Vol 5 No 3		April 2003

Katt & Company is a fee-only life insurance / actuarial 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. We also assist clients with disability income and long term care insurance. The June 2002 Forbes magazine named Peter Katt as one of only four nationally recognized advisors, stating, "…advisers are well worth the money…[T]hese savants are working for no one but you…" For references please contact us.

Alert

DO NOT LET YOUR CLIENTS BUY PERMANENT LIFE INSURANCE POLICIES WITH LARGE SURRENDER CHARGES EXTENDING FOR UP TO SEVEN YEARS.

About a dozen times a year we have clients that either want to terminate or restructure a permanent life insurance policy but don't realize that the nice numbers in the Account Value are mostly worthless. It's the Surrender Values stupid. Only upon trying to terminate or restructure a policy do clients and their advisors realize that those ZEROS in the Surrender Value column have very adverse implications. Clients and their advisors don't think about surrendering or doing a major restructure of the policy in the short term, but 20% to 25% of permanent policies will be terminated within five years and many more are in need of restructuring.

Last year I was retained by a client who had purchased a $2,000,000 universal life policy three years earlier. The $35,000 annual premiums were becoming a burden because of declines in his business and his stock portfolio. His attorney, acting as trustee, wanted guidance on what options he had, especially as to whether he could reduce the policy value to give the grantor some reprieve from making premium payments. The policy had a cost basis of $105,000, an Account Value of some $85,000, but a Surrender Value of zero due to surrender charges of $200,000 that would continue to remain extraordinarily high for another 12 years. Obviously, if there is no surrender value and the policy is terminated, the trust gets nada. Not obvious is that if the death benefits are reduced this will also cause surrender charges to be incurred. That is, if the death benefit were to be reduced to $1,000,000, half of the surrender charges are incurred eliminating all of the Account Value and terminating the policy.

After considering his alternatives, my client decided to cancel the policy. I was stuck with the only rescue plan possible in this case, preserving the cost basis. While the cost basis of $105,000 would not be considered a loss for tax purposes, it could be preserved and used in a deferred annuity if I could convince the insurance company to grant the policy $1 of surrender value. If so, We could then do an IRC Section 1035 exchange with a deferred annuity. My client was prepared to add to this exchange a payment of $100,000.

After a good deal of begging, the insurance company relented and granted us $1 of surrender value. With the addition of the $100,000 premium, the deferred annuity had $100,001 in initial value and a cost basis of $205,000. This means that the first $105,000 of annuity earnings will be tax free, whether the client decides to annuitize it and take lifetime payments or keep it until his death.

Usually 1035 exchanges are associated with avoiding taxable gain when exchanging annuities, life insurance policies or life insurance for annuities, but in this case there was no taxable income to avoid-only the preservation and use of the client's otherwise lost cost basis. This strategy isn't exactly a planning home run-it's more like moving the runner from first to third.