A Possible Tax Law Change in 2017 May Lead to Another Use for ILITs

Earlier this year, the Senate Committee on Finance voted to kill a strategy used to greatly enhance the value of an Individual Retirement Account (IRA). Permitted since 1987, the so-called “Stretch IRA” plan allows an IRA beneficiary to take distributions from an inherited IRA out over his or her lifetime, allowing the IRA account to grow tax-deferred and stretching the tax bill over many years. Many IRA owners have named children and even grandchildren as beneficiaries, making the strategy a useful tool to leverage assets to later generations.

This is not the first time the strategy has caught the eye of legislators, probably because it is projected the change will generate $5.5 billion in additional revenue over 10 years, but the Republican-led Committee, which includes 14 Republicans, voted unanimously, leading many to believe that, this time, action will be taken.

The change affects only non-spousal beneficiaries, who would have to pay taxes on an inherited IRA within five years of the owner’s death, with the first $450,000 excluded. However, the balance would be taxed at the beneficiary’s marginal rate. Surviving spouses could still stretch the taxes out over their lifespan or even roll the inherited amount into their own retirement plan.

With over $25 trillion in untaxed retirement accounts and $7.8 trillion in IRAs alone, (1) it is no wonder the government is looking to gather its tax money as soon as possible.

If the law is enacted, some financial advisers suggest converting to a Roth IRA. However, under the proposal, a Roth IRA left to a non-spousal beneficiary would also have to be distributed within five years, just like a traditional IRA. While the eventual Roth IRA distributions would be tax-free to the beneficiary, the conversion would be taxable to the IRA holder.

Another option that might provide more flexibility and greater leverage would be the use of an Irrevocable Life Insurance Trust (ILIT). As with the Roth IRA strategy, the IRA distributions to fund the plan would be taxable, but the life insurance death benefit could be passed on free of federal and state income and estate taxes.

According to Ed Slott, a noted IRA authority, life insurance makes sense. In an article just published in a financial planning magazine, he suggests, “Forget the stretch IRA. You’re better off taking the money out now, paying the taxes, and putting that money into a life insurance policy that will be tax-free when it’s cashed in. You could easily take a $300,000 IRA and turn it into a $1 million life insurance policy.” (2)

The next few years will provide challenges and opportunities for trust advisors to help clients rethink their financial plans and goals. ILITs will remain a viable tool for leveraging assets.

 

  1. From information provided by the Investment Company Institute, Washington, D.C.
  2. Stretch IRA: Are Its Days Numbered?, Financial Advisor Magazine (www.fa-mag.com), December 27, 2016

Latest Federal Reserve Hike Viewed as Generally Positive for Life Insurance by Moodys

Less than two weeks ago, we reported that Moody’s had downgraded its 2017 outlook for the life insurance sector from Stable to Negative. A new Moody’s report published after the Federal Reserve raised its benchmark federal funds target rate by 25 basis points last week indicates that hike will benefit life insurers and “help reverse the downward march in investment portfolio yields.” (1)

The federal funds rate is the interest rate that depository institutions charge each other for an overnight loan. Banks are required to keep a minimum reserve requirement and will move monies back and forth, charging a rate based on the target rate set by the Federal Open Market Committee (FOMC), which is the Federal Reserve’s primary monetary policymaking body.1-fedres2

As can be seen in the graph to the right,
the federal funds rate that is actually charged dropped dramatically through 2008 as the target rate sank and stuck at 0 to .25 percent. A bump in December of 2015 pushed the target to .25 to .50 percent. Last week’s increase pushed the target rate to .50 to .75 percent.

While the rate only pertains to overnight loans among very creditworthy financial institutions, its effect is actually broader since banks use it for the basis of all other short-term rates. It also indirectly affects longer-term rates, such as home mortgages. An article in the Wall Street Journal yesterday declared, “The era of the ultralow mortgage is over.” It also pointed out that after the US election, even before the Fed acted, rates on a 30-year mortgage jumped .76 percentage points, to 4.38%, (2) the “post U.S. election bump in yields” we mentioned in our prior blog.

The increase in long-term rates would be a welcome relief to life insurance carriers who have struggled mightily in this low interest-rate environment. Insurance companies attempt to match their investment time horizon with their liabilities, and life insurance is a long-term liability. The Moody’s report points out that “new money rates on long-duration investments are more important for insurers,” a good benchmark for new money rates of life insurers being the 10-year treasury plus a credit spread, which has seen a “100 basis point rise…from… summer lows.”

Should the long-term rates become sustainable, Moody’s sees the profitability of older annuity blocks improving and believes “interest-sensitive life insurance,” like universal life, would benefit, along with other “long-tailed specialty products” like long-term care, both of which have seen dramatic cost increases in the last few years. With increased rates, the pressures on carrier reserves would lessen, and the chances of GAAP charges and write downs would decrease.

The Moody’s report believes this might be a first step toward a “more normalized policy rate environment that would be conducive to better long-term operating conditions and profitability.” Let’s hope so, but let’s also remember that the current target rate hike, only the second in 8 years, only pushed the rate from .50 to .75 percent. A decade ago, a “normal” fed funds rate was 5.25 percent. We are a long way from that.

  1. Moody’s Sector Comment, December 14, 2016, Financial Institutions, United States
  2. Rising Rates Ripple Through Mortgage Market, Wall Street Journal, December 19, 2016

The Biggest Story in Trust Owned Life Insurance (TOLI) in 2016? Trustees Running Away From Their Portfolios-How Can They?

In blogs published throughout 2016, we highlighted the increased challenges for TOLI trustees attempting to manage life insurance policies prudently. Life insurance cost increases more than doubled the carrying costs of many policies, while there were increased fiduciary and regulatory burdens and a multimillion dollar verdict against a major financial institution over a life insurance policy. All this occurred in 2016 and underlined the difficulties and risks associated with managing this asset.

Many banks and trust companies have TOLI portfolios that are filled with “orphan” trusts, with clients that have no other wealth-management relationship with the bank. These portfolios, many obtained through acquisition, often contain much more risk than revenue, and as institutions await a new presidential administration that appears to favor an end to the federal estate tax, some are looking for an exit strategy.

In the past year, we have witnessed and assisted in a number of “bulk transfers” of TOLI portfolios from institutions wishing to exit the business to other firms still committed to servicing this asset. The exiting firm can offload all of the TOLI trusts in their portfolio or just a select group. Generally, in a bulk transfer the selected trusts are moved at once, with one trustee taking control over them from another at a specified date. Obviously, this is not a transaction that will fit with every firm’s business goals, but for those that can take advantage of the transaction, it can be a true win-win scenario.

On Tuesday, December 13, at 2 p.m. Eastern time, ITM TwentyFirst University will feature Leon Wessels, a 15-year veteran of the TOLI industry, who will discuss Knowing Why, When and How to Move ILIT Accounts Out of Your Portfolio. This will be our last session of 2016, and if you are contemplating any changes to your TOLI business in 2017, it will be one you will want to attend. To register, click on the following link: https://www.itm21st.com/Education

 

Ratings Agency Downgrades Outlook For Life Insurance Sector, But Others See Positive Opportunities For The Future

A report just out from Moody’s on the global life insurance market has downgraded the sector for 2017 from Stable to Negative. (1) The historically low interest rate environment is cited as a main reason. Moody’s acknowledges the “post-U.S. election bump in yields” we have seen after Donald Trump’s victory, but still believes the low rates will continue “to depress the sector’s investment returns and profitability.” While interest rates may be pushing slightly higher, rates credited to policies take a longer time to turn around, a fact we acknowledged over two years ago (see: Turning the Battleship Around…An Update.) For Moody’s, the low rates are “the main driver for the outlook change to negative.”

Another consideration was the increased market volatility that could occur because of higher worldwide political risks and uncertainty in 2017. This could negatively affect carriers’ earnings and drive risk-averse clients to products containing higher guarantees, which demand larger and costlier reserves. Increased regulation and higher reserve requirements were other factors affecting the rating downgrade.

The low interest rate environment also drives carriers to chase higher returns in illiquid and alternative investments, as well as equities. While these asset classes may bring higher returns, they pose more risk than the fixed investments that make up the bulk of a carrier’s portfolio.

The United States, Japan, the United Kingdom, Germany and the Netherlands were among the specific countries Moody’s cited as earning a Negative grade.

In another report out this year, EY believes “stagnant growth and lingering low interest rates” mean the life insurance sector “faces a challenging future,” but points out some areas of change that might positively affect the industry. (2) These include “new thinking and cultural shifts,” especially in the area of innovation. The industry as a whole has been slow to modernize, and developers in other areas are beginning to creep into the life insurance space. These “disruptors” are providing applications and systems designed to improve the customer experience, while streamlining the life insurance process. Data-driven companies entering or in the marketplace, including ITM TwentyFirst, will change the way life insurance is underwritten, sold, and monitored. The report points out the “perception problem” of an industry with difficult to understand products that many believe are out of touch with today’s consumers and cites the need for “engaging and educating customers with media…that customers are comfortable with.” By adapting to the changing world, EY sees tremendous opportunity for innovative companies in the space.

The ITM TwentyFirst team of independent life insurance professionals helps to empower policy owners to make informed decisions and realize the full value of life insurance assets. We appreciate the opportunity to be a part of the state-of-the-art changes taking place in the evolution of life insurance and life insurance policy management.

  1. “Life Insurance – Global: 2017 Outlook – Low Interest Rates, Risk of High Volatility and Legislative Changes Turn Outlook to Negative,” Moody’s Investors Service, December 5, 2016
  2. “2016 Life Insurance and Annuity Executive Survey,” EY, 2016

Dividends at The BIG 4 Carriers Mostly Down, But Are Interest Rates Finally Going Up?

A couple of weeks ago, we reported that Northwestern Mutual had declared its 2017 dividend and had not only lowered it but also increased some costs (see: Northwestern Mutual Dividend and Crediting Rates Drop, Expenses Rise). Northwestern Mutual was the first of the so-called “Big 4” mutual carriers to report. These A++ (AM Best)–rated companies are considered to be the gold standard among life insurance carriers. The others in the group (New York Life, Massachusetts Mutual, and Guardian Life) have now all reported in, and all but New York Life experienced a drop in their dividend interest rate (DIR).

These Big 4 mutual carriers are among the most solid, stable businesses in the country. Unlike the vast majority of carriers, which sell their products through a brokerage system, the Big 4 sell their products directly to the public through an agency system of career agents tied to the companies. The career model tends to increase persistency and repeat business among clients and loyalty among agents. However, even these firms have felt the sting of low interest rates and are struggling with their investment returns. As we noted in our prior post, Northwestern Mutual’s chief investment officer told the Milwaukee Business Journal that the low interest rate environment resulted in the company’s generating $6 billion less in income than it would have in a normal interest rate environment.

The DIRs below-right represent the investment components of the dividends paid. Other factors besides the investment portion include 1-divactual expenses and mortality experiences. If mortality and expenses are more favorable than expected, it positively affects the dividend paid.

While the DIR may have dropped at most of the carriers, the actual total dollar amount paid out to policyholders actually increased at two of the carriers. Policyholders own mutual carries like the Big 4 carriers, and the divide1-payoutnds received represent a portion of the divisible surplus left after all expenses and claims have been paid. As can be seen in the chart to the right,  New York Life and Guardian Life will pay out more to policyholders in 2017 than in 2016.

Since the presidential election, we have seen a bit of an upturn in interest rates, and many prognosticators are anticipating a trend to higher rates in the Trump administration. An article in the Wall Street Journal last week cited the head of U.S. short-rates strategy at a major US bank, who believes that “government bond yields are likely to rise further.” That same article pointed out that “Investors have been scrambling for the past two weeks to position themselves for a Trump presidency that they believe will mean higher growth, higher inflation and a Federal Reserve that will be under pressure to raise interest rates in a way that hasn’t been seen for more than a decade.” (1.) While higher rates are not a simple fix, as they will affect many parts of the economy negatively, for many carriers that rely on fixed vehicles as their primary investment, higher rates, on balance, would be welcome.

  1. Traders Convinced Higher Rates Are Near, Wall Street Journal, by Min Zeng, November 23, 2016

New York State Floats Regulation To Require Life Insurance Carriers To Justify Cost Increases

Yesterday, the New York State Department of Financial Services proposed a new regulation designed to “protect New Yorkers from unjustified life insurance premium increases.”

In a press release dated November 17, 2016, Maria T. Vullo, the Financial Services Superintendent, proposed a regulation to “govern life insurance company practices related to increases in the premiums of certain life insurance and annuity policies.”  The regulation would provide the agency the opportunity to review increases by requiring the carriers to provide notification “at least 120 days prior to an adverse change in non-guaranteed elements of an in-force life insurance or annuity policy.” In addition to notifying the agency, the regulation would require the carriers to “to notify consumers at least 60 days prior to an adverse change in non-guaranteed elements of an in-force life insurance or annuity policy.”

According to Superintendent Vullo, “under New York law, life insurers may only increase the cost of insurance on in-force policies when the experience justifies it and only in a way that is fair and equitable.” She went on to note that her agency “will not stand by and provide life insurers free reign to implement unjustified cost of insurance increases on New Yorkers simply to boost profits.” (1)

The regulation is designed to “establish standards for the determination and any readjustment of non-guaranteed elements that may vary at the insurer’s discretion for life insurance policies and annuity contracts.” It requires carriers to “establish board-approved criteria for determining non-guaranteed charges or benefits” and mandates an agency review of “the anticipated experience factors and non-guaranteed elements for existing policies whenever the non-guaranteed elements on newly issued policies are changed.” The regulation defines experience factors as “investment income, mortality, morbidity, persistency, or expense that represents the insurer’s financial experience on a policy. Profit margin is not an experience factor.” (2)

An article in The Wall Street Journal (WSJ) notes that although the regulation only applies to New York state, it “could be widely copied by other insurance departments.” We at ITM TwentyFirst have reported often about the cost of insurance (COI) increases that have hit the life insurance industry and the lawsuits that have followed. The WSJ article reports that those lawsuits have alleged that “insurers are hiding behind the little-used contract provisions to rummage up cash for shareholder dividends.” But the article also points out that “insurers maintain they are acting in accordance with policy provisions allowing higher charges up to a maximum amount, based on expectations of future policy performance.”  (3)

According to the press release from the New York State Department of Financial Services, “the proposal is subject to a 45 day public comment period following publication in the State Register on November 30, 2016 before its final issuance.”  We will be following the progress of the proposed regulation and provide updates when warranted. For a copy of the NY Department of Financial Services Proposed Insurance Regulation 210, contact mbrohawn@itm21st.com.

 

  1.  NY Department of Financial Services Press Release, November 17, 2016
  2. NY Department of Financial Services, Proposed Insurance Regulation 210, November 17, 2016
  3. New York Regulator Aims to Require Life Insurers Justify Higher Rates on Old Policies, Leslie Scism, The Wall Street Journal, November 17, 2016

Judge Rules That Consolidated Lawsuit Against Transamerica for COI Increase Can Be Heard

On November 8th, a United States District Court judge in California’s Central District ruled that a consolidated class-action lawsuit against Transamerica could move forward. The lawsuit’s main allegation concerned Transamerica’s “breach of faith” for the cost of insurance (COI) increase in their Universal Life policies.
We reported back in September of 2015 that Transamerica increased costs in several of its Universal Life insurance policies (see: Transamerica Cost Increase Causes Premium to Maturity to More Than Double: A Case Study for Trustees). Earlier this year we discovered another Transamerica cost increase while working on a policy review, which we subsequently covered in Transamerica Cost of Insurance Increases: Is the Other Shoe Now Dropping? That increase was dramatically higher than the first one. Transamerica acknowledged this new increase shortly after we discovered it.
The Transamerica cost increase dramatically raised the carrying costs of life insurance policies and several class-action lawsuits were filed against the carrier. Three of those lawsuits were combined: one filed in California by Consumer Watchdog (see: Consumer Group Files Suit Against Transamerica for Cost of Insurance Increases); a second California lawsuit, Thompson v. Transamerica Life Insurance Company (see: Another Class Action Lawsuit Filed Against Transamerica for Cost Increases); and one originally filed in the Southern District of Florida (see: Preliminary Injunction Motion Filed in South Florida Against Transamerica to Stop Cost of Insurance Increases). In a June 10, 2016, Consolidated Class Action Complaint filed in the Central District of California, the plaintiffs asserted “seven claims against Transamerica on behalf of themselves and all others similarly situated”. On August 1, 2016, Transamerica filed a motion to dismiss the complaint.
In the complaint filed, the plaintiffs argued that Transamerica was not allowed to set monthly deductions (which included the COI) “in whatever amount or by whatever method it determines.” The plaintiffs also argued that the standardized policy language requires that Transamerica can only change deductions based on underlying mortality rates and that Transamerica was not allowed to “set or increase [monthly deduction rates] to recoup past losses” because of low interest rates or other factors. They further argued that the deduction increase of “as much as 100%” caused “an astronomical increase in the premiums necessary to maintain coverage under the policies” which was designed to induce “shock lapses.”
On October 31, 2016, the court heard oral arguments. On November 8th, the Honorable Cristina A. Snyder ruled against Transamerica; their motion to dismiss the plaintiffs’ claims was denied.
For a copy of the Civil Minutes in the case, please email mbrohawn@itm21st.com.