Fiduciary Professions: Legal Challenges and Solutions for Trustees of Trust-Owned Life Insurance
Active and careful management is required
By Grace Bronstein & Ian Weinstock
Many trustees mistakenly believe that life insurance is a static financial instrument. However, trust-owned life insurance (TOLI) requires active and careful management. Recent case law provides a roadmap for how trustees can adequately manage TOLI pursuant to the Uniform Prudent Investor Act (UPIA). Trustees should be aware of their exposure to liability, as there’s been an increasing trend towards lawsuits filed against trustees for policy mismanagement.
Elevated Trustee Liability
Trustees assume fiduciary duties to manage the risks and performance of all trust assets, and TOLI is no exception. However, trustees are often unaware of the numerous risks associated with life insurance policies, such as policy sustainability, solvency and performance. Various factors, particularly sustained low interest rates, have adversely affected policy performance and have rendered traditional policy illustration tools inadequate. Trustees need access to better tools to manage life insurance, and they potentially face a severe liability risk for not properly managing life insurance as prescribed by the UPIA. Trustees can reduce litigation exposure and better serve trust beneficiaries by following the prudent investor standard outlined by the UPIA, which recent case law has clarified.
Lapsed Policies
An enormous number of life insurance policies lapse prematurely due to mismanagement. Based on the false premise that policies are fixed “buy and hold” financial instruments with guaranteed benefits, many trustees mistakenly believe that their duties are limited to handling gifts made to the trust, paying scheduled premiums and timely sending Crummey notices. However, policies aren’t static and are subject to changing premium amounts, cost of insurance (COI) increases and other critical variables, all of which can affect policy performance. Consequently, Americans ages 65 and older let approximately $112 billion in benefits lapse each year,1 and 34% of TOLI policies are rated “high risk”—meaning they’re either projected to lapse prior to maturity or the no-lapse guarantees have been compromised.
Policies need to be treated as investments that require regular review and management. Insurance companies, agents and brokers don’t have the responsibility of monitoring life insurance policies. Most policies are currently managed by trustees who are family members, accountants, attorneys or close friends of the settlor of the trust. These trustees may lack the expertise to manage life insurance effectively and should therefore engage an independent consultant to satisfy their fiduciary responsibilities and mitigate liability.
Prudent Investor Standard
In most states, trustees are held to the prudent investor standard under the UPIA. This standard requires trustees to manage assets with reasonable care and prudence and therefore to maximize the benefits and minimize the costs of investments, implicitly including life insurance policies, on behalf of trust beneficiaries. Proper management is explained as monitoring the “suitability” of existing investments, including life insurance policies.2 Doing so requires trustees to understand the underlying COI charges, policy earnings assumptions, actual life expectancy projections, policy expenses and other vital variables. Trustees who violate their fiduciary duties can be held responsible for damages in the form of recovery of the losses incurred caused by ineffective management. Therefore, trustees should understand what proper management of life insurance entails, and the case In re Stuart Cochran Irrevocable Trust provides a clear roadmap to avoid liability.3
In this case, irrevocable life insurance trust beneficiaries sued the trustee, KeyBank, for breaching its fiduciary duties by mismanaging their TOLI. In 1999, relying on the recommendation of the insured’s insurance advisor (who sold life insurance to the insured), KeyBank approved an exchange of policies that increased the collective death benefit from $4.7 million to $8 million, and the new policies were variable universal life (VUL) contracts. Their cash value declined precipitously due to external economic conditions. As a result, the trustee retained an independent insurance consultant to review the policies in 2003, when the insured was 52 years old. The independent consultant recommended keeping the policies and further monitoring them, but the same insurance advisor who conducted the original sale and previous policy exchange decided to undertake his own review and recommended replacing the policies yet again, replacing the $8 million VUL policies with a $2.5 million guaranteed UL policy. The trustee again consulted the independent insurance consultant, who noted certain disadvantages of the new policy—particularly the lower death benefit— but also noted the advantages of the new policy— that the death benefit was guaranteed with no future premium payments, while the VUL policies would lapse without substantial additional premium payments from the settlor, who didn’t have the financial wherewithal to make those payments. The independent insurance consultant therefore rated the new policy more highly under the circumstances. The trustee exchanged the policies, and the trust realized a 20% loss of assets due to the $107,000 surrender charge the trust had to pay to exchange the policies. Moreover, the insured unexpectedly died a year later at the age of 53, and his beneficiaries lost out on millions of dollars of death benefit. The beneficiaries subsequently sued the trustee for breach of fiduciary duty. The court, however, ruled that the trustee acted prudently by engaging “an outside, independent entity with no policy to sell or any other financial stake in the outcome.”4 The trustee’s act of retaining an independent consultant saved the trustee from liability under the UPIA.
This case illustrates the importance of independent review and the pitfalls of merely following the advice of an insurance advisor or broker, whose primary goal is to sell new insurance. While the court in Cochran didn’t expressly say so, the implication of the case is that, had the trustee not sought the independent consultant’s opinion and simply relied on the insurance advisor’s recommendation to replace the existing policies, the result of the case could have been different because the trustee’s conduct may not have been deemed prudent.
Trustees should also be aware that exculpatory clauses may not protect them from liability if they don’t adequately manage trust-owned life insurance. Rafert v. Meyer established that trustees have a non-waivable duty to keep beneficiaries informed about the status of policies held in trust, to act in good faith and in the best interest of the beneficiaries—all despite exculpatory clauses in trust agreements.5
Potential for Liability
Trustees should ask the following questions when ascertaining their potential for liability:
Is the trust being administered in accordance with the terms of the trust agreement?
Is the policy being properly funded?
Is the projected premium payment on the most recent policy statement the payment the insured should actually be making?
Is the policy being reviewed annually by qualified, independent experts?
If the policy is underperforming, are the relevant issues being addressed and remediated?
Are Crummey notices handled properly?
Active Management
Unbeknown to most policyowners, insurance carriers can adjust insurance premiums and other aspects of policies as necessitated by market forces and fluctuating costs. Policies are designed to deliver a certain rate of return to the insurance carrier, and this return is affected by interest rates, premiums, the projected future death benefit and other carrier costs. Trustees should understand and analyze these variables because they affect the premiums required to sustain the policy. For example, premiums can be influenced by a life insurance carrier’s mortality experience across its portfolio of policies as well as other undefined operational expenses. There’s also a direct correlation between interest rates and the COI, as insurance carriers effectively pass interest rate risk on to the policyowner. Understanding the variable nature of life insurance costs is critical to effective policy management.
Insurance premium illustrations that were created in the 1980s and 1990s were predicated on interest rates maintaining levels that are now detached from reality. Subsequent events proved that these illustrations were based on unrealistic economic variables and, therefore, didn’t accurately predict length of coverage and relevant costs. When interest rates began to decline, most policyowners and trustees weren’t aware that they had to increase the amount of premiums they were paying. Moreover, most policyowners and trustees are unaware that it’s not the insurance carrier’s duty to notify the policyowners to increase their payments, but rather it’s the policyowner’s responsibility to increase their payments proactively or risk their policy’s cash value being depleted, which typically exacerbates the risk of the policy lapsing. The insurance company only has to provide the death benefit coverage and send the policy owner an annual statement.
The insurance industry increased the internal COI for the first time in 2016. Regulators and policyowners alike were surprised at how fast these increases took place, and several class actions ensued. Carriers such as Transamerica Life Insurance Company settled class action lawsuits brought on behalf of policyholders alleging that Transamerica improperly increased monthly charges for universal life policies.6 However, carriers may still be able to increase the COI at any time with only 30 days’ notice to the policyowner. Depending on the policy type, carriers also have the ability to increase premium amounts, as well as change other factors
.
Life Insurance Agents
Life insurance agents—whether they describe themselves as insurance agents, brokers, advisors, or otherwise—earn commissions for selling insurance and are therefore incentivized to replace existing policies with new ones. There are many well-intentioned life insurance agents who genuinely want what’s best for their clients, but given their financial incentives, it may be difficult for them to provide unbiased opinions to their clients after selling them the original policy. Moreover, even more general financial advisors can’t necessarily manage policies as prescribed by the UPIA, not only because of the incentive issue noted above but also because they may be getting information about the policy only from the issuer. Active policy management requires an independent third party with access to tools for independent policy evaluation.
Trustees aren’t the only parties with potential liability for mismanaging life insurance. Life insurance agents may also have exposure if they advise clients to whom they sold life insurance. By retaining an independent consultant, those agents can limit their own liability as well.
Several cases illustrate the risk to insurance agents for providing (or failing to provide) advice to their clients. For example, in Joseph Nacchio et al. v. David Weinstein et al., the insured sued his insurance advisor Ayco Co., a unit of Goldman Sachs, and former financial advisor, David Weinstein, for negligence and breach of fiduciary duty for failing to properly explain the risks of variable life insurance.7 Nacchio bought $95 million in variable life insurance coverage as part of an estate enhancement plan, believing that the policies would cover him until age 100. Ten years after purchasing the policy, Nacchio discovered that the policies would lapse once he reached age 72, and Nacchio replaced the policies with more appropriate ones. The jury found that Weinstein breached a duty of care as a financial advisor in not properly managing and conveying cost and performance expectations and awarded Nacchio $14.2 million in damages—the difference between the actual cost of the replacement policies and what those polices would have cost had they been purchased at the outset in 2000.8
Agents can also have exposure for failing to advise clients of their options regarding existing coverage. For example, in Larry Grill v. Lincoln National Life Insurance, an insurance agent’s client brought suit against the agent because the agent didn’t tell the client about the possibility of a life settlement.9
How to Satisfy Fiduciary Duties
To fulfill their fiduciary duties, trustees should engage an independent consultant to perform annual reviews of the performance of the policy, the carrier and the suitability of the insurance. Policies have to be evaluated to determine how much longer the policy is expected to remain in force based on the current premium, whether additional premiums are required and the possibility of strategic payment reductions.
The independent consultants that trustees engage should:
1. Determine the monthly COI and all additional applicable charges, which may deviate materially from the projected premiums illustrated by the carrier;
2. Review and justify the relevance and continuation of supplementary benefits and riders;
3. Review in-force illustrations and annual statements and obtain the most current statement;
4. Obtain and analyze life insurance carrier ratings;
5. Evaluate policy performance;
6. Obtain actual life expectancy reports from an established and reliable third party;
7. Review policy features, including guarantees, evaluating the risks they present to the trust;
8. Confirm net death benefit amount from insurance carrier;
9. Confirm net cash surrender value from insurance carrier; and
10. Analyze previous payment history, including exact dates of payment.
Most policies typically don’t perform according to the life insurance company’s projections at the time the policy is originally issued. Premiums are projected using fixed or constant interest rate assumptions, although the carrier has reserved the right to change these assumptions, as well as the COI, at any point. Moreover, insurance companies don’t re-evaluate the insured’s health or life expectancy after the initial sale.
To monitor a policy effectively, as prescribed by the UPIA, trustees should hire an experienced independent consultant with extensive knowledge of actuarial assumptions and life expectancy underwriting. The independent consultant can obtain current life expectancy reports and calculate the COI by applying the same methodology that insurance companies use when issuing the policy. By essentially re-underwriting the insured, the third party consultant can more accurately predict future required premium payments and whether the policyowner’s actual payments should differ from the carrier’s suggested annual payments.
Attorneys drafting trust agreements for trusts intended to hold life insurance should advise the trustees (or advise their clients to advise their trustees) to review policies annually with independent consultants. The UPIA implies this level of monitoring, but trustees may be oblivious as to what their responsibilities entail, so attorneys can do a service to their clients and to their clients’ trustees by emphasizing the importance of the trustees’ active management of life insurance.
Endnotes
Life Insurance Settlement Association, “American Seniors Forfeit $112 Billion Annually Due to Lapsed or Surrendered Insurance Policies, According to Research Presented at LISA Institutional Investor Conference,” GlobeNewswire (Feb. 24, 2015), www.globenewswire.com/news-rele ase/2015/02/24/709266/10121642/en/American-Seniors-Forfeit-112-Billion-in-Benefits-Annually-Due-to-Lapsed-or-Surrendered-Life-Insurance-Policies-According-to-Research-Presented-at-LISA-Institutional-Investor-Confer.html.
Uniform Prudent Investor Act, Section 2, Standard Of Care; Portfolio Strategy; Risk And Return Objectives, Uniform Act Commentary.
In re Stuart Cochran Irrevocable Trust, 901 N.E.2d 1128 (Ind. Ct. App. 2009).
Ibid., at p. 1137.
Rafert v. Meyer, 859 N.W.2d 332 (Neb. Feb. 27, 2015).
Thompson v. Transamerica Life Insurance Co., No. 2:18-cv-05422, 2018 WL 6790561, (C.D. Cal. Dec. 26, 2018).
Nacchio v. Weinstein, L-3298-10, Superior Court of New Jersey, Morris County (2016).
Ibid.
Larry Grill, et al. v. Lincoln National Life Ins. Co., EDCV 14-0051-JGB (SPx), 2014 WL 12588653(C.D. Cal. Sept. 4, 2014).
Grace Bronstein is the CEO of Trust Life Insurance Management in Boca Raton, Fla. and Ian Weinstock is a partner at Kostelanetz & Fink LLP in New York City
