Vol 4 No 1		February 2002

Katt & Company is a fee-only life insurance advising firm. We work with clients throughout the U.S. - primarily by phone, mail, email and telecopy. Typically, we assist clients buying life insurance, those who need existing policies reviewed and managed, and in support of litigation. For references please contact us.

Alert and Information

The desire to substantially discount a financial asset's value at the precise moment it is being measured for tax purposes has spawned many creative planning and financial products. Unfortunately, while some of these techniques are legitimate many are little more than tax-avoidance tricks that will collapse upon the first IRS audit. Because permanent life insurance is inherently complicated some planning and product developers repeatedly use it as the centerpiece of their tax-avoidance schemes. Tax attorneys, CPAs and financial advisors will generally fall into three camps regarding these plans. Those who are skeptical of such planning and research does not improve their confidence will generally advise clients to avoid such asset purchases and planning. A second group takes a rather aggressive approach either approving or remaining neutral relying on the worst-that-can-happen-is-paying-taxes-that-would-be-paid-anyway approach. The final category comprises those who recommend such aggressive schemes, introducing their clients to the sellers of such products. This latter group seems to be motivated, at least in part, by increasing competition among advisors from the too-good-to-be-true tax planning school.

Our comments are directed to the middle group as little needs to be said to the first group and I'm not sure the latter group has much interest in more cautious musings (an aggressive advisor recently admonished my cautious opinions by reminding me that "we should be working for the client not the IRS", which I have a feeling may have been the attitude taken by Enron's advisors). Therefore, is the worst-that-can-happen-is-paying-taxes-that-would-be-paid-any-way approach appropriate? Depending on the details of the planning, the answer is often NO. There can be worse things that can happen and the worst-that-can-happen attitude begs the question of whether clients would be pursuing the planning without tax-avoidance in the first place.

Two typical uses of depressed-value life insurance are: 1) policy owned by a tax-qualified retirement plan is distributed; and 2) policy funded with a single-premium is transferred to an irrevocable trust. In both cases an insurance company is willing to certify that a policy's cash values or reserves are much lower than their true asset share so its value for tax purposes is very low but then the cash values dramatically increase in value. This trick has come to be known as springing cash values or reserves. For example, a permanent life policy whose asset share is $500,000 has claimed cash values or reserves of $100,000. Then after a year or two the insurance company projects the policy's cash values will begin to soar to levels a conventional policy would already have reached. While everyone has been distracted by the clever tax-avoidance little attention has been paid to three very real potential problems.

First, if the insurance company involved runs into financial trouble and is seized by regulators policyowners have no right to the missing policy values and it is very unlikely the promised increase in values when the company may reappear from rehabilitation will materialize. In the past five years I am aware of two instances of companies seized by regulators due to pending insolvency that had blocks of policies whose values were depressed (actually zero in one case) from their actual and promised future values. One of the companies had been selling policies associated with VEBAs dressed up to appear to be two separate insurance policies not one in a new twist on the old springing cash value trick. (See my September 1999 Journal of Financial Planning column. Also see Neonatology Associates v. Commissioner that can be found at www.ustaxcourt.gov in the historical opinions section.) The other instance involved a company that used a considerable amount of what is known as lapse-supported pricing that is similar to springing cash values. (For information about lapse-supported pricing see my November 1994 AAII Journal column). The second problem with depressed policy values is if the client has to terminate the policy because of his own financial difficulties. The final potential problem is buying policies from the kind of insurance company that would be party to such subterfuge in the first place. Such companies must be given an extraordinary amount of trust because they are denying the policyowner any right to the full cash values until a promised time in the future. The failure of such a company to fully honor the promised return of full policy cash values at a later time shouldn't be too shocking. (Think of having to pass through a border check point between the Afghanistan / Pakistan border requiring you to pay a large percentage of any cash you might be carrying so you give your backpack with $1,000,000 cash to a Taliban who promises to take it through the mountains and meet you 10 miles down the road for a fee one-tenth the official tax).

Chasing too-good-to-be-true tax planning can result in problems more significant than just having the IRS catch it. I wonder if the Enron experience will cause advisors' to be more cautious.

Tip

A client recently asked me whether I thought there is an advantage to being insured by several insurance companies instead of one for diversification. The company I was recommending has the highest financial strength rating from all rating services and it has the best legitimate current pricing of which I am aware. Therefore, whether he should have diversity would be based on some general financial planning principal, not due to some practical consideration in his instant case. Diversification should be used when you lack confidence in predicting which of many possible choices will produce a better result. Buying stocks might be a good example of the virtue of diversification because the performance of companies within a given financial sector varies and the sectors themselves have uneven results. This makes predicting stock prices very difficult and buying diversity a necessity. However, when objective prediction is possible, as I think it is with a handful of life insurance companies that have shown remarkably competent and ethical management for a very long period of time, diversification for the sole purpose of some abstract principal is a mistake.