Journal of Financial Planning - April 1995

Life insurance salespeople, advisors, and fiduciary trustees are vulnerable to lawsuits for a number of reasons. Our columnist provides a ten-step approach for minimizing legal exposure.

Minimizing Legal Exposure

by Peter Katt, CFP, LIC

In an inherently litigious society, there is no reason to believe that events surrounding the purchase and management of life insurance are immune to legal actions. In fact, life insurance has two characteristics that make it particularly vulnerable to legal actions against sales people, advisors, and fiduciary trustees.

1. Life insurance is priced to the market without any significant controls on policy performance promises. The most obvious example of this is the vanishing premium that won't vanish because company investment yields have dropped.

2. The ideal life insurance program is much dependent on an unknown event, the death of the insured(s). A life insurance program set up for wealth transfer, which initially has premiums that are maximized while the death benefits are minimized, doesn't look very good if the insured(s) die in the short term.

Lawsuits

I recently heard of a threatened action against a corporate trustee because the trustee accepted a life insurance policy with very large premiums, relative to the initial death benefits, that were projected to vanish in five years. When the insured died within the first year, the trust's beneficiaries claimed that much more life insurance could have been purchased for the same premium. I understand that the corporate trustee paid the beneficiaries $1 million to settle this perceived error in judgment. Conversely, putting all future-value premium dollars into an annual term policy, and the insured lives the year, is also, in retrospect, a poor choice.

The point, of course, is that the perfect life insurance program can't be known in advance. But this won't stop trial lawyers from going after salespeople, advisors, and fiduciary trustees because of problems only obvious in retrospect.

Minimizing Legal Exposure

In my fee-only life insurance advisory practice, I am very aware of potential legal entanglements and have designed methods for working with clients that maximize the quality of planning and purchase decisions while minimizing my legal exposure. I have never had a legal challenge and hope to keep it that way.

The following are the methods I use, in a chronological sequence. You will notice that whenever possible my role is to present the client with a range of options from which the client selects. My goal is to make the client an informed customer of life insurance planning and purchases.

1. Engagement Agreement. A written agreement is required under my Life Insurance Counselor's license in Michigan; however, even if it weren't, a signed agreement is essential to clearly identify my responsibilities so that if a client claims I failed to perform a particular function that wasn't specified in the agreement, I will be protected. My agreement also establishes binding arbitration to resolve disputes.

2. Data Collection and Assessment. The first planning step is to obtain pertinent financial and family information from the client. This allows me to assist the client in establishing his or her goals related to life insurance.

3. Preliminary Life Insurance Planning and Purchase Report. After obtaining financial and family information, I prepare a preliminary planning and purchase report. This report identifies a reasonable range of planning and purchase options. For example, if the life insurance purchase is associated with estate planning needs, the report might depict the current estate settlement costs and project those into the future. Then I would typically present single-life and survivorship-life insurance purchase options with various policy designs for each policy type.
   
   After studying and discussing this preliminary report, the client selects the planning and purchase options the client believes are in his or her best interests.

4. Case-Management Memos. All client decisions are written down in follow-up management memos that recite the decisions made, describe the next action to be taken, and inform the client how much time has been taken (my fees are based on the time spent on a case). These case-management memos continue throughout the case as needed.

5. Supplemental Reports (as needed). The most common supplemental report I prepare is to simulate a comparison of variable and universal (or whole) life. This comparison isn't made with specific proposals; rather, I use historical stock-market performance and intermediate-bond yields. The important concept to introduce is the much greater year-to-year volatility inherent with equity backed variable-life policies.
   
   In any event, the client reviews this information and decides whether to purchase variable or universal life, or perhaps a combination. Again, this decision, future work, and time expended are written in a case-management memo.

6. Existing Life Insurance Report. Concurrent with the reports described above, I review, evaluate, and comment on life insurance the client already has. These reviews are usually completed about the time final decisions on the overall life insurance program are made so that the existing life insurance can be melded into the new program.
   
   Recommending the replacement of existing policies is a rare event. Replacement is recommended only when the existing policy appears to be substantially overpriced, the financial strength ratings of the company are below average, or the policy setup is a problem and there isn't any prudent way to change policy ownership or beneficiary without causing potential adverse tax consequences.

7. Company and Policy Selection Report. I use three criteria in recommending a specific company and policy.

• The financial strength ratings from A.M. Best, Standard & Poor's, Moody's, Duff & Phelps, and Weiss Research.

• The reputation the company has for fair policyholder treatment. This is based on my experience and is a matter of judgment.

• Legitimate pricing advantages, such as low-load and blending full-load policies to reduce their selling expenses. In larger cases, I recommend two or more companies to provide diversification.

8. Purchase Report. When the specific policy(ies) has been selected, I present the client with a purchase report. This report identifies and explains all of the policy riders, such as waiver of premium. We require the client to indicate which riders he or she wishes to purchase. The report also depicts a range of policy performance based on different pricing assumptions, from below market to historical. If the client is purchasing a level death-benefit policy, the client indicates which of the various target premiums he or she wishes to use; that is, if the annual target-premium range is $9,000 to $12,000, depending on the pricing assumptions, I require the client to indicate which target premium is to be used in the early years of the policy. I make clear that if the higher premium is used it will be less likely the premium will be subsequently increased. Conversely, the client understands that if the lower premium is chosen it will be more likely that the premium may have to be increased. A copy of this purchase report is returned to me with decisions noted and initialed by the client.

9. Application Completion. I make sure the owner and beneficiary are correct and such things as 1035 forms are properly handled.

10. Policy Reviews. Every two years I review clients' life insurance programs. I am interested in discovering if the client's financial, family, or health situations have changed to an extent that may affect our policy design. For example, if the life insurance was originally purchased to provide liquidity in an estate where the predominant asset had been a closely held business, but now the business has been sold and the predominant assets are marketable securities, the policy design may change from liquidity to wealth transfer. I also prepare another range of target premiums, making a recommendation regarding the amount of premium to be paid the next two years.

Several Accomplishments

By following the steps outlines above, I accomplish two things:

1. I put the client in charge of designing his or her own life insurance program by presenting the client with a series of options, in logical sequence, from which the client must select. These options also serve to educate the client, making him or her a better-informed life insurance consumer.

2. I substantially reduce my exposure to possible litigation.

Reprinted with permission by the Financial Planning Association, Journal of Financial Planning, April 1995.

Peter Katt, CFP, LIC, sole proprietor of Katt & Co., is a fee-only life insurance adviser located in Kalamazoo, Michigan (269.372.3497).