Chapter 15: Survivorship life.
In its pure form, survivorship life (SL), which is also called second-to-die or last-to-die life insurance, is a life insurance policy or, often, a combination of policies and riders that pays a death benefit only when the last of two or more named insureds dies. It is most frequently used to insure two lives, typically a husband and wife, but some companies offer products that will insure three or more lives.
The three-or-more-insureds policies offer some variation on the last-to-die concept. In some policies, the policyowner may choose at the time of issue at which death policy proceeds will be paid. For example, if the policy covers four lives, the policyowner could elect to have the proceeds paid after the third death, rather than the last death. In addition, some of the three-or-more-lives policies allow the policyowner to choose to have multiple payouts. For instance, the policyowner might elect to have the face amount paid when the first and last, but not the second and third, of four named insureds dies.
The basic policy in a survivorship life plan is generally a permanent form of life insurance--traditional whole life, current assumption whole life, or universal life--but some companies offer term survivorship life. As a result of competitive pressures in the industry to keep premium costs down, many survivorship life plans now involve a combination of permanent and term life elements.
WHEN IS THE USE OF THIS TOOL INDICATED?
1. To provide estate liquidity at the second death of a married couple--SL is most often used where there is a substantial estate and heavy use will be made of the marital deduction. Use of the unlimited marital deduction, either outright or in conjunction with some form of marital trust, permits deferral of all or most federal estate taxes until the second death. SL provides liquidity when it is most needed, upon the second death, often at the lowest possible outlay.
2. To protect two-career families--If both husband and wife have successful
careers, the loss of one income may be tolerable, but the loss of both incomes would leave remaining dependents with no support. SL provides a relatively low cost method of protecting the family against the loss of the income of both parents.
3. To provide key person business insurance--In many cases, the loss of a single employee in a key area may present some transitional inconvenience, but it is not insurmountable. Often, companies cross-train employees or assign some overlap of responsibility among key executives to minimize the risk of loss of just one key employee. However, the loss of two key employees in a sensitive area may cause serious disruption in a development effort. Similarly, the loss of one key financial backer may be acceptable, but the loss of two could seriously jeopardize a company. In these types of situations, survivorship life may provide the most economical means of protecting the company.
4. In split dollar plans--The same rationale used to justify the use of a split dollar single life applies to survivorship life. The annual taxable cost of insurance should be calculated by taking into account the probability of both insureds dying in a given year, rather than the costs that are used for single life insurance policies. Consequently the tax cost to the employee is many times lower than what the cost would be on separate policies at the same ages.
5. To help fund charitable bequests--The use of survivorship life can provide the resources necessary to fund charitable bequests after both husband and wife have died. Also, when properly used in combination with contributions of appreciated assets to charitable remainder trusts, all or most of the assets passing to the charity can be replaced by insurance proceeds at a low overall premium cost. In many instances, the combined income and estate tax savings will be more than the total premiums paid on the insurance.
1. If used in conjunction with the unlimited marital deduction, proceeds are payable when needed--at the second death.
2. Premiums are lower than for equivalent coverage in two separate policies.
3. There are a number of alternative term/permanent life combinations available that provide wide latitude and flexibility in premium payment and death benefit arrangements.
4. A lower taxable "economic benefit" is reportable in split dollar plans.
5. Medical underwriting standards are often eased (at least for one of the two insureds) due to the fact that death benefits are not paid until the last death.
1. SL provides no benefits at the first death if needed, without the addition of a special rider.
2. In term/permanent plans, there is a risk that premiums could escalate prohibitively if dividends are lower than projected and/or term rates increase.
General Income Taxation
SL is treated in the same manner as other types of life insurance for income tax purposes. Death benefits are paid tax free. If the policy is not classified as a modified endowment contract (MEC), nonannuity distributions or withdrawals will be taxed on the "cost recovery" or first-in first-out basis. That is, amounts received will be treated as a tax-free recovery of investment in the contract until the entire cost basis is recovered. Once basis is recovered, any further amounts will be taxed at ordinary rates as gain in the policy. Annuity distributions will be taxed as a combination of tax-free recovery of cost basis and taxable interest or gain as described in IRC Section 72. Loan proceeds are not taxable and, in general, interest paid on policy loans will be treated as nondeductible consumer interest. (1)
If an SL policy is treated as a MEC, lifetime distributions and loans are essentially taxed under the "interest-first" rules applicable to annuities. (2) In addition, if amounts are received prior to age 591/2, a 10% penalty is imposed on the taxable portion of the distribution. However, in the typical case where an SL policy is part of an estate plan that makes maximum use of the unlimited marital deduction to defer estate taxes until the second death, MEC status may be almost immaterial. In these cases, there is little incentive to withdraw cash values since it could jeopardize the plan. In cases where it is unlikely cash values will be withdrawn prior to the second death, tax treatment of the SL policy as a MEC will be of little consequence.
Consequently, it may be advantageous if sufficient cash is available to pay up the policy as quickly as possible, even if it will result in the policy being treated as a MEC. However, care should be taken to avoid MEC status if the plan contemplates borrowing from the policy to pay premiums. Also, MEC status could lead to adverse consequences if borrowing becomes necessary to finance premiums because dividends are lower than projected and/or term rates are higher than projected in a plan using a large portion of term insurance.
Income Tax Implications in Split Dollar Plans
SL policies provide a significant income tax advantage while both insureds are alive when the policy is used in a split dollar arrangement with an employer. In a basic endorsement split dollar plan with a single life policy, the employee is generally taxed on the term cost of the insurance as measured by the lesser of the P.S. 58 costs or Table 2001 rates (for plans entered into after January 28, 2002) or the actual term rates used.
If a SL policy is used (typically naming the employee and his or her spouse as the insureds), joint and survivor rates based on U.S. Table 38 or the joint and survivor life mortality factors underlying Table 2001 (for plans entered into after January 28, 2002) are typically used to measure the pure term cost. The joint and survivor rates are significantly lower than the single life rates. At younger ages, for a spouse five years younger than the insured, the joint and survivor rates can be 1/200 of the corresponding single life rates. This differential declines at older ages but still may be as much as 1/20 the single life rates at age 75.
After the first death, the single life rates apply with respect to the survivor, not the joint-life rates.
SL is treated in the same manner as other types of insurance for estate tax purposes, with certain special consideration because there are two insureds and death proceeds are paid only upon the second death. There may or may not be estate tax consequences as of the first death depending on who owns the policy. (Throughout the following discussion, it should be kept in mind that insurance proceeds received by an insured's estate are also generally included in the insured's estate under IRC Section 2042 even if the insured is not the policyowner.) Basically, the policy may be owned in one of three ways:
1. A third party may own the policy.
2. The policy may be owned exclusively by one or the other insured.
3. The policy may be owned jointly by both insureds.
Similar to any other insurance policy, if neither insured has any incidents of ownership in the policy and they have not transferred ownership within three years of death, it will not be included in the gross estate of either insured. However, under the three-year rule of IRC Section 2035, the policy will be included in the estate of the second to die if, and only if, both spouses die within the three-year period after the policy is transferred and the transferor spouse is the last to die. If both spouses die within the three-year period and the transferor spouse is the first to die, there should be no inclusion of the proceeds under IRC Section 2035. (3) If the transferor is the first to die, the policy would not have been included in his gross estate under IRC Section 2042 or any of the other specified code sections had the transfer not been made. Therefore, the policy proceeds do not fall within the scope of IRC Section 2035 and should not be included in the gross estate of either insured if the transferor is the first to die within the three-year period following a transfer of the policy.
Under IRC Section 2033, an insurance policy owned by the decedent on the life of another is included in his gross estate at the replacement cost of comparable policies of the issuing company or the interpolated terminal reserve. (4) If the policy is owned jointly by both insureds, the deceased's portion of the policy's value (which is arguably best determined as the actuarial value of his probable survivorship benefits estimated as if he had not died) is included in his gross estate. If the policy is transferred by will to the surviving insured who is the decedent's spouse, the transfer qualifies for the marital deduction. In this case, there will be no estate tax at the first death. If the surviving insured becomes the owner of the policy when the first insured dies and continues to own the policy until the second insured's death, the proceeds of the policy will be included in the second insured's gross estate. However, if the first-to-die policyowner transfers the policy by will to someone other than the surviving insured, the proceeds will generally not be included in the gross estate of the surviving insured when the surviving insured dies. The proceeds would be included only if the three-year rule of IRC Section 2035 discussed above applied or if the surviving insured retained an incident of ownership in the policy.
If the second insured dies within six months after the policyowner dies, and the policyowner's executor elects to have the assets of the estate valued as of the alternate valuation date, the proceeds of the policy will be included in the policyowner's estate. The death benefits will not be included in the estate of the second to die (assuming he was not the policyowner at any time within three years of his death and proceeds are not received by his estate).
If the insured who does not have any incidents of ownership in the policy dies first, nothing will be included in his estate since the policy proceeds are not payable at his death and such insured has no ownership rights in the policy. At the owner-insured's later death, the proceeds will be includable in the owner-insured's gross estate, unless he has transferred the policy more than three years before his death and has retained no incidents of ownership.
Estate Inclusion When Policy Owned by Corporation
If a key employee/controlling stockholder of a corporation dies and the corporation has complete control over the policy or at least the right to borrow against the policy, the employee/stockholder will be treated as having sufficient incidents of ownership for the policy to be included in his estate. (5)
Gift taxation becomes an important planning issue when a married couple wants a very large policy to be owned by a third party so it will not be included in their estates and also wants to make gifts of premiums at minimal gift tax cost. If the policy is owned outright by a son or daughter for instance, the parents may make tax-free joint gifts of up to $24,000 (as indexed for inflation in 2007) each year under the annual gift tax exclusion. If annual gifts in excess of the annual gift tax exclusion amount are necessary, the parents will have to use up part of their unified gift and estate tax credit.
The amount qualifying for the annual gift tax exclusion can be leveraged by making gifts to multiple beneficiaries, which is most appropriate if the parents have several children. However, as more independent donees are included in the arrangement, the risk increases that the gifts will not be used as intended to pay the required premiums. Also, outright ownership of the policy by the parents' children presents other related problems. The parents have no assurance that the children will not raid cash values and essentially undermine their not-so-well-laid-out plans.
These problems are often avoided by using an irrevocable life insurance trust to own the policy. Through proper planning and use of the Crummey withdrawal rights (6), the parents can provide up to $24,000 (as indexed for inflation in 2007) of annual premium gift tax-free to the trust for each primary and contingent beneficiary of the trust. (7) In addition, they can put certain restrictions on how trust assets are used for the benefit of the beneficiaries and when principal passes to the beneficiaries.
Survivorship life is a unique life insurance product for its intended purpose: to provide death benefits only when the last covered insured dies. The closest alternative strategy is to insure each life separately, but that strategy may often be a relatively poor solution.
Typically, after a death, the estate's personal representative has three principal alternatives if estate taxes must be paid: (1) to sell estate assets; (2) to borrow money; or (3) to have cash available.
Selling estate assets may result in an economic loss to the heirs because of adverse economic conditions at the time assets must be sold. Also, forced sales of illiquid assets may in fact become fire sales, where the amount received is only a fraction of the real value.
Borrowing may only delay the day of reckoning, while incurring additional interest expense to further deplete the estate. Cash will be available in the absence of life insurance only if assets were converted to cash before death. Since most people do not know when they will die, this implies they must keep a large portion of their assets in low-yielding liquid instruments at all times.
The opportunity cost of foregoing more lucrative but less liquid investments can be sizable over time. If preservation of wealth for heirs is a major objective, life insurance is frequently the best way to reach this goal. If the goal of the estate plan is also to defer much of the estate tax until the second death, survivorship life is frequently the best choice.
WHERE AND HOW DO I GET IT?
Many U.S. insurers offer survivorship life products. Since the market for survivorship life is dynamic and competitive, with new product innovations, riders, and package plans being introduced at a rapid pace, it is probably wise to consider products from several companies as well as alternative plans offered by the same company.
WHAT FEES OR OTHER ACQUISITION COSTS ARE INVOLVED?
There are many different survivorship life plans that use the various types of permanent policies as the base policy and a host of riders and premium payment plans. The fees, charges, and commission rates are similar to those charged for similar types of single life policies with similar riders and premium payment plans, relative, of course, to the generally lower premium level for survivorship life for any given level of coverage. There will generally be additional charges for riders or options that are unique to survivorship life such as the split options available with many plans.
HOW DO I SELECT THE BEST OF ITS TYPE?
Survivorship life policies may require more careful scrutiny and analysis than other life insurance products both because of the extended expected period of coverage and because of the many options and policy features. A key consideration when selecting any insurance policy, but especially survivorship life because of the relatively long term of coverage, is the financial strength and stability of the insurance carrier. See Chapter 3, "How to Determine the Right Company," for a discussion of this issue. The following discussion outlines the key issues and questions concerning the selection of a SL policy.
What is the Composition of the Base Policy?
The base policy is typically a permanent type of insurance--traditional whole life, current assumption whole life, or universal life. Whole life is generally preferable in the simpler situation where a vanishing premium is desired that will endow the policy. Universal life is usually more desirable for older insureds who are looking for a low premium and more flexibility. For example, using current (non-guaranteed) assumptions to determine the premium can produce a premium that is as little as half that for a traditional whole life policy. However, the low premium universal life plan will usually require premium payments each year until the second death. Premium payments under the whole life plan may vanish well before the expected time until the second death. In general, the present value of the premium payments can be expected to be about the same under each policy. Therefore, the critical element is the desire for flexibility versus relative certainty. Although the performance of each type of policy is uncertain, since both dividends and interest credits are not guaranteed, the whole life plan typically involves more advanced and "forced" funding. Therefore, the policyowner has more assurance the plan will be completed as originally contemplated, even if the premium payment period must be extended beyond that originally planned if dividends are lower than projected.
If a growing benefit is desired to cover a potentially increasing estate tax liability, a whole life policy without a vanishing premium (and without term insurance blends) where dividends are used to buy paid-up additions or a universal life policy under option B (net level death benefit plus cash value) is often the preferred plan of insurance. Assuming premium payments and other elements are similar, in most cases the UL plan will provide a faster growing benefit. However, at longer durations the whole life plan may surpass the benefits provided under the UL plan.
How Much Term Insurance is Included in the Recommended Plan?
Many survivorship life plans involve combinations or blends of permanent and term insurance. Critical questions include what are the proportions of term and permanent insurance and what term cost is built into the sales illustration. What is the difference between the illustrated term cost and the maximum cost the company may charge in the future under the contract?
The objective of the term/perm blending technique is to reduce the required premiums. Since term insurance generally builds no cash values and premium costs increase with age, the initial term premium is typically only a fraction of the premium cost of the permanent insurance. In theory, dividends on the permanent insurance should be sufficient to buy paid-up additions that reduce the amount of term insurance required over time before the escalating cost of the term insurance explodes. The death benefit of a term/perm plan will generally remain level until the term insurance is entirely replaced by paid-up additions.
The period until the term insurance is phased-out depends on the proportion of term to permanent insurance, the design of the term rider, the dividend performance of the permanent insurance, and the term rates. Insurers use variations on essentially three types of term riders in their term/perm plans, which involve varying degrees of risk to the policyowner.
1. Term rider cost paid by dividends--The riskiest plan, but also, all else being equal, the lowest premium plan, is where the term insurance cost is paid entirely by policy dividends. Excess dividends are used to buy paid-up additions that theoretically will ultimately entirely replace the term insurance.
This type of plan is the riskiest because its performance depends on two variable and non-guaranteed factors: (i) the dividends that will actually be paid on the underlying permanent policy; and (ii) the term rates actually charged for the term coverage. Although term rates may not exceed guaranteed maximums, most illustrations use current term rates that are below the guaranteed maximum. If dividends fall short of projections and/or term rates increase, the dividends available to purchase paid-up additions will fall short of projections. If the paid-up additions grow too slowly, the ever increasing cost of the term at each advancing age may ultimately exceed the dividends available to pay for the term coverage and the policy will "explode." The policyowner is then left with the choice of paying significantly higher premiums or reducing the amount of coverage.
Most experts suggest that the risk of an exploding policy can be minimized if this type of term insurance does not exceed 50% of the total coverage.
2. Term rider cost paid by additional premium--The risk of an exploding policy is reduced but not entirely eliminated, depending on the term/perm blend, if an additional premium is charged for the term rider. In the typical additional-premium plan, the additional premium is a level annual amount that vanishes once paid-up additions entirely replace the term coverage. Since the premium is level, it initially exceeds the actual term cost. The excess term premium in the early years and policy dividends are used to buy paid-up additions that grow more quickly than in the dividend-only-pay-term/perm plan. Since the term rates may increase to guaranteed maximums and dividends on the permanent insurance are not guaranteed, the policyowner still may bear some risk that the policy will explode. However, for term/perm blends of about 50/50 or less, this risk is virtually eliminated. The only risk is that the premium vanish may take longer than projected.
3. Convertible term rider--A convertible term rider is the least risky, but generally the highest premium alternative, all else being equal. Dividends are generally used to buy paid-up additions and to increase the total face amount of coverage, but they may be applied against premiums to keep the face amount of coverage level while net premiums decline over time. The principal risk with this plan is that the conversion right may expire before the second death. To keep the coverage in place, the policyowner must convert, which will require an increase in premiums. Also, often there are charges associated with the conversion.
How is the Policy Affected by the First Death?
Originally, survivorship life policies were designed to revert to single life pricing after the first death. As a result, the mortality charges for the pure insurance protection jumped significantly after the first death. However, reserves and cash values also increased substantially after the first death, reducing the pure insurance protection. Depending on when the first death occurred and whether the older or younger insured died first, there could be a sizable increase in the premiums required to keep the level of coverage in place. To avoid the possibility of a premium increase after the first death, some policies were essentially priced to include a first death element that would provide enough additional cash value to keep premiums level after the first death. Most permanent policies are now designed to avoid a premium increase after the first death. Some companies even offer a rider (what is essentially a joint life--first death--rider) for additional premium that pays up the policy and eliminates the need to pay premiums after the first death.
However, term/perm plans are still often subject to the risk of a premium increase after the first death. Companies use one of two term pricing strategies. Some companies have two schedules of term rates. The rates used when both insureds are living are the low second-death rates. This keeps premiums to the absolute minimum while both insureds live. However, after the first death, the term rates jump up to the single life mortality rates, which can be a sizable increase. Other companies use a blended rate both before and after the first death. All else being equal, the required premium for a plan using blended rates will be higher than for a plan using two schedules of rates while both insureds live, but the premium will not increase after the first death.
What Yields or Interest Rates are Assumed?
Are illustrated yield values based on the company's "portfolio rate" or a "new money" rate? Policy illustrations with new money rates will tend to look more favorable than those using portfolio rates when market rates are currently high. Similarly, policies using portfolio rates may look more favorable than those using new money rates when market rates are currently down.
Is the Level of Projected Yields or Interest Rates Reasonable?
If one company's illustration uses higher yields than another, are they justified based on the portfolio compositions of the insurers? If not, illustrations should be based on similar yield assumptions. If a higher yield assumption is warranted based on differences in the insurers' portfolios, are the investments of the higher yielding company riskier and is the additional risk justified?
What is the Sensitivity of the Plan to Changes in Yields or Interest Rates?
Typically, plans that employ a greater proportion of term insurance are more sensitive to changes in the interest rate. Survivorship plans that combine participating whole life and term insurance often use dividends to buy paid-up additions to reduce the term component over time. If interest rates fall below the yield assumed with projected dividends, the actual dividend payments will be insufficient to reduce the term component as projected. Since term rates escalate rapidly as age increases, the term cost can explode.
The interest rate sensitivity is also significant if the insurance is designed as a vanishing premium plan. Under a vanishing premium plan, no further premiums are required after a specified period if interest credits accrue as assumed and cash values reach the equivalent of the paid-up level. However, if interest rates are not maintained at the assumed level, the vanishing point will lengthen, perhaps substantially. With some products, a 2% decrease in a dividend interest rate may double the number of years needed for premiums to vanish. The premium paying period will tend to lengthen more for a given deficiency in the interest rate for plans that are more heavily weighted with term insurance. Even if the premium vanishes at one point, it may reappear later at a substantially higher rate than the original premium. In some cases, policyowners may be faced with the unpleasant choice of paying substantially increased premiums or reducing the face amount of coverage.
To determine the sensitivity of the plan to changes in interest rates and to avoid unpleasant surprises, illustrations should be prepared showing how the plan plays out with the initial premium based on current rates but with future projections based on lower assumed dividend rates or cash value credit rates.
Do the Illustrations Assume Bonus Credits or Terminal Dividends?
Bonus credits, which are designed to reward persistency, usually take the form of an extra crediting rate to policies in force for a specified period of years. Often the illustrations will show higher rates being credited to policies after the 10th year, even higher rates after the 15th year, and even higher rates after the 20th year. These bonus credits are usually not guaranteed, so there is a potential that excessive illustrated bonus credits could be used to enhance the illustrated performance relative to competitive policies that do not project bonus credits.
Terminal dividends, which are paid at death or when a policy is surrendered are similarly used to reward persistency. They are typically greater the longer the policy remains in force. Although many companies provide some form of guarantee with respect to bonus credits (although it generally is a relative guarantee that dividends or cash value credits will be relatively higher on policies that have been in force longer, not an absolute guarantee as to the actual dollar level of credits), terminal dividends are not generally guaranteed.
If bonus credits and terminal dividends are not guaranteed, the results should be illustrated in 3 ways: (1) with the projected bonus credits and terminal dividends; (2) without these credits; and (3) with an intermediate assumption such as at two-thirds the projected rates.
Are Mortality Assumptions Realistic?
Both dividend illustrations on participating policies and the interest credited on "excess" premiums and cash values in current assumption and universal life policies depend on the assumed mortality charges. Lower assumed mortality charges allow an illustration to show favorable results at a lower premium cost. In addition, some companies show illustrations that assume mortality will improve in the future. However, if actual mortality experience is worse than assumed, the long-term cost of the policy will increase either because dividends are lower than projected or because direct charges to cash values are greater than assumed. In either case, net premiums effectively will have to increase from the level projected to maintain benefits as projected.
Care should be exercised in selecting policies with lower than average assumed mortality charges. Is it reasonable to assume a company may be so much more selective in its underwriting that it can maintain lower than average mortality costs even well beyond the 10-to-15-year period when the benefit of selective underwriting is usually assumed to completely "wear off"? If a company that has used aggressive mortality assumptions or has projected mortality improvements turns out to be correct, it is also quite likely other companies that have used more conservative assumptions will also experience better than projected mortality. These companies will be able to pass on substantially better results in future years than are currently being illustrated. All else being equal, it may be better to select companies using more conservative mortality assumptions. This may reduce the risk of having to pay additional premiums in the future to maintain the level of benefits when such payments may be most difficult to sustain. The alternative may be a decrease in benefit levels. If mortality experience is better than assumed, few policyowners will complain if their premium costs decline or vanish sooner than projected.
Does the Policy Illustration Use Loans to Finance any Premium Outlays?
Some plans show very quick premium vanishes based on borrowing the required premium from the cash values. These illustrations assume that dividends will be sufficient to pay interest on the loans. If dividends are lower than projected, the policyowner will have to pay more into the policy than projected to pay interest or borrow more each year to cover the shortage. Since loans are netted against the death benefit, this could lead to substantially lower net death benefits than projected.
Are Assumed Lapse Rates Realistic?
Another component of policy pricing and illustrations is the assumed lapse rate for blocks of similar policies. The lapse rate assumption is a two-edged sword that can have adverse effects if it is either over estimated or under estimated. Although most experts expect lapse rates for survivorship policies to be two to four times lower than for single life policies, there has not yet been enough experience to know for sure. If a product is priced for a number of early lapses, the company may have a problem if the lapses do not occur as expected. The company will have to pay higher death benefits than assumed and higher cash values on later lapses. However, if more policies are lapsed and they are lapsed sooner than assumed, the company pricing will not include sufficient loadings to recover initial policy issue expenses and commissions. In either case, remaining policyowners ultimately must pay the cost of incorrectly estimating the number and timing of policy lapses.
It is generally not easy to discover what lapse rate assumptions a company uses. General information may be acquired from the state department of insurance or the company may be asked to provide the assumptions in writing.
What Split Options are Offered?
The policy split option is a desirable feature, since it permits the policy to be split into two individual policies. Most split options may be exercised if a married couple becomes divorced. Others also permit the policy to be split if the tax law changes in such a way that the survivorship life policy would no longer be an effective estate planning tool, such as if the unlimited marital deduction was repealed. In some cases the split option may be exercised only if both insureds show evidence of insurability. In general, the split option allows each insured to acquire individual coverage equal to half the face amount of the survivorship policy. However, some companies allow the policyowner to elect unequal splits at the time the survivorship policy is issued. If a couple's assets are not split 50/50, as is generally the case, this feature is attractive.
What are the Underwriting Standards?
Most companies will issue policies on highly rated lives if the other life is within the standard rating class or only slightly rated. Some companies will even issue policies if one of the insureds is otherwise uninsurable if the second life is insurable. In these cases, the premium is usually about equal to that for a single life policy on the insurable life alone. Since there is always some probability that the insurable person will die before the highly rated or uninsurable person, a survivorship life policy can be of immense benefit in providing protection where there would otherwise be none.
What is the Death Benefit Internal Rate of Return?
Given the broad array of plan designs and options, comparisons of SL plans for a given case are difficult. A method frequently used to evaluate SL plans is the "death benefit internal rate of return" (IRR). First, each potential policy's illustration is inspected to assure that the assumptions used and the projected premiums are reasonable. Then the IRR method basically answers the question of what rate of return a person would have to earn to equal the benefit payable after the second death if net premiums were invested outside the life insurance policy. Typically, the second death is assumed to occur, for instance, in 15, 20, 30 years, at the insureds' joint and survivor life expectancy and 5 years before and after the insureds' joint and survivor life expectancy. The plan with the highest IRR is the "best" buy.
Although the IRR method ignores intermediate cash values, they are usually irrelevant in the typical survivorship life plan where the principle objective is to as sure payments of benefits at the second death. The IRR method puts all policies on a common base, regardless of whether premiums are high or low, whether plans are current assumption or not, whether the insurance plan includes term coverage or not, whether premiums are level or changing, or whether premiums are to be paid until death or are expected to vanish at some specified time.
However, if access to cash values in the intermediate term is an important consideration, the death benefit IRR method would be a less satisfactory method of plan comparison unless all the plans being considered had similar projected cash value buildups. To overcome this limitation, the IRR method can also be applied to cash values at various durations, in addition to death benefits. To compare policies one would apply a weighting factor to the cash value IRR ranking and the death benefit IRR ranking. For example, if the death benefit IRR is considered three times more important than the cash value IRR, a plan's composite "score" at any specified duration for comparison purposes among policies would be .75 multiplied by the death benefit IRR plus .25 multiplied by the cash value IRR. Or if the cash value return is considered just as important as the death benefit return, the score would be computed by dividing each IRR by two and adding the results together.
WHERE CAN I FIND OUT MORE?
Although the references cited in the other chapters contain discussions of survivorship life, the dynamic nature of this relatively new product market makes any discussion dated relatively quickly. Perhaps the best and most up-to-date source is the product information brochures prepared by the various insurers. In addition, the following articles may be informative:
1. "Factors to Analyze in Selecting a Second-To-Die Life Insurance Policy," Philip J. Lyons, Estate Planning, May/June 1991, pp. 166-171.
2. "Survivor Life Insurance and The Gatewood Endorsement: An Update," Robert P. Gatewood, Journal of the American Society of CLU & ChFC, July 1991, pp. 42-46.
3. "Survivorship Riders: Funding Estate and Buy/ Sell Plans," Timothy J. Archbold, Life Insurance Selling, October 1991, pp. 164-169.
4. "Due Diligence and Product Design Considerations in Purchasing Survivor Life Insurance," Robert D. Stuchner, CCH Financial and Estate Planning, Vol. 3, 1991, 129,551, pp. 24,945-24,950.
5. "Evaluating A Survivorship Life Insurance Plan for Clients," James Brogan, Trusts and Estates, January 1991, pp. 35-38.
6. "Survivorship Life Insurance: Providing The Liquidity to Preserve Family Wealth," Thomas J. Hakala and David S. Dauman, The Journal of Taxation of Trusts and Estates, Winter 1990, pp. 47-51.
7. "New Developments Affect Second-To-Die Insurance Policy Products and Planning," Howard Saks, Estate Planning, November/December 1990, pp. 372-374.
8. "An Agent's Guide to Last Survivor Plans 1991," Life Insurance Selling, October 1991, pp. 90-144.
QUESTIONS AND ANSWERS
Question--Why is the premium for survivorship life insurance so low relative to two single life insurance policies on the same insureds?
Answer--One of the key attractions of SL is that the premium cost for a SL policy is less than the combined premium cost to purchase separate policies on each named insured. This is possible because the premium is based on the probability of paying benefits on someone other than the first to die. To illustrate, based on the IRS' most recent mortality table in nine out of 10 cases involving two people of average health who are age 55 and 52, at least one will die within 31.3 years. However, the probability that both people will die within 31.3 years is only 46%. In other words, an insurer would be almost twice as likely to pay a death claim within 31.3 years if it issued two separate policies rather than a single survivorship life policy.
Premiums normally continue after the first death, and in some plans may increase dramatically. Other plans provide that premiums cease after the first death. The premium schedule depends on how the plan is designed, the relative proportions of permanent and term coverage, as well as other factors. Since the insurer's reserve requirements are low while both insureds live, even relatively modest premiums (compared to the total payments that would be necessary for two separate policies) may build substantial cash values. However, after the first death, the policy essentially becomes a traditional single life policy. As a result, the company's reserves generally must increase substantially after the first death. If earlier premium payments were not sufficiently high to build the cash value necessary to support the higher required reserve, the policyowner may have to pay higher premiums or suffer a reduction in the face amount of coverage.
Question--What is the difference between survivorship life and joint life insurance?
Answer--Timing! SL and joint life are at opposite ends of the spectrum. SL is last-to-die insurance and joint life is first-to-die insurance. They are designed to satisfy entirely different estate and financial planning needs. SL provides cash to meet the costs resulting from the last death among the covered insureds and is typically used to provide estate liquidity. Joint life provides cash to meet the costs resulting when the first of the covered insureds dies and is more frequently used in business applications, such as to fund buy-sell agreements.
Question--How does SL fit into an estate plan?
Answer--SL is uniquely designed to provide for a married couple's estate planning needs. The demand for this popular product has grown in recent years because of several distinct needs created by the second death of two spouses. First, the number of two-income families has increased which means that significant income will continue to be available to the family after the death of the first spouse to die in a two-income family. The need for death benefits to protect dependents is often greatest at the second death of two income-earning parents. SL exactly matches the maturity of the need with the maturity of the policy should both parents die prematurely with young children still dependent upon the parents' income. In addition, SL is generally a less expensive method to provide this coverage for young two-income parents on a tight budget.
Second, estate plans typically are designed to take advantage of the current tax laws and the unlimited marital deduction to defer most or all estate tax until the surviving spouse dies. The unlimited marital deduction permits most or all of the couple's assets to pass to the surviving spouse without estate tax. As a result, the typical estate plan defers the most significant death taxes until the second death of the two spouses. Once again, the timing of SL's death benefit perfectly matches the timing of the need.
Finally, SL is appropriate for even the most rudimentary estate plan. Many married individuals own much of their property jointly in the form of tenancy by the entireties. This means the surviving spouse automatically has survivorship rights in the property that passes by operation of law when the first spouse dies. This automatic transfer avoids probate costs and qualifies for the unlimited marital deduction from estate taxes. All probate costs and federal estate taxes associated with property held jointly by the spouses will be incurred at the second death-the exact time when SL will provide its cash benefit.
Question--Should single life insurance be considered as an adjunct to survivorship life?
Answer--Survivorship life, although a useful tool, is not a panacea for all estate planning needs. In many cases there are complicating factors that make survivorship life alone an insufficient tool to meet estate liquidity needs and asset transfer objectives. Single life insurance is often needed when use of the maximum marital deduction is inconsistent with wealth transfer objectives. For instance, if a significant estate tax liability is anticipated at the first death, it is obviously important to continue to hold individual insurance on the life of each spouse. If first death costs are anticipated to be minor, the cash surrender value on the SL policy may be available to provide liquidity to the surviving spouse to handle these costs. In many SL plans, the cash surrender value under the SL policy increases dramatically at the death of the first spouse. This substantial cash surrender value may alleviate any liquidity problems caused by first death costs.
Single life insurance may also be advisable in other circumstances. For example, in some cases one spouse has children from a prior marriage that he or she wishes to provide for at his or her death without having to wait until the subsequent death of the spouse. In these cases amounts transferred outright to children are included in the deceased's estate. Single life insurance can provide the necessary cash to pay estate taxes without the need to liquidate estate assets, thus preserving the assets for the children.
It may also be advisable to consider keeping assets with substantial appreciation potential out of the surviving spouse's estate. Life insurance on the first-to-die (payable to an irrevocable trust or a family partnership) could be used to purchase the assets. Under current law, the income tax on any unrealized gain at the time of the first death is avoided because the assets receive a step-up in basis. If, as is commonly the case, the insurance proceeds are invested to provide income for the surviving spouse and the appreciation potential of the assets is substantially greater than any accumulated income on the insurance proceeds, the differential in value avoids estate taxation at the second death.
Question--Would not individual policies on each spouse meet their estate planning needs as well as a SL policy?
Answer--Individual policies on the life of each spouse certainly would provide benefits to fund the costs of the death of either spouse. However, if the insurance programming is designed to provide for the costs of the second death, the SL policy is substantially more cost-effective. As described earlier, the addition of a second life in a SL policy dramatically reduces the cost for a given level of coverage.
In cases where the estate plan is designed to defer most or all of the potential estate tax liability to the time of the second death, the use of single life policies on each spouse will provide benefits at the first death, which is earlier than needed. If the deceased has any incidents of ownership in the policy these benefits will be included in his or her estate and generally added to the assets included in the estate of the surviving spouse. Although these benefits will provide liquidity for the costs of settling the second estate, they unnecessarily increase the tax base of that estate. It is easy to demonstrate that SL is the most cost-effective method to provide life insurance benefits to handle the liquidity needs caused by the second death of two spouses.
Question--Why not simply insure the spouse with the longest life expectancy (generally the younger spouse)?
Answer--In some instances, one spouse is much younger than the other. Under these circumstances, the younger spouse is quite likely to be the last-to-die. A single life policy on the younger spouse would provide the necessary liquidity for the second death costs in most cases. This approach, however, has some inherent flaws. First, despite any differences that exist between the age and health of the two spouses, it is never a certainty that one particular spouse will die first. Most people underestimate the probability of the younger spouse predeceasing the older spouse. The probability remains quite significant even for sizable differences in ages.
For example, the probability that a 40 year old will predecease a 65 year old is 11%, or more than one in ten, based on mortality factors in the IRS Table 80CNSMT. If the older spouse should survive, the single life policy on the younger spouse will pay the benefits at an inappropriate time and further increase the settlement costs of the older spouse's eventual estate. Also, as described earlier, an individual policy covering the younger spouse will be more costly than a SL policy covering both spouses. In all events, the addition of this life will cause a decrease in the required premium for a given face amount if all other factors are equal.
Question--But isn't a single life policy on the younger spouse the only option if the older spouse has impaired health or is uninsurable?
Answer--No! Most insurers will issue SL policies even if one of the insureds is highly rated or otherwise uninsurable. The insurance company is never at greater risk on a SL policy where one spouse is highly rated or otherwise uninsurable than they would be on a single life policy issued on the healthy insurable spouse. There is always some probability that the healthy spouse will die first, regardless of the severity of the second spouse's health impairment. Although the premium for the SL policy may be almost as great as the premium for the single life policy on the healthy spouse, it will never be more.
Therefore, a SL policy can be obtained that should always cost less than the single life policy and that will provide the necessary coverage for the surviving impaired-health spouse in the event the healthy spouse dies first. In other words, the single life policy will always provide less advantageous coverage for greater cost in these circumstances. A SL policy is an especially attractive plan of insurance in these cases.
Question--Can a SL policy be used with an irrevocable life insurance trust to keep policy proceeds out of the estate of the second-to-die?
Answer--A SL policy may be transferred to an irrevocable life insurance trust and is often the solution for many estate planning problems. First, if the SL policy is owned by the trustee of an irrevocable life insurance trust, death proceeds will not be included in the estates of the insured spouses (assuming the spouses held no incidents of ownership within three years of death). The SL trust will pass the substantial death benefits to the heirs of the insured spouses outside of their estate tax base. Therefore, the SL trust will avoid compounding estate settlement costs facing the usual estate. A SL trust will also avoid the risks associated with using the children as individual third party owners. The assets of the SL trust will generally be protected from the creditors of both the insureds and the beneficiaries.
Question--Can SL be used to meet the insurance needs of a closely-held family business owner?
Answer--SL can be an effective tool in the estate plan of the family business owner. Often the parents will retain majority ownership of a family business until the death of the second spouse. To avoid estate tax upon the first death, much of the deceased parent's ownership interest will be transferred to the surviving spouse, which qualifies for the marital deduction. As a result, most of the business value will be included in the surviving spouse's estate for estate tax purposes and death taxes could be significant. Frequently the family business, which is usually highly illiquid, is the major estate asset. In addition, the family heirs often desire to continue the business. If the liquidity needs cannot be met out of other estate assets, the family business may have to be liquidated or sold to outsiders to pay these costs.
SL coverage on the lives of parents who own a family business is designed to provide for these liquidity needs. A SL policy will provide benefits at the exact time they are needed--when the surviving spouse dies. The SL benefits can be used to provide the needed liquidity to the estate and provide distributable cash for family members who will not inherit the business interest. The use of a SL policy in these circumstances will both preserve the business of the family heirs and provide family harmony for the next generation.
Question--How can SL be used in split dollar plans?
Answer--Like single life policies, SL can be used in split dollar plans, permitting business funds to finance the purchase of insurance coverage. This is particularly attractive if the retained corporate dollars used to finance the premium payments are taxed at a corporate rate that is lower than that of the stockholder-employee. Since the premium payments are nondeductible, it will be tax cost effective to use lower-taxed corporate dollars to finance this insurance.
The stockholder-employees share of the split dollar SL proceeds can provide estate liquidity to solve the problems discussed earlier for the family-owned business. The corporation can retain a share of the proceeds through a collateral assignment split dollar arrangement and be repaid fully for its entire contribution. Alternatively, the corporation share can be rolled-out or bonused to the stockholder-employee at a later date.
The split dollar SL plan can be designed favorably for both income and estate tax purposes. All estate tax consequences to the insured stockholders can be avoided if a SL trust enters into the split dollar agreement with the employer. The insureds should obtain no incidents of ownership in the policy if the SL trust is the policyowner and applicant. In addition, the corporation should avoid obtaining incidents of ownership (e.g., access to the cash surrender value) if an insured is a majority shareholder. Any incidents of ownership held by the corporation will be attributed to the majority shareholder if the proceeds are not payable to or for the benefit of the corporation.
The design of the plan controls the income tax consequences of the split dollar SL plan. If the employer pays the entire premium, the stockholder-employee is taxed annually on the economic benefit of the coverage.
The SL split dollar plan works the same way as the single life split dollar plan except that very low rates are likely to be used to measure the pure term insurance cost while both insureds under the SL policy are alive. Depending on the age of the insureds, the premium rates may be dozens or even hundreds of times lower than the single life rates. What this means is that the taxable benefit in the employer-pay-all SL split dollar plan is only a fraction of what it would be if the plan used a single life policy.
Question--What happens if a married couple insured under a survivorship life policy becomes divorced?
Answer--Almost all currently available survivorship contracts allow policy splits between divorced spouses. However, some policies force the husband and wife to prove evidence of insurability at the time of the split, which is a major disadvantage, especially at older ages, when a person is more likely to be rated and it is more difficult to find coverage for substandard risks. In addition, some split-option riders or exchange riders add significant costs to the contract each year the policy is in force or allow the company to charge a split or exchange fee that can further erode cash values. Also, survivorship plans that use term riders often exclude them from the split option.
Usually two new single life policies are offered with premiums based on the insureds' ages when the survivorship life policy was issued. The cash value is generally evenly split into the new policies. A problem may arise if the premium on the new policy and the divisible share of the cash value from the survivorship policy are insufficient to cover the necessary reserves on the new policy. If a policy split occurs many years after issue of the survivorship policy and dividends have been sizable, the probability that this problem will arise is negligible. However, the likelihood of a problem increases if the split occurs soon after issue or if dividends have been low, especially in the male's policy. Alump-sum payment may be required to cover the shortfall or the benefit may be reduced. Some companies offer the option of paying higher premiums to fund the shortfall over time. Other companies avoid this problem by issuing new policies at attained ages. In these cases the premiums are based on higher mortality charges and the policyowners must pay full commissions and other new policy costs once again. If the split occurs at later ages, many insureds may find the premium cost prohibitive.
Other companies issue survivorship policies that allow splits without evidence of insurability and without new policy charges. However premium costs may be somewhat higher on the survivorship policy to compensate the company for these potential costs.
Question--What are some of the unique characteristics of the SL product that should be considered?
Answer--Competition and special needs have fostered the development of a number of new SL product innovations including:
* Graduated premiums--Graduated premium policies that start with lower premiums which increase over time may make an SL plan more affordable for couples who expect to have a greater premium-paying capacity over time. Care must be exercised in selecting these policies, however, since they may fail if the policyowner(s) are unable to pay the increasing premiums. Also, if the policy is put in trust, as the premiums increase they may exceed the amount the policyowner(s) can give the beneficiary without adverse gift tax consequences.
* Substitute insured--Some companies will permit substitutions of insureds, with evidence of insurability. This feature is attractive when SL is used in business insurance applications such as when used to fund partnership buy-sell agreements where partners may change and in key person insurance situations.
* Enhanced death benefit--Death benefits payable to an irrevocable trust on a policy transferred by the deceased within three years of death are included in the estate. To cover this contingency some companies will increase the death benefit during the policy's first three years to cover the additional estate tax.
* Guaranteed death benefit--Universal life SL policies typically do not guarantee the death benefit. Some companies, however, provide death benefit guarantees on their universal life SL policies.
* First-death rider--SL policies with this rider provide a specified death benefit to the surviving insured to cover probate, funeral, and other expenses associated with the first death.
* Survivorship riders -These riders, which are attached to single life policies on a husband or wife, can be tailored to mimic a SL policy while providing important additional flexibility.
Question--How do survivorship riders work?
Answer--Survivorship riders are a form of guaranteed purchase option. A survivorship rider naming someone other than the insured as the "designated life" is attached to a single life policy. If the designated life dies before the insured, the policyowner has the right to increase coverage on the insured without evidence of insurability. The rider provides "wait-and-see" flexibility since the policyowner may exercise the right to the full amount of additional insurance or any portion thereof.
Use of survivorship riders with single life policies on a husband and wife can be designed to mimic a SL plan. Each spouse names the other spouse as the designated life. This arrangement is essentially equivalent to a three-policy survivorship life plan where there is a single life policy on each spouse and a SL policy on both spouses. In contrast with many SL plans, the survivorship rider plan will require additional premiums to pay for the added coverage after the first death. However, premium payments will cease (if they have not already ceased under a vanishing premium plan) on the policy of the deceased. Also, depending on how ownership and beneficiary designations are selected, the death proceeds from the single life policy on the first-to-die may be available to pay premiums on the survivor's policy or as a lump-sum payment into the survivor's policy. Similar to SL, the policies may be held in an irrevocable life insurance trust. Because the additional coverage is optional, the trustee has the flexibility to select only that amount of additional coverage that is deemed necessary after the first death.
Survivorship riders can also provide great versatility in business insurance planning, such as in cross-purchase buy-sell arrangements. For example, assume each of three shareholders (A, B, C) purchases policies on the other two shareholders equal to one-sixth of the company's value. They also attach survivorship riders to the policies allowing them to purchase additional insurance on the survivors equal to one-third of the business value. In specific dollar terms, if the company is worth $6 million, A would purchase policies on B and C with base amounts of $1 million. The policy on B would name C as the designated life and vice versa. The survivorship riders would permit A to buy an additional $2 million of coverage on B if C died first or on C if B died first. B and C would make analogous arrangements.
Now assume C dies. A and B would receive $1 million each in insurance proceeds, which together is enough to buy out C's $2 million interest in the company. A and B now each own 50% of the $6 million company, but the face value on the base policies each owns on the other is only $1 million. However, the survivorship rider permits them to purchase an additional $2 million of coverage on each other for a total of $3 million. They each will then have sufficient insurance in the event of the other's death to buy out the other's $3 million interest in the company.
(1.) Deductibility of interest on policy loans may depend on how the loan proceeds are used as described in IRC Section 163. See Chapter 21, Taxation of Benefits, for a complete discussion of the taxation of policy loan interest.
(2.) For a complete discussion of the MEC rules, see Chapter 19, Modified Endowment Contracts.
(3.) This conclusion is based on the language of IRC Section2035(a)(2), which provides that transfers made within the three-year period prior to death will be included in the gross estate of the transferor only if "the value of such property (or an interest therein) would have been included in the decedent's gross estate under section 2036, 2037, 2038, or 2042 if such transferred interest or relinquished power had been retained by the decedent."
(4.) The interpolated terminal reserve is essentially the cash value of the policy adjusted for any unearned premiums, earned dividend credits, partial mortality charges, and other expense adjustments.
(5.) Treas. Reg. [section]20.2042-1(c)(6); Rev. Rul. 82-145, 1982-2 CB 213.
(6.) See Chapter 30, Irrevocable Life Insurance Trusts, for a thorough discussion of irrevocable life insurance trusts and Crummey powers.
(7.) The Tax Court's decision in Est. of Maria Cristofani v. Comm., 97 TC 74 (1991), acq. in result, 1992-2 CB 1, held that Crummey powers granted to minors who were contingent remainder beneficiaries of a trust created gifts of a present interest qualifying for the annual exclusion. The IRS argued that holders of such Crummey withdrawal powers must have current beneficial interests in the trust for gifts to be present interests qualifying for the annual exclusion.
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|Title Annotation:||PART I TOOLS|
|Publication:||Tools & Techniques of Life Insurance Planning, 4th ed.|
|Date:||Jan 1, 2007|
|Previous Article:||Chapter 14: Single premium life insurance.|
|Next Article:||Chapter 16: Term insurance.|