The Hazards of Unmanaged Life Insurance Policies

The Hazards of Unmanaged Life Insurance Policies

Article posted in Intangible Personal Property on 22 August 2001| 10 comments
audience: National Publication | last updated: 18 May 2011


What happens to a life insurance contract after it is contributed to a charitable organization? Unfortunately, in most cases, not much. In this edition of Gift Planner's Digest, Certified Insurance Consultant Austin "Dunny" Barney discusses the review process that organizations should conduct prior to and after accepting outright gifts of life insurance, as well as insurance used in conjunction with gift plans.

by Austin D. Barney II, CIC


When some development professionals are asked if their organizations promote, accept or hold gifts of life insurance, one can hear a variety of responses ranging from "Why?" to "We don't like life insurance -- it's too risky!" Both answers are fairly commonplace within the nonprofit community, but there are compelling reasons for charities to pay attention to life insurance policies--both those that have been contributed to them and, believe it or not, policies donors have purchased as wealth replacement tools inside irrevocable life insurance trusts. This article will explore the potential hazards charitable organizations face in accepting and owning life insurance and how, as fiduciaries, to mitigate them.

Life insurance is so often seen as a mysterious black box--one that plays tricks and never completely reveals itself. Therefore, it is often not understood and, due to misconceptions, is often refused as a gift if offered. When a gift of life insurance is accepted by a charitable organization, it is often booked and then ignored--as long as the donor continues making gifts to pay the remaining premiums. The biggest misconception is that life insurance is guaranteed at issue or is otherwise a static financial instrument. In either case, it is felt the policy doesn't warrant continual examination. And then again, who in most planned giving offices knows enough about insurance to question these assumptions? So the policy is filed and as long as annual statements reflect the payment of premiums, all is well . . . or is it?

Advisors to the wealthy who have created estate plans for their clients using life insurance to create liquidity for paying estate taxes now have the challenge of reassessing the need for those policies. Although under current law, the estate tax is scheduled to phase out by 2010, it will reappear by virtue of the sunset provision in 2011. Currently proposed bills would make repeal permanent. If passed, this radical change in the tax landscape could create a new huge source of transferable life insurance policies as gifts to charities. By then many of these policies will not need further external premium payments -- but they will still need independent evaluation!

Lack of Review

Studies have found that 90% of life insurance policies held institutionally have never been reviewed or thoroughly evaluated since inception or donation. These same studies show the financial strengths of nearly 10% of insurance carriers have degraded since policies were issued and that 60% of polices are performing poorly (i.e., below their original projections). The most common problems one finds in reviewing a portfolio of polices include:

  • the carrier's strength may have diminished to an unacceptable level of risk.

  • potential policy under-performance may taint donor/recipient expectations.

  • loans could be crippling policies.

  • policies in the 1980s and early 1990s were sold at higher crediting rates than today.

  • mortality tables/expectations have changed substantially.

  • policies could lapse before mortality due to underfunding.

  • payments (i.e., gifts) of premiums may be required many years beyond the original "as sold" illustrations.

  • lower expenses in current policies could create higher death benefits or lower premium costs than in older policies.

Given the possibilities of these problems arising, advisors must ask themselves and the intended charitable donee the following questions in regard to an intended charitable gift of a policy:

  • Are all the policies under their care financially sound?

  • Are they able to assure the donor that their gift expectations will be met?

  • Are they familiar with the myriad of issues that could negatively affect the donor's policies?

  • Do they have the necessary knowledge of life insurance to perform the needed evaluations themselves?

  • How effective are their current risk management strategies and are they doing their best to protect the value of the donor's gift?

  • If continued premiums are required and the donor fails to make additional gifts, is the institution prepared to make an informed decision regarding what to do with it?

Most often the answers to these questions are "no," for very valid reasons. Life insurance is complicated. Every policy is different -- carriers, product design, guarantees, expenses built into the policies, riders of many types, policy construction, endowment considerations, mortality assumptions, and agent compensation. No similar assumptions can be made when looking at two different policies. There are relatively easy ways, both on-line and off, to check the carrier's financial strength. But remember, only about 10% of possible problems are based on the quality of the company. The major source of problems comes from the details inside the policy and how the contract was structured. These issues can be accessed and analyzed only by experts in life insurance policy analysis. It is unrealistic to think many charitable institutions would have such expertise on their staff.

Do all policies held by a charity need annual reviews? What is a sufficient review schedule? There is a federal standard for all fiduciaries in OCC/OTS regulation-that all "investments," including insurance contracts, must be reviewed before acceptance and annually thereafter. That is the recognized rule of prudence. Practically, however, the answer depends on the portfolio of policies owned by the institution. To start the review process, all policies should be reviewed to establish a baseline of performance and to find out which ones are sound, which are in trouble today, and those that could be getting into trouble tomorrow.

Whole Life Contracts

We see whole life policies without term riders rarely having problems. Whole life policies are generally the most expensive as more of the premium is required in the base cost of insurance. The policies, in return, have higher than usual guarantees of level, though inflexible, premiums and guaranteed death benefits. Because whole life policies are funded with dividends, as opposed to interest credited to the policy as with universal life, the whole life policy is less exposed to the vagaries of the interest rate environment, and thus far more stable. If constructed properly, they require a three to five year review interval.

Universal Life Contracts

Universal life policies create most of the problems because their performance is highly dependent on credited interest rates, which fluctuate constantly. As crediting rates go lower, which they have done for many years, a policy's need for an outside infusion of additional cash to pay premiums is extended beyond original projections. For the donor who annually contributes the premium to the charity that owns the policy, these premium payments (annual gifts) can be extended dramatically. If payment of this extended schedule of gifts interferes with the other elements of a donor's financial life (i.e., retirement, educational needs, medical requirements), it can create a difficult decision for the donor who originally created the gift with a dollar limit in mind. One of charitable recipient's greatest fears of such a policy is that the donor will cease giving the premiums and "stick" the institution with the decision of how to proceed. With periodic analysis, generally every other year, these types of problems can be avoided completely with advanced warning. If problems do arise, they can often be resolved to the donor's and policy owner's satisfaction.

Term Insurance

Term policies are annual contracts that are renewable with continuing premium payments. Policies can take the form of ART (Annual Renewable Term) with annually increasing premiums, or Levelized Premium Term with level annual premium amounts for a specified number of years; often 5, 10, or 20. Thirty-year term today is offered less due to financing requirements on carriers from recently instituted regulations. Term insurance has no cash value; therefore, a gift of such a policy is not really a gift at all and produces no charitable deduction to the donor.

Term policies should be reviewed and discussed as the premium cost can escalate quickly. This is the reason that only about 6% of term policies survive until death. If conversion of a term policy to a permanent form of insurance is possible, with or without medical evaluation, it is an option to be fully explored.

Pre-Acceptance Reviews/Mitigation

Most problems can be foreseen from the initial design of the policy, and thus the problems can be avoided before they land in the charity's lap. However, charitable organizations should have policies and procedures in place for the systematic review of all policies being considered for donation and those already on their books. Objective review at the time of a gift as well as periodic review offers a cost-effective method for the organization to fulfill its fiduciary responsibilities.

What options are there if a policy gets into trouble? Often it depends on a great unknown -- the current health of the insured(s). If through lower crediting rates the number of premiums is substantially extended on a policy (mostly UL), adjustments in the premium levels (annual gifts to the charity) can often bring the term of years a policy will require outside funding back to original expectations. If the required premium exceeds 30% of original expectations, shopping the coverage -- only if the insured(s) are healthy and willing to be medically re-examined -- may make sense. If a different policy can provide better premium levels for the same death benefit, or a better death benefit from equal premiums, using a tax-free exchange of policies under IRC Section 1035 might make sense. This process requires great care and the need for policy exchange/replacement to be documented very well. Again, an objective assessment of the original troubled policy lays the groundwork for justifying such an exchange. Occasionally the donor will be willing and able to pay in a single premium all remaining premiums required for the policy become self-sufficient from internal earnings. Or they may want to stop paying premiums or pay for a stipulated number of years, despite projections, and give whatever amount of insurance their payments have purchased. These strategies can limit huge premium increases.

Know When to Hold 'Em and When to Fold 'Em

When should a charity surrender a policy and apply for the cash surrender value? The answer comes from an analysis based on the time value of money and the donor's basis in the policy, the amount of contributed premium. If the donor will/can not pay further premium and the policy in all other respects is on target, it actually might behoove the charity to assume the premium payments themselves if the internal rate of return on the projected death of the donor is high enough. The cash surrender value can be higher or lower than the donor's basis, leading to a tax loss (if less) or an often under-anticipated taxable gain (if greater). Advisors need to be sure to calculate this figure as at times the tax liability can be substantive.

Look Out for Policy Loans

A policy with a loan against it presents a difficult set of options. Again, analysis of the values will determine if the options of the charity paying off the loan -- as policy owner -- is a worthwhile investment. The real question is why would a charity accept a policy with a loan against it in the first place? The hazard to the charity is the creation of unrelated business income if there is a loan on the policy. Although not disastrous if the gift is made directly to a charitable organization, a gift of such a policy to a charitable remainder trust could cause the loss of the trust's tax exempt status. In addition, there can be adverse income tax consequences to the donor. Such transfers not only reduce the value of the donor's deduction by the amount of any indebtedness, they are treated as a bargain sale with the donor considered as having received the amount of the loan. If the donor has gain in the contract, such gain will be allocated on a prorata basis to the amount realized. In most cases, all efforts should be made to have the loan paid off before the policy is given, avoiding these tax consequences for both parties.

Wealth Replacement Insurance

The estate/gift design technique of replacing the value or a portion of the value of a major gift to charity for the donor's heirs with a "wealth replacement" life policy in an irrevocable trust is well known. The most common example involves a charitable remainder trust, where tax savings and cash flow from the trust are used to fund life insurance premiums. The life policy, owned by the irrevocable trust, pays the death benefit to the beneficiaries at the death of the insured(s) income and estate tax free. It is rarely recognized that all of the problems with life insurance policies described above can also occur inside the wealth replacement trust. Why should the charitable remainderman care about these trusts they don't own or control?

As part of the design process in estate planning for a donor, the wealth replacement trust is included as an element from the beginning. To be able to take an estate taxable asset, give it to charity, sell it without paying immediate capital gains tax, receive a charitable income tax deduction, and utilize a portion of the tax savings and cash flow to purchase life insurance to replace the gift tax-free for the donor's heirs is often considered by donors as being too good (legally speaking) to be true. From the charity's point of view, the least amount of attention in the design of the plan is spent on the wealth replacement trust, the details of the policy(s), the trustee designation, the beneficiaries, etc. The charity's focus is on the actual gift, its structure, purpose, timing and the amount. The fact the donor is happy with having a wealth replacement option in place is sufficient for the charity -- but is considered outside of its purview.

Like any trust, an irrevocable life insurance trust (ILIT) has a trustee who/which can be an individual or institution. As with all trusts, there can be successor trustees. Let's look at the job description of a trustee of an ILIT and what they need to know -- and why they could affect the charity dramatically.

One of the major tasks of a trustee of an ILIT is to prepare, send, and receive back Crummey letters from all trust beneficiaries, stating that they recognize, as trust beneficiaries, they have a current interest in the gifts to the trust each year, but forswear payment out to them. By doing so, the beneficiaries leave the annual gifts to the trust intact for use by the trustee for the payment of policy premiums. The trustee must collect the annual gifts from the grantor and then pay the premium as needed. The trustee, as owner of the policy, is fiduciarily responsible for the care of the trust's assets and has statutory obligations to be prudent and fully knowledgeable about the trust's assets (including life insurance). But are they?

Whether the donor chooses an institution with annual fees ranging from $500 to $1,500 to perform the trustee's duties, or a responsible friend/relative who usually will charge no fee -- is of no consequence. For the most part, both forms of trustees are unknowledgeable about life insurance and do not perform annual or even periodic thorough reviews of the policy. The hazards from the policy(s) to the beneficiaries are the same despite the type of trustee. They are both inadequate to the full task as seen in repetitive cases. "Uncle Bill," the non-fee friend/relative, is unwittingly uneducated as to his full responsibilities and is uninsured for errors and omissions. He has no clue as to what the annual statements are saying -- which are never enough to fully inform the prudent trustee about the policy's real condition. As said earlier, 90% of ILITs have never had their policies reviewed -- and that figure includes the largest and most experienced trust companies in the country, as well as "Uncle Bill." The institutional trustees rarely make this review a priority, claim not to be able to afford to hire internal staff with sufficient knowledge, or to hire outside review services, as often their annual fees are too low to cover their full responsibilities as trustees. In the final analysis, they are reticent, at best, to raise their fees to meet their fiduciary obligations.

Why is this scenario of a policy failing in a wealth replacement ILIT a problem for charity? Quite simply, if the institution receives a large gift, offset in the donor's estate plan with an ILIT -- and the ILIT's life insurance policy lapses, what might the donor do? They now realize they have given away a large portion, possibly, of their net worth with the expectation -- actually a gift design requirement -- that the value be replaced to their heirs. In this planning, the use of an ILIT represents the donor's key interest in keeping their heirs whole. Without the wealth replacement element viably in place, the donor might not have made the gift at all. With a failed policy in an ILIT, the donor might well sue the recipient charity for return of the gift to keep their estate intact. Whether the donor would be successful or not in their efforts, the attending negative publicity, fractious relations with a major donor and their family, and the costs of defense all make this a situation to avoid.

The solution to managing the hazards of life insurance, either given as a gift directly to charity, or used in a wealth replacing ILIT is the same. Hire an outside vendor of policy review services that will objectively review the policies' financials, the carrier's financial strength, and how the policy is performing relative to initial expectations. It is critical the review be performed by a certified and licensed insurance consultant (not sales agent) who may not sell life insurance or be remunerated from its sale directly or indirectly. As to a donor's ILIT, I am suggesting that the charity offer to underwrite the expense of reviewing the policy(s) in a donor's ILIT. The first review should be done before the gift is accepted or trust funded to insure the integrity of the entire gift design. The annual cost will be far less than the value of the gift -- and will make the donor feel the charity is truly interested in them and their family -- not in just getting the gift.

One is always asked, "Isn't this policy review the responsibility of the agent who sold the policy?" The answer is in about 85% of cases they can't be found after the sale, having moved on to different carriers and/or professions. It could be argued their review, even at the time of sale, would not carry as much objective integrity as that done by an independent reviewer.


In summary, there are certain definable hazards to unmanaged life insurance policies. They can provide a serious problem in policies used as gifts and/or as wealth replacement devices. The good news is these hazards can be mitigated and the many benefits of leveraged gifts of life insurance enjoyed by our nation's charities. The benefits far outweigh the costs of mitigation and should make every planned giving officer confident in seeking out and accepting life insurance gifts.

Would you like to contribute an article to Gift Planner's Digest? Contact GPD Editor for further information.

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"experts in life insurance policy analysis"

We have conducted reviews of the policies held by the non-profit organization I work for, however in our case we have had a couple of different insurance agents review the policy and their motivation seems to be how can I turn that into another sale. I am at a loss as to who to turn to as "experts in life insurance policy analysis" as stated in your article. Who should we turn to for help with completing the governance policy and completing a regular review/analysis?

Life Insurance Audits

Mark, I have done insurance audits for the last ten years or so (probably reviewed 2-3 thousand policies) and do qualified appraisals as well (see some of my articles on life insurance on PGDC) - website is The only other two people I know actively working on these kinds of projects are Alan Breus and John Elbare (John wrote a great piece for a NCPG conference on managing policies and has a pretty cool kit you can purchase as well). JJ McNabb used to do it, but she was kind enough to transfer her practice to me about five years ago. As a suggestion, and this is not always the case, but it may be best to use someone who doesn't actually sell life insurance. In essence, you want a fee only review. Otherwise, it becomes a "this block should be converted to a new policy and this block should be sold in the secondary market" kind of "free" engagement. There is some finesse in dealing with donors, your business office and the original writing agents that can sometimes be missed I have found. Anyway, hope this is helpful. Bryan

Life Insurance Audits

Thanks Bryan for the note. I am swamped right now but will put a tickler on this file to review your website and the individuals you suggested. We are getting ready to publicly announce a capital campaign next month as you can image I am burning the candle at both ends. Thanks again for taking the time to respond, this is exactly what I was looking for. I even offered to pay a fee to the insurance people that reviewed our policies but they said no and then try to sell me on why they should turn the policies into new policies. I was very suspect.

Relative Merits of ULSG and Whole Life

The article by Austin Barney seems to me to be very thorough and practical. I expect to use it in the future as a reference. However, I am writing to take exception to the comments by Blake Woodard and Douglas Delaney to the effect that Universal Life with the Secondary Guarantee (ULSG) is the safest, most reliable form of life insurance. It is true that UL with the SG is preferable in most charitable planning situations to UL without the SG, but the truly important thing to realize is that the "guarantee" of the Secondard Guarantee is a CONDITIONAL guarantee, NOT the UNCONDITIONAL guarantee that is found in a whole life policy. In a typical ULSG policy the SG can go away if the premiums are not paid in a timely fashion, or if loans are made against the policy, or if other changes are made in the policy. In contrast, the premium and death benefit in a whole life policy are guaranteed for life. Late premium payments, policy loans and policy changes will not void the guarantees. In addition, ULSG typically has much less cash value than a comparable ULSG policy. If the donor stops paying premiums, the higher cash values of the whole life could offer a significant advantage to the charity policy owner/beneficiary. In my 43 year life insurance practice, I have often found myself using ULSG because of its lower premium, but I always make sure my client and his/her advisors realize that the trade off of the lower premium is less certainty that the policy will remain in force until the death of the insured PLUS much less cash value. In fact, in many cases the cash value of the ULSG policy will be zero long before the insured's life expectancy has been reached. If ULSG is used, it should be monitored frequently to make sure the SG has not been inadvertantly lost, an event I have seen happen more than once over the years.

State Guaranty Funds

Very well written article. Just one note with respect to any concerns about the insolvency of the insurance company. Every state has a guaranty fund association which would guarantee the insurance policyholder, in the event of the demise of the insurer, up to a minimum of $100,000. on life health and annuities. Some states have higher limits such as Pennsylvania which has coverage for death benefits and annutiies up to $300,000.

Guaranteed premium universal life insurance

Mr. Barney's statements about universal life insurance are correct, but only for policies sold before 2001 and some policies sold after 2000. Since 2001 (a year or two earlier in some states), insurers have offered guaranteed premium universal life policies. These policies offer a guaranteed premium that will not change in amount or duration, regardless of changes in interest rates or mortality costs, as long as the policyowner pays all premiums on time and does not borrow or withdraw funds from the policy. Such guaranteed premium universal life policies are a more reliable, stable form of insurance for charities than whole life, term, or non-guaranteed universal life policies. Periodic reviews are still a good idea, just to keep the insurer honest.


I agree, Blake. The guaranteed death benefit universal life (GDBUL) policies are stable, safe and reliable. It is for that reason that they are used in the CHIRA fundraising plan. Douglas S. Delaney, JD, LLM Managing Director CHIRA USA, LLC (843) 815-9777


Mr. Barney is referring to a nonprofit as a fiduciary of an asset that has been "gifted" to the nonprofit. I agree with the logic that a nonprofit should review their life policies regularly, but I am curious how a nonprofit is a fiduciary. If the nonprofit were protecting the policy for a different beneficiary that is what defines a fidcuiary. Am I way off base here?


Charitable organizations may themselves be fiduciaries as well as their managers. Typically, every donor to a charitable organization expects the organization to deal with the donated assets for charitable purposes, thus creating a fiduciary responsibility. The "beneficiaries" are the public or other charitable class of individuals intended to benefit from the organization's charitable mission. Typically, the fiduciary responsiblities would be enforced not by any individual beneficiary, but by the Internal Revenue Service or the attorney general of a state. In addition, managers such as trustees or directors have fiduciary responsibilities to the organization. Generally, these responsibilities will align with the responsibilities of the organization itself.

thank you

Daniel, Thank you for your response. That is a very clear understanding of the charitable organizations role as a fiduciary in this sense. My perception is that charitable organizations, in general, take the role of fiduciary much more serious when they are ttee of a CRT, for example, then they do with a completed gift of life insurance. An attorney also suggested to me that communicatng with a donor after they've gifted a life insurance policy, and encouraging them to "improve"their policy (i.e., 1035 exchange) could expose the charity with more liability than if they just left the old policy alone. Thus, its difficult to consider implementing a policy to review life insurance a charity owns looking at the risks from every angle.

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