LIFE INSURANCE: TRENDS, TIPS, AND REVIEW

Greg Lowe, McKonly & AsburyDonna Wanamaker, 1802 Insurance

Mark Pulaski, 1802 InsuranceRachel Lower, 1802 Insurance

INTRODUCTIONS

Greg LoweMcKonly & Asbury

Partner/Chief Operating Officer

Donna Wanamaker1802 Insurance

Principal & Director, Insurance Operations

Mark Pulaski1802 Insurance

Principal

Rachel Lower1802 Insurance

Senior Consultant

INSURANCE BASICS

WHAT YOU DON’T KNOW CAN HURT YOU!

EXECUTIVE SUMMARY – LIFE INSURANCENo Longer a “Set It and Forget It” Purchase!

• Insurance products have changed significantly over the past 20 years• Policy owners and fiduciaries are often unaware of how small changes in the

underlying assumptions can dramatically affect their policies• Most products have shifted the risk from the insurance company to the policy

owner• The key is understanding the possible pitfalls of each product

HISTORY LESSON

In the beginning…there was…

WHOLE LIFE

WHOLE LIFE - BASICSPremiums paid for the “whole of life”.• Other variations– 10 pay, 20 pay, life paid up at 65.

Maturity –set at age 95 or 100• Guaranteed cash value = face amount

• Check written to the policyowner if the insured is still alive at that time!

• “Undoes” estate planning – taxable at ordinary income rates over basis!

Guaranteed elements:• Death benefit, cash values, premium amounts/duration

WHOLE LIFE - BASICSPremium pricing:• Set assuming carrier guarantees – assuming no dividends or excess interest are ever

earned. Translation – while the amount is guaranteed – it’s extremely high.

Dividends – not guaranteed:• Return to the policyowner of the “overpricing”.• Based on “current” mortality and expense assumptions.• Options: reduce premium, accumulate at interest, purchase paid-up additions

WHOLE LIFE…Flexibility of premiums:• Amounts – NONE• Skip or defer - Premiums must be paid in some way! Cash/policy loan.• APL – automatic premium loan – sometimes standard - protects against lapse.• WATCH OUT! Extended Term – often the standard non-forfeiture option. Risk – if

client doesn’t pay premium, policy lapses and purchases term insurance! Number of years in force – based on cash value at lapse time!

WHOLE LIFE…Premium “suspension” vanish• Dividends begin to purchase PUA • When combination of current year’s dividend + surrender of PUA can cover

the future premiums = suspensionReappearance Risk:

If dividends reduced – premiums can reappear. If policy owner unaware – can lapse into extended term or premiums borrowed – either of which can lapse policy.

WHOLE LIFE BLENDS – THE NEXT EVOLUTION- Introduced as a way to lower premium amounts.- Blend of whole life and term insurance.• Dividends first purchase the target term amount; Balance purchases (PUA).• As PUAs increase, amount of term needed decreases – but cost of term

increases as insured gets older.

- Risk - High ratio of term to whole life puts the target death benefit at risk!

WHOLE LIFE BLENDS - RISKSDividends can be and have been reduced over time• If dividends reduced = less paid up additions purchased

• Less PUA = higher term amounts needed

• Higher term needed = more dividend $ to provide target death benefit.

• Reverse compounding effect – as term rates increase due to age and more term needed, eventually dividend can no longer support the full death benefit.

Effect? • Live with less death benefit (only the “base” death benefit is guaranteed)• Pay for the cost of the term – at whatever age it’s needed!

Term insurance rates can change• If underlying term rate scale changes in addition – to dividend reduction – exacerbates the problem.

HISTORY LESSON

Then there was…

UNIVERSAL LIFE

UNIVERSAL LIFEA permanent life insurance product - which offers flexible premiums based on the policyholder’s objectives.

Key features:• Unbundled - specifically separates and identifies the mortality, expense, and cash

value parts of the policy.• Think – “term insurance with a bank account”

UNIVERSAL LIFESimply stated:Additions to bucket:• Premiums• InterestSubtractions:• Mortality charges• ExpensesSurrender charges – assessed if policy surrendered

UNIVERSAL LIFEDeath Benefits Options:• Level, increasing = to face + cash value; return of premiumInterest rates:• Based on earnings of carrier’s investment portfolio• Guaranteed minimum – 2-4%Mortality and expense charges:• Two tables – current and guaranteed

UNIVERSAL LIFE - PREMIUMS•Flexible - No set amount – within minimum and maximum range•Can be modified each year to adapt to changing circumstances.•Initially set based on illustration assumptions:

• Current or alternate interest (crediting rate)• Current mortality/expenses charges

UNIVERSAL LIFE - COMPARISON•Premiums:• Lower than whole life on a “life pay basis” under current interest/charges. If all

assumptions were guaranteed; would be similar.• Can “overpay” to shorten up premium payment period.• Can be “skipped” without incurring a loan on the policy - can be made up with

interest at a later time. • Advantage - death benefit not reduced by a policy loan.

• Death benefit flexibility – decrease / increase• Cash value access – lifetime access to cash values. Policies

designed for it!

UNIVERSAL LIFE – MORTALITY CHARGES• Mortality charges – think 1 year term insurance for current age. Increased cost per

thousand each year.

UNIVERSAL LIFE EXAMPLE – LEVEL PREMIUM

UNIVERSAL LIFE – EXAMPLE OF LEVEL DEATH BENEFIT POLICY PREMIUMS PAID FOR LIFE• Mortality charges are assessed on NAR. The higher the cash value, the lower the

NAR. The lower the cash value, the higher the NAR.

UNIVERSAL LIFE EXAMPLE – MAX FUNDED

UNIVERSAL LIFE EXAMPLE – MAX FUNDED 7 YEARS

UNIVERSAL LIFE - RISKSLAPSE:• If premiums + cash value insufficient to cover charges, coverage TERMINATES!

Increased Premium:• Option – at lapse date, pay the cost of insurance similar to buying term at that age!

Probably not affordable!• Minimally funded policies illustrated back in the 1980’s – interest rates were 11%+ -

now 4% - think BIG INCREASE in premiums – or must have a “death claim” prior to the lapse age!

HISTORY LESSON

Then there was…

NO LAPSE UNIVERSAL LIFE

NO LAPSE GUARANTEE UNIVERSAL LIFEAdds a guaranteed element – but at a price!• Higher premium than traditional UL.• Lower usually than whole life.Think “term insurance for life”• Little to no cash value• Not very flexible.• Guaranteed death benefit and premium amount – assuming all premiums paid ON

TIME each year.

WHEN IS “GUARANTEED” NOT GUARANTEED?Premiums not paid on time!• What is definition of “on time”? • Depends on carrier – often is:• On the due date – not one day earlier, not one day later!• Yes – earlier can negatively affect the policy in some cases!

• Advice - Request an inforce illustration for these policies – see if the guarantee period is still the same as originally illustrated – could be in for a rude awakening!

HISTORY LESSON

Then there was…

VARIABLEUNIVERSAL LIFE

VARIABLE UNIVERSAL LIFE• Simply put – Universal Life where the cash value is invested in various stock/mutual

funds offered by the insurance company.• Shifts more risk to policyowner.• Upside – unlimited• Downside – unlimited! Loss of 20% in one year then gain of 20% next year does not

equal zero!• Reverse compounding effect - remember the NAR chart and mortality charges!

VARIABLE UNIVERSAL LIFEAdditional charges vs. traditional UL• Investment Management Fees and Direct Operating Expense• Mortality & Expense Risk charge (NOT regular mortality charge)

VARIABLE UNIVERSAL LIFE Key to keeping a “sound policy”• Initial conservative hypothetical investment rate assumption.• Can illustrate up to 12% - don’t do that!• Stress test the illustration at various rates.

And finally –

MONITOR – MONITOR – MONITOR!!• How is the policy doing vs. original assumptions!

HISTORY LESSON

And finally…

INDEXEDUNIVERSAL LIFE

INDEXED UNIVERSAL LIFECombines some of the downside protection of a universal life insurance policy with some of the upside potential of a variable universal life insurance product.

How?• Credits the policy with a rate of return based on the change in an equity index.• Cap rate (max earnings) – currently 9-11%• Floor – yearly earnings can’t go below 0%!!

Each premium deposit is allocated to the specific index account chosen by the policy owner:• Index accounts generally include:• 1 year, 2 year, 5 year accounts• International indexed accounts• A fixed rate account with a declared crediting rate set by the carrier (similar to that of a traditional UL)

• The Index Performance Rate is then multiplied by the Segment’s Participation Rate. The product of these two rates is the “Growth Rate”

•The Growth Rate is applied to the cap and floor.

Retains all the flexibility of traditional Universal Life.

As in the case of Variable Universal Life:• Original illustration should be based on conservative assumptions.• MONITOR – MONITOR - MONITOR

INSURANCE REVIEWS

Time to face the music – fix the problems – before it’s too late

INSURANCE REVIEW - COMPONENTSProduct selection

• Did the products chosen meet the client’s original objectives.

• Have those objectives changed?Performance

• What was the policy originally designed to do and using what assumptions?

• What does it look like today?

• Will the policy lapse (terminate) too early?

INSURANCE REVIEW - COMPONENTSEnhancements• Can the existing policy be enhanced?• Does the carrier have any type of internal exchange program?• Other examples:• Change of death benefit from increasing to level• Reduction of face amounts, removal of riders

• Replacement – 1035 exchange (if the insured is still insurable)• Can the existing policies be replaced with more competitive products?• Today’s underwriting classes have more than just smoker and non-smoker classifications

INSURANCE REVIEW - COMPONENTSInsurance Carrier Financial stability analysis• Will the carrier be there to pay the death claim?• Ratings analysis• General account – asset quality analysis

INSURANCE REVIEW - COMPONENTSLife Insurance Mistakes and Tax Traps - Ownership/Beneficiary Problems• Estate as beneficiary• No contingent policy owner or beneficiaries• Insurance owned by the insured • Irrevocable Trust owned – but no administration ever completed• The “unholy trinity” (personal and/or business)• The 3 Year Rule• Split Dollar Issues• The Transfer for Value Rule

LIFE INSURANCE – MISTAKE #1Insured’s Estate as Beneficiary

• Policy proceeds may be subject to:• Probate

• Creditor’s claims

• Estate or inheritance taxes (possibly both) at the state and federal levels.

LIFE INSURANCE – MISTAKE #2No contingent policy owner or beneficiariesIf the policy owner and the insured are two different people, and the owner dies first, the policy ownership has to pass to a successor owner until the death of the insured.

• If no successor owner, policy passes as a probate estate asset to the next owner either by will or by intestate succession.

• Could cause the policy to pass to an unintended owner or multiple owners.

LIFE INSURANCE – MISTAKE #3Insurance Owned by the Insured • The life insurance proceeds will be included in the estate of the insured for federal

estate tax purposes. • If the insured’s estate is greater than the federal exemption amount, federal estate

taxes will be due on the proceeds.

LIFE INSURANCE – MISTAKE #4Irrevocable Trust owned – but no administration ever completed• Failure to qualify the premiums as “gifts of a present interest” and send the proper

notifications to the beneficiary (Crummey letters), can cause the policy to be included in the estate of the insured and subject to estate taxes.

LIFE INSURANCE – MISTAKE #5AThe Personal “Unholy Trinity”• Exists when three different parties are designated as the owner, the insured, and

the beneficiary.• If the insured dies, proceeds considered to be a gift from the owner to the

beneficiary.

• Unnecessary use of lifetime exemption or gift taxes.

LIFE INSURANCE – MISTAKE #5BThe Business “Unholy Trinity”• Similar to the Personal Unholy Trinity, but in this case a business is the

policy owner rather than an individual.•If the insured dies, subjects the proceeds to income tax to the beneficiary.• Exact nature of taxation depends on the parties’ relationship – if beneficiary is a

shareholder, may be taxable as non-deductible dividend. If employee, as compensation.

LIFE INSURANCE – MISTAKE #6The 3 Year Inclusion Rule• If the insured dies within 3 years of transferring a policy as a gift, the policy

proceeds will be included in the estate of the insured and subject to estate taxation.

•The better method – avoid the rule -

• Sell the policy if possible, to the transferee…

LIFE INSURANCE – MISTAKE #7Split Dollar Issues:

1. Arrangements Not Properly Structured post final regulations

2. Equity split dollar prior to 2003 – rollout issues

3. No economic benefit recognized

4. No gifts of economic benefits to trust

5. Majority shareholder inclusion issues

6. Improper accounting of cash value/death benefit

LIFE INSURANCE – MISTAKE #8The Transfer for Value Rule• Life insurance proceeds are generally not subject to income taxation (IRC

§101). However, if the policy or an interest in the policy was transferred after the initial purchase for “valuable consideration”, the rule is triggered and the death benefit is subject to income tax.

UNLESS – the transfer falls into one of the exceptions!

THE TRANSFER FOR VALUE RULE - CONTINUEDExceptions – transfers to:

• To the insured

• To a partner of the insured

• To a partnership in which the insured is a partner

• To a corporation in which the insured is an officer or shareholder

• Carryover basis exception (gift) - Where the individual/entity receiving the basis in the policy is determined by whole or in part by reference to the basis of the transferor.

NON-QUALIFIED PLANS

Informally Funding Liabilities with Life Insurance

NON-QUALIFIED PLANS - FUNDING• Majority of Non-Qualified plans are informally funded by some

permanent insurance• Corporate-owned life insurance is an attractive option for informal

funding of nonqualified plans.• Premium dollars can be converted to cash value that grows-tax deferred.• Investment earnings that would have otherwise been taxed currently can

now accumulate on a pre-tax basis inside the policy.• Immediate death benefit payable to the corporation upon insured’s death.

NON-QUALIFIED PLANS - FUNDINGImportant items to note:• Have all insured’s signed a consent to insure for 101(j) compliance?• Don’t minimally fund the policies!• Don’t assume people will die too early – plan for everyone reaching

ripe old age of 100+

NON-QUALIFIED PLANS - FUNDINGMonitor policies:• Investment allocation in policies vs. projected liabilities.• When is cash flow needed?• If cash flow is to come out of the policy, make sure cash value can sustain withdrawals

and/or loans against the policy.• Don’t let policies lapse! Anything over basis taken out in a loan will be taxable!• Ordinary income tax rates.• INCLUDES accrued loan interest – phantom income!

WHO WE ARE• 1802 Insurance™ is a new division of Cornerstone Advisors

• Unbundled • Professional insurance services have been separated from estate/business plans

created under Cornerstone Advisors.

•True Insurance Professionals

M POWEREDM Financial Group Member Firm• M Financial is the nation’s leading financial services design/distribution company for

the ultra-affluent market

• Team of 200 professionals in Portland dedicated to supporting M Firms as they serve their clients

• Individuals specializing in product development/management, sales support, underwriting, finance, reinsurance• Includes 18 full-time actuaries, and 2 full-time underwriters

M CARRIER RELATIONSHIPSTHE COUNTRY’S MOST PRESTIGIOUS INSURANCE CARRIERS

PRODUCT OFFERINGSLife Insurance:• “Traditional” Universal Life• Variable Universal Life• Indexed Universal Life• Term Insurance• Private Placement Variable Universal Life – • Brings hedge funds within a life insurance wrapper

• Disability• Long Term Care

M ADVANTAGESInnovation: M Proprietary Products• Exclusively available through Member Firms

• Proprietary insurance products designed/priced using over 30 years of mortality, persistency, policy size & expense experience

• Only the experience of the “pool” of insureds within the M system backs our products!

• Higher face amounts = less expensive to administer

• Mortality – currently outperforming general public

• All this = fewer underlying policy expenses

M ADVANTAGES – TREATMENT OF INFORCE POLICY HOLDERS

• In-force management is based on:

• Belief that existing policyholders should be treated as well as new policyholders!

• Continually monitors product performance and pricing

Results:• 54 re-pricings for both new and inforce-policies

• Cost reductions totaling $200 million!

• Not typical in regular distribution systems!

CONTACT INFORMATION

Greg LowePartner/Chief Operating Officer

Glowe@macpas.com(717) 761-7910

Donna WanamakerPrincipal & Director, Insurance Operations

dwanamaker@cornerstoneadvisors.com(610) 437-8980 (Direct Dial)

Mark PulaskiPrincipal

mpulaski@cornerstoneadvisors.com(717) 903-1323 (Cell)

Rachel LowerSenior Consultant

rlower@cornerstoneadvisors.com(610) 437-8353 (Direct Dial)

CONTACT INFORMATION

Greg LowePartner/Chief Operating Officer

Glowe@macpas.com(717) 761-7910

Donna WanamakerPrincipal & Director, Insurance Operations

dwanamaker@cornerstoneadvisors.com(610) 437-8980 (Direct Dial)

Mark PulaskiPrincipal

mpulaski@cornerstoneadvisors.com(717) 903-1323 (Cell)

Rachel LowerSenior Consultant

rlower@cornerstoneadvisors.com(610) 437-8353 (Direct Dial)