) tax can be avoided if the issuing carrier does not make an IRC § 953(d) election.[76] However, where no § 953(d) election is made, a 1% U.S. federal excise tax applies to premium payments on the life of U.S. citizens.[77] The combined savings from avoidance of state premium tax and DAC tax can meaningfully improve net policy performance.

To secure the offshore tax benefits, all aspects of the policy—application, medical examination, initial premium payment, and policy delivery—must be conducted offshore.[78] When selecting a foreign jurisdiction and carrier, attorneys should consider whether the jurisdiction provides statutory separate account protection, creditor protection, adequate regulatory oversight, and political and economic stability.[79] The additional complexity of offshore PPLI, including trust reporting requirements and the interplay of U.S. and foreign tax rules, is considerable and requires specialized counsel.

3(h)(2) Investor Control and Diversification Requirements

The income tax advantages of PPLI depend on the policy satisfying the definition of life insurance under IRC § 7702 and compliance with the diversification requirements of IRC § 817(h). Failure on either front causes the policy owner to recognize all income generated by the underlying investments on a current basis—effectively eliminating the core benefit of the structure.

Diversification under § 817(h) requires that no single investment exceed 55% of the separate account’s value, no two investments combined exceed 70%, and that the portfolio include a minimum of five distinct positions.[80] Family offices and high-net-worth investors who favor concentrated, conviction-driven strategies should carefully evaluate whether their intended investment approach can satisfy these thresholds before committing to PPLI.

The investor control doctrine is an equally important constraint.[81] To retain the tax benefits of the insurance wrapper, the policy owner must not exercise meaningful control, direct or indirect, over the selection of specific investments within the separate account. The policy owner may select an independent investment manager, but once selected, the manager must operate with genuine independence. The IRS has ruled that even routing investment preferences through intermediaries such as attorneys or advisors can constitute prohibited investor control.

The investor control doctrine has been developed through a series of revenue rulings and private letter rulings. In Rev. Rul. 81-225, the IRS held that if a policy owner’s position within the contract was “substantially identical” to what the owner would have held outside the contract, investor control was presumed and the owner was taxed on all investment income. An exception exists where the fund is an insurance-dedicated fund not publicly available to individual investors—which is why many hedge funds now offer insurance-dedicated versions.

In Rev. Rul. 2003-91 and Rev. Rul. 2003-92,[82] the IRS confirmed that PPLI owners may allocate among a limited menu of insurance-dedicated funds without triggering investor control, but further ruled that hedge funds not exclusively offered to insurance companies are impermissible separate account investments. These rulings were followed by final Treasury Regulations (T.D. 9185, February 28, 2005) that codified the permissible investment framework.[83] In summary, underlying investments in a PPLI policy must be either insurance-dedicated funds or separately managed accounts over which the policy owner exercises no discretion or influence. Priv. Letter Rul. 200420017.

This remains an active area of IRS enforcement. The Tax Court’s 2015 decision in Webber v. Commissioner, 144 T.C. No. 17, illustrated the risk vividly: the IRS introduced extensive documentary evidence of indirect investment influence, and the policy owner lost the tax treatment for the entire policy. Attorneys advising clients on PPLI should confirm that robust governance procedures—designating an independent manager, maintaining investment separation, and conducting annual diversification reviews—are in place from the outset.

Finally, section 205 of the Consolidated Appropriations Act, 2021, amended IRC section 7702 by replacing the prior fixed statutory interest-rate assumptions used in the cash value accumulation test and guideline premium test with a more dynamic interest-rate structure tied to market rates.[84] The practical effect was to permit many newly issued cash-value life insurance policies to accept higher premiums relative to the death benefit while still qualifying as life insurance for federal income tax purposes, thereby affecting the design of whole life, universal life, indexed universal life, variable universal life, and private placement life insurance products issued after the change.[85] The amendment did not eliminate the need to monitor MEC status, guideline premium limits, policy funding, or policy performance, but it materially changed the tax-design constraints applicable to new policies.[86]

3(h)(3) PPLI Costs, Policy Design, and Lapse Risk

PPLI policies involve several layers of cost. Every policy is subject to mortality and expense (“M&E”) charges, which generally range between 0.5% and 1.1% annually—lower than most retail VUL products, though small offshore carriers tend toward the higher end. The cost of insurance (“COI”) varies based on the age, health, and sex of the insured, the amount of coverage, and the carrier’s reinsurance costs. In the aggregate, the inherent costs of a PPLI policy make it approximately 1% to 1.5% more expensive on an annual basis than a comparable taxable brokerage account.[87] For the high-net-worth investor, that cost differential is typically more than offset by the avoidance of annual income taxes on investment returns.

Because PPLI is a custom-designed product, a number of policy-specific design issues require careful attention. The policy must satisfy the definition of life insurance under IRC § 7702, and the terms should be reviewed by an actuary before purchase—particularly for offshore policies issued by smaller carriers, where qualification as life insurance for U.S. tax purposes is more uncertain. Attorneys should also ensure that loan spread provisions are favorable; in a MEC structure, cash withdrawals are taxable, making access to policy loans essential.

A further risk that is often underappreciated is force-out: if the policy’s cash value grows faster than projected, the net amount at risk may fall below the minimum required under IRC § 7702, causing excess cash value to be forced out of the policy as ordinary income. This requires ongoing monitoring by a qualified PPLI servicing agent.[88]

Perhaps the most significant and underappreciated risk in PPLI structures is policy lapse. A PPLI policy lapses when its cash value falls below the level needed to cover ongoing mortality charges and policy fees. In a leveraged structure—where a premium finance loan is outstanding at the time of lapse—the loan balance in excess of the policy owner’s cost basis becomes taxable as ordinary income, often resulting in a large, unexpected tax liability arriving at the same time the family is experiencing investment losses or liquidity pressure. The policy contract operates according to its own internal logic, independent of market conditions or the family’s circumstances. Clients and their advisors should model this scenario explicitly before committing to PPLI.

3(h)(4) Premium Financing

Many PPLI purchasers use third-party premium financing, typically through an ILIT as the borrowing entity. The economic premise is spread arbitrage: the portfolio inside the policy earns a return exceeding the loan’s interest cost, and the growing cash value eventually retires the debt. When interest rates were lower (e.g., during the years 2020–2022), such structures carried a wide and comfortable spread. By 2023, financing rates had risen materially, significantly narrowing or, in some cases, eliminating the spread.

When spread compression occurs, the loan balance compounds faster than the policy’s cash value. The lender may require additional collateral, potentially forcing the family to liquidate assets at unfavorable valuations. Attorneys involved in reviewing or drafting PPLI or premium finance documents should ensure that the governing documents address stress-tested exit scenarios: asset repositioning, policy refinancing, or performance-driven loan retirement. Structures built on optimistic assumptions, without contingency planning, have created significant financial and legal exposure for families when conditions change.

 

3(h)(5) Legislative and Regulatory Environment

PPLI has faced recurring legislative scrutiny. The Biden Administration’s FY2025 budget proposed taxing all PPLI distributions—including loans and death benefits—as ordinary income and eliminating the estate tax exclusion for PPLI death benefits. Senate Finance Committee investigators also noted a structural enforcement gap: PPLI ownership carries no specific federal reporting requirement, limiting the IRS’s systemic visibility into noncompliant structures.

PPLI reform provisions were ultimately excluded from the One Big Beautiful Bill Act, signed into law on July 4, 2025, providing a near-term legislative reprieve. However, the IRS enforcement posture under existing doctrine remains unchanged, and congressional interest in restricting PPLI as a high-net-worth tax shelter is likely to recur in future legislative cycles. Families and their advisors should not treat the current legislative environment as a permanent safe harbor.

In summary, PPLI can deliver compelling tax benefits for the right client with the right governance infrastructure. It is, however, a highly specialized and operationally demanding product. General practice attorneys who encounter PPLI in estate planning or transactional contexts should engage specialized PPLI counsel, and should be attentive to the investor control, diversification, lapse, and premium finance risks described above.

3(i) TOLI Management & Trustee Best Practices

Clearly, while there are a certain number of life insurance policy types, they can vary wildly and produce a nearly infinite range of options. Given how frequently attorneys serve as trustees for trust-owned life insurance (“TOLI”), providing counsel with some “best practice” tips is thus warranted.[89]

From a trustee’s “best practices” perspective, term insurance, because of its simplicity, requires the least amount of annual TOLI management. Naturally, the monitoring duties increase substantially for other types of policies—particularly universal life, variable universal life, indexed universal life—or any policy dependent on non-guaranteed assumptions.

At a minimum, the trustee should conduct an annual review to determine whether the policy remains suitable for the trust’s purposes, whether the death benefit remains appropriate, whether premiums are being paid as planned, whether the policy is sufficiently funded to remain in force for the insured’s projected life expectancy, whether policy loans or withdrawals are impairing performance, and whether the policy is performing consistently with the assumptions on which it was purchased. The annual review should include obtaining and reviewing an in-force illustration, current policy values, premium history, loan history, lapse-risk projections, carrier ratings, and, where appropriate, alternative scenarios using more conservative interest-crediting, dividend, subaccount-performance, or cost-of-insurance assumptions.

Recent litigation underscores that trust-owned life insurance is not a “set it and forget it” asset. In In re Stuart Cochran Irrevocable Trust, 901 N.E.2d 1128 (Ind. Ct. App. 2009), beneficiaries sued KeyBank as trustee after the trustee exchanged deteriorating variable universal life policies with a larger illustrated death benefit for a guaranteed universal life policy with a smaller death benefit. Although KeyBank ultimately prevailed, the case is instructive because the court evaluated the trustee’s conduct under prudent-investor principles and focused on whether the trustee acted reasonably based on the facts known at the time, including the risk that the existing policies could lapse before the insured’s life expectancy. KeyBank’s decision was aided by the fact that it obtained an independent evaluation from a disinterested insurance consultant before acting. The lesson for attorneys and trustees is not that every policy replacement will be protected, but that fiduciaries responsible for ILITs and other life-insurance trusts should maintain a disciplined review process, document the basis for decisions, seek independent expertise where needed, communicate material issues to appropriate parties, and take corrective action when a policy is underfunded, unsuitable, at risk of lapse, or no longer serving the trust’s objectives.

 

4. UNDERSTANDING LIFE INSURANCE RISK FACTORS[90]

The somewhat simplified goal of a life insurance company is to keep the premium dollars received invested for a period of time and at a rate of return sufficient to permit it to make a profit, while maintaining adequate reserves to provide the promised death benefit when the insured dies. This is accomplished by pricing the policy to reflect four primary risk factors that impact the insurer’s profitability.

  (1) Mortality or claims experience (based on mortality tables that usually assume all of the insured have died by age 100);

   (2) Interest/investment experience (e.g., return on the policy’s savings component, and the return on the insurance company’s general account investments);

  (3) Lapse rates; and,

  (4) Loading/expenses (insurance company business expenses such as actuarial design, marketing expenses, sales commissions, costs of underwriting, administrative expenses, etc.).[91]

Since each risk factor affects the pricing of, and the amount of premium needed to sustain, a policy, each risk factor should be viewed as an independent and dynamic part of the insurance contract.[92] Prior to the 1980s, life insurance companies absorbed the risk factors and sold policies with fixed guarantees as to cost, cash values, and death benefit. In other words, the policies guaranteed a specified death benefit and cash value in exchange for payment of a fixed, lifetime premium. In the last thirty years, increased competition in the financial services industry has resulted in available policies evolving into financial products whose death benefit and cash values parallel other contemporary financial instruments, e.g., universal life, variable life, and variable universal life. In large measure, contemporary life insurance policies differ from one another in how the risk factors interact and the extent to which these policies result in the risks being retained by the life insurance company, shared with the policy owner or passed along to the policy owner.[93] In many products, the insured assumes risk in return for potential investment reward. Unfortunately, the insured all-too-often is either unaware of the risks, fails to realize the full extent of his or her exposure, or does not adequately monitor the risk and policy performance over time.

4(a) Mortality Risk

Mortality[94] risk is the likelihood of the insured dying in a particular year. Statisticians are unable to determine individual mortality but can predict mortality with great accuracy for large groups of individuals. For example, the probability that a 40-year-old male non-smoker in good health will die within 20 years is 10%, while the probability that a 60-year-old male non-smoker in good health will die within 20 years is 50%. Such statistics are often referred to as mortality or life expectancy tables. Insurance companies refer to such statistics as mortality experience or claims experience.

If the majority of persons insured by a company survive to the age indicated in the life expectancy tables, the life insurance company has an average mortality or claims experience. If the majority of insured survive longer than indicated in the tables, the life insurance company has a better than average mortality or claims experience, i.e., a lower mortality experience. A life insurance company that has average or better than average mortality experience should theoretically be more profitable than a company that has below average mortality experience. If a majority of the insureds die sooner than indicated in the life expectancy tables, the insurance company has a below average mortality or claims experience, i.e., a bad or worse mortality or claims experience, and is paying death claims sooner than anticipated, and the company may be less profitable.

4(a)(1) Do The Mortality Assumptions Reflect The Life Insurance Company’s Actual Experience?

It is important to determine if the mortality assumptions in the illustration represent the actual mortality experience of the life insurance company; and if not, inquire as to why. (Additionally, you may also want to ask for a copy of industry-standard tables as a method of comparison). Some insurance illustration software includes an annual decline in mortality experience, based on assumed improvements in medical care. Ask if the illustrations assume future mortality improvements. If so, obtain an alternative illustration that does not incorporate such ongoing mortality improvements so that the effect of such assumptions on the premium will be clearly identified. If two life insurance companies provide illustrations and there is a substantial spread in the mortality assumptions, what facts—such as stricter underwriting—justify the assumption that one company will have lower mortality experience than the other? If the life insurance company claims that strict underwriting is responsible for lower than average mortality experience, does actual experience match the assumed mortality rate?

If mortality or claims experience is worse than illustrated, the life insurance company’s increased costs can be passed along to the policy owner. In a term life insurance policy, adverse mortality or claims experience can be passed along by adjusting the illustrated premium up to, but not in excess of, the higher guaranteed premium. In most permanent products (other than variable products), the life insurance company is able to pass along adverse mortality experience through a decrease in the crediting rate or dividend rate (but not below the guaranteed rate). The life insurance company can also pass along its adverse mortality or claims experience through increased mortality charges (“cost of insurance” or “COI” charges) up to the guaranteed maximum charges as stated in the policy.

4(a)(2) Cost of Insurance Increases and Related Litigation

In recent years, a number of life insurers have increased current cost-of-insurance (“COI”) rates on in-force universal life insurance policies. These increases often affected policies that had been sold, illustrated, or maintained for many years on the assumption that current COI rates would remain at the then current rates stated in the policy. Although many policies permit insurers to change current COI rates within contractual limits, policyholders have challenged increases where they contend that the insurer used the COI mechanism for purposes not permitted by the policy, such as recouping past losses, improving profitability, offsetting lower-than-expected investment returns, subsidizing other blocks of business, or loading non-mortality expenses into a charge that the policy language tied to mortality-related factors.[95]

The resulting litigation has focused heavily on the words of the particular policy. Some policies provide that COI rates are “based on” expectations as to future mortality experience or other enumerated factors; others contain broader or different language. Courts have therefore been asked to decide whether those listed factors are exclusive, whether insurers may consider profit, expenses, persistency, reinsurance, capital, or prior losses, whether COI changes must be applied uniformly to insureds in the same class, and whether the implied covenant of good faith and fair dealing limits the insurer’s discretion even where the policy gives the insurer room to adjust current rates. These cases do not stand for the proposition that every COI increase is unlawful. They do, however, demonstrate that a COI increase is not merely an actuarial adjustment; it may become a contract, disclosure, fiduciary, and litigation issue, particularly where the increase threatens the continued viability of policies purchased for long-term estate, business, or trust planning purposes.[96]

The practical consequences of a COI increase can be severe. Increases frequently occur late in the policy’s life, when the insured is older, replacement coverage may be unavailable or prohibitively expensive, and the policy owner may already have paid premiums for many years in reliance on prior projections. A policy that appeared adequately funded may suddenly require substantial additional premiums. A trustee may be forced to seek additional gifts or contributions to prevent lapse. A policy intended to be held until death may instead lapse, eliminating the intended death benefit and, in some circumstances, triggering adverse income tax consequences if the lapse occurs with outstanding loans or gain in the policy.

For attorneys, trustees, and policy owners, the lesson is that non-guaranteed COI rates should be treated as a material policy risk. Ongoing review should include annual in-force illustrations using current assumptions and guaranteed assumptions, together with stress-tested scenarios where appropriate. If an insurer announces a COI increase, the policy owner or trustee should promptly review the notice and policy language, obtain updated projections, determine the additional premium needed to maintain the policy to the desired maturity or life expectancy, evaluate alternatives, and preserve all communications, illustrations, annual statements, and notices relating to the increase. In the trust context, this review should be documented as part of the trustee’s ordinary fiduciary administration of the policy.

4(a)(3) Who Bears The Mortality Risk Depends On The Contract[97]

  • Traditional Whole Life. The policy owner bears the mortality risk (through reduced dividends or a reduced crediting rate), but only up to the maximum amount specified in the contract. The insurance company bears any excess mortality risk.

  • Universal Life. The policy owner bears the mortality risk (through increased charges), but only up to the maximum amount specified in the contract. The insurance company bears any excess mortality risk.

  • Variable and Variable Universal Life. The policy owner bears the mortality risk (through increased charges), but only up to the maximum amount specified in the contract. The insurance company bears any excess mortality risk.

4(b) Interest/Investment Risk

Interest/investment risk is the risk that the life insurance company’s general investment account or the policy’s cash value will earn less than initially projected. The life insurance company’s investment experience directly affects the interest or dividends credited to cash value policies. Whether the life insurance company’s investment experience is a major risk factor depends on the type of policy. At one extreme, the typical term policy, which has no cash value, is not dependent on the life insurance company’s investment experience, except to the extent that investment performance affects the continued viability of the life insurance company or causes the company to increase premiums to the maximum allowed in the contract. At the other extreme, variable policies, such as variable life and variable universal life, pass the entire investment risk to the policy owner if the cash value component is invested in a non-guaranteed investment subaccount. In between these are general account cash value policies, such as whole life and universal life policies. For these, the life insurance company guarantees a minimum crediting rate, usually between 2 and 3 percent. On the other hand, higher crediting rates are almost always used to illustrate projected policy performance, particularly in “vanishing” premium illustrations. The life insurance company bears the risk involved in meeting the guaranteed crediting rates. Most or all of the risk in meeting the higher illustrated rates are shifted to the policy owner. Investment risk affects not only the crediting rate of the policy’s cash value account but also the safety of the underlying principal. Accordingly, it is necessary to determine the degree of market risk the insurance company is assuming with invested assets.

4(b)(1) Who Bears The Interest/Investment Risk Depends On The Contract[98]

  • Traditional Whole Life. The life insurance company bears the interest/investment risk up to the guaranteed cash value of the policy.

  • Universal Life. The life insurance company bears the interest/investment risk up to the policy’s minimum crediting rate guarantee.

  • Variable and Variable Universal Life. The policy owner bears all the interest/investment risk, except on cash value allocated to the guaranteed interest account.

 

4(c) Lapse Risk

Lapse risk is the risk that the policy owner will surrender or cancel the policy before the life insurance company has recouped its initial costs of placing the life insurance coverage. Thus, lapse risk deals with the number and timing of policy surrenders and cancellations. Low lapse rates[99] tend to increase an insurer’s profitability.[100] Insurance companies charge underwriting costs, commissions and establish first year cash values in the year the policy is issued rather than amortizing those costs over future years. This results in the life insurance company losing money in the first year. Thus, if a policy lapses before the life insurance company recovers its policy acquisition costs (commissions, underwriting, allocable share of administration expenses, etc.) the company will incur a loss. Life insurance companies with low lapse rates are able to recover first year costs over the lifetime of the policy. Moreover, most lapses in early policy years are by persons who are confident of their ability to obtain new insurance; few persons who are uninsurable or suspect future health problems permit policies to lapse. So a high early lapse rate is a warning sign that the insurance company may be incurring a higher than normal rate of loss. Companies with low lapse rates, on the other hand, retain a higher proportion of insured, and the company should, theoretically, be more profitable.

4(c)(1) Who Bears The Lapse Risk Depends On The Contract[101]

  • Traditional Whole Life. The life insurance company bears the lapse risk, and hedges that risk by providing a low initial cash value in the policy.

  • Universal Life. The policy owner bears the lapse risk up to the amount of the policy’s surrender charges.

  • Variable and Variable Universal Life. The policy owner bears the lapse risk up to the amount of the policy’s surrender charges.

4(d) Expense Risk

Expense[102] risk is the risk that costs of administering the life insurance product will be greater than initially anticipated by the life insurance company. Expense risks are borne similarly to mortality risks. All policies have maximum expense charges as a contractual provision. The policy owner bears the expense risk up to the maximum amount specified in the contract; the life insurance company bears the expense risk in excess of that amount. The life insurance company’s overhead is the least important part of the four risk factors enumerated in section 4(a), above. Mortality and investment performance have a greater impact on a life insurance policy’s performance. However, poor management practices can result in a decreased crediting rate on the policy’s cash value account. The life insurance company’s expenses are reflected in the discussion of earnings in most life insurance company rating reports.

4(d)(1) Who Bears The Expense Risk Depends On The Contract[103]

  • Traditional Whole Life. The policy owner bears the expense risk (through reduced dividends or a reduced crediting rate), but only up to the maximum amount specified in the contract. The insurance company bears any excess expense risk.

  • Universal Life. The policy owner bears the expense risk (through increased charges), but only up to the maximum amount specified in the contract. The insurance company bears any excess expense risk.

  • Variable and Variable Universal Life. The policy owner bears the expense risk (through increased charges), but only up to the maximum amount specified in the contract. The insurance company bears any excess expense risk.

 

5. UNDERSTANDING LIFE INSURANCE POLICY ILLUSTRATIONS

After a life insurance company has been selected, “illustrations” are presented for various policies. What do these illustrations mean and how do you make sense out of them?[104]

5(a) How Illustrations Work

A life insurance illustration is a scenario based on a specific set of assumptions involving the company’s anticipated mortality experience, lapse rate, investment performance, and expenses. However, the assumptions are usually not guaranteed by the insurance company and the risk of non-performance is borne by the policy owner, as discussed above. In other words, a life insurance illustration is simply a tool to “illustrate” how the policy will work; it is not predictive. For example, an illustration showing the performance of a policy based on a 9% crediting rate illustrates the cost and performance of that policy, but only if the company’s expenses and earnings meet a specified goal each year and the company’s mortality or claims experience is at least as good as projected. However, the insurance company does not guarantee that claims, expenses, and investment experience in the future will be as shown in the illustration.[105]

As a practical matter, the insured and any trustee overseeing a TOLI should be certain to carefully review the entire illustration, not just an excerpt of it (and, for variable policies, the prospectus).[106] The illustration will state, usually in the lower margin, its total number of pages. Review or reliance on only selected portions of the illustration may lead to serious misconceptions. Critically, an illustration is not a substitute for the actual policy. For the more cautious policy owner, a specimen life insurance policy (and its applicable riders) should be reviewed before making a final purchase decision. The life insurance policy is the contract between the parties and it is the document that the policy owner should rely on for a clear statement concerning what premiums, death benefits and cash values are guaranteed.[107]

In this regard, a “Monte Carlo” simulation can be a useful supplement to a traditional life insurance illustration because it does not assume a single constant credited rate or a single projected outcome. Instead, the policy is modeled across hundreds or thousands of potential future market-return sequences, using assumptions regarding volatility, caps, participation rates, floors, spreads, policy charges, premiums, loans, and withdrawals. The result is not a prediction, but a probability distribution showing how often the policy remains in force, lapses, requires additional premium, supports projected loans or withdrawals, or produces the intended death benefit under varying market conditions. This is particularly helpful for indexed universal life and variable universal life policies because the order of returns, not merely the average return, can materially affect policy performance. A policy that appears sustainable under a static illustration may perform poorly if weak crediting years occur early, if caps or participation rates are reduced, if loans compound faster than credited interest, or if policy charges increase as the insured ages. Thus, Monte Carlo analysis can help attorneys, trustees, and policy owners evaluate not only the illustrated outcome, but the range of reasonably possible outcomes and the policy’s margin for error.

5(b) What Happens If The Assumptions In Illustrations Are Not Realized?

If the company’s claims, expense, and investment experience in the future are worse than illustrated, one of two possible scenarios will generally result:

(1) Either the company reserves the right to increase the costs it will charge for the policy, up to a guaranteed maximum; or,

(2) The premium will remain level, but the number of years that the premium must be paid will increase.

5(c) Look For A Guaranteed Maximum Period

Most insurance illustrations contain footnotes or other annotations that should divulge whether the premium being illustrated is the guaranteed maximum. If the illustrated premium is not the guaranteed maximum, or if the illustration does not permit you to determine the guaranteed maximum, a new illustration should be prepared that sets forth this information.

5(d) Look Out For Excessive Optimism

When reviewing an illustration, bear in mind that the illustration assumes that the life insurance company will attain a specific profit goal and will credit a general account policy with a certain dividend level or percentage rate of return for the life of the policy. Always ask for an alternative illustration with reductions of 100 basis points (i.e., 1%) in the crediting rate or dividend rate and 200 basis points (i.e., 2%) in the crediting rate or dividend rate. Research and identify the insurance company’s current net return. If the illustration for a general account policy is projecting a higher crediting rate or dividend rate than what the life insurance company is currently earning, request a written explanation for this optimistic forecast.

5(d)(1) New Money Or Portfolio Basis

Determine whether the rate of return that the life insurance company is earning is being computed using a portfolio or a new money basis. The portfolio approach takes into consideration all assets, while the new money approach looks to the rate at which the carrier can currently invest assets. If interest rates are declining, the portfolio approach tends to overstate probable future earnings since older assets that are producing a higher rate of return tend to average out the declining interest rates on new investments. If the market is rising, the new money approach tends to exaggerate the company’s earnings since new investments will not be burdened with the lower overall return of the company’s older assets that are producing a lower rate of return. You must accordingly ask some questions, especially if the policy being illustrated appears much less expensive than competing policies and other factors, such as blending, are equal.

 

 

* Based on the original work of the late Sebastian Grassi, with updates and revisions by Robert Adler and Joseph Gentile. The authors gratefully acknowledge Sebastian’s meticulous research and clear writing, and are privileged to preserve and build upon his efforts.

       Robert Adler is the founder of Adler & Adler, PLLC, and is admitted to practice in New York, New Jersey, Maryland, and the District of Columbia. He advises individuals and families on wills, trusts, estate planning, high-net-worth estate tax planning, asset protection, business succession, and estate administration. Robert is known for combining technical expertise with a clear, practical approach to counseling clients. More information is available at https://www.adlerandadler.com.

      Joseph Gentile is a member of the Bar of the State of New York and a co-founding partner of Sarraf Gentile LLP (www.sarrafgentile.com) where he has litigated insurance and complex financial disputes including class actions involving policy misrepresentations, unsuitable policy designs, and contractual breaches. The lawsuits in which he represented policyholders include In re State Farm Cost of Insurance Litigation, which resulted in a $325 million recovery for policyholders, and In re Lincoln National COI Litigation, which resulted in a recovery of more than $117 million. Joe is also a licensed insurance agent and the chief strategist at Left Tail Risk Advisors (www.ltrallc.com), an insurance advisory and consulting firm. He holds both the CLU® (Chartered Life Underwriter) and CLTC® (Certified in Long-Term Care) designations and previously served as a life insurance agent with one of the country’s largest mutual insurers. He is a FINRA-approved arbitrator, a former licensed securities representative who passed the Series 7 and Series 66 examinations, and a graduate of Fordham University and Boston College Law School.

[1] The authors acknowledge the contributions of Jon J. Gallo, Esq. of Greenberg Glusker Fields Claman Machtinger & Kinsella, LLP, Los Angles, California; Gary R. Lee, Esq. LLM (Tax), CPA, CFP of Deloitte & Touche, LLP of Boston, Massachusetts; Jane A. Hays, Esq., CLU of The Downey Group, Inc., of Champaign, Illinois; Craig A. Wilkey, MBA, CLU, ChFC of Financial Architects Partners of Boston, Massachusetts; Leslie C. Giordani, Esq. of Giordani, Schurig, Beckett & Tackett, LLP of Austin, Texas; Douglas W. Stein, Esq. of Barris, Sott, Denn & Driker, PLLC of Detroit, Michigan; and Stephan R. Leimberg, Esq. of Bryn Mawr, Pennsylvania. See Jon J. Gallo, “Life Insurance Due Diligence for Dummies: What the Attorney Preparing a Life Insurance Trust Ought to Know,” 44 The Practical Lawyer, 75 (September 1998), portions of which have been reproduced, edited and modified with the permission of Jon. J. Gallo, Esq. and ALIABA; Jonathan C. Blattmachr, “Some Fundamental and Fine Points in Uses of Life Insurance in Estate and Financial Planning,” 37 Heckerling Institute on Estate Planning, Chapter 2 (Matthew Bender/Lexis-Nexis, Newark, NJ 2003); Harold L. Wilshinsky, “Life Insurance Products For The High-Net-Worth Client,” 135 Trusts & Estates 56 (October 1996) (“Wilshinsky”); Malarkey and Leimberg, “Innovative Planning With ‘No Lapse Guarantee’ Life Insurance,” 32 Estate Planning 3 (July 2005) (“Malarkey and Leimberg”); Leimberg and Doyle, Tools & Techniques of Life Insurance Planning— 3rd Edition, The National Underwriter Company, Cincinnati, Ohio (2004), www.nuco.com (“Leimberg & Doyle”); Chapter 1 of Zaritsky and Leimberg, Tax Planning With Life Insurance Analysis With Forms-2d Edition, Warren Gorham & Lamont, Boston, Massachusetts (Supp. 2007) (“Zaritsky and Leimberg”); Lee and Wilkey, 827 T.M., Life Insurance—A Practical Guide for Evaluating Policies, Bureau of National Affairs, Washington, DC (“Lee and Wilkey”); Chapters 1, 8, 9, 10, and 11 of Ben G. Baldwin, The Lawyer’s Guide to Insurance (Personal Insurance Coverage for Professionals and Their Clients), American Bar Association, Chicago, Illinois (1999) (“Baldwin”); and ¶4.04 of Jonathan D. Pond, Personal Financial Planning Handbook: With Forms & Checklists (Warren, Gorham & Lamont, Boston, Massachusetts) for more detailed information about the different types of life insurance products that are available. See also Stephan R. Leimberg and Albert E. Gibbons, “Performing Due Diligence With Respect to Life Insurance Trusts Is Crucial,” 30 Estate Planning 248 (May 2003); and Brody, Richey, and Baier, 828 T.M., Compensating Employees with Insurance (Bureau of National Affairs, Washington, DC) (“Brody, Richey and Baier”).

[2] This paper discusses legal, fiduciary, tax, insurance, and financial concepts that frequently arise in connection with life insurance, including issues that may be the subject of past, ongoing or prospective legal disputes. It is intended solely for general educational and informational purposes and should not be relied upon as legal, tax, fiduciary, insurance, investment, or financial advice with respect to any particular policy, transaction, trust, estate plan, dispute, claim, or client matter. Readers should consult their own qualified legal, tax, insurance, and financial advisors before acting or refraining from acting based on any discussion in this paper. The views, descriptions, examples, and summaries in this paper do not express, and should not be attributed to, the personal views, litigation positions, client positions, or institutional views of the authors, their law firms, their clients, or any affiliated entities. The authors and/or their law firms are, have been, or may in the future be involved in litigation or advisory matters involving insurance products, policy illustrations, cost-of-insurance charges, policy performance, carrier conduct, fiduciary obligations, suitability, best-interest obligations, premium financing, and other issues discussed in this paper. Nothing in this paper is intended to comment on, prejudge, concede, waive, or preserve any argument, position, defense, claim, or issue in any pending or future matter.

[3] Today, there is no “right” life insurance product or even a fixed number of product types. While this paper discusses the principal product types with a focus on the five most common – term, whole life, universal life, indexed universal life and variable universal life (see Table 1, below) – there are an infinite number of variations. “Where diversification is warranted, certainly each type should be seriously considered. Where diversification is not appropriate, the agent and other advisors must take into account the client’s personal investment philosophy, his or her gift tax status, cash flow capabilities and health condition in determining policy suitability.” Wilshinsky at 70.

[4] “Permanent” insurance is a misnomer since some “permanent” policies can (and are designed to) last for a finite period of time. Steve Leimberg and Timothy Malarkey suggest that the correct nomenclature is “cash value” insurance (for what has been traditionally referred to as “permanent” insurance). Malarkey and Leimberg at 4. Term insurance deals with the “If I die situation.” Permanent insurance, on the other hand deals with the “When I die situation.” Typical cash value life insurance policies include, whole life, universal life, indexed universal life and variable universal life, all of which are discussed in section 3, below. Term insurance has been compared to renting a house—the policy owner can never build up any equity in the policy. Permanent insurance has been compared to owning a house—the policy owner can usually build up equity in the policy.

[5] See Burke A. Christensen, “Life Insurance: The Under-appreciated Tax Shelter,” 135 Trusts & Estates 57 (November 1996). Additional federal income tax advantages of cash value life insurance include: (1) income tax free death benefit; (2) tax deferred growth of cash values; (3) payment of premiums with pre-tax dollars; (4) tax free withdrawals; (5) tax free loans; and (6) tax free repayment of loans at death. Id. at 58.

[6] For a non-resident non-domiciled individual, a life insurance death benefit is free of any estate tax, even without an ILIT.

[7] “Independent academic research, however, suggests that it is not possible to construct reliable models for prediction of carrier insolvency….” Kathryn A. Ballsun, Patrick J. Collins, and Dieter Jurkat, “Evidencing Care, Skill and Caution in The Management of ILITs (Part 3 of 4),” 32 ACTEC Journal 145 (Fall 2006).

[8] Baldwin at 22-23. See Worksheet 5 of Lee and Wilkey for a sample life insurance broker questionnaire.

[9] See, e.g., James D. Schwartz, Gordon W. Netzorg, and Susan Bernhardt, “Due Diligence in Life Insurance Selection,” 8 Probate & Property 39 (March/April 1994).

[10] Glenn S. Daily, “Danger: Fiduciary Liability Ahead,” (May 10, 2004), http://www.glenndaily.com/fiduciaries.htm.

[11] Id.; see also Regulation 187 – Suitability and Best Interest in Life Insurance and Annuity Transactions (https://www.dfs.ny.gov/apps_and_licensing/life_insurers/guidance_Reg187_Filings).

[12] When life insurance policies are compared on the basis of “risk” to the policy owner, the definition of “risk” usually involves the amount and duration of premiums. However, a more practical definition of “risk” will also incorporate the policy’s ability to adapt to the policy owner’s changing circumstances. Under this broader definition of “risk,” life insurance products thought to be the least risky because of their guarantees may turn out to be the riskiest because of the policy’s inflexibility; and products thought to be riskier because of their lack of guarantees may be less risky and more suitable in adapting to the policy owner’s changing needs. To control the level of risk in a non-guaranteed product, the product’s performance and appropriateness must always be monitored.

[13] Major life insurance company rating services are: A.M. Best Company (www.ambest.com), Moody’s (www.moodys.com), Standard & Poor’s (www.standardandpoors.com), Fitch (www.fitchratings.com) and Weiss Research (www.weissratings.com). Many of these companies’ ratings are published annually in The Insurance Forum (www.theinsuranceforum.com). Generally, Moody’s and Weiss are the toughest raters.

Superior track records in the insurance industry are as ephemeral as those in the money management industry. This should not be surprising because insurance carriers invest in the same capital markets as other institutional money managers; and, it is rare in even moderately efficient markets to find investments that offer more than zero net present value when properly adjusted for their risk. Just as the persistence of abnormal returns generated by top ranked money managers into future periods is often no better than chance, so also, the predictability of investment results from insurance carriers is low. Indeed, modern portfolio theory suggests that the best track record may merely reflect the fact that the winner assumed the highest amount of risk (and was fortunate enough to have the bets pay off during the period under evaluation).

Kathryn A. Ballsun, Patrick J. Collins, and Dieter Jurkat, “Standards of Prudence and Management of the Insurance Portfolio (Part 2 of 4),” 32 ACTEC Journal 66, 84 (Summer 2006). (Citation omitted.)

[14] Examples of mutual life insurers include: New York Life, Northwestern Mutual, MassMutual, Guardian Life, and Penn Mutual.

[15] Examples of fraternal benefit societies include: Thrivent, Knights of Columbus, Modern Woodmen of America, Royal Neighbors of America, Catholic Financial Life, Gleaner Life Insurance Society, Sons of Norway, and Woman’s Life Insurance Society.

[16] The increasing convergence of life insurance, private credit, asset management, and offshore reinsurance has received substantial regulatory and rating-agency attention. The NAIC has noted that life insurers are significant participants in private credit markets because long-duration private credit assets may match long-duration insurance liabilities, but it has also emphasized the need for regulatory attention to asset valuation, liquidity, complexity, affiliated transactions, and the risk characteristics of private credit and structured investments. AM Best has likewise observed that affiliated and offshore reinsurance are widely used by life and annuity insurers to manage capital efficiency, risk diversification, and earnings volatility, while also noting that private-equity- and asset-manager-backed insurers have materially contributed to the industry’s increased use of affiliated investments and offshore structures. See NAIC, Private Credit Issue Brief; NAIC, Private Credit—Insurance Topics; AM Best, Shifting Tides in U.S. Life/Annuity Industry Include Dropoff in Offshore Reinsurance Deals (Mar. 3, 2026); AM Best, Private Equity and Asset Managers Are Driving Growth in Affiliated Investments (Dec. 11, 2025). See also U.S. Dep’t of the Treasury, Federal Insurance Office, Annual Report on the Insurance Industry (Sept. 2025) (discussing offshore reinsurance and private-credit-related developments).

[17] See Table 1, below, for a chart that compares and contrasts the general features of term life, whole life, universal life, indexed universal life and variable universal life insurance policies. See also “Menu of Life Insurance Products” at 183 of Baldwin; and Figures 1.3, 18.3, and 18.4 of Leimberg and Doyle at 13-14, 283 and 284.

[18] See Chapter 16 of Leimberg & Doyle; and ¶1.02 of Zaritsky and Leimberg.

[19] “Cost of insurance charges (COIs) . . . to cover the insurer’s anticipated payments for death claims. They are the largest single cost of any policy, typically accounting for about 75% of total premiums. (Indeed, if claims are not the largest single cost factor, then the product probably isn’t really insurance against the risk of death.) These deductions are much like term life insurance premiums in that they are predominantly for claims paid during a given period (typically 1 year). For this reason, COIs are frequently referred to as the pure ‘risk’ portion of the premium, reimbursing the insurance company for the risk associated with paying the death benefit. Because the risk of death increases with age, so does the COI. COI is calculated each year using two factors: the net ‘at-risk’ amount [i.e., the NAR] of the policy death benefit and a COI rate provided by the insurance company for each age corresponding to each policy year for each product. The net at risk amount is multiplied by the rate to determine the COI; the higher the death benefit or the rate, the greater the COI and therefore the higher the premium. For example, assume an insurance company provides permanent life insurance for a group of 1,000 policyholders whom all are insured for $100,000 and three (3) insureds out of the group of 1,000 die in a given year. The insurance company pays $300,000 to the beneficiaries of those three insureds. The insurance company must therefore collect $300 from each policy owner over the course of the period in order to pay this $300,000. The COI Rate would equal $3.00 per $1,000 of death benefit (i.e. each insured paid $3.00 multiplied times 100 for each $1,000 of death benefit). Of course, as the average age of the population increases, the risk of more deaths increases and so does the COI and therefore the premium.” Christopher P. Cline and Barry D. Flagg, “Fiduciary Pitfalls with Trust-Owned Life Insurance,” American Bankers Association Teleconference Meeting 8 (August 24, 2006). “The medical underwriting and the proposed insured’s rating will affect the COI.” Douglas Moore and Mitchell K. Higgins, “Planning and Investing With Private Placement Life Insurance” 30 Estate Planning 336, 340 (July 2003).

[20] “The NAR is, of course, not the entire death benefit, but only the amount of the insurance company’s money your beneficiary gets if you die while the policy is in force. Death benefit amounts in excess of the NAR are either: (i) money the policy owner has paid into the policy or (ii) money earned by the policy owner’s money. A term insurance policy is nearly all NAR because it has no cash value. A cash-value life insurance policy with a $100,000 death benefit and a $60,000 cash value has only $40,000 of NAR….” Burke A. Christensen, “Life Insurance: The Under-appreciated Tax Shelter,” 135 Trusts & Estates 57 (November 1996). Thus, NAR = policy death benefit amount – policy cash value.

[21] “In addition to COI and M&E, there are two separate taxes associated with obtaining a domestic life insurance policy. First, the federal deferred acquisition cost (DAC) tax is applied to each premium payment. Each carrier calculates the DAC tax and may pass through different levels of DAC tax charge to the policy owner. This tax cannot be avoided. The second tax is a state premium tax. Each state imposes its own premium tax. This tax varies considerably from state to state. Some carriers charge ‘state specific’ taxes, while other carriers charge a level amount for all states. This can have a dramatic effect on premium tax costs. Hence, the state in which the policy is issued may be an important factor. States such as Delaware, South Dakota, and Alaska have premium tax rates that tend to be more favorable than those of many other states. The return on the investments of the policy is then reduced by traditional investment management fees and administration expenses of the fund managers that would ordinarily apply. The better the investment performance, the less significant the COI and M&E are to the overall return.” Douglas Moore and Mitchell K. Higgins, “Planning and Investing With Private Placement Life Insurance” 30 Estate Planning 336, 340 (July 2003).

[22] The notion of “buy term insurance and invest the difference” can be accomplished in two ways. The first way is to buy term insurance and invest the premium savings in the financial markets, and hope for the best. The second way is to buy permanent insurance. The second way is the preferred method for long term life insurance coverage since the permanent product is doing exactly what the insured desires—the insured is buying term insurance (the risk portion) and investing the difference (the cash value component). Some of the key differences between the first and second method is: (i) the first method is a voluntary saving method, whereas the second method is a forced method of savings (assuming the policy owner refrains from borrowing against or withdrawing cash from the policy), (ii) under the first method the insured assumes all the risk with regard to the investment, whereas under the second method, the investment risk can, depending on the policy, be shifted to the life insurance company, (iii) under the first method the insured is always using after-tax dollars to purchase term insurance coverage, whereas under the second method the insured can use “tax free” dollars to purchase term coverage, (iv) under the first method the investment may be subject to capital gains or income tax if the insured liquidates some of his or her investments before death (or after death under a carry-over income tax basis regime), whereas under the second method the insured may be able to make “tax free” withdrawals (up to basis), and the insured’s beneficiaries can receive the death proceeds income tax free (and death tax free if the policy is owned by an ILIT), and (v) under the first method, if the insured dies after the term insurance coverage ends, there will be no death benefit—only the investment monies (if any).

[23] Term life insurance is an inexpensive way to replace lost income due to the premature death of a wage earner (such as a working spouse-parent), or as an inexpensive way to provide income to pay for the cost of a replacement caregiver if the primary caregiver (such as a non-working spouse-parent) dies prematurely. Because term life insurance is designed for a specified term of years—it is not designed to provide an inheritance. Permanent life insurance that provides a cash surrender value, such as whole life, universal life, or variable universal life is, however, designed to replace lost income and to provide an inheritance. “Term insurance is indicated when the need for life insurance is temporary, when the largest possible amount of coverage is desired for a given amount of annual cash outlay, when the need is intermediate or long-term but the buyer’s cash flow is currently insufficient to purchase the needed coverage under a higher premium permanent policy, when the policy owner has better investment opportunities outside the insurance policy than inside it, and as a ‘rider’ when additional death benefits are desired in conjunction with cash value life insurance or ‘packages’ of policies.” Malarkey and Leimberg at 4.

[24] A prospective purchaser should always determine: (1) Whether the policy is convertible to all of the life insurance company’s cash value products (whole life, variable life, universal life, and variable universal life) or just certain of those products, and are those products attractively priced? If not, the conversion rider will be of limited value. (2) How long is the conversion feature is valid? This can be a trap for the unwary, particularly the younger insured who may ordinarily decide to convert at an age that is well beyond the policy year mandated by the contract. (3) Will the conversion be done at the same underwriting classification as the term policy for the entire amount of the new policy, or will evidence of insurability be required at the time of the conversion? (4) What credits, if any, will the life insurance company offer for converting to a cash value policy? (5) Will the life insurance company permit a conversion when a disability waiver of premium is in effect and will it apply the waiver to the new policy?

[25] These and other types of term and permanent  life policies can be sold, for cash, as a “life settlement,” the market for which is now mature and robust, but beyond the scope of this paper.

[26] According to Wilshinsky:

Advantages Of Whole Life Insurance: (1) It guarantees a level premium, minimum cash value and minimum death benefit. (2) The quasi-compulsory nature of whole life (pay the premiums when due or else the policy lapses) removes the temptation to skip premium payments, which can result in future funding problems. (3) Because a whole life premium is fixed, policy owners can be more certain about cash flow planning. (4) Policy owners are not involved with the personal management of the underlying investment assets. The insurer’s bond and mortgage portfolio of assets held in the general account is managed by investment professionals and is intended to provide relatively stable results. (5) Because it is a relatively simple product to administer, whole life may tend to have somewhat lower long-term expenses than variable life, although its initial charges are often higher.

Disadvantages Of Whole Life Insurance: (1) Because conservative assumptions are used with a whole life policy, its premium level, while guaranteed, is high compared to the potential cost of a universal life or variable universal life policy. Blending term with whole life can bring the initial premium more in-line. However, as more term insurance is used, the guarantees of whole life weaken. Furthermore, few insurance companies guarantee their term rates on this rider and the paid-up additions that are intended to replace the term insurance are based on dividends that are also not guaranteed. (2) There is much less premium flexibility with whole life than with universal life or variable universal. (3) Whole life does not have the capability for face amount increases or decreases. If additional coverage is needed, a new policy has to be bought, generally resulting in duplicative charges. (4) The whole life contract is a bundled product using a black-box approach. The policy components are not clearly defined which makes it more difficult for the policy owner to analyze the reasonableness of the underlying policy design assumptions in the sales illustration. (5) Since it has no investment options, whole life provides no investment flexibility to policy owners.

Wilshinsky at 57 (citations omitted).

[27] All permanent insurance has two components: (1) a term (i.e., the net amount at risk (“NAR”)) component, and (2) and a cash value (i.e., the investment) component. Thus, all permanent life insurance is term insurance coupled with an investment component.

[28] According to Lee and Wilkey,

In many ways, cash value is the measure of product stability and an indicator of the viability of the product in terms of being able to deliver long term performance. Although it may be tempting to structure a policy with a minimum of cash to maximize the internal rate of return on the death benefit, unless there is a premature death, contracts funded at lower premium levels generally provide lower future values and are more prone to lapse. In most policies cash value growth serves a dual role of enhancing policy performance by reducing the net amount at risk in a policy—the pure death benefit amount against which insurance charges are applied. The one exception is for increasing death benefit universal life products (option B) where the net amount at risk remains level throughout the life of the product. Finally, the cash value represents the policy asset value that can be exchanged for a new policy if the policyholder becomes dissatisfied with the current carrier. A policy can be terminated for the cash surrender value or the cash surrender value can be used in a §1035 exchange to obtain another life insurance policy or an annuity product.

Lee and Wilkey, § V, B, 3, a.

[29] See Chapter 13 of Leimberg & Doyle; and ¶1.03 of Zaritsky and Leimberg.

[30] Some whole life policies have a modified premium format, whereby the premium increases by 50% or 100% in the 11th or 16th policy years, respectively.

[31] A participating whole life policy may earn dividends. Dividends reflect better investment, mortality and expense results than are used in determining the premium, i.e., they are the “surplus” or profit of the insurance company. For a whole life policy sold by a life insurance mutual company, the dividend is distributed to the whole life policy holders as owners of the mutual company itself.  Dividends are considered a tax free return of premium to the extent they do not exceed the premiums paid into the policy. Dividends are not guaranteed. The dividends can generally be applied in several ways: (1) be paid in cash to the policy owner; (2) be used to reduce the next premium payment; (3) purchase paid-up (single premium) additional insurance coverage; (4) be held by the carrier in an interest bearing account for the benefit of the policy owner; (5) be used to purchase units of one year term insurance (typically equal to the cash value amount in the policy), and (6) be used to reduce policy loans. Dividends are most commonly used, however, to purchase paid-up additional insurance coverage that will increase the death benefit or to reduce the premiums with the death benefit remaining level. It is the paid-up additions that generate values and death benefits in excess of those guaranteed by the policy.

[32] A great virtue of whole life is that once the dividends comfortably exceed the (fixed) premium, they can be used to reduce the premium and then buy paid-up additions. The insured can be fairly certain that while no further premiums will be required, the values and benefits will continue to grow. Cash payment of premiums can actually become unnecessary earlier if policy values and dividends can meet the required premiums without the policy’s death benefit ever dropping below the initial face amount. This technique is known as “vanishing premium.” The premiums do not really vanish; they simply are paid by the policy and not by the policy owner. Some mistakenly assume that the policy is fully “paid-up” at that point; i.e., that the company has guaranteed that it has received all of the premium it needs to maintain the death benefit. This assumption is not valid. Technically and contractually, the premiums do not vanish. The “vanish” depicted in an illustration is merely the company’s projection that as of a certain time, the policy’s cash values and dividends/excess credits will be sufficient to pay the premiums internally and still maintain the death benefit. Again, these are only projections, which are exquisitely sensitive to assumptions about mortality, interest, lapses and expenses. It is pure conjecture as to when cash premiums will no longer be required and whether premiums, once vanished, might subsequently reappear.

[33] See Chapter 12 of Leimberg & Doyle; and ¶1.04 of Zaritsky and Leimberg.

[34] See Chapter 14 of Leimberg & Doyle; and ¶1.10 of Zaritsky and Leimberg.

[35] See Chapter 9 of Leimberg & Doyle; and ¶1.08 of Zaritsky and Leimberg. Current assumption whole life is essentially the same as a participating whole life policy, except that the better results are reflected in excess interest credits rather than dividends.

[36] See Chapter 16 of Leimberg & Doyle; and Glenn S. Daily, “The Basics of Blending,” NAPFA Advisor (August 1997), http://www.glenndaily.com/fiduciaries.htm.

[37] “An alternative to a whole life/term blend product where a permanent product is desired but budget constraints exist, is to purchase a universal life policy funded at a minimum premium level that approximates a term policy. So long as the cash value remains at a sufficient level to pay mortality costs and administrative expenses, the coverage will remain in force. Premiums can be increased to make the product more stable in later years when budget constraints no longer exist.” Lee and Wilkey, § III C 4.

[38] The caveat with the blend is that if the dividends or crediting rate drops and/or term charges rise, the replacement of the term component will take longer, perhaps much longer. In some cases, additional premium would be required to maintain the death benefit if dividends or the crediting rate fall far enough and fast enough. So, to cushion the policy for adequate performance under lower dividends or crediting rates, it is common to add a “paid-up additions rider” or add additional premium that buys paid-up additional insurance at virtually net rates. These riders or additional premium can be a very cost-effective way for the policyholder to create a strong policy.

[39] The use of a term rider with base whole life, universal life, or variable life coverage can significantly reduce total out of pocket outlay and the level of annual premiums. The use of a term rider can significantly enhance early cash values, reduce policy loads and commissions, and alternatively enhance the death benefit and help the policy owner fund the policy with lower total outlays. See Charles L. Ratner, “Life Insurance Policy Replacements: Real Peanuts or Just a Shell Game?,” 139 Trust and Estate 12 (April 2000). The safest plan may be to use a policy with a substantial term/base blend but fund it aggressively, especially in the early years, with outlays based on all-base design, and on a conservative dividend, interest, or return rate.

[40] See Chapter 17 of Leimberg & Doyle; and ¶1.06 of Zaritsky and Leimberg; and Howard J. Saks, “Comparing Universal Life and Whole Life Policies for Both Individual and Survivorship Insurance Needs,” 21 Estate Planning 312 (September/October 1994).

Advantages Of Universal Life: (1) Universal life has premium flexibility, which can be easily tailored to the policy owner’s cash flow needs. (2) Universal life offers a relatively low initial premium. Because it uses current assumptions and not guarantees in establishing a premium level, the going-in costs may be much lower than those for whole life. (3) Universal life has death benefit flexibility. There are definite cost savings if the policy face amount is increased rather than having to purchase a brand new policy for additional coverage. Should projected, future estate settlement costs warrant lower taxes, the face amount can be easily decreased and the premium adjusted downwards without the expense of surrendering a portion of the policy. (4) Universal life is more explicit and transparent in its charges than whole life, wherein sales illustrations and the actual policy will explicitly state the current and guaranteed maximum charges. Annual universal life policy statements show the amount of credited interest and the actual expense and mortality charges deducted during the policy year. (5) Universal life has no investment options, so its expenses may be somewhat less than those associated with a variable universal life product. (6) As an interest-sensitive product with a guaranteed minimum interest rate, universal life has cash value build-ups that will always increase (at least the . . . guaranteed rate). Since there are no investment choices, management of the investment aspects of the product is left with the insurance company and not the policy owner.

Disadvantages Of Universal Life: (1) Universal life offers fewer guarantees than whole life. (2) Universal life often requires closer monitoring than whole life. Its premium flexibility can often tempt policy owners to skip payments or pay less than was initially determined to be prudent relying upon higher interest earnings higher future payments being made, if needed. (3) When features like the guaranteed minimum death benefit are used, the potential lower cost of universal life versus whole life often disappears or becomes less significant. (4) Since the interest rate credited to universal life is based on the company’s general account, a portfolio of primarily short-term and intermediate-term bonds, the policy’s cash value performance is limited. (5) Because there are no investment options, there is no investment flexibility for policy owners.

Wilshinsky at 58.

[41] According to Malarkey and Leimberg:

Universal life (“UL”) is a “flexible-premium” “current assumption” “adjustable death benefit” type of … [permanent insurance]. These contracts are also referred to as flexible premium adjustable life.… UL is indicated in long-term coverage needs where maximum flexibility of premium cash flow is desired, and where the insured’s financial needs and cash flow are likely to change. This makes UL suitable in the business, retirement planning, and employee benefits fields to finance salary continuation and nonqualified deferred compensation plans, death benefit only plans, key person coverage, buy-sell agreements, and insurance inside qualified retirement plans.

Malarkey and Leimberg at 8 and 9. According to Zaritsky and Leimberg:

[A]s the term “flexible premium adjustable life” suggests, the policy owner can pay whatever premium he or she chooses to pay, within certain limits. The amount of premium paid can be changed at any time, and premium payments can even be skipped if there is enough cash value to pay for the equivalent of the term coverage provided under the contract. Skipping premiums is not treated as the creation of a policy loan.… [A]s the term ‘current assumption’ suggests, current interest rates, as well as current mortality and expense charges, are directly and immediately reflected in the policy cash values.… [A]s the term “adjustable death benefit” suggests, the policy death benefits can be increased or decreased at the policy owner’s demand. Increases typically require evidence of continued insurability.

Zaritsky and Leimberg at ¶1.06[1]. Note: Adjustable life is a flexible premium life insurance product that is a hybrid of traditional whole life and universal life. With the introduction of universal life, the popularity of adjustable life has waned over the years. See Chapter 7 of Leimberg & Doyle; and ¶1.09 of Zaritsky and Leimberg.

[42] By increasing premium payments the UL policy owner can increase his or her investment in the contract and the policy’s cash value account. If the Option B/Option 2 payout is chosen, the cash value account and its earnings will be paid, income tax free, to the beneficiary as part of the death benefit.

[43] The UL policy can be cushioned against an increase in mortality charges or a decrease in interest rates by paying a premium designed to endow the policy at an assumed interest rate lower than the life insurance company’s current crediting rate. The result will be a policy that appears to the policy owner (and more particularly to his or her checkbook) like a whole life policy.

[44] With Option A/Option 1, the policyholder only pays cost-of-insurance charges (i.e., the net amount at risk) for the ever-decreasing difference between the initial face amount and the cash value. Option B/Option 2 is more expensive than an Option A/Option 1 payout because the UL policy owner must always pay the net amount at risk or cost-of-insurance to maintain the initial face amount of coverage without the cash value account being used as an offset to reduce the net amount at risk. The policyholder can change the death benefit option. For example, the policyholder may select an increasing death benefit for the first 16 years of the policy (i.e., an Option B/Option 2 payout) and then change to a level death benefit (i.e., an Option A/Option 1 payout). This approach allows the policyholder to pay more premium into the policy in the funding years. Option B/Option 2 is not available for a no lapse guarantee UL policy.

[45] See Leimberg Newsletter #891. See also Randolph Whitelaw and Richard M. Weber, “Trust-Owned Life Insurance: Risk Management Guidance for Fiduciaries,” 32 Estate Planning 14 (September 2005), where the authors discuss the risk of liability for trustees who handle TOLI (especially non-guaranteed policies), and suggest a “best practices” standard of care with respect to TOLI risk management. According to the authors, a trustee’s conduct of prudent investing is evaluated against a process standard – not a performance standpoint. Consequently, the prudent investor rule places great importance on the establishment, documentation and implementation of prudent decision-making procedures. Some of the pitfalls that lay in wait for unsuspecting ILIT trustees are “flexible premium” non-guaranteed death benefit policies, such as UL, variable UL, and adjustable life policies. To be a flexible premium policy means that the policy owner has a contractual right to basically pay whatever premium he or she wants whenever he or she wants to maintain a positive account balance. Flexible premium policies have a guaranteed schedule of insurance charges, but allow the life insurance company to charge less than the guarantees when appropriate. The problem with these types of policies is that many ILIT trustees do not have the expertise to actually calculate the needed premium schedule in order to maintain a 100% premium adequacy at the time of policy acceptance, as well as in subsequent years. Many ILIT trustees are less than diligent in their review of premium adequacy. Additionally, many trustees mistakenly rely upon the policy illustration in their file for this premium adequacy calculation. The mistake is that illustrations assume constant interest rates and the current scale of insurance charges, while in reality, market conditions and actual interest returns, among other factors, dictate the future cost of insurance charges. A common result of the ILIT trustee’s faulty reliance upon policy illustrations is a situation where the grantor has to make much larger than expected gifts (or loans) to the ILIT in order to sustain the flexible premium policy. Failure to pay the increased premium can either cause the policy to lapse in the near future or to substantially shorten its guarantees. Some of the steps that ILIT trustees can take in order to reduce criticism of their acquisition of a flexible premium life insurance product are: (1) Be involved in the policy selection. Focus on the product suitability, particularly the premium adequacy for the life of the grantor. (2) Ignore sales illustrations as accurate determinations for future premium adequacy. (3) Prior to the ILIT’s receipt or acquisition of a flexible premium non-guaranteed policy, receive confirmation from the grantor of the policy’s suitability as well as current and future premium adequacy issues. (4) Confirm annually that: (a) the scheduled premiums are adequate to sustain the policy to the insured’s life expectancy; (b) the policy is performing up to the expectations of the insured; and (c) the insurance carrier’s third-party financial ratings are stable. (5) With regard to policies with investment options, such as variable UL policies, the trustee should always be aware of the asset allocation strategy to ensure that it meets the insured’s objectives and the prudent investor rule.

[46] A no lapse guarantee rider is typically attached to a traditional UL policy, and modifies the policy.

[47] See Malarkey and Leimberg concerning no lapse guarantee universal life insurance (“NLGUL”).

In the opinion of many, the NLGUL asset class is unique. It features (relatively inexpensive) permanent death benefit guarantees at the expense of cash value performance. Analytically, NLGUL policies typically offer very attractive guaranteed death benefit internal rates of return (“IRR”) up to, and a bit past, life expectancy. (It is not uncommon to see these death benefit IRRs approach, and exceed, an after-tax rate of 7% even beyond life expectancy.) WL [whole life] and UL death benefit returns may be (or may not be, depending on the case) projected to be as favorable, but the illustrated WL and UL death benefit returns will assuredly carry the assumption of performance risk by the policy owner…. Some argue that it is prudent to think of NLGUL policies as largely illiquid. The reason is that it is unlikely that these contracts will have a cash value that is attractive for any other possible uses in the future—due to the projected underperformance of the cash value. The lack of a significant cash value is clearly a disadvantage if a cash value that can be rolled over to another new product innovation is desired in the future. Nevertheless, most who use NLGUL are not uncomfortable with the illiquidity, given the relatively certain shifting of permanent death benefit risk to the insurance carrier. Further, proponents argue that, in many cases of trust-owned insurance, the existence of a notable cash value is, at best, a secondary bonus to a family, given that the cash is likely to have been tied up in trust anyway…. Finally, the last potential disadvantage of NLGUL is that, while the death benefit is likely to have relatively little downside, NLGUL is also less likely than alternative contracts to have a notable performance upside in the event of rising interest rates, or bull equity markets (which could positively drive the WL/UL and VUL [variable universal life] markets, respectively). Those who favor NLGUL would counter that the lack of upside is a fair trade-off for the very attractive “locked-in” IRR at death. Obviously, an NLGUL contract is most appealing and appropriate for clients seeking to assure the financial security of future generations through the most cost-and tax effective and economically certain wealth transfer mechanism possible…. But because of NLG’s illiquidity, inflation vulnerability and consequent lack of flexibility, in most cases clients will be best served by using NLG as a relatively modest portion of an insurance portfolio that is carefully diversified across carriers, products, and cash value/death benefit performance projections.

Malarkey and Leimberg at 13-14.

[48] This guaranty is in addition to the life insurance company’s guarantee with regard to its minimum crediting rate, maximum mortality costs, and maximum load expenses; hence the name “secondary guarantee.” Some life insurance companies also offer a secondary guarantee variable UL product, but in doing so may limit the type of sub-account investments available to the policy owner. These secondary guarantee variable UL policies are referred to a “Guaranteed Variable Universal Life.”

[49] However, life insurance companies domiciled or doing business in New York are now required to hold higher reserves for no-lapse/secondary guarantee universal policies.

[50] The term “no lapse/secondary guarantee,” refers collectively to both a “traditional” UL policy with a no lapse guarantee rider, and to a secondary guarantee UL policy.

[51] See John T. Bannen, “No Lapse/Secondary Guarantee Life Insurance Policies: What Are They, And Are They Appropriate For Estate Planning?,” 12 ALI-ABA Estate Planning Course Materials Journal 5 (June 2006). See Paragraph 7.1(D)(2) of Sample ILIT for sample exculpatory language.

[52] See, e.g., Peter Katt, “The Potential Problems with No-Lapse Premium Guarantees,” XXV AAII Journal 33 (July 2003), http://www.peterkatt.com/articles/AAII _jul2003.html. In his article, Mr. Katt opines that no lapse premium guarantee (“NLPG”) universal policies “should not be used: (i) in place of term insurance; (ii) for designs that require large cash values; (iii) when increasing death benefits are needed; or (iv) when there is much of a chance that future premium payments will be missed.” Id. According to Katt:

It is liquidity for estate taxes that puts NLPGs on its natural turf. Compared to market-priced policies with a defined-benefit design [such as participating whole life and traditional universal life policies], NLPGs have one potential advantage, two potential disadvantages and one potential disaster, [as follows]:

  • The static-pricing [i.e., fixed premium amount] of NLPGs provide premium certainty. Future pricing factors (primarily fixed-income yields), in retrospect, may cause market-priced policies’ premiums to be consistently higher than NLPG guaranteed premiums. Advantage NLPG.

  • If fixed-income yields increase, market-priced policies [such as participating whole life and traditional universal life] may turn out to be a much better value. Advantage market-priced policies.

  • Market-priced policies have much higher cash values that can be withdrawn, borrowed, or available upon termination. Advantage market-priced policies.

  • NLPG policies can become such a good deal that the [life insurance] company becomes insolvent and is seized. NLPG disaster. ”

Id. (emphasis added). According to Hays:

If the cash surrender value must be accessed for lifetime needs by policy loans or withdrawals, the guarantee may be forfeited or reduced. A guaranteed policy is relatively inflexible and involves a greater solvency bet on the carrier than exists with a variable policy. Some observers question whether the carriers can financially support the aggressive guarantees they made in certain blocks of business. The terms of the guarantee are generally complex. The policy will be relatively rigid with regard to the amount and timing of premium payments. The carriers do not typically notify a policyholder of a change in or loss of the guarantee. Such policies, therefore, require careful monitoring. If the Code §1035 exchange amount paid to the policy at the outset varies from the amount originally estimated, the guarantee may be shortened or ineffective. Illustrations need to be examined after the policy is issued. In-force illustrations need to be reviewed to confirm continuing guarantees. Underwriting may also be more variable between carriers than is the case with non-guaranteed policies. In short, there are a multitude of questions that should be analyzed carefully in advance of purchase having to do with the definition and mechanics of the guarantee, such as: (1) What happens to the guarantee at age 100? (2) What happens to the guarantee with post-issue policy changes? (3) Can the guarantee be restored, and if so how? (4) What are the restrictions on the guarantee? (5) What is the effect of the guarantee on current assumption performance? In many cases, after review a client may decide that he or she is better off with a well-designed, flexible premium policy that is monitored appropriately and is well funded.

Jane A. Hays, “What Every Estate Planner Needs To Know About Life Insurance,” Estate Planning for Illinois Attorneys: The Basics and Beyond 2005 Edition, Section 12.22 (Illinois Institute For Continuing Legal Education, Springfield, IL, 2005).

[53] See John T. Bannen, “No Lapse Guarantee Life Insurance Policies: The Answer to an Insured’s Payer or a Fiduciary Nightmare?,” 30 ACTEC Journal 246 (Spring 2005). However, in August 2006, Pacific Life raised its premiums for its no lapse guarantee UL products. According to Whitelaw and Weber:

Clients and their advisors who are contemplating policy restructuring should consider contemporary policy options, which in turn often depend on the age and health of the insured. For example, it may be more effective from the standpoint of ongoing premiums/gifts to consider exchanging account values (assuming the insured is insurable on a favorable basis) into a ‘no-lapse’ guarantee universal life policy. At best, no-lapse guarantee policies provide the advantage of an attractively low, guaranteed premium, and seemingly offer the best features of whole life (guaranteed premiums) and universal life (lower premium outlay). While such [no-lapse guarantee] policies may well resolve the crisis of a failing policy, it’s critical that the trustee understand what the [no-lapse guarantee] policy is and is not. It is equivalent to a level premium term insurance policy with little or no cash value. It is not likely to develop any more death benefit than the stipulated death benefit, long-term cash values will be minimal or non-existent, and because these “secondary guarantees” may produce a strain on the carrier’s reserves, only insurers with very strong financial strength ratings should be considered. These trade-offs require confirmation of current trust objectives and product suitability by the trust beneficiaries.

Whitelaw and Weber at 24.

[54] That pricing pressure largely materialized: NLGUL products remain available, but they are generally far more expensive than they were when carriers were competing aggressively for this business. The market for these products has also become much smaller, as many carriers reduced, repriced, or exited lifetime secondary-guarantee offerings after concluding that policyholders were keeping the policies in force longer than originally assumed. Lincoln Financial Group’s 2022 experience illustrates the risk: the company reported a $2.2 billion reserve charge tied primarily to updated lapse assumptions for its guaranteed universal life block, reflecting the financial consequences of pricing long-duration no-lapse guarantees too aggressively.

[55] The “participation rate” dictates how much of the underlying market index’s gains are credited to the cash value. Thus, if the “participation rate” is 200% and the index gains 4%, then the policy is credited with an 8% gain.

[56] Because the overwhelmingly popular form of variable life policies is variable universal life (VUL) insurance contracts, we and most commentators, unless specifically noted, discuss variable products with VUL as the principal, if not sole, product type. See Chapter 18 of Leimberg & Doyle; and ¶1.05 of Zaritsky and Leimberg. According to Wilshinsky:

Primary Advantages of Variable Life: (1) Variable universal life offers a relatively low initial premium to policy owners, compared to whole life. (2) Variable life provides the most growth potential of any type of life insurance so the opportunity exists for either the lowest cost or the most death benefit for the same premium level. Ibbotson Associates, Inc., has documented the relative historical performance of common stocks and bonds in a study of financial instruments over the past 70 years from December 31, 1925 to December 31, 1995. For most time periods, stocks, as represented by Standard and Poor’s 500 Index, generally produced higher returns than bonds (the primary asset backing whole life and universal life policies) by 2 percent to 3 percent a year. In fact, the results of investing $1000 and letting it grow over this 70-year period clearly favored stocks, though they have also been more volatile in the short-term than bonds. (3) Variable universal life allows policy owners to determine the amount and timing of premiums within broad limits as well as increasing or decreasing the face amount. (4) Policy owners choose how their money is invested, so they have more investment flexibility compared with whole life or universal life. (5) Variable life also provides that amounts not in the guaranteed interest account are protected from the claims of the insurer’s general creditors in the event of a company insolvency. (6) Like universal life, variable universal life clearly discloses the charges in the policy. Since variable life insurance is considered to be a security, prospective buyers get a prospectus that describes policy charges in some detail. The annual policy statement shows the actual expenses charged during the policy year as well as the investment performance of any options with money allocated to them.

Primary Disadvantages Of Variable Life: (1) The biggest disadvantage of variable universal life is investment risk. Some policy owners will not have the risk tolerance for variable life because they fear coverage may lapse or higher premiums will be necessary if investment performance is poor (less than originally illustrated). (2) The age and/or health of some insureds will suggest that the long-term growth potential of stocks may not have adequate time to work to their advantage. (3) Because of the potential for negative investment returns and the fact that premiums can be easily skipped, there is a greater need to monitor the policy’s investment performance than with whole life. (4) Variable life policies tend to have somewhat higher expenses over the long-term than do whole life and universal life. This—explained by variable life’s more expensive administrative systems and its security status—demands that it comply with certain regulatory requirements (like providing a prospectus to potential buyers).

Wilshinsky at 60-61 (citations omitted).

[57] However, any rate of return can be illustrated. It is recommended that several illustrations be run so the client can better understand the risk and the reward inherent in a variable policy. Previously, the Securities and Exchange Commission (“SEC”) prohibited the use of a Monte Carlo simulation for variable policies. However, this rule changed in 2005 when the SEC approved NASD rule 22 rule 2210 (IM-2210-6) which allowed the use of Monte Carlo simulations for variable life insurance policies after February 2005. A Monte Carlo simulation produces a number of mathematical possible outcomes by generating a random investment return for each period. The more simulations run the more accurate one can expect the result to be. Since the SEC now permits the use of a Monte Carlo simulation an advisor should ensure that one is run and that the number of simulations is sufficient to allow the client to make an informed decision.

[58] Adapted from Figures 1.3 and 18.3 of Leimberg & Doyle.

[59] Adapted from Figures 1.3 and 18.3 of Leimberg & Doyle.

[60] See Chapter 18 of Leimberg & Doyle; and ¶1.07 of Zaritsky and Leimberg. See also Peter Katt, “The Do’s and Don’ts of Buying Variable Life Insurance Policies,” XXI AAII Journal 37 (July 1999), http://www.peterkatt.com/articles/AAII_jul1999.html; Peter Katt, “Variable Life Insurance: Be Wary of Policy ‘Delusions’,” XXV AAII Journal 34 (November 2003), http://www.peterkatt.com/articles/AAII_nov2003.html; and Charles L. Ratner, “Private Placement Life Products: Domestic, Offshore or Atoll? The Reality Check Please,” 140 Trusts & Estates 48 (July 2001), which discusses the tax and investment aspects of variable universal life insurance in the context of a domestic “off-the-shelf” product, and as a domestic and offshore private placement product. According to Leimberg & Doyle:

Variable life products are most suitable for those individuals who want control over their cash values and need or desire increasing life insurance protection. VUL offers greater certainty of death benefit levels than VL as long as premiums continue to be paid at the level necessary to maintain the death benefit. Under option B, death benefit levels are more certain to increase. VUL also permits the policy owner to increase the face amount of coverage with evidence of insurability. Given the risks and uncertainties associated with both cash values and death benefit levels, variable life products can be attractive supplements to an existing life insurance plan that assures a minimum required base level of coverage. It is less suitable as the means of providing the minimum basic level of coverage. VL and, more particularly, VUL are especially suitable for many business insurance needs where flexibility and growth of cash values and death benefits are necessary or attractive features. It can be used to provide potentially higher tax-deferred cash value accumulations in nonqualified deferred compensation plans than traditional policies or UL. With successful investment of cash values, the death benefit levels of variable products are more likely than those of traditional products to keep pace with increases in the values of closely-held business interests when a variable product funds a buy-sell agreement. VL and VUL may be equally attractive for key person insurance and other business applications or in insured pension plans.

Leimberg & Doyle at 270-271.

[61] See infra notes 36-39 and accompanying text, concerning term blending.

[62] Because of the administration expenses and taxes assessed against new money coming into a VUL, it is generally less expensive for the policy owner to borrow from the policy than to make a withdrawal that the policy owner plans to repay. See Baldwin at 220 for further discussion on VUL policy loans versus withdrawals.

[63] Adapted from Figures 1.3 and 18.3 of Leimberg & Doyle.

[64] Adapted from Figures 1.3 and 18.3 of Leimberg & Doyle.

[65] See Robert D. Colvin, “Planning for International Private Placement Insurance: The U.S. Perspective,” 96 Journal of Taxation 94, 100 (February 2002).

The DAC tax is actually not an additional tax paid to the Treasury but rather a charge—typically passed on to contract holders by domestic carriers—approximating the present value of the increased cost resulting from the insurance carrier’s being required to amortize certain policy acquisition expenses over ten years rather than immediately deducting such expenses. Carriers typically charge approximately from 30 basis points [i.e., 0.30%] to 1.50% [i.e., 150 basis points] of contributed premiums to recover this cost. Many carriers offer the contract holder an option to amortize this cost over an extended period. Other carriers may not explicitly add a DAC tax as a separate expense but rather will recover this cost through an increased M&E charge.

[66] According to Baldwin:

Loans or withdrawals will reduce a [VUL] policy’s cash value and death benefit. By borrowing or withdrawing funds from a policy, funds are no longer available to earn returns available from the underlying investment options where they previously resided, which will have a permanent effect on policy performance…. All or part of the amounts withdrawn may be included in gross income depending upon the investment [i.e., basis] in the contract. Withdrawals in excess of cost basis are taxable as ordinary income.

Baldwin at 219.

[67] See Chapters 11 and 15 of Leimberg & Doyle; and ¶¶1.11 and 1.12 of Zaritsky and Leimberg.

[68] See Leslie C. Giordani and Michael H. Ripp, Jr., “Private Placement Life Insurance Planning (Part 1),” 12 ALI-ABA Estate Planning Course Materials Journal 43, 46 (June 2006).

[M]any offering memoranda for offshore PPVUL [a.k.a. PPLI] policies reference “qualified purchaser” or “accredited investor” standards, as used in U.S. securities law, to describe suitable investors. In the offshore context, this should be considered merely a guideline and not a strict requirement because offshore policies are not actually subject to SEC regulations [i.e., the private placement product is not registered with the SEC]. However, if the premiums of an offshore PPVUL policy are to be invested in funds that do require investors to be “qualified purchasers,” then the policy owner must be a “qualified purchaser” for that purpose. In the domestic context, because private placement products in the United States are subject to SEC regulations, each purchaser must be a “qualified purchaser” under section 2(a)(51) of the Investment Company Act of 1940, 15 U.S.C. §80a-2(a)(51) and an ‘accredited investor’ under section 501(a) of Regulation D of the 1933 Act, 17 C.F.R. 230.501(a).

Id.

[69] Several carriers have developed shelf products with a broad range of investment options, including hedge funds, offered as private placement products through their normal distribution channels with traditional, if sometimes reduced, sales commissions. Companies that have offered such products include American International Group, Inc., Sun Life Financial, Massachusetts Mutual, and New York Life, among others.

[70] See James R. Cohen and Jeffrey S. Bortnick, “PPLI Invested In Hedge Funds,” 145 Trusts & Estates 52 (May 2006).

[71] See Leslie C. Giordani and Michael H. Ripp, Jr., “Private Placement Life Insurance Planning (Part 2),” 12 ALI-ABA Estate Planning Course Materials Journal 25 (August 2006); Charles L. Ratner, “PPLI Primer,” 144 Trusts & Estates 32 (September 2005); Douglas Moore and Mitchell K. Higgins, “Planning and Investing with Private Placement Life Insurance,” 30 Estate Planning 336 (July 2003).

[72] See Richard L. Harris, “The Problems With PPLI,” 143 Trusts & Estates 40 (May 2004).

[73] Because more funds are invested earlier in a MEC policy, a MEC policy will generally have a larger initial cash value account than a non-MEC policy, resulting in lower COI and M&E charges. MEC status will not create adverse income tax issues if the policy owner does not plan on withdrawing money from the PPLI policy during his or her lifetime.

[74] See Zaritsky and Leimberg ¶1.16 (discussing offshore life insurance companies); see also Craig Douglas Hampton, “International Life Insurance Presents Unique Planning Opportunities,” 24 Tax Management Estates, Gifts and Trusts Journal 175 (July 8, 1999).

[75] Policies issued by offshore insurance companies are generally not subject to U.S. state premium taxes, though this is a state-by-state issue. Certain states claim that if the insured is a resident, a sufficient nexus exists for taxation regardless of other factors. See Robert D. Colvin, “Planning for International Private Placement Insurance: The U.S. Perspective,” 96 Journal of Taxation 94, 100 (February 2002).

[76] The IRC section 953(d) election allows a foreign life insurance company to be treated as a domestic corporation for tax purposes. Most offshore subsidiaries of U.S. insurers make this election.

[77] IRC section 4371.

[78] Although an offshore PPLI policy may be offered to non-accredited investors, the conservative practitioner should follow SEC regulations to avoid any uncertainty. Using an offshore ILIT to own the policy raises additional complex income tax issues, including special rules under IRC sections 672, 679, 684, and 665–668 (the throwback rules), as well as significant reporting requirements. See Elizabeth M. Schurig and Carolyn M. Beckett, “Foreign Reporting: Get it Right,” 145 Trusts & Estates 32 (July 2006).

[79] Bermuda, the Bahamas, the Cayman Islands, and Guernsey are among the jurisdictions that have separate account legislation.

[80] IRC section 817(h) requires that no single investment may represent more than 55% of the value of the separate account, no two investments more than 70%, no three more than 80%, and no four more than 90%. In addition, no more than 55% of the value of a segregated account may be attributable to cash, cash items, government securities, and securities of other regulated investment companies.

[81] See Rev. Ruls. 77-85, 1977-1 C.B. 12; 80-274, 1980-2 C.B. 271; 81-225, 1981-2 C.B. 12; 82-54, 1982-1 C.B. 11; 2003-91, 2003-2 C.B. 347; and 2003-92, 2003-2 C.B. 350. See also Richard L. Harris, “The Problems With PPLI,” 143 Trusts & Estates 40 (May 2004).

[82] See Ralph Carter, Jr., “Crackdown Requires Review of Variable Insurance and Annuity Set-Ups,” 72 Practical Tax Strategies 298 (May 2004).

[83] REG-163974-02 (7/29/03). These regulations were made final on February 28, 2005, per Treasury Decision 9185.

[84] Consolidated Appropriations Act, 2021, Pub. L. No. 116-260, div. EE, Section 205, 134 Stat. 1182, 3057-59; IRC Section 7702.

[85] See Interstate Insurance Product Regulation Commission, IRC Section 7702 Revisions Resource Page (noting that the 2021 amendments required insurers to revise affected individual life insurance products and related filing materials); Ernst & Young LLP, Consolidated Appropriations Act, 2021 Includes Change That Impacts Life Insurance Contract Qualification Test (Jan. 8, 2021) (explaining that the amendment replaced fixed interest-rate assumptions with a dynamic interest-rate model for purposes of the Section 7702 life insurance qualification tests).

[86] See IRC Sections 7702 and 7702A.

[87] See Richard H. Mayer and Donald R. Levy, Planning for the Affluent, page 12-9 (Aspen Publishers, New York, NY 2003).

[88] See Leslie C. Giordani and Michael H. Ripp, Jr., “Private Placement Life Insurance Planning (Part 1),” 12 ALI-ABA Estate Planning Course Materials Journal 43, 64 (June 2006).

[89] See Christopher P. Cline and Barry D. Flagg, “The Prudent Investor and Trust Owned Life Insurance (TOLI)—Part 1,” 115 American Bankers Association Trust & Investments 38 (January/February 2007) (ftp://theinsuranceadvisor.com/documents/ABA_TOLI.pdf); Christopher P. Cline and Barry D. Flagg, “The Prudent Investor and Trust-Owned Life Insurance (TOLI)—Part 2,” 116 American Bankers Association Trust & Investments 34 (March/April 2007) (ftp://theinsuranceadvisor .com/documents/ABA_TOLI_PartII.pdf); Christopher P. Cline and Barry D. Flagg, “The Prudent Investor and Trust-Owned Life Insurance (TOLI)—Part 3,” 117 American Bankers Association Trust & Investments 42 (May/June 2007) (ftp://theinsuranceadvisor.com/documents/ABA_TOLI_PartIII.pdf) (“Suitability of TOLI holdings is largely determined by two criteria: investment performance and policy expenses.”); Stephan Leimberg, “TOLI Risk Management at Litigation Crossroads,” Steve Leimberg’s Estate Planning Newsletter # 1110 (April 12, 2007) at http://www.leimbergservices.com; Stephan Leimberg, “Trust-Owned Life Insurance—Risk Management Guidance for Professional Advisors,” Steve Leimberg’s Estate Planning Newsletter # 891 (November 16, 2005) at www.leimbergservices.com (“Leimberg Newsletter #891”). See, also, Kathryn A. Ballsun, Patrick J. Collins and Dieter Jurkat, “Trustee Administration of Life Insurance (Part 1 of 4),” 31 ACTEC Journal 280 (Spring 2006); E. Randolph Whitelaw and Richard W. Weber, “Trust-Owned Life Insurance: Risk Management Guidance for Fiduciaries,” 32 Estate Planning 14 (September 2005) (“Whitelaw and Weber”); Mark A. Teitelbaum, “Trust Owned Life Insurance: Is It An Accident Waiting To Happen?,” National Underwriter Life & Health 38 (May 17, 2004) (“Teitelbaum”); and C. Markham Whitelaw and William C. Ries, “Managing Trust Owned Life Insurance—Revisited,” 138 Trust & Estates 38 (April 1999) (“Whitelaw & Ries”), where the authors discuss potential TOLI problems, such as: (1) underperforming policies, (2) policies that are insufficient for the insured’s current needs, (3) newer products that may be more cost efficient, (4) new products and riders that may offer better options, (5) policies scheduled for a big increase in premiums, (6) trustee negligence in maintaining the current life insurance policy, (7) bad trustee investment decisions concerning the retention of a variable life insurance product, (8) trustee negligence in poor life insurance design or an improper policy, and (9) trustee negligence in poor selection of a life insurance agent. “For skilled and unskilled trustee, TOLI management should include policy monitoring, suitability and restructure criteria….Four R’s describe the TOLI management process—review, restore, restructure or replace.” Whitelaw & Ries at 38.

A trustee, skilled or unskilled, can accept a guaranteed death benefit policy and transfer all premium adequacy risk to the underwriting carrier, or can retain premium adequacy risk by accepting a non-guaranteed death benefit policy and actively managing policy values. Acceptance of premium adequacy risk implies the grantor’s approval to do so, expertise in TOLI risk management, and an affirmative election by the trustee to manage the insurance investment consistent with the trust’s objectives. If a trustee does not obtain the grantor’s approval, or lacks TOLI risk-based procedures or expertise in policy evaluation, the trustee must recommend restructuring to a guaranteed death benefit policy.… The critical asset management considerations applicable to insurance trusts are product suitability, premium adequacy, and carrier selection. For guaranteed policies, premium adequacy is not a risk, but the carrier’s size and ratings must be evaluated. For non-guaranteed policies, premium adequacy is the obvious risk that mandates active management using TOLI-specific risk management procedures and expertise in evaluating premium adequacy. Actuarial evaluation must be used for all determinations regarding premium adequacy, as well as policy acceptance, management and restructuring.

Whitelaw and Weber at 16. Teitelbaum recommends that life insurance agents help trustees in: (1)

Setting goals and standards regarding trust owned life insurance. This includes examining life insurance policies and comparing these to alternatives…. Examining client goals and beneficiary needs. (2) Examining policy funding and determining if additional funding is necessary. This includes considering whether or not a client’s gifting capacity is able to support future premium needs. (3) Considering life insurance performance: Will UL [universal life] policies or participating whole life policies perform within a reasonable tolerance of the original illustrations or new client goals? With VL [variable life] insurance, do the subaccounts need to be re-examined based on evolving client needs and subaccount performance?

Teitelbaum at 43.

The annual performance monitoring questions that should be asked and answered by trust fiduciaries to assure that the trust does not receive too little or pay too much for life insurance coverage include the following: (1) Has the policy inadvertently become a MEC? (2) Should a split-dollar agreement be modified to comply with the most recent split-dollar rules? (3) What is the impact of demutualization on the economic results of trust held coverage? (4) If the policy was issued as other than ‘preferred risk,’ has the insured stopped smoking or has there been an improvement in the insured’s health? (5) Are there recently issued policies that might provide a better return for the trust’s beneficiaries and if so, what are the costs of replacing present coverage? (6) Is there a policy that might lapse and if so, what are the tax and other economic consequences?

Zaritsky and Leimberg, ¶5.03. Lee and Wilkey recommend that the following factors be examined when evaluating a policy on an ongoing basis: (1) obtain an in-force illustration of the existing policy; (2) review the current premium payment amount and determine if the insured may qualify for a premium reduction due to improvement in health, cessation of smoking, etc.; (3) review the policy’s beneficiary designation to see if it is are up to date and reflects the policy owner’s current desires; (4) ascertain the amount of current loans or withdrawals against the policy, and determine their effect on the policy’s future performance and death benefit payout; and (5) consider all the possible “exit” strategies if the policy owner no longer desires or can no longer afford to retain the policy, such as a surrender of the policy, purchasing extended term coverage, electing reduced paid up coverage, an IRC section 1035 exchange to an annuity, or a life settlement. Lee and Wilkey, § VII.

An in-force illustration is an updated projection of an existing policy. By incorporating known historical performance data from purchase to the date the in-force illustration is run, and then projecting policy performance forward based on assumptions, an up-to-date projection can be obtained showing how the policy actually performed in the past and how, using actual past performance as a base, the policy is likely to perform in the future. A policy owner has a right to obtain an in-force illustration without cost from his agent or broker on an annual basis. By reviewing in-force illustrations, the policy can be monitored to see if it is performing as expected. It is an invaluable tool for gauging required premium payments, accumulations of cash values, and the effect of loans on policy performance. By monitoring a policy through review of in-force illustrations, under performance can be discovered and appropriate adjustments made to insure the policy stays in force without fear of lapsing.

Lee and Wilkey, §VII, A.

[90] See Table 1, below, for a chart that compares and contrasts the general features of term life, whole life, universal life, indexed universal life and variable universal life insurance policies. See also Burke A. Christensen, “Insurance Sales Illustrations To Avoid,” 137 Trusts & Estates 96 (October 1998); Ben G. Baldwin, Jr., “Risk & Return Potential in Life Insurance Products,” 137 Trusts & Estates 42 (April 1998); “Menu of Life Insurance Products” at page 183 of Baldwin; and Figures 1.3, 18.3 and 18.4 of Leimberg and Doyle at 13- 14, 283 and 284.

[91] “While different insurers use different names for these expenses, they all fall into one of three categories: fixed administration expenses, cash-wrap fees, and premium loads.” Christopher P. Cline and Barry D. Flagg, “The Prudent Investor and Trust Owned Life Insurance (TOLI)—Part 2,” 116 American Bankers Association Trust & Investments 34, 39 (March/April 2007).

[92] The basic pricing formula for an insurance contract is based on three (3) components:

  (1) the death benefit or costs associated therewith (“COI”);

  (2) the expenses associated with the policy design and administration (“E”); and,

  (3) the policy investment earnings (“i%”).

The basic formula is thus: Premiums = (COI) + (E) (i%).  See Barry D. Flagg, CFP, CLU and ChFC, The Insurance Advisor.com (http://www.theinsuranceadvisor.com/index.asp?id=68).

[93] A contract is merely an agreement concerning the allocation of risk between the parties regarding the subject matter. In the life insurance context, risks are allocated between the insurance company and the policy owner, depending on the type of policy, its terms, and guarantees.

The sharing of risk between the carrier and the policy owner is depicted in the life insurance illustration through the display of two projected performance calculations—“guaranteed values” and “current values.” The guaranteed values reflect the total amount of risk the carrier is willing to assume. The current values are hypothetical projections of what product performance would be based on current pricing and performance assumptions. The difference between the guaranteed values and the projected values is the amount of risk assumed by the policy owner in relying on the illustrated numbers.

Lee and Wilkey at section III,B,1.

[94] According to Leimberg and Doyle:

Mortality represents the insurer’s ability to match risk with premiums, i.e., how carefully the insurer underwrites policies and how closely the experience (rate of deaths) that actually occurs parallels what was projected by the insurer in setting its rates. If more deaths occur in a given period than expected, [policy] dividends will be adversely affected. If fewer deaths occur than projected, [policy] dividends will be positively affected.

Leimberg & Doyle at 94.

[95] See, e.g., Norem v. Lincoln Benefit Life Co., 737 F.3d 1145, 1147–50 (7th Cir. 2013) (addressing COI language stating that rates were “based on” specified factors); Vogt v. State Farm Life Ins. Co., 963 F.3d 753, 758–61 (8th Cir. 2020) (affirming judgment for policyholders where plaintiffs alleged that State Farm impermissibly included non-listed factors in COI deductions); Johnson v. Protective Life Ins. Co., 93 F.4th 1315, 1320–24 (11th Cir. 2024) (discussing policy language and competing approaches to “based on” COI provisions).

[96] Examples of significant COI-related recoveries include Vogt v. State Farm Life Ins. Co., 963 F.3d 753 (8th Cir. 2020), which affirmed a policyholder judgment exceeding $34 million before further proceedings on prejudgment interest; the nationwide State Farm COI settlement reportedly resolving related claims for $325 million; In re Lincoln National COI Litigation, No. 2:16-cv-06605-GJP (E.D. Pa.) and In re Lincoln National 2017 COI Rate Litigation, No. 2:17-cv-04150-GJP (E.D. Pa.), which resolved COI-rate-increase claims through a settlement fund of more than $117 million; and Glover v. Connecticut General Life Insurance Co., No. 3:16-cv-00827-MPS (D. Conn.), which resolved COI-deduction claims through a settlement of approximately $147.5 million. As noted above, Joseph Gentile represented policyholders in In re State Farm Cost of Insurance Litigation, which resulted in a $325 million recovery, and In re Lincoln National COI Litigation, which resulted in a recovery of more than $117 million.

[97] Adapted from Lee and Wilkey. According to Brody, Richey and Baier:

The risk for the policy owner with regard to mortality pricing is that the actuary may have been too optimistic in making mortality projections. For example, if the actuary projects an annual improvement in the mortality rate of two percent, but the annual improvement proves to be less than the projection, the actual cost of the policy will be higher than originally illustrated. For term policies, this means that a higher than scheduled premium increase will occur. For participating policies from a mutual insurer, the mortality shortfall may result in a lower dividend.  The bottom line of an overly optimistic projected mortality rate is that the policy owner will end up with less than projected unless the shortfall is made up in one of the other risk areas. The advisor should be especially aware that companies who make optimistic mortality assumptions in pricing their products will produce illustrations that look consistently better than their competition. The best way to compare policies is to become informed and to consult a reputable consulting actuary or life underwriter.

Brody, Richey, and Baier at section II,A,3,a.

[98] Adapted from Lee and Wilkey. Ben Baldwin offers this warning concerning interest/investment risks:

All life insurance containing investment capital, be it whole life, universal life, variable life, or variable universal life, runs on the investment returns earned on the investment capital. Earnings on the investment capital are limited by the amount the policy owner chooses to invest within the contract (little investment means little returns), and what the government and the marketplace permit the investment to earn. When policy earnings are less than policy costs, policy owners must pay more into the policy to cover costs or the policy will use [i.e., consume] the capital in the policy to cover costs. When capital has been completely used up [i.e., entirely consumed] to cover costs, policies terminate, unless policy owners can make substantial payments to cover ongoing policy costs. Policy owners must evaluate all the risks and potential investment earnings on the investment alternatives offered by insurance companies, both general and separate accounts.

Baldwin at 207. According to Brody, Richey and Baier:

In a one-year term policy with no dividends or cash values, all investment risk is borne by the company. However, in variable life products without guarantees, the investment risk, including loss of principal, belongs to the policy owner. Investment risk in other policies is shared, in varying degrees, between the company and policy owners. The effect of a company’s failure to meet its projected investment return or interest rate assumptions is generally a reduction in cash values, dividends or death benefit. In such cases, a policy owner must make additional premium contributions to the policy to maintain the values originally illustrated. In evaluating a policy illustration shown to a client, the advisor should make certain that interest rate assumptions made in the illustration are reasonable in light of current interest rates and investment returns. Even if an insurance company’s general portfolio is higher than average current interest rates and investment returns, those market forces, if sustained, will exert a downward pressure on the company’s portfolio. Thus, even though current company rates are illustrated, to be conservative, the product illustration should also provide a projection based on an interest rate that is one percent or two percent lower than current company rates. Another way to protect the client is to recommend variable policies that provide a guarantee against loss of principal, especially if the client is an individual to whom the death benefit is important. Large companies may be willing to assume greater risk and buy a variable policy that does not have a guarantee against loss of principal.

Brody, Richey and Baier at section II,A,3,b.

[99] Lapse rates are also known as “persistency experience.” A high persistency means a low lapse rate, and usually greater profits for the life insurance company.

[100] Generally a life insurance company makes a profit on whole life policies that have been in existence for at least seven years.

[101] Adapted from Lee and Wilkey. According to Brody, Richey and Baier:

Lapse risk is the risk that a policy will terminate or the policy owner will surrender the policy before the company can recoup its costs of selling and issuing the insurance. A surrender or lapse in the early years will generally result in a significant loss to the insurance company. On the whole, a company with lower lapse ratios can price its products lower than a company with higher lapse ratios because it has a greater chance of recouping its initial investment and making money. A low lapse ratio also indicates the stability of the risk class being underwritten. This often goes hand-in-hand with lower mortality risk.

Brody, Richey and Baier at section II,A,3,c.

[102] Expenses are also referred to as “loading,” which is a “term that encompasses all the insurer’s business expenses in marketing, issuing, administering, and paying claims on policies. If the insurer’s cost of doing business is greater than projected, [policy] dividends will be adversely affected. If the insurer is able to contain costs and keep them below projected amounts, [policy] dividends will be positively affected.” Leimberg & Doyle at 94.

[103] Adapted from Lee and Wilkey. “Compared to the other risks, expense risk is of less concern. Many insurance products guarantee expense levels. In those policies, the company bears this risk. Even when the level of expenses is not guaranteed on a particular product, the impact of this item on the policy owner’s overall risk is minimal.” Brody, Richey and Baier at section II,A,3,d.

[105] See also Kathryn A. Ballsun, Patrick J. Collins and Dieter Jurkat, “Standards of Prudence and Management of the Insurance Portfolio (Part 2 of 4),” 32 ACTEC Journal 66, 89 (Summer 2006).

However, the actual assumptions that underlie policy illustrations are proprietary information; and, without knowing the underlying assumptions, it is difficult to determine how single variable changes illuminate actual policy risks. Actuaries, in part, focus on the risk that the assumptions underlying product development and pricing are misspecified or incorrectly determined. Actuaries term the risk that a pricing model’s flaws preclude corporate profitability objectives ‘pricing risk.’ If there is a high degree of pricing risk (e.g., each relevant variable can be at the upper bound of ‘reasonableness’ at some time but the assumption that all variables exhibit favorable interaction for most or all of the time may be unreasonable), then there is a high probability that the insurance contract will fail to deliver adequate return on equity to the carrier; or will fail to deliver projected values to the policyholder absent additional premiums.

Id.

[106] See TOLI Management & Trustee Best Practices, section 3(i), above.

[107] See Indexed Universal Life, section 3(d), above; AG-49, section 3(d)(1), above.