CGNA: Chapter 6 - Life Insurance, Intermediate

CGNA: Chapter 6 - Life Insurance, Intermediate

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This article is an excerpt from Charitable Gifts of Noncash Assets, a comprehensive guide to illiquid giving by Bryan Clontz, ed. Ryan Raffin. Published by the American College of Financial Services for the Chartered Advisor in Philanthropy Program (CAP), with generous funding from Leon L. Levy. For a free digital copy, click here, and to order a bound copy from Amazon, click here.

Below is a review on gifts of life insurance. Life insurance topics are based on my article, “Charitable Gifts of Life Insurance: The Lone Ranger or Black Bart.” For quick take-aways on gifts of life insurance, see Life Insurance Quick Take-Aways. For a review based on that article, see Life Insurance Inter- mediate. For an in-depth examination adapted and excerpted from the article, see Life Insurance Advanced. For further details, see Life Insurance Additional Resources.

This review of the different ways life insurance can be used to give to charity has four parts. It starts with a discussion of simple transactions, and then proceeds to more complex gifts. The third part examines gift strategies that are more situational and less clear-cut. Finally, the review concludes with an overview of considerations that apply regardless of the structure of the gift.

As a planned gift, life insurance’s flexibility is both a strength and a weakness. The donor and charity may structure the donation in any number of ways, with varying degrees of complexity. A gift of life insurance can be a simple way for the donor to guarantee the charity an eventual fixed payment. However, it can also include wrinkles relating to premium payments, annuities, policy sales in the secondary market, premium financing, etc.

Review Part 1: Keeping It Simple

The simplest and most intuitive transactions are usually best, such as cut-and-dried donations of a policy. The donor can designate the charity as beneficiary, but this is revocable and therefore provides no charitable income tax deduction. This is an appealing option for its ease and flexibility. The allocation can be a percentage of the total benefit, or a specific dollar amount. Unlike many other planned gifts, there is usually no need for an attorney, accountant, or other financial professional.

A more tax-advantaged, but still simple, alternative is donating the policy. The policy owner assigns all rights in the policy to the charity (or charities). She receives an income tax deduction of the lesser of the policy’s fair market value or cost basis. The charity must hold all ownership rights to the policy. Who pays any additional premiums due will depend on negotiations between the donor and the charity, as well as the policy’s structure. Slightly more complex is the charity purchasing a policy on the donor, using funds the donor provides (depending on state regulations on insurable interests).

Wealth replacement strategies can also utilize life insurance to facilitate more or larger donations. Donors may donate all or a portion of the estate as an outright, life income, or estate gift. Heirs receive the “replacement” benefits of a life insurance policy. Typically, the donor’s irrevocable life insurance trust owns the policy so the proceeds are received tax free. This can be a very flexible strategy, because the donor can increase the size of the gift or adjust the policy as needed. A simple option is buying a policy with a fixed bequest target for heirs (i.e., $4 million death benefit providing $1 million to each of four children), with the donor’s entire estate then donated to charity (although this simplicity may not be ideal for tax or estate planning purposes).

Another option for charities is gift annuity reinsurance. This strategy has the charity purchasing insurance to match its contractual liability on its gift annuities. This shifts the investment and longevity risk of the annuity to the insurer, and allows the immediate remainder to be used currently or invested more aggressively in the endowment.

Review Part 2: Getting Tricky

More complex transactions generally have bigger risks, and can lead to occasionally contentious interactions between charities and the insurance industry. Vanishing pre- mium universal life insurance was the trendy strategy in the late 1980s and early 1990s. When actual interest rates were lower than illustrations projected, the premiums did not vanish. Tens of millions in life insurance death benefits were lost, angering donors and nonprofits alike. This frustration reoccurred in the late 1990s with charitable reverse split-dollar life insurance. There, donors made a deductible donation to the charity, the charity purchased a policy, and part of the death benefit went to the family estate, trust or heirs.

Other creative approaches still exist today. Prior to the crash of 2008, some chari- ties would engage in interest rate arbitrage called premium financing by borrowing money at rates expected to be less than the policy would earn. The policy’s benefit and cash value were collateral, and the charity would eventually pocket any leftover amount after paying back the loan. In essence, this was “free” insurance to the charity. However, many of these structures collapsed when banks started calling in loans during the financial crisis. With credit scarce, refinancing the loans was difficult, if not impossible. Newer versions of premium financing generally have longer financing terms and other structural changes to mitigate interest rate risk.

“Dead pools” were another questionable strategy. Best known for corporate use, the idea was that a charity would take out a group policy on a large number of donor lives—typically over one thousand in total. The charity borrows money to pay for the premiums, collect tax-free death benefits, grow the cash value of the policies, and then deduct the cost of interest. Congress significantly curtailed this strategy for corpora- tions in the Pension Protection Act of 2006. Nonprofits can still utilize this strategy, if it can gather enough insurable lives. Even so, the optics can be off-putting to charities, regulators, and even donors whereby promoters are seeking to “rent” or “lease” donors for a small fee.

A second type of “donor rental” scheme uses Charitable/Foundation/Stranger/Investor Owned Life Insurance. Regardless of the type of insurance, these strategies were usually structured the same way. The promoters helped charities find high net worth donors that would allow the charities to take out policies on their lives. The charity paid the premiums (usually through premium financing), and sold the policy. The downside was that the insured donors did not typically realize that the charity was taking out large policies rendering them “overinsured,” so they had difficult securing more personal insurance for estate or business liquidity needs.

Nonprofits, donors, and insurers did not receive these donor “rental” programs well. The promoters would collect their fee no matter the result, but the nonprofits and donors got only minimal benefits, if any, for the risk they were taking on. The insurance industry also takes a dim view of these strategies—even saying they have no business purpose and can be actively harmful, and in some cases, has sought to nullify the transactions.

Review Part 3: Ambiguous Strategies

Not all strategies have a “good” or “bad” feel to them. Some approaches are less clear-cut, and unsurprisingly, these tend not to be the simplest plans.

Life settlement is one such process. In this case, a charity sells a qualifying insurance policy—usually with a death benefit over $1 million, in-force for at least 2 years, with an insured over 70 years old, and a life expectancy between 2 and 10 years. The insured must also release all medical records to the broker / buyer. Bids are made based on cash value, death benefit, insured’s age and health, and the type of policy, and represent a 10 to 14 percent internal rate of return (often 16 to 20 percent after the 2008 crash). Despite the complexity, estimates put the secondary market for life insurance at $200 billion. Charities who do not want to hold the policy due to the risk, cost, or headache of administration might therefore consider this option.

Another strategy is life insurance/annuity underwriting arbitrage. Here, the charity takes a donor between 70 and 85 years old with a nonterminal health issue, and has a number of life insurance carriers submit bids for a large policy (say, $5 million). Then the charity asks the same carriers to bid on an immediate annuity in the same amount. Then it selects the insurance policy with the longest life expectancy, and the annuity with the shortest. This means the premiums are lower than the annuity payments, so the charity keeps the difference. In some scenarios, this equates to a six to ten percent guaranteed rate of return no matter when death occurs.

Gifts of life insurance may also be combined with charitable remainder trusts (CRTs). CRTs can own life insurance policies, with the primary purpose of providing addi- tional income to the surviving income beneficiary after the death of the first income beneficiary. Additionally, the IRS recently ruled privately that charitable remainder annuity trusts (CRATs) can own immediate annuities. This allows the CRAT to essentially reinsure its liability by transferring longevity and investment risk for a portion of the assets. These new options may be appealing as they guarantee an income stream or fixed death benefit, rather than relying purely on market-based investments.

Review Part 4: Issues to Consider

As with nearly every kind of estate and financial planning, careful preparation can prevent many problems. Life insurance, in particular, benefits from advance planning and communication, since most nonprofits do not have robust Gift Acceptance Policies for life insurance. Informal, verbal, or handshake agreements are typically recipes for disaster—a formal Memo of Understanding is essential to setting expectations from the start.

Another issue with life insurance donations is the IRS appraisal requirement. The Pension Protection Act of 2006 made clear that for any donated policy valued over $5,000, the donor must obtain a “qualified appraisal.” Indeed, in 2007, the Journal of Accountancy stated:

“The questions of appraiser qualification and responsibility remain an area of concern for the IRS due to a long history of valuation problems dealing with gifted life insur- ance. Life insurance can be prone to incorrect valuation because of the plethora of types of policies available, ownership and beneficiary issues and misunderstanding of valuation methods of how to apply fair market valuation principles.”1

Improper appraisals and substantiation have resulted in the IRS disallowing deduc- tions if the appraiser was not properly qualified. For this reason, failing to properly obtain an appraisal can lead to unhappy donors and nonprofits.

It can be challenging for nonprofits to manage the donated policy as well, especially if it is unexperienced at receiving gifts of life insurance. The nonprofit should have someone with expertise evaluate whether to accept the gift, and review its past and current performance. Risk disclosure is essential. Nonprofits must also determine who is getting paid (and how), and who will be performing critical pre- and post-gift functions.

Options to address situations where the donor no longer will pay premiums—or for underperforming policies—are: the charity surrenders the policy for the cash value, sells the policy (as in life settlement), takes a reduced death benefit paid-up policy, makes premium payments on its own, or simply does nothing. Not only is it wise to decide on a strategy in advance with the donor, the charity should have internal policies on how it makes these decisions.

Additionally, a staff person should organize any required annual statements, coordinate information for audit and FASB reporting purposes, ensure outstanding premium payments are being made, and monitor any material changes (i.e., life insurance company ratings drop, new policy loans, negative changes in assumptions).

Conclusion

Charitable gifts of life insurance are a broad category of planned giving, at least in terms of how the gifts are structured. The simpler structures are usually better, depending on the experience and goals of the parties involved. More complex gifts that involve arbitrage or remainder trusts can be successful as well, but require advanced planning. In cases of strategies that resemble dead pools or involve “renting” donors, an abundance of caution is the best approach. Even once the structure is settled, there are still potential hurdles like payment of future premiums, monitoring policy performance, and obtaining a qualified appraisal. Nonetheless, the flexibility of life insurance as a donated asset has strong appeal, and charities may wish to develop solid policies and procedures to confidently receive these gifts.

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