Managing Trust-Owned Life Insurance: Trustee Lessons

Transcription

1 Managing Trust-Owned Life Insurance: Trustee Lessons Melvin A. Warshaw, J.D., L.L.M. (Tax) General Counsel Financial Architects Partners

2 Overview More than sending Crummey notices, paying premiums States have adopted Uniform Prudent Investor Act (UPIA) requiring new responsibilities for (ILIT) trustees How should ILIT trustees comply with UPIA? Recent cases provide some guidance

3 UPIA Section 1 Prudent Investor Rule Default rule (may be modified, eliminated) Trustee may reasonably rely on trust provisions Example: In French, trustee allowed to self-deal (conflict of interest permitted) Section 2 Standard of Care Trustee must exercise reasonable care, skill and caution Trustee must consider circumstances (economic, inflation, tax consequences, liquidity) Duty to investigate security of investment; duty to monitor investment Example: In French, trusts held significant liquid assets and beneficiaries personally owned liquid assets, reducing need for policy cash value

4 UPIA Selection 3- Diversification Among different top-rated carriers Different types of products (death benefit or cash value focus?) Hedge Section 5 Loyalty A trustee shall invest and manage the trust assets solely in the interest of the beneficiaries But donor selected trustee, funds premiums Section 6 Impartiality Fiduciary duty to act in best interests of all beneficiaries Example: In Paradee, second wife became trustee of trust for husband s grandson and allowed policy to lapse; previously wife convinced prior naïve trustee to make loans without beneficiary s knowledge

5 UPIA Section 7 Investment Costs Improved health may reduce premiums New carrier mortality tables reduces premiums Restructured premium schedule increases IRR/decreases NPV Section 8 Reviewing Compliance Compliance with Prudent Investor Rule evaluated at the time of the decision, not in hindsight Example: In Cochran, unexpected death of insured could not have been anticipated at time variable policies were exchanged for fully guaranteed, fully paid NLG policies Section 9 Delegation of Investment Decisions UPIA requires trustee to delegate to expert Example: In Cochran, trustee asked insurance consultant (with no policy to sell) to review exchange

6 Cochran v Key Bank ILIT initially owned $4.75M in conservative UL, WL policies Agent recommends replacing with $8.0M in aggressive VUL funds, trustee approves VUL cash values decline 7% (in 2001) Agent recommends replacing $8.0M VUL with $2.5M GUL (at a 20% realized loss in cash value) GUL has secondary guarantee (no more premiums due) GUL proposal reviewed by independent agent 7 months after implementing $2.5M GUL, Cochran dies(54) Children sue for breach of fiduciary duty Trial court: Was it prudent to move from VUL policies with significant risk of loss to much smaller guaranteed death benefit? Yes. Ct of Appeals: Affirmed, in favor of ILIT trustee

7 Cochran Takeaways Trustee will not be reversed in hindsight if following a prudent process to monitor Insurer ratings, claims paying capacity Insured s health updated Testing for policy lapse before life expectancy Trustee has duty to investigate alternative policy designs based on risk: reward strategy Trustee has duty to manage TOLI to minimize costs/maximize return relative to risk by Increasing premium funding Decreasing death benefit Changing cash value asset allocation Exchanging policies Sell policies Wait and see (do nothing) Reliance on independent third party consultant was key

8 French v Wachovia ILIT owned a $5M policy on JFrench and $5M survivorship policy on JF and spouse, with premiums scheduled to increase (1991) Policies had $2.2M combined cash value, ILIT held $5M in other liquid assets and received annual distributions from another trust (2005) Wachovia becomes successor trustee and asked its affiliate to explore options for policies Insured and Wachovia agreed to exchange original policies for new policies with same $10M guaranteed death benefit but much reduced cash value Wachovia affiliate earned over $500,000 in commissions from exchange of policies Due to significant affiliate compensation, there was a potential conflict of interest so French was asked to sign waiver but he refused Trust document specifically permitted self-dealing Commission paid affiliate not disclosed to French until after exchange French children sued Wachovia for breach of trust to recover lost cash value and fees paid to Wachovia and affiliate alleging bank profited from selfdealing

9 French Takeaways Disclose potential conflicts The ILIT specifically authorized the trustee to engage in a self-interested transaction whether or not it obtained waiver. (Wachovia had power to engage affiliate to exchange policies and be fairly compensated; since ILIT permitted self-dealing, conflict did not matter) Sufficient disclosure and independent analysis- French and counsel 1) analyzed the exchange with Wachovia and affiliate over many months, 2) knew affiliate would receive a commission, and 3) were told a conflict waiver would be required; (French knew that exchange of policies maintained death benefit but reduced premiums by $620,000; tradeoff was loss of most of cash value but trust owned other assets) Trustee acted as Prudent Investor ILIT beneficiaries cannot use hindsight to now prefer cash value; presence of other assets indicates cash value not a primary concern; declining cash value offset by reduced premiums and guaranteed death benefit

10 Paradee v Paradee C Paradee created ILIT for grandson, buys $1M survivor policy on CP and second wife (grandson unaware of ILIT) Insurance agent named ILIT trustee Second wife requested loan from ILIT to family business which ILIT funded with policy loan ILIT loan to business by producer-trustee was unsecured, lower interest rate than policy loan After husband, producer-trustee die, second wife appoints herself as trustee (though grandson had right to appoint himself) Second wife never notified grandson of the ILIT or his rights Family business stopped paying interest on loan and never repaid debt but second wife- trustee took no action to collect against business Interest accrued on policy loan and eventually caused policy to lapse Grandson is notified of ILIT and past events, sues trustee

11 Paradee Takeaways Failure to be loyal, impartial - Producer-trustee breached duty of loyalty in making loan to business, placing his long-time client s interests above grandson s interests; second wife as trustee breached duty by not enforcing collection of debt and allowing policy to lapse Must follow advice for protection- Producer-trustee did not follow legal advice to secure ILIT loan to business Must disclose trust, beneficiary rights- Neither trustee disclosed the existence of the ILIT to the grandson nor his right to appoint himself trustee

12 General Takeaways for ILIT Trustees Who is monitoring policy after the sale? (Does agent provide annual reviews to the ILIT trustee) Understand duties State law (UPIA) Trust instrument Customized (eliminate trustee duty to monitor performance, permit self-dealing transactions) Indemnify for negligence Unique duties Preserve gift/estate tax benefits Crummey notices Incidents of ownership No transfer for value Demonstrate Independence from Donor-insured Third parties not beneficiaries Duty is to ILIT beneficiaries Hard for family, friend serving as trustee Appoint unrelated professional as trustee

13 General Takeaways for ILIT Trustees Engage in Regular Process of Evaluation Regularly (annually) evaluate insurance performance Compliance audits (for non-professionals) Written Documentation of Actions Create a record of deliberations and reasoning Document independent analysis of advantage/disadvantages to ILIT of various courses of actions Disclose and obtain waivers and releases Compare French (grantor-insured had significant information) with Paradee (beneficiary never informed of his rights in ILIT) Consents and waivers protect against conflicts or no indemnification language in trust