Authored by: Laura Wartner, Esq.

An Irrevocable Life Insurance Trust (“ILIT”) is a commonly used estate planning tool. The purpose is to own one or more policies of life insurance on one or more individuals (the “Insureds”). While the value of the death benefit of a life insurance policy owned by an Insured is included in the Insured’s estate for federal estate tax purposes, such a policy owned by an ILIT, if properly drafted, is not. An ILIT thereby provides death benefits in the form of liquid funds to the ILIT beneficiaries which death benefits will not be subject to federal (or state) estate taxes.

What happens in an ILIT after the insurance policy is purchased? Quite often, other than the payment of premiums, nothing. And in today’s economic environment, that could be a big mistake.

A recent case is illustrative. An Insured created an ILIT in the 1980’s for the benefit of his children, naming a local bank as Trustee. The ILIT purchased policies having a collective death benefit of $5 million. Ten years later, the advisor who originally sold the policies recommended replacing them with a different kind of policy having a death benefit of $8 million, and the Trustee agreed. Over the next few years, the policies lost value due to economic conditions. So in 2004, the Trustee retained an independent consultant to audit the policies, who concluded that the policies would likely fail to stay in force (due to diminished case values) before the Insured reached his life expectancy. The Trustee, therefore, exchanged the policies yet again, purchasing new policies guaranteed to the Insured’s age 100 and having death benefits of $2.5 million. Unfortunately, six months later the Insured died unexpectedly, and the trust received the $2.5 million life insurance proceeds for the benefits of the trust beneficiaries, rather than the $8 million it would have received from the prior policy, or the $5 million death benefit from the original policy.

The beneficiaries were disappointed with that result. They sued the Trustee for breach of fiduciary duty. The court ultimately found that the Trustee had not breached its duties to the beneficiaries and therefore was not liable for the reduction in benefits. Even so, that case tells us a lot about the duties of Trustees and the care and feeding of ILITs. Some of the lessons that can be applied to our own ILITs:

1. When was the last time the ILIT policies were reviewed? Under the laws of most states, Trustees are subject to the Prudent Investor Act which requires Trustees, in the investment and management of trust property, to exercise the same degree of judgment and care as a prudent person in like circumstances. Failure to audit the ILIT policies on a regular basis may constitute a breach of that duty. Some questions to be considered:

• Is the policy still suitable for its intended purpose, given the situation as it exists today?
• Is the policy performing as it should? Have the original illustrations been compared to the “in-force ledgers” to determine if the policy is meeting expectations?
• How does the existing policy compare to comparable policies? Other types of policies? Other types of investments?
• Is there a potential for the policy to lapse?

2. What is the status of the existing carrier? A number of insurance companies today are experiencing financial difficulties. Have the carrier’s ratings changed?

3. Is there an insurance policy management statement? Similar to an investment policy statement, this document provides guidelines for selecting and managing the policy. If none exists, how will the trustee be able to properly evaluate the policy?

4. What is the status of the insured’s health? Health changes may have a significant impact on the decisions to be made.

5. How is the policy being funded? Does that funding mechanism still work?

6. If the policy is a variable policy, are the current investments still appropriate? Do the investments need to be changed? Rebalanced?

7. Does the ILIT Trustee have the requisite knowledge and expertise to make an appropriate evaluation? If not, consultation with a knowledgeable professional may be advisable. Should the original salesperson be consulted? An independent consultant? The most prudent choice may be an independent advisor who will not stand to benefit from the decisions made.

ILITs can be very useful estate planning tools. Without proper attention, however, they may not be as useful as the beneficiaries expect.