National Association of Estate Planners and Councils

February, 2009 Newsletter
Provided by Leimberg Information Services

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Summary of Key Life Insurance Developments

Lee J. Slavutin of Stern Slavutin 2, Inc. in New York City is the author of the just revised PPC's Guide to Life Insurance Strategies [ (800) 323-8724.]

Lee provides LISI members with an excellent review of the most important events of the last year impacting on life insurance.


This commentary summarizes some of the more important trends, developments, rulings, and legislation in the life insurance field during 2008. It also look at many "common sense" action items that planners should be keep in mind.


In 2007 and 2008, the sub-prime mortgage market collapsed, several large financial institutions failed (e.g., Bear Stearns, Lehman Brothers, and Washington Mutual) and, in early 2009, the US finds itself in its longest and deepest recession since the Great Depression. Life insurance companies, with the exception of AIG (discussed below), have been less severely affected than the banks and brokerage houses.

Life insurers, however, do face significant pressure from a number of possible sources:

·        Losses from investments in AIG, Lehman Brothers, and Washington Mutual;

·        Losses from sub-prime residential mortgages and mortgage backed securities;

·        Losses from commercial mortgage loans;

·        Losses from variable annuity business lines. Variable annuities, with guaranteed minimum withdrawal benefits and guaranteed minimum death benefits, in a declining stock market sound like the perfect storm. Some companies have larger exposures than others.

We will look at the AIG story and then at how we should monitor our clients' policies going forward.


What happened with AIG has never happened in the life insurance industry; the federal government has yet to bail out a life insurance company. AIG's troubles were caused by one particular instrument, the credit default swap, a form of insurance against default of mortgage-backed securities. AIG's exposure on credit default swaps for mortgage-backed securities was estimated to be $441 billion. (See Bob LeClair's Finance and Markets Email Newsletter - Archive Message #462)

Had AIG collapsed, it would have affected banks across the world, which is one of the primary reasons why the government stepped in. AIG's issues were not with its insurance company subsidiaries, but rather were in the parent company, which is in sharp contrast with previous large insurance company failures of the early 1990's such as Executive Life and Mutual Benefit.

The major AIG life insurance subsidiaries that do business in the United States are American General, Variable Annuity Life, AIG Annuity Insurance Company, Sun America and United States Life Insurance Company of New York. These subsidiaries retained investment-grade ratings and are protected by state law which effectively walls off the assets of the subsidiaries from the parent company.

Many expect that the life insurance subsidiaries will be sold to one or more large life insurers. What do we advise clients who have life insurance policies with these subsidiaries? We are advising our clients to sit tight, and we have been reassured by the Insurance Commissioner in New York that the insurance subsidiaries of AIG are solvent and able to pay claims. We are further reassured by the Federal Government's support of AIG which now exceeds $100 billion.


As a result of what happened in 2008, we believe our clients face at least two important risks in their life insurance portfolio in 2009 and beyond:

1.     Policy lapses because of investment losses in the stock market. This will be an issue for some variable life policies invested in equity sub-accounts.

2.     Insurance company impairments or failures.

Monitoring of insurance policies will require greater vigilance in 2009:

1.     More frequent checks (e.g., monthly or quarterly) on variable life insurance account values and "re-testing" policies, i.e., obtaining current in-force illustrations to see if current premiums are adequate to maintain the policy.

2.     More frequent checks (e.g., weekly) on insurance company ratings with all the rating services (visiting the web sites requires registration, but no fee, to obtain current ratings). Some companies have already been downgraded and others have been taken over by state regulators (e.g., Standard Life Insurance Company of Indiana and Penn Treaty Network America Insurance Company).

The rating services are not perfect, but can be a valuable source of information on the financial strength of the insurers. If a company is downgraded and the client is thinking of replacing his policy with a new policy from another carrier, please review carefully the following "replacement" issues:

·        is replacement really in the client's best interests;

·        is the old policy favorably priced and already "paid up;"

·        are there significant surrender penalties if the old policy is canceled; and

·        is the client insurable at favorable rates.


Some clients may prefer to buy large amounts of term insurance for estate planning needs until their cash flow improves. For clients like these, check the conversion option of the term policy for the following features:

·        Duration – does the option last the full term of the policy?

·        Can the term policy be converted to any permanent insurance product (WL, UL or VL) or is conversion limited to a particular product?

·        Will the client keep the same underwriting class after the conversion? For example, will a preferred nonsmoker class before conversion stay the same or drop down to standard nonsmoker after conversion?

·        Is partial conversion permitted? For example, can a client convert $500,000 of term to whole life when the term policy starts as a $1 million policy? Can the other $500,000 be converted at a later date?


Divorced clients sometimes forget to change the beneficiary of their life insurance from the ex-spouse to their children or someone else.

If the client dies without making the change, the ex-spouse in many states will get the proceeds. However, some states protect the decedent who had no intention of leaving the insurance to his ex-spouse.

New York broadened the revocatory impact a divorce has on beneficiary designations. (See: )

In New York, divorce now revokes not only a disposition in favor of a former spouse in a will, but also in any revocable transfer, including life insurance and retirement plan beneficiary designations, to the extent permitted by law.


The Pension Protection Act imposed a new reporting rule on employers that own life insurance policies on their employees (including key person insurance, split dollar, buy sell, and deferred compensation plans). The final regulations were released in late 2008. (See LISI Estate Planning Newsletter #1369)

The final regulations are applicable for tax years ending after November 6, 2008. However, because the temporary regulations were effective for tax years ending after November 13, 2007, and there are no substantive changes, the new reporting requirements became effective for most employers for the 2007 tax year, and new Form 8925 must be filed.

Form 8925 ("Report of Employer-Owned Life Insurance Contracts"), should be filed with the employer's tax return. Every employer with one or more employer-owned life insurance contracts issued after August 17, 2006, must file Form 8925 for each tax year ending after November 13, 2007, during which the employer-owned policies are in effect.

Form 8925 asks four questions:

1.     How many employees does the employer have;

2.     How many employees are insured by employer-owned policies issued after August 17, 2006;

3.     How much life insurance is in force for the policies described in # 2; and

4.     Does the employer have a valid consent for each employee included in # 2?


Is the sale of interests in an LLC, which owns life insurance policies, treated as a sale of interests in the policies, and therefore a possible transfer for value?

In PLR 200826009 (See LISI Estate Planning Newsletter #1314), an LLC operating as a partnership purchased life insurance policies on a number of homeowners to protect its investment in the future appreciation of their homes.

Putting aside the details of the real estate transaction and focusing on the life insurance policies owned by the LLC, the ruling addressed an interesting question on possible transfer for value.

The LLC planned to sell membership interests to third party investors for cash. Would the sale of the membership interests be a sale of interests in the policies owned by the LLC and therefore trigger transfer for value?

The IRS ruled that there would be no transfer for value of the underlying policies, unless there was a constructive termination of the LLC under Code section 708(b)(1). This ruling continues the long string of favorable transfer for value rulings the Service has issued over the past 10 years.


The IRS has expressed its concerned that some taxpayers may enter into a transaction similar to the transaction in the case of Conway v. Commissioner (111 T.C. 350, 1998; AOD 1999-016), often referred to as a "partial exchange," to reduce or avoid the tax that would otherwise be imposed by section 72(e)(2).

For example, if a taxpayer withdraws $1000 from an annuity contract with a cash surrender value of $2000 and investment in the contract of $800, the entire $1000 of the withdrawal would be included in income pursuant to section 72(e)(2).

However, if that same taxpayer assigned 50 percent of the cash surrender value of the annuity contract in a partial exchange, such that the cash surrender value of each contract after the exchange was $1000 and the investment in each contract after the exchange was $400, and then surrendered either the existing annuity contract or the new annuity contract, under section 72(e)(2) only $600 would be included in income and $400 would be excluded as a return of investment in the contract (See IRS Notice 2003-51 )

Under Rev. Proc. 2008-24 (See a partial annuity exchange will be treated as a tax-free exchange under IRC section 1035 if either:

(a) no amounts are withdrawn from, or received in surrender of, either of the contracts involved in the exchange during the 12 months beginning on the date on which amounts are treated as received as premiums or other consideration paid for the contract received in the exchange (the date of the transfer); or

(b) the taxpayer demonstrates that one of the conditions described by IRC sections 72(q)(2)(A), (B), (C), (E), (F), (G), (H) or (J), or any similar life event (such as divorce or loss of employment), occurred between (i) the date of the transfer, and (ii) the date of the withdrawal or surrender.

Note: Rev. Proc. 2008-24 shortened the waiting period under Notice 2003-51 from 24 months to 12 months.


In Revenue Ruling 2008-42 (See LISI Estate Planning Newsletter #1317), the IRS concluded that premiums paid by an S corporation on an employer-owned life insurance contract, of which the S corporation is directly or indirectly a beneficiary, do not reduce the S corporation's AAA.

It also concluded that the benefits received by reason of the death of the insured from an employer-owned life insurance contract do not increase the S corporation's AAA. (See )


The impact of the GSTT rules cannot be overemphasized.

For purposes of the deemed allocation rules under Code section 2632, most irrevocable life insurance trusts (ILITs) will be treated as GST trusts and any unused GST exemption will be automatically allocated to the ILIT. It is very important for accountants who are filing gift tax returns to remember this rule and to allow the automatic allocation or elect out of it if desired.

The election out of the automatic allocation rule is made on Form 709, Schedule A, Part 3, Indirect Skips, by checking the box in Column C and attaching a statement that describes the election you are making. Instructions can be found on page 9 of the 2008 Instructions for Form 709 – see "Column C. 2632 (c) Election."


Life insurance policies are often transferred as a gift (e.g. to an ILIT) or a sale (e.g., from a retirement plan to an ILIT). In the past many relied on the insurance company Form 712 for gifts. This may not be sufficient.

There are many ways to value a whole life, universal life or variable life policy:

·        A newly issued policy (a few months old) is usually valued at the annual premium needed to acquire the policy;

·        Interpolated terminal reserve plus unearned premium if premiums are being paid and the policy has no unusual features;

·        The PERC value (Revenue Procedure 2005-25) if the policy has a springing cash value; and

·        The policy's life settlement value if the insured is in poor health.

Note: The insurance company usually issues a Form 712 with a gift tax value based on method (i). This may not always be appropriate and it may be necessary to ask the insurer for the PERC value or obtain the life settlement quote from a settlement broker.


If the parties to a split dollar arrangement modify the terms of the arrangement, but do not modify the terms of the life insurance contract underlying the arrangement, that modification will not be considered a material change in the life insurance contract for purposes of either section 101(j) or 264(f), even if it is a material modification for purposes of the split dollar regulations (See LISI Estate Planning Newsletter # 1266 and IRS Notice 2008-42 )

·        Example: Bob created an endorsement equity split dollar arrangement (SDA) in 1998. The policy is owned by Heavy Metal, Inc., and Bob and his son own Heavy Metal and are employees of the company. The company endorses the death benefit in excess of any premiums it pays to a trust for Bob's family.

The company is entitled to the lesser of premiums paid or cash value when the SDA terminates. It is therefore an equity SDA (employee or trust is entitled to excess of cash value over premiums paid if SDA terminates during life).

The SDA is grandfathered for purposes of the split dollar regulations because it was set up before January 28, 2002. The policy was purchased before August 2006 and is, therefore, not subject to the reporting rules under 101(j) for employer-owned life insurance.

In 2008, Bob modifies the SDA to allow the arrangement to continue after Bob retires. No change is made to the insurance policy. Under IRS Notice 2008-42, the policy is still grandfathered for purposes of section 101(j). It is not clear from the final split dollar regulations whether this change will cause the SDA to lose its grandfathered status under sections 61 and 7872 (split dollar economic benefit and loan rules).


A key ingredient of any successful SDA or loan arrangement ("premium financing") is an exit strategy. Today's low interest rates make GRAT's an attractive technique assuming you can fund it with an asset that is growing or throwing off good income. By naming the ILIT in a SDA the remainder beneficiary of a GRAT, the ILIT can get funded after a few years with sufficient assets to repay the premium donor in the SDA and make ongoing premium payments.


Over the last few years, a new variant of private split dollar has been promoted, and is sometimes referred to as "discount" private split dollar. These transactions are frequently structured in the following manner:

·        Grandparent (GP) creates an irrevocable grantor trust for the benefit of his grandchildren (GC).

·        The trust (ILIT) buys an insurance policy on the grandparent's child (C).

·        GP enters into a non-equity collateral assignment SDA with ILIT.

·        SDA qualifies for economic benefit treatment

·        GP cannot terminate SDA unilaterally and is entitled to greater of premiums paid or cash value at death of C.

·        GP makes several large annual payments to the trust under the SDA. The policy is funded after 5 years. C gifts the term cost each year to the trust.

·        When GP dies his estate is entitled to GP's interest in the policy.

The $64,000 question is how the estate's interest is valued. One theory holds that the estate's interest is the present value of the repayment of premiums, which is greatly discounted because the premiums will be repaid when C dies in, say, 30 years.

In the marketing materials, the hoped-for result is that GP's estate is paid a relatively small sum and the policy is funded with little or no taxable gift. Is this too good to be true?

Could the different steps be collapsed and the GP be deemed to make large gifts up-front? We have no IRS ruling on this plan, and it does seem aggressive.


Every split dollar agreement must be properly documented, including the split dollar agreement, corporate resolution to adopt the agreement, and collateral assignment filed with the insurer, if the policy is owned by the employee or a trust.

·        Every year the term cost (what we used to call "PS 58" amount and now call Table 2001 cost) should be paid by the employee or reported as income;

·        Consider paying interest rather than accruing it in loan arrangements;

·        Comply with the new rules under 101(j) and 409A; and

·        Design an exit strategy before the term costs or loan interest costs start to escalate.


STOLI litigation is proliferating. Consider the following partial list: (For Steve Leimberg's Heckerling "white paper" on this topic, drop Steve a request:

·        Jefferson-Pilot Life Ins. Co. v. Marietta Campbell, 2008 U.S. Dist. LEXIS 61511; Marietta Campbell Ins. Group, LLC v. Jefferson-Pilot Life Ins. Co., 2007 U.S. Dist. LEXIS 79075 (D.N.D., Oct. 24, 2007); N.D. Cent. Code § 26.1-29-25.

·        William T. Wuliger v. Manufacturers Life Insurance Company, 2008 U.S. Dist. LEXIS 9809, Case No. 3:03 CV 7457;

·        First Penn-Pacific Life Ins. Co. v. Evans, Slip Copy, 2007 WL 1810707 (D.Md.);

·        American General Life v. Schoenthal, 2008 U.S. Dist. LEXIS 2973 (N.D. Georgia, January 15, 2008);

·        Life Product Clearing, LLC, v. Angel, ___ F.Supp.2d ___, 2008 WL 170193 (S.D.N.Y. Jan. 22, 2008);

·        Lincoln National Life Insurance Co. V. Gordon R. A. Fishman Irrevocable Life Trust, Case No. 5:2007cv 01338 (C.D. Cal. Oct. 11, 2007)}

It is particularly instructive to read New York Life's Memorandum in Support of its Motion for Summary Judgment in Stalsberg v. New York Life Insurance Company, et al (Docket No. 2:07-cv-29, US District Court, Utah).

Two portions of the memorandum are worth quoting:

·        "…first that the insurable interest rule cannot be satisfied if the intent at the time the policy was first issued was to sell the policy to persons lacking any insurable interest; second, the courts must look to the substance of the transaction, not its form, in deciding whether the insurable interest rule is satisfied."

·        "The underlying principle is that all valid contracts are assignable, but that contracts are not necessarily valid and free from the taint of gambling because upon their face they appear to be regularly and properly issued. In order to ascertain the truth, all the facts and circumstances may be proved, and if it appears that the parties intended by the contract to enable a third and uninterested party to speculate upon the life of another, the court will declare such contract invalid, not because of the assignment, but in spite of it."

Anti-STOLI legislation was enacted into law in 13 states in 2008 and over 20 states are expected to work on legislation in 2009.  (For more information on recent developments in STOLI, drop Steve Leimberg an e-mail: )


Lee Slavutin


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