White Paper: Everything Charities Need to Know About Life Insurance Gifts

White Paper: Everything Charities Need to Know About Life Insurance Gifts

An Objective Primer for Planned Giving Officers
Technical Report posted in Insurance on 7 March 2014| 1 comments
audience: National Publication, Two Hawks Consulting, LLC | last updated: 4 June 2014


Life Insurance can be an important asset to charities because if it is structured, funded, and managed properly it is capable of providing a significant amount of liquid wealth that is not correlated to traditional investments or market results.  These policies can, in turn, reduce portfolio risk while providing predictable amounts of funding over time.  If implemented properly and owned broadly enough, cash flow from life insurance policies can be statistically determined by charities and foundations for which this asset class is appropriate.

Richard M. Weber, MBA, CLU, AEP®
President, The Ethical Edge, Inc.

Randy A. Fox, ChFC, CFP®
Founding Principal, Two Hawks Consulting, LLC

Purpose of this paper:  Life insurance is often proposed as an appropriate gifting vehicle for charity. Some of the time it is the gift of an existing policy or policies that are offered directly by a donor. At other times charities are ideal prospects for agents seeking to promote life insurance policies that may add value to a charity’s or foundation’s investment portfolio, and which may also provides substantial financial motivation to the agent.  This paper seeks to describe the legitimate attributes of various types of life insurance as it pertains to charities so that Development and Planned Giving Officers can broaden their understanding and be clearer about the implications of accepting, owning, and managing life insurance as an additional asset class.


Life insurance is generally purchased to protect the financial well being of those who are dependent on the insured (families and businesses) in the event of premature death – to replace income, protect assets, assure business continuity, create an estate, or to provide liquidity for an estate.  Perhaps less obvious may be a benefactor’s intention to leverage current cash flows into substantial endowments to favorite universities, museums, and other 501(c)(3) organizations at the death of the insured.

Life insurance can come to charities in several different ways: a donor may make an irrevocable gift of an existing policy that is fully paid for; or they may make the gift of a policy that requires additional annual premiums; or the charity may simply be named as a beneficiary of a policy that the donor continues to own and pay for. The charity may not even know that is a named beneficiary until the donor dies and the insurance proceeds are delivered, or the charity may choose to purchase a new life insurance policy on the life of one of its important donors or board members. Each of these different possibilities carries with it tremendous financial potential along with its own set of tax rules, risks and evaluation issues.

For these and other important reasons, life insurance may be considered a problematic asset for Development and Planned Giving Officers.  Life insurance is understandably viewed as something that “pays off” only at the death of the insured and is therefore dismissed because a tangible present benefit cannot be perceived.  Even though some policies may be cashed in or sold in the settlement market, cash or readily marketable securities are often the preferred gift.  While many “permanent” life insurance policies have cash value (also referred to as “living benefits”), it has been unclear how a not-for-profit entity can enjoy those living benefits without undermining the future value of the death benefit.  Often, even after charities receive a policy, the policy is placed in a file cabinet somewhere and forgotten about or ignored until the donor passes away. It is generally not considered or treated like the asset that it is, nor is it integrated into the charity’s investment portfolio, which is otherwise actively managed, regularly reviewed, and scrutinized with the fiduciary responsibility that accompanies such assets.

It is not only organizations that may be reluctant to deal with the complexities of life insurance.  Even individuals who have a more discernible need for life insurance may take no action, or may not completely insure their human life value due to the veil of confusion and complexity surrounding the many new and sophisticated product offerings of the last few years.

Not withstanding these possible barriers to accepting life insurance as a desired asset, by the end of 2008, more than $19.1 trillion of life insurance covered the lives of American policyholders. To put the total volume of life insurance in perspective, the U. S. economy’s gross domestic product for 2009 was approximately $14.3 trillion. At the end of 2007, $580 billion of total life insurance policy benefits (including death benefits, dividends, and surrender values) were paid to beneficiaries and policy owners. According to survey respondents (Appendix A) - this group of charitable institutions alone is beneficiary to at least $590 million in policy death benefits. What?

The issues surrounding the viability of institutional ownership of life insurance on the lives of its benefactors is further confused by the manner in which such policies are proposed. It must be acknowledged that insurance commissions are extremely favorable to the selling agent in the year in which the policy is placed.  While this is an understandable deterrent, Development and Planned Giving Officers may be unduly and negatively influenced by the compensation issue, and not explore further the relevance and value that such policies may still represent to the organization’s overall investment portfolio.

In many ways, the subjective and often negative issues surrounding the acquisition of life insurance policies can be balanced by viewing life insurance in its more sophisticated form: an asset class for which living values not only coexist with the corpus of the foundation or institution’s investment portfolio, but for which it can also be demonstrated to both moderate the volatility and somewhat increase the yield of an investment portfolio.

While insuring the lives of benefactors may have an element of unseemliness, the timing of an individual death is unknown, both to the insurer, the institutional owner, and the insured.  While we will all die, there is an amazing predictability to the distribution of deaths among a large population, allowing an institution to anticipate cash flows from death benefits back to the endowment.

Life insurance is both a formidable economic presence and one of the most complex financial tools Development and Planned Giving Officers may consider as they pursue the financial well being of their organizations.  It is the intention of this paper to look at life insurance objectively from the standpoint of the benefactor and the institution, and to promote a clearer understanding of whether and when life insurance may prove suitable in a variety of circumstances.  Ultimately, the use of life insurance will be best appreciated (and accepted by institution's trustees) when it can be discussed in the context and vocabulary for which institutions already manage their investment portfolios.


At the request of the authors of this white paper, PPP conducted what we believe to be the “first ever” comprehensive survey of not-for-profit/charitable institutions to better understand their considerations about – and investment in – life insurance. The survey reviewed the number of policies, the types of insurance, the premium funding levels, the existence of comprehensive gift acceptance policies, and the consistency of normal review processes. These preliminary findings will enable us to establish meaningful industry benchmarks as various charities begin the process of formalizing their knowledge and capabilities in the area of life insurance ownership and gift acceptance.

The survey and survey results are in Appendix A

Chapter 1

Life Insurance “101” - What Development and
Planned Giving officers need to know about life insurance

Term life insurance

The simplest form of life insurance has always been term insurance.  As its name implies, it is purchased for a term of years generally extending from one-year (yearly renewable) term to 30-year term.  The cost of the yearly renewable variety is most directly tied to the underlying probability of death this year and is perhaps the purest form of life insurance.  Next year’s price will be slightly higher, and the progression will continue until some advanced age when it is generally no longer renewable at the insured’s option.

The modern term insurance policy purchased for a specified period of years is almost always priced with an initial premium that is guaranteed and level.  That level premium is simply a mathematical “smoothing” of what this year might be $270 for a $1 million policy to what 20 years from now would be $3,230 for the risk of death for someone who is then 20 years older.  It should be noted that once the initial premium period has passed, the policy can generally be renewed annually at the discretion of the policy owner without further medical evaluation – but at the premium demanded by the insurance company (subject to certain contractual guarantees).  These post-guarantee renewal premiums will typically start out at a significant multiple of the original, level premium.  Actual premium structures for a multi-year level guaranteed premium may follow the model as described in the previous section, or may heavily discount the premium for the initial period and make it almost immediately unaffordable for renewal once the initial guarantee period has expired.  

Term life insurance is designed and priced for defined periods of time.  Term insurance is an impractical solution for lifetime durations, since the cumulative, lifetime “price” will typically be 60 - 70% of the death benefit itself.  Charitable institutions will almost always want to own policies that are designed for lifetime use.

Permanent styles of life insurance (see also Appendix B)

Just as the premium for a 20-year term policy can be understood on the basis of a mathematical leveling, a simple explanation for the “permanent” (or cash value) forms of life insurance is that the increasing risk cost is mathematically leveled out for an entire lifetime. 

There are a number of life insurance products that have evolved to meet the various needs and considerations for long-term (typically lifelong) life insurance purchases.

Whole Life is the oldest form of lifetime, level-premium life insurance, dating back to at least 1759 with the formation of the first life insurance company in the United States called the “Corporation for Relief of Poor and Distressed Presbyterian Ministers.” Whole life insurance is entirely guaranteed by the issuing carrier, and the payment of a death benefit is subject only to the policyholder’s timely payment of a fixed and guaranteed premium and the solvency of the insurance company.  Premiums are set, reserves are created, and death benefits are paid based on actuarially conservative expectations.  Because of the guaranteed nature of the contracted death benefit obligation which may span decades, an insurer needs to carefully “price” its product to deliver a reasonable return to the company’s shareholders, be competitive in the marketplace, and be fiscally sustainable through “boom and bust” economic cycles.

Participating Whole Life (PWL) is a variation on the whole life concept wherein the insurance company – typically beneficially owned by its policyholders rather than outside shareholders – hedges the pricing of a long-term commitment by charging (and guaranteeing) a somewhat higher premium, and returning to its policyholders their pro-rata share of gains through investment returns, mortality experience, and expenses that are more favorable than those incorporated in the pricing of the guaranteed premium. Historically, dividend-paying policies have generally provided greater long-term value than those policies that did not pay dividends. 

Universal Life (UL) was first introduced in the late 1970’s at a time when interest rates in the U.S. were approaching unprecedented high levels in the economy.  The first insurers selling such policies were able to segregate new investment portfolios earning as much as 15% in federally guaranteed bonds, resulting in “current assumption” policies initially crediting as much as 14% to its cash value account (after deductions for insurance, expense charges and profits).  In fact, a key feature of such policies was the “unbundling” or “transparency” of the various components of crediting rates, cost of insurance, and other expenses.  Additional characteristics distinguishing UL policies from their whole life forbearers was there were no guaranteed premiums or benefits and the policy owner had only to pay enough into the policy to maintain a positive balance in the cash value account so that the policy could be sufficient for another 30 days until the next policy accounting.  With 14% initial crediting rates and the ability to “calculate” a premium based on the current assumptions (which, in turn, were based on current market returns), projected premiums were often a fraction of the equivalent whole life policy.  Not as transparent, at least initially, was that the universal life policy design transferred to the policy owner the risk that the policy – based on the requirement there be at all times a positive balance of paid premiums, credited interest, and debited expenses – would be in force when the insured died.

Current Assumption Whole Life is essentially a hybrid of whole life and universal life policy design.  The modern non-participating whole life policy has fixed premiums and guaranteed cash values based on the policy’s underlying structure of guarantees however death benefits, cash value, and/or premium payment periods can be improved when the carrier credits a rate higher than that guaranteed (and/or assesses a lower insurance charge than that guaranteed).

Adjustable Life insurance policies are essentially whole life policies that within limits have the premium and death benefit flexibilities of UL.  Unlike UL, these policies are not “transparent” and contain non-forfeiture values.  Policy premiums and death benefits can be adjusted along a continuum ranging from limited pay policies on a guaranteed basis to term insurance for limited durations.  These policies have had a rather limited distribution, as they were only sold by a small number of insurance companies.

Variable Life (VL and VUL) policies are a unique variation on whole life and universal life design in that the policy owner has the opportunity and responsibility to allocate and invest her premiums in designated sub-accounts for the support of the underlying policy and death benefit.  Variable whole life policies still contain death benefit sufficiency guarantees, but the more popular variable universal life policies only guarantee certain expense elements and an upper limit to the scale of insurance charges that can be assessed against the policy from year to year.  A variable universal life policy typically provides a variety of proprietary and non-proprietary mutual fund-like sub-accounts across a spectrum of fixed and equity accounts.  The long-term viability of the policy becomes a function of the funding premiums paid and the market returns of the chosen sub-accounts.

Equity Indexed (EI) insurance policies are still another variation on universal life, the key difference being that the policy’s crediting rate is not subject to the insurance company’s own investment experience and the subsequent decisions of a Board of Directors.  EI policies employ an elaborate formula and matrix of criteria to determine how much of the gains in a broad index of stocks (such as a S&P500™ index) will be credited to the cash value.  Additionally, the typical Equity Indexed policy will never post a “negative” return as will occur from time to time in variable universal life.  Equity Indexed products have a number of investment attributes, but under current regulation can be sold both by agents with and without securities licensing.

No-Lapse-Guarantee (NLG) universal life is a major subset of universal/variable universal life design in which – in exchange for the prompt payment of a stipulated (and guaranteed) premium – the policy will not lapse regardless of the fact that the cash value may decline to $0, a condition that would normally cause a universal life insurance policy to lapse.  This is a significant departure from the principles of universal policy design and is the one type of universal-style policy that falls within the “guaranteed premium” category of term and whole life insurance products.  There are, however, substantial restrictions on NLG Universal Life policies, including limited cash value.  Such policies are often considered “term to age 120” to reflect the reality of the lifetime guarantee but without the typical cash value that would accompany a lifetime policy.  Because of the significant guarantee of sufficiency, owners should not anticipate accruing substantial cash values; in fact, the relatively nominal guaranteed cash value is all that should be expected.  While the guarantees of NLG Universal Life are especially appealing in times of low credited interest rates, they could lose their appeal to non-guaranteed UL competitors when crediting rates in the marketplace exceed 5 or 6%.

Policy illustrations

The process of evaluating and making decisions about life insurance policies will almost always involve reviewing a policy illustration.  Policy illustrations are generally used to numerically project guaranteed and non-guaranteed policy values over the lifespan of the insured.  The illustration, however, is not the policy.  While the policy is the legal contract between the insurance company and the policy owner, the illustration is an attempt to explain how the policy works.  An illustration inherently projects the insurance company’s current experience in death claims, general expenses, and investment return as those elements might affect the long-term financial outcome of a policy.  The illustration suggests to the buyer a view of how the policy's values might look in the future through economic enhancements that exceed its guaranteed pricing elements.  The illustration may also be used to demonstrate the policy's flexibility (i.e. the ability to suspend premium payments and/or withdraw cash values from the policy) in the event the insurance company continues to be able to enhance policy values in excess of the underlying guarantees contained in the policy.  Policy illustrations, however, are merely projections far into the future of a current set of assumptions (and which assumptions will almost assuredly vary from those that are projected).  By comparison, it would be as if an investor were considering the purchase of two different mutual funds, each of which takes the average return it achieved over the last twenty or thirty years and projects that rate of return – along with its current, changeable fund management fees – to suggest a specific outcome far into the future.  In fact, such an “illustration” of projected values for a mutual fund – or any related use of marketing material – is specifically prohibited by securities regulations; life insurance illustrations (even those representing policies that are deemed securities) are exempt from such regulation.

The use of policy illustrations

The use and flexibility of a policy illustration can be manifested in a number of ways.  One method of utilizing the potential excess earning power of the policy is to let the enhancements take over the payment of premiums at some future time.  The term "premium vanish," "disappearing premium," or “premium offset” is most often associated with this type of illustration.  But the policy itself is not designed to "vanish" the premiums; the illustration simply calculates the current point in the future where non-guaranteed, projected enhancements give the policy owner the option of paying premiums out of excess policy values  if those values in fact materialize due to favorable expense and investment experience.

In 1992 The Society of Actuaries published an extensive examination of illustrations and illustration practices associated with the purchase of life insurance.  Its conclusion: " ... (when) illustrations are used to show the client how the policy works; (it is) a valid purpose of policy illustrations.   Illustrations which are typically used, however, to portray the numbers based on certain fixed assumptions - and/or are likely to be used to compare one policy to another - are an improper use of the policy illustration. " Furthermore, the Executive Summary of the Society's report concluded:  " ... How credible are any non-guaranteed numbers projected twenty years in the future, even if constructed with integrity?   How does the consumer evaluate the credibility of two illustrations if they are from different companies? Or even if they are from the same company how are different products with different guarantees being considered?  Most illustration problems arise because the illustrations create the illusion that the insurance company knows what will happen in the future and that this knowledge has been used to create the illustration.  (emphasis added)"

These cautionary words from the Society of Actuaries help to summarize the reasons policy illustrations cannot effectively facilitate a cost/benefit analysis or other comparisons within multiple policy possibilities.  Illustrations are representations of assumptions made in policy design.  These assumptions have to do with the building blocks of carrier expense and earnings: mortality costs, overhead expenses, investment income, the length of time a policy "persists" with the carrier, and the percentage of policyholders who drop out of the pool of insureds for reasons other than death.  By regulation, the assumptions manifested in the policy illustration should reflect only the current and actual experience of the carrier.  The dilemma, however, is that even though the policy illustration being reviewed has assumptions incorporating only those based on current experience, those assumptions are nonetheless being projected into an unknown future; the future will only reveal itself one year at a time.

Chapter 2

Tax issues of life insurance gifts

One of the important considerations regarding the transfer of life insurance to charity is the tax consequences for both the donor and the non profit. By tax consequences, it is necessary to address income tax issues separately from estate and gift taxes. While these areas can be somewhat confusing and complex it is very important to have a basic understanding of the rules before accepting any policy as a gift.   The good news is that the transfer and acceptance of a life insurance policy itself is generally fairly simple to accomplish. Most necessary forms are available directly from the life insurance company of the transferring policy and are reasonably simple to complete.

There are two major qualifying factors regarding the income tax deductibility of the donation of a policy.  First, the charity must have an “insurable interest” in the donor’s life. While insurable interest rules vary from state to state, all are substantially the same. They define insurable interest as one in which the beneficiary (the charity in this case) would suffer loss if the event insured against occurs (in this case, the death of the donor). There have been instances when a deduction was denied because under the laws of the state involved, the charity had no insurable interest in the donor.   It is important to note, however, that the insurable interest concerns only apply to new insurance policies that the charity may be applying for on the life of a donor. Existing policies that are being gifted to charities do not fall under this constraint.

One of the main reasons these laws exist is to prevent abusive practices. There have been instances where policies were taken out on misinformed insureds and the proceeds assigned to various not-for-profits. However these insureds really had no interest in the cause of the charity. These types of situations have caused the tightening of some of the insurable interest rules in some states.

The second major factor that is necessary for a life insurance policy to be income tax deductible is that the donor must relinquish all incidents of ownership in the policy to be donated. That is, all financial and economic rewards must be given away. These benefits include ownership of the policy, the right to change the beneficiary, the right to borrow from a cash value policy, the right to surrender the policy for its cash value, the right to pledge the policy as collateral, and the right to select settlement options for the policy. Simply naming charity as irrevocable beneficiary is not enough because the policy owner still has access to ownership rights in the policy that could harm the charity’s interests while continuing to benefit the owner.

Once the requirements for a completed transfer are met, it is important to understand the income tax consequences for the donor. Life insurance is considered ordinary income property. Therefore, a gift to a public charity will create an income tax charitable deduction up to 50% of the donor’s adjusted gross income (AGI). The deduction that the donor receives for a policy with cash value is the LESSER of the cash value or the total premiums paid. This amount can be ascertained in several different ways. First, the charity should request Form 712 from the life insurance company directly. The company will not send it unless requested but it does contain the current policy values and the total premiums paid to date. The second method is to have the company prepare an “in force” policy illustration. This should contain roughly the same data but is also helpful in projecting the policy out into later years. This can be valuable information in certain types of policies that may or may not be paid up. Note that some cash value policies may have premiums that are meant to continue after the donation and these policies must be carefully evaluated before the gift is accepted by the charity. The ability to meet the future financial obligation to keep the policy in force as well as the return on investment must be weighed by the charity.

Policies on which the donor has a loan - that is, they have borrowed some of the cash value of the policy and have not paid it back - present a different income tax scenario. These policies fall under the bargain sale rules. The transfer of a policy with a loan will create taxable ordinary income to the donor for the amount of the loan since the debt is being “forgiven” and an income tax charitable deduction for the remaining basis in the policy.

Many donors own individual term insurance. Term insurance is pure insurance with no cash value accumulation. It still may be a viable idea to transfer a term insurance policy to charity. From an income tax perspective, it is unclear what the deduction for the policy should be.  Arguably, it is the amount of any unearned premium.  For example, if a term policy has a $1,000 premium due and payable and the donor irrevocably transfers the policy on the day the premium is due and paid, then 100% of that  premium should be deductible since is as yet unearned by the insurance company. If the donor pays on January 1st but transfers on June 30th of the same year, the $500 of the premium has been earned by the insurance company (that is, it has provided coverage for exactly half of the coverage period) and therefore the unearned half, or $500, should be deductible by the donor.

Many employers offer group term policies for their employees. The same basic rules apply to gifts of group term insurance as apply to personal term insurance. A donor may irrevocably assign his interest to charity. However, since the donor doesn’t own the policy, it is not necessary to transfer ownership in the policy. In this case, the donor should be entitled to an income tax deduction for any unearned premium.

Policies gifted to charities having a value of greater than $250 fall under gift substantiation requirements. Technically, the valuation of the policy must come from a disinterested party to the transaction. This means that the issuing insurance company’s estimate of value is probably not an adequate valuation. Nor should it be an agent of the issuing company. The safest valuation should come from an independent source such as an independent actuary or appraiser. 

Estate and Gift tax rules are somewhat easier to sort out. If a donor retains a policy and names a charity as either the sole beneficiary, a partial beneficiary or even a contingent beneficiary, the insurance proceeds will be in the donor’s estate when he dies, but the esatate will receive an offsetting estate tax charitable deduction for that amount which passes to the charity.

If the donor irrevocably transfers the policy to a charity, the donor may be entitled to  both an income tax deduction for the lesser of cash value or premiums paid and the policy should be excluded from the donor’s estate for estate tax purposes.  If, however,  the donor dies within three years of making the gift, the face value of the policy will be included in his estate but then receive an estate tax charitable contribution for the same amount.

Chapter 3

Life insurance as an asset class in the context of
charity/foundation investment portfolios


Stock values rise and fall on a daily basis, giving rise to short-term risk and market value volatility for which some charity/foundation investors experience substantial anxiety.  If an institution has a reasonable time horizon, the long-term growth statistics tell a more satisfying story.  For example, from 1980 through 2009, total equity returns of Large Cap stocks (comparable to the S&P500™) reflected a 11.24% compound annual rate of return.   However, this historic observation of significant long-term equity returns (and the underlying volatility) is only part of the story. Inflation and fees can significantly reduce the real real return of any investment (taxes represented 1.78 % of the reduction in return in the cited study but are not a concern for 501(c)(3) organizations). Thus, for the 11.24% nominal return for large cap equities in this 30-year period, more than 1/3 of that return was taken away by a compound rate of inflation 3.69%.  Investment fees of another .56% reduce the apparent double-digit return to a real compounded return of 6.99%. 

In contrast to the investor willing to incur risk, there was a shockingly low reward for those at the beginning of this 30-year period seeking an investment strategy with less short-term risk and volatility.  A portfolio comprised of completely safe U. S. Treasury Bonds had a gross 20-year compound rate of return of 9.68%, but just 5.43% after accounting for inflation and fees.  Short-term U. S. T-Bills suffered the most: a gross 5.49% resulted in a real real return of just 1.24 after inflation and fees.  In the last few years since the “Great Recession,” short-term interest rates calculated on this basis have been less than 0%.

It is intuitively obvious that diversifying one’s investments might avoid the worst effects of a market “crash.”  Stocks and Bonds have historically been the main ingredients of diversification.  Worried about volatility risk?  Buy bonds.  Worried about securing adequate long-term returns?  Buy stocks.  But just how to diversify?  Diversify when?  Only from the perspective of the end of the year can it be determined which of these major types of investments would have produced the better return if acquired at the beginning of the year.  The lack of a workable method to diversify a portfolio with the objective of maximizing returns in the context of a known level of risk-taking gave rise to the development of Modern Portfolio Theory (MPT).  This paradigm shifting approach to investment methodology (utilizing an “efficient frontier”) was introduced by Harry Markowitz in 1952.   In 1990, he shared a Nobel Prize with Merton Miller and William Sharpe for what has become one of the best known approaches to portfolio selection. 

An inherent part of MPT is to assess an existing portfolio  by its component “asset classes.”  Most advisors agree that the primary asset classes include Equities (common stocks), Fixed Income (bonds and mortgages), and Money Market (cash).  Some experts extend the list to include Guaranteed (annuities), and Real Estate.  Each of the primary asset classes have sub-categories; for example, equities can be further categorized as Large Cap, Small Cap, International, etc.  As a matter of caution, a portfolio would consist of assets that are diversified amongst these asset classes.  The type of diversification, however, can have a significant affect on portfolio performance.  Diversification can be quantified, ranging from “+1.0” for assets that have similar volatility/return characteristics and are perfectly and positively correlated (market forces will “pull” asset values in the same direction and are in “lock-step”) to “– 1.0” for those assets that have similar volatility/return characteristics and are perfectly negatively correlated (market forces will “push” asset values in different directions).  Assets that neither “push” nor “pull” will be close to a correlation rating of “0.0” and are considered un-correlated.  While perfectly negatively correlated assets don’t really exist, asset combinations that have “negative tendency” will generally produce a better long-term return/risk relationship than will more positively correlated assets.  The return of a portfolio consisting of such assets will be the weighted average of the returns of each asset, but the volatility of the portfolio will be less than the weighted volatility of the individual assets.

Life insurance as an asset class

For this brief explanation of MPT and the categorization of asset classes, we believe that life insurance meets the important criteria of this designation:

  • The death benefit is cash (itself a major asset class) at the precise time it is needed and without valuation adjustment based on up or down phases of the equity or bond markets;
  • The living benefits – the cash value – take on the asset class attributes of the policy itself.  A universal life or whole life policy’s cash value has the dominant characteristic of a fixed account with a minimum guaranteed return.  A variable universal life policy’s cash value is itself a portfolio with the opportunity to reflect the asset allocation of the policy owner;

  • The unique characteristics of life insurance relating to 501(c)(3) institutions - the availability of policy cash values and the inherent leverage of relatively low periodic payments into a capital sum – are attributes that allow a life insurance policy the tendency to be at least uncorrelated against most other asset classes;
  • The death benefit is based on the event of death – not a market event which in turn can cause a change in value.

  • Permanent life insurance intended for a lifetime can produce at least as favorable a long-term return with less risk within a portfolio of equity and fixed components than a portfolio without life insurance (a favorable efficient frontier result.)

Life Insurance and Efficient Asset Allocations:  Building an Efficient Investment Portfolio by including Life Insurance

Charitable institutions use a combination of current contributions and income from portfolio investments to pay for the expenses of paying salaries and overhead for the organization.  Investment strategies will include a spectrum of fixed and equity asset classes to maximize yield, temper volatility, and provide the needed income stream for current expenses.  Many such institutions recognize the potential value of life insurance, but may be concerned that it “ties up” resources.  This section will explore whether there is a synergy of investment plus life insurance that can serve at least as well – and with less volatility and market valuation risk – as a portfolio that does not contain life insurance.  To avoid getting mired in too much jargon and statistical complication, the following analytical discussion will simply compare an existing portfolio of fixed and equity elements with and without permanent life insurance.


We will use the example of a 45-year old male in good health (and in a relatively high income tax bracket) and an endowment fund whose investment portfolio includes $500,000 of intermediate duration bonds as a portion of the portfolio’s fixed asset class component.  The current yield of 4% produces a non-taxable cash flow of $20,000.  While it is unrealistic to assume level interest rates over the next 40+ years of this investor’s life expectancy for this asset class (which would produce fluctuations in the value of the bonds), the income from the initial bond acquisition will remain constant over the life of the bonds.  We note that with respect to the life insurance policy alternative, neither the guaranteed cash value, the guaranteed value of paid-up additions cash value (once created), or the total death benefit (once created) is subject to market value adjustments.

A projection of portfolio growth over the donor’s lifetime (life expectancy + 5 years is age 89) suggests that the institution’s bond portfolio would accumulate to an asset value $2,920,588 if simply left to accumulate at the nominal assumed return of 4%. 

Alternatively, the $20,000 of initial bond income could be used to purchase a participating whole life policy.   This next graph reveals that the all-bond option produces slightly more asset value than the bond+cash value alternative for the first 19 years. 

Of course, the death benefit produces a significantly greater result in every year:

As the next graph demonstrates, there is synergy in funding a life insurance policy from the income stream of a component of the fixed portfolio.  It produces a more favorable result than if the policy weren’t part of the portfolio: the return is higher and the risk is lower for the existence of needed life insurance. 

In a classic view of an efficient asset allocation (in this case the Intermediate Bonds+Life Insurance vs. Bonds alone) based on legacy value at life expectancy + 5 years:

Chapter 4

Efficient choices - portfolios of life insurance policies

As previously noted, when constructing an investment portfolio, it’s a well-established principle of Modern Portfolio Theory that appropriate (or “optimal”) diversification is how investors maximize returns for a given amount of risk.  Modern Portfolio Theory “…stresses that it is wise to invest in a broad array of diverse investments. ”  A sophisticated form of this type of diversification is called “Efficient Frontier” analysis in which assets with different correlations are used to produce expected rates of return with lower volatility than that which could be expected from just one of those assets.  A similar process of diversification can be applied to the efficient selection of life insurance policies intended for lifetime uses, especially (from a practical standpoint) when acquiring total life insurance in excess of $3 - $5 million.

A life insurance policy has 4 dominant attributes:  1) its “price” (premium outlay); 2) its “cost” – (the net of the premium outlay and resulting cash value; 3) its likely death benefit (as generated by dividends or the cash value “pushes” the IRC Sec. 7702 “corridor”); and 4) any risk (to the policy owner) associated with the investments used to support the policy reserves.  The specific mixture of these attributes result in a “style” of policy.

Table 7 demonstrated that NLG, universal, variable universal, and participating whole life are styles of permanent insurance that produce a “better buy” than term insurance for lifetime needs.  But which style is “best?”

It should be obvious that no one style of insurance could be “best” for all circumstances or situations.  Rather, the type(s) of insurance should be tailored to the insurance buyer’s unique mix of considerations about these attributes.
Each of the 4 dominant forms of life insurance present different combinations of these attributes.  Quantitatively they might be considered :

If the institution’s focus is on lowest actual outlay for policies it is going to maintain, NLG may be the best selection, yet for best cost, it might consider WL or VUL.  Similarly, if risk tolerance is relatively low, consideration of the amount of inherent risk might dictate NLG – yet this style can produce the highest cost.  No one style contains elements that will satisfy the various combinations of considerations.

The starting point for selecting from  a range of policy styles is to determine the appropriate amount of policy investment “risk” the institution is willing to take.  (It is assumed that carrier selection will depend heavily on financial stability, therefore we will focus solely on the investment risk underlying the selection of a policy style):

  • As suggested in the above table, NLG has no investment risk (that is to say, the investment risk is the insurance company’s and not the policy owner’s – unless of course the adverse investment experience is so severe that the carrier becomes insolvent).  Assuming the selection of a financially superior insurance company, we would assign NLG a “Risk Index” of 0. 
  • At the other end of the spectrum, a VUL entirely utilizing an S&P500™ Index sub account typically has a standard deviation (a measurement of risk) of 15%; we would assign such a VUL allocation a “Risk Index” of 15.

  • Participating whole life is comprised of two components: the underlying guaranteed policy which, as with NLG has no explicit investment risk, and a non-guaranteed dividend whose risk of meeting dividend projections is most closely associated with an investment in investment-grade bonds.  As indicated in the last section, we assign a “Risk Index” of “1.8” to participating whole life policy a “Risk Index” of 1.8 (blending the underlying guarantees of the base whole life policy with the bond-like portfolio returns of the non-guaranteed dividend scale).
  • Because the UL policy doesn’t offer sufficient unique or advantageous attributes compared to the other policy styles, it will not be considered in this context.

Appendix C  includes the complete Matrix of Risk Indices demonstrating all the possible ratios of NLG, VUL, and Par WL as components in a portfolio of policies ranked by “Risk Index.” For ease of explanation, we will divide the range of “Risk Indices” into 4 narrative labels:  Conservative (0 to 3.9), Balanced (4.0 to 7.9), Growth (8.0 to 11.9), and Aggressive Growth (12 to 15).  Note that these are Risk Indices and not rates of return  merely allowing us to identify and stratify risk.

A process for determining a reasonable, responsive, and effective blend of policies for maximization of desired qualities would be as follows:

  1. What is the risk tolerance and time horizon of the institution’s investment portfolio, using the labels described above?  For the first example, we’ll assume that the response is “4” – in other words, the lowest range within “Conservative” (and comparable to a 20/80 mix of fixed and equity asset classes in a general portfolio).
  2. Determine which of the following is the greater priority:  Lowest premium outlay, development and access to cash value, or the ability to generate excess death benefit.  Since the existence and access to cash value is closely linked to the ability to generate increases in death benefit (Section 7702 of the IRC) we will combine the cash value and death benefit criteria for the following choices:

    a. Lowest premium outlay; or
    b. Development and access to cash value and subsequent ability to generate excess death benefit
  3. From the Risk Index Table, select  a matrix ranging from 3 steps below to 3 steps “above” the Risk Index closest to “4.”

The following example demonstrates  the process of “mixing” life insurance styles to obtain an efficient result for a “Balanced” Risk Index with respect to a $50 million portfolio of life insurance policies:

Here we assume that the charitable institution indicates a Risk Index of 7 (comparable to a 60/40 mix of equity and fixed asset classes in a general portfolio).

With a view to the different “mixes” of product styles in the chosen risk matrix:  if lowest premium outlay is the greater priority, we’ll focus on the NLG column and maximize the amount of NLG suggested in the matrix.  This results in 50% NLG with the accompanying 0% WL and 50% VUL.

If, on the other hand, availability and access to cash value – as well as the potential for an increasing death benefit over time – is of greater importance, we’ll focus on the Par WL column and maximize the amount of WL suggested in the matrix.  This results in 60% WL with the accompanying 0% NLG and 40% VUL.

By selecting an appropriate mix of policies based on the underlying Risk Index, the resulting cumulative premium, cash value, and death benefits of these mixes allows the insurance buyer to achieve a more favorable result than would occur from the exclusive selection of one type of policy or another.  A results summary is shown below.


  1. We assign Risk Indices to policy styles in order to provide an objective basis within which to clarify the different attributes of the various forms of permanent life insurance.  Once the institution has stipulated an appropriate Risk Index for the purchase of a portfolio of policies, it can then rank its considerations of price, cost, “upside” death benefit, and access to cash value to help determine the ideal mix of policies that will best serve their tolerance for risk and desire for “reward.”  This is a process with which the institution’s investment committee is well acquainted. 
  2. As can be seen, the portfolio of policies has been optimized within a given range of Risk Indices for a desired premium outlay budget and considerations of access to cash value and increasing death benefit.
  3. It might appear that it takes some effort to mix policy styles to derive the most efficient blend based on risk tolerance.  It would be fair to ask: “Why not just buy a VUL and adjust the sub-account selection to match investment risk?”

    (a)  Many buyers of life insurance have a subjective concern about the “risk” of supporting a foundation asset with an aggressive investment approach.  Further, it may not simply be the investment risk concerning the investor, but the consideration – rational or not – of depending on a policy that has no guaranteed premium, not to mention a policy style that’s been labeled “risky.”  Technically, of course, it is possible to accomplish the underlying objective of matching risk tolerance and “return” optimization by purchasing, appropriately allocating, and carefully managing a VUL policy.  But some buyers of life insurance may want guaranteed components, which a VUL can only simulate but not replicate.

    (b)  A VUL policy may – based on its allocation and market volatility acting on  the policy’s sub-accounts – be at the extreme of policy risk.  A key issue is that the  entire death benefit is subject to investment risk in the event the policy is not able to sustain itself based on premiums paid, assessed expenses and insurance charges, and portfolio gains or losses.  At the other end of the risk spectrum, WL and NLG policies do not put the death benefit at risk as long as the required premium is paid.
  4. While the mixing of policy styles based on Risk Indices can be a productive approach to getting the best result consistent with risk tolerance, it’s also important to again point out that cash values in a participating whole life policy are not subject to market value adjustments (wherein fixed values fall when interest rates rise and fixed values rise when interest rates fall).  This is true even though the insurance company’s investment portfolio, underlying its ability to declare and pay a dividend, is subject to market value adjustment.

Chapter 5

Life insurance, once acquired, must be periodically
managed, evaluated and maintained

It’s notable that most articles and discussions about life insurance are focused on whether it is needed, and if so, how to buy it as cheaply as possible.  Or if the policy already exists, whether it should be replaced with a more “modern” version.  Of great importance (but receiving little attention) is the need to have an ethically and objectively directed process of ongoing evaluation.  This includes observing but not relying on non-guaranteed in-force illustrated “numbers” -  and employing independent, actuarial-based processes by which life insurance can be managed and assessed for a more realistic expectation over the lifetime of the insured. 

Since an underlying strategy of this paper is to apply to life insurance the concepts and terminology of broader financial planning and investment management, it is not enough to focus on the up-front (i.e. time of purchase) evaluation process without recommending a process by which lifetime “in-force” progress will be measured.  Indeed, in the authors’ respective consulting practices, even those who are paid and charged with professional stewardship of life insurance assets will often not have a “reasoned investment strategy” with respect to charity-owned policies.  Often there are no written, formal processes by which policies will be evaluated.  By contrast, the typical institutional investment manager has very specific and personalized investment policies to guide asset allocation, review criteria, and specify triggers for redeployment and/or reallocation for the client’s investment portfolios.  The skills and processes applied to investment portfolios need to be applied to a charity’s management of life insurance, taking into account each unique policy type’s (or style’s) property rights.

In-force policy illustrations have typically been the primary (if not exclusive) tool by which non-guaranteed policy sufficiency has been measured.  But as discussed in this paper, policy illustrations are of minimal value in projecting the effect of volatile market conditions - whether for interest credits or equity returns.   Not only will future market conditions inevitably affect both policy costs and underlying earnings, they  will in turn affect the level of funding premiums.  Thus, the likely sustainability of the policy over the insured’s lifetime will be in jeopardy when using in-force policy illustrations and underlying non-guaranteed projected expenses.  This is especially true when evaluating minimally funded policies, which comprises the vast majority of universal, variable universal, and equity indexed policies - as well as  whole life policies with term riders in excess of 20% of the total death benefit.

Institutional trustees are guided by the Uniform Prudent Investor Act as enacted by most states.  A charity’s investment manager also has a duty to apply professional management to the assets placed under her care for the ultimate benefit of the charitable institution.  At a minimum, the following life insurance assessment tools and monitoring/management processes should be required of a charity’s investment manager:

  1. Charity-owned life insurance should include a Life Insurance Investment Policy Statement, confirming the charity’s expectations, considerations and instructions regarding such key issues as change in the insurance carrier’s financial strength, what procedure to follow if annual gifts are temporarily or permanently suspended, the timeframe in which unsustainable policies should be remediated, and whether remediation should focus on rebalancing sustainability with changes in death benefit or enhanced premium gifts.   Further, personalized longevity-matching techniques will allow for important cash flow management of policy premiums for an insured  with impaired health.
  2. If policies are or can be investment-oriented (i.e. EI, VWL or VUL), there should be - at a minimum - instructions about the charity’s intention with respect to time horizons, range of investment risk, and a targeted long-term return that is consistent with the recommended risk levels.  Guidance should also be provided regarding the criteria to use in asset evaluation, as well as memorializing the practical manner in which the charity’s rights and obligations will be executed as directed in the trust agreement.  There may be other issues specific to the charity, that should be contemplated in the establishment of its investment portfolio, specifying which assets will include life insurance.

  3. Charities should periodically address their policies based on policy design.  For example, VUL should be evaluated at least annually  on the performance of the portfolio of sub-accounts as well as  monitored on the expense component of the policy.  Even underlying premium sufficiency guarantees (NLGUL) require annual confirmation that the guarantee is still in place.   Whole life policies with significant amounts of blended term insurance should be evaluated more frequently than such policies that have no term insurance and for which there are no policy loans.  In addition, consider:

    (a) Does the life insurance policy remain suitable for the purpose set out in the Life Insurance Investment Policy Statement?

    (b) Are scheduled premiums adequate to sustain the policy to contract maturity? 

    (c) If the policy requires self-directed investment of the premium and cash value into sub-accounts, have sub-accounts performed within an acceptable range for the asset classes and the planned asset allocation?

    (d) Have returns in the self-directed sub-accounts been further assessed with “monte carlo” volatility testing to make certain that constant rate, in-force illustrations don’t distract from an emerging funding deficiency?  For example, an in-force illustration’s assumption of a long-term average gross return of 8% may suggest a funding level that shows the policy sustaining beyond the insured’s life expectancy, when in fact more sophisticated analysis suggests that the same funding level causes policy lapses to statistically occur 10 and even 15 years prior to life expectancy.

    (e) Have the insurance company’s financial ratings deteriorated?

    (f) If there is a significant enough deviation in performance that the policy is in jeopardy to meet its long-term sustainability objectives, a third-party expert should be retained (if such expertise is not available “in house”) to make recommendations that will include remediation alternatives.  The resulting decisions - lower the death benefit, increase the premium, or  consider replacing the policy with a lower-premium guaranteed policy - can only reasonably be made with actuarially appropriate analysis that is independent of policy illustrations.
  4. In-force policy illustrations and updated reports from the major financial rating agencies will be a useful start in the periodic review of life insurance.  But any realistic attempt to fulfill the primary responsibility of the trustee - assuring the viability of trust assets for the benefit of the beneficiaries - requires actuarial evaluation of the policies.  Going far beyond an in-force illustration projected with constant numbers that will change over time, actuarial evaluation includes statistical analysis (i.e. volatility testing of equity-based policies and undulation testing of fixed return policies), benchmarking long-term cost of insurance and other expenses with peer policy styles and peer carriers.  We would typically recommend the use of professional life insurance policy managers, and such managers will typically charge a flat annual fee per policy, or assess fees in the range of 5 - 25 basis points of the death benefit based on policy style and size.

  5. Life insurance agents historically have rarely had the resources and ability to facilitate a high level assessment of the charity’s need to manage its life insurance assets.  Charities should expect agents to initiate periodic reviews, but the charity will generally also require independent, actuarially-based services through advisors versed in this rapidly emerging technology.
  6. Variable universal life policies are especially vulnerable to lapse before the insured’s death if policies are underfunded and if the underlying sub-accounts are not actively managed.  This dilemma anecdotally accounts for 90% or more of all variable policies still in force in the U.S.  In order for a variable policy to meet its fundamental expectation to deliver a death benefit, policy management must include not only initial asset allocation and subsequent rebalancing, but include assuring  that the fundamental allocation continues to meet the charity’s risk/reward criteria.  Since many insurance agents lack the experience or resources to make specific investment selection recommendations, it is critical for those considering variable policies to obtain professional management of the sub-accounts.  We would typically recommend the use of investment managers with whom investors are actively engaged.  It should be anticipated that such managers will charge fees - typically 1% of net asset value - comparable to what is paid for investment portfolio management. 

Chapter 6

Life insurance acceptance issues:
Enumerating a gift acceptance policy for life insurance by category of policy style

Most non-profits maintain some form of “gift acceptance” policy outlining the type of assets they are willing to accept as gifts, and the criteria under which they will accept those gifts.  For instance, some charities will accept real estate gifts, while others find dealing with this type of gift too cumbersome.  Before accepting a gift of life insurance, a charity should have a clearly delineated set of criteria to determine whether or not a policy would be a good asset to receive.

Any gift of life insurance has many issues that should be taken into consideration. Not only are there various types of policies (as discussed in prior chapters) but the financial efficacy of every policy must also be examined. It is not unusual for donors to seek an exit strategy from a failing policy by attempting to give it away. A well-structured, well-crafted policy acceptance will provide the charity with guidance on which policies fall within their criteria. 

While doing research for this white paper the authors were unable to identify any gift acceptance policies for life insurance that were more than two sentences long.  The following discussion of acceptance policy, while generic in nature, can be adopted to the specific charitable organization’s needs.


XYZ Charity agrees to accept gifts of life insurance policies under the following terms and guidelines:

All gifted policies will be accompanied by a current, in-force illustration and other evidence that the policy is still a valid life insurance contract.  Ideally, there should be no loans, collateral pledges or other encumbrances on the policy at the time of the gift without substantial further analysis.  In addition it would be desirable to obtain:

  • An understanding of the health of the insured at the time of transfer (as evidenced by a general health questionnaire)

  • Future gift intentions/commitment with respect to future premium support.  If it is the grantor’s intent to define the death benefit, the policy needs to be evaluated in advance for its ability to meet grantor and charity expectations.  On the other hand, if the grantor intends to donate fixed future premiums for UL/VUL/EI style policies, premium commitments should be balanced with an appropriate death benefit to assure long-term policy sufficiency.

Ownership:  Donor will irrevocably transfer 100% of any policy to  XYZ Charity and will forfeit any further rights to said policy.  Such transfer document will be acknowledged and signed by the donor’s spouse.  In addition, the transfer document will be acknowledged and signed by any beneficiary registered with the insurance company  immediately prior to the transfer.  The donor will be responsible for obtaining - generally from the insurance company - a valuation assessment for tax purposes as of the date of the transfer of the policy.  The charity will not provide such valuation.

Beneficiary: XYZ Charity must be named as an irrevocable beneficiary of no less than ____% of any transferred policy. Donor may name up to ____ additional 501(c)(3) organizations to receive the balance of the death benefit (total must equal 100%).

Once the policy has been transferred, premium donations, if any, will be paid directly to XYZ Charity by Donor and XYZ Charity agrees to handle all administrative functions of said donated policy including but not limited to the following:

  • Remittance of Premiums
  • Delivery of Gift Receipt to Donor
  • Ordering of in-force policy illustrations as needed
  • Portfolio rebalancing
  • Policy monitoring and review
  • Claims

XYZ Charity will accept policies from life insurance carriers that carry a “COMDEX” rating of __ or higher when there are two or more ratings from a recognized ratings company.

XYZ Charity agrees to consider gifts of the following types of life insurance from donors whether on a single life or on joint lives:

___ Term insurance
___ Whole Life Insurance
___ Universal Life Insurance
___ Adjustable Life Insurance
___ Guaranteed Universal Life Insurance
___ Equity Indexed Life Insurance
___ Variable Life Insurance

For gifts of Life Insurance in excess of $ ________, XYZ Charity agrees to place the name of the Donor, or such appropriate person as he/she selects, in a place of prominence at the site of XYZ Charity. Further, for gifts in excess of $ ______________, XYZ Charity, will discuss with Donor, their preference for allocation of the proceeds from said gift.

Appendix F contains a chart provided to suggest a charity’s primary policy acceptance and management considerations, and the annual policy performance verification that should be expected by the charity’s Board of Directors and/or Finance/Investment Committee.

Chapter 7

Charitable life insurance schemes - "we've got a way of raising millions of dollars for your charity” - The Good, The Bad, and The Ugly

One of the financial dangers facing charities is discerning between legitimate and illegitimate “schemes” that have been offered by life insurance promoters in the name of creating substantial endowments for the organization.  The term of art is CHOLI (Charity Owned Life Insurance).  Appendix G contains the Department of the Treasury / IRS 2010 Executive Summary of its CHOLI study, which was mandated by the The Pension Protection Act of 2006 (PPA).  The PPA also required that charities engaging in those arrangements report certain information to the Internal Revenue Service during a two-year period.  While not all CHOLI schemes are “bad,” in the past, such planning schemes as “Charitable Split Dollar” have ultimately generated public embarrassment and loss of good will from key donors.  After 2500 years, the ultimate human condition of Aristotle's day still prevails: “… we are drawn to the attractive impossibility rather than the less attractive probability.”

Unfortunately, the prevalence of such schemes tend to give the life insurance industry a bad name and have kept charities wary of even legitimate and reputable life insurance professionals.  Certainly charities must be cautious with whom they deal, and it is difficult to differentiate the promoters from the true professionals.  Therefore, it seems appropriate to focus on a few of the more notorious “too good to be true” schemes that have been circulated by life insurance sales organizations in the charitable sector.  Many of them come with names that have fancy acronyms and are accompanied by slick brochures and multi-media presentations.  It is not to say that all of them are bad, but it is important to heighten awareness so that caution and due diligence can be applied to every proposal.

Charities are often approached with the idea of “no cost” insurance that appear to produce very large gifts. Usually this type of plan involves several elements: first, a group of donors who have not utilized all of their insurance capacity.   This group of donors normally needs to consist of at least twenty-five individuals, and is confined to a narrow age range (typically 45 to 75).  Second, needs to be a “lead” donor, typically a high net worth (at least $10 million) individual, who is willing to pledge an amount of collateral that will cover financing for the insurance on the pool of donors.  Third, a willing bank serving as lender for the financed insurance.  Finally, of course, there is the insurance company and agent who will put the policies in place.  In theory the collateral is pledged, money is borrowed from the bank to pay premiums,  and as the pool of insureds dies, the loans are paid off and the charity collects the remaining proceeds.  Some CHOLI schemes may also provide a “front-end” bonus to the charity allowing the program to be initiated on its behalf.

While this type of program is often sold as “free,” there are many complications that cause them to be anything but “free.” 

First, the unintended consequence for the lead donor who pledges collateral is often an impairment of his personal future borrowing power.  And, tracking those assets and maintaining the collateral is a big responsibility and can be a large burden for the lead donor.  Additionally, what happens if the lead donor dies? 

Second, the pool of donors has utilized their excess insurance capacity, sometimes without realizing they have impaired their ability to acquire life insurance for their own purposes in the future.  If family circumstances change (e.g. divorce and the start of a “new” family), donors may become resentful of the charity and wish to cancel their policy.  What happens then? 

Third, there have been a substantial number of lawsuits against insurance companies and third-party owners (corporations, trusts, and charities) of substantial life insurance by surviving spouses and beneficiaries when policy proceeds are not paid to the family or for their benefit.  Charities may find themselves embroiled in lengthy and costly litigation if caution isn’t taken at the outset of the acquisition to make certain that all possible parties at interest have acknowledged that this policy will not benefit them. (see Chapter 6 for policy acceptance)

Fourth, policies usually don’t perform as projected in the sales illustration.  Depending on the type of insurance used, cash values may not accumulate at the projected rate, tying up the collateral for a longer period, requiring more premium than planned, which in turn requires more borrowing and, ultimately less money for the charity and a lot of unhappy donors.  Of course, the loan interest rates will rise or fall, even though the typical financial analysis assumes no volatility in borrowing rates.  This means the cost of borrowing to pay premiums may rise dramatically, in turn very likely causing the entire program to underperform expectations - or fail completely.

Clearly there are numerous moving parts and variables to be considered when reviewing this type of plan. These programs are neither good nor bad in and of themselves, but must be reviewed thoroughly and carefully to assure that all risks are understood and deemed acceptable.

Another popular approach to charities is to utilize a life insurance policy coupled with an immediate annuity, with the intention of creating an arbitrage between the annuity payout and the insurance premium. That is, an insured makes a deposit into an annuity which will pay the entire insurance premium less expensively than if the insured simply paid the insurance amount alone.  While this may sound unreasonable, it is occasionally possible - due to the different mortality tables used for purposes of underwriting life insurance and issuing annuities - to discover favorable underwriting or mortality table arbitrage.  However, this is another instance where this type of “program” can be over-sold.  It is not logical to assume that this type of arrangement will be applicable to everyone.  Also, it represents another instance where excess insurance capacity is utilized without the donor really being aware of the implications of that decision.

There are many other ideas that have come and gone and there are more that are sure to follow.  The best advice is that whenever a scheme is proposed to enrich the charity’s resources with a broad-based sale of life insurance to grantors - deploy a common sense test of “is this too good to be true?”  Approach each plan carefully utilizing 3rd party, independent experts to evaluate each proposed opportunity.  If the plan promoters resist independent assessment, that is almost always a tipoff that no further effort should be expended.  Some approaches will require a signed confidentiality agreement before promoters will even discuss the concept - which should be entered into with caution and the advice of counsel.  Even if meriting further exploration, it is imperative to perform thorough analysis, seek outside opinions as to risks that are not revealed in the promotional literature, ask  rigorous questions, and do everything a prudent and professional investor would do prior to making any major investment.

Chapter 8

Premium financing

A recent addition to the sale of life insurance, especially larger policies, has been the promotion of “premium financing.”  Premium financing involves using a third-party lender to borrow policy premiums, and then using the policy death benefit or cash value to ultimately pay back the loan.  While this sounds (and is) extremely complex, the appeal to the consumer is that they are often led to believe that they are getting the life insurance for “free”. It should be obvious that just like everything else in life, there is no “free.”

There have been, and continue to be promoted, numerous variations of premium financing.  Many structures exist with the basic proposition that the person insured will have little, if any, out of pocket costs for the purchase of a large life insurance policy.  Premium dollars are borrowed from a lender, often tied to a recognized loan rate index, such as a One-Year LIBOR (London Interbank Offered Rate). This rate may be fixed for a period of years or may float periodically.  Normally, premium financed policies are at LIBOR plus some additional amount that reflects the borrower’s credit history or borrowing capacity, often ranging from 150 to 350 basis points or more.   Additionally, the insured must often post collateral, either by pledging a securities account or by a Standby Letter of Credit.  The lender also receives an assignment of a portion of the death benefit that will pay back the loan plus interest at the death of the insured.

While all of this may sound attractive, there are many variables that come into play in this type of transaction.  Many of the clients who would benefit from a financed premium structure lack liquidity and cash flow because their wealth is often tied to real estate or other illiquid business assets.  Yet it is exactly for this reason that they often lack assets that banks are willing to accept  collateral.  While this may not appear to be a significant issue, as the balance of the loan grows over time it can produce real challenges. Further, while LIBOR rates are broadly accepted and published, they also are subject to volatility as with any other interest rate. As interest rates rise and the unpaid loan balance rises simultaneously, it is conceivable that the entire amount of the policy’s cash value will be needed to pay off the indebtedness, leaving nothing for the intended beneficiaries.

Other variables include the performance of the life insurance policy itself.   Fixed policies, that is those that pay an interest rate determined by the insurance carrier, may have internal interest rates that are lower than the borrowing rate for periods of time. This means that the loan costs will ultimately consume policy values entirely unless some action is taken.  One recent remedy is to use policies that are “indexed”, usually to some common index such as the S & P 500. However, indexed policies don’t return 100% of the index but usually some fraction of it.  While this may reduce the interest rate risk, it may just re-cast it as market risk.  While most indexed policies guarantee that the return will never be negative, costs of insurance and other fees can quickly reduce policy values during difficult market periods.

As it involves charities, premium financed life insurance can be a risky proposition. There have been several “schemes” that have involved charities and premium financed life insurance. Charity Owned Life Insurance (CHOLI) is probably the most common. Under this plan, insurance is purchased on donors who agree to let the charity utilize some of their insurability and an outside financing program. While these offerings may seem attractive on the surface, experience has shown that the charities can be put in a very bad position and irritate their donors at the same time. The pay off in death benefit can be a fraction of what’s expected because of the same risks associated with other premium financing structures. That is, the compounding of accrued interest on the debt erodes the face value of the policy over time.

In addition, what many benefactors don’t realize (and aren’t told) is that every individual has what is known as “insurance capacity.” This is an arbitrary number set by the insurance companies that limits the total amount of life insurance any one person can purchase.  For instance, an individual who is 70 years old and has a $2 million net worth won’t likely be allowed to purchase $10 million of life insurance. This would provide too much benefit based on his circumstances. When a premium financing program such as CHOLI is undertaken, some of each person’s insurance capacity is used up. Therefore, if that individual is unaware of this and seeks to acquire more life insurance for family or business needs, they may be foreclosed from that option because of the CHOLI insurance that’s in place. Certainly, the disclosure of this complication and its consequences are vital information that must be carefully communicated to any insured. Inserting the charity into the middle of this transaction can lead to unintended bad feelings between donor and charity and charities need to be very cautious in their approach and communication with potential participants.

Chapter 9

Life Settlements

Not all life insurance policies become death claims.  It’s been anecdotally observed within the life insurance industry that fewer than 5 percent (and possibly fewer than 3%) of term policies are in force at the time of the insured’s death, primarily because of replacement with other policies, elimination of need, or the inexorable increase in the cost of maintaining non-guaranteed premium policies at older ages.  By definition, there is no cash value in a term policy; when it is dropped or terminated, there is no further value to the policy owner.  This was the case until a “secondary market” for life insurance, commonly known as life settlements, emerged in the 1990s - itself evolving from Viatical settlements.  A term life insurance policy about to lapse for non-renewal could be worth as much as 25 percent of the policy’s death benefit on the life of someone over age 70 – with impaired but not immediately life-threatening health issues – who no longer needed the policy.  As a result of life settlements, a whole new industry has emerged, introducing “fair market value” as a term of art into policy terminology.

Because of the emerging secondary market in life insurance policies, life settlements have literally breathed new life and value into about-to-lapse policies.  In the typical life settlement, the ideal candidate is over age 65, has experienced a deterioration of health but is not terminally ill, has a life insurance policy with a death benefit of at least $250,000, and no longer needs or can afford the policy.  The University of Pennsylvania’s Wharton School estimated that in 2002 policy owners received $242 million more in sales proceeds than would have been forfeited to insurers.

The subject policy can be either term or permanent.  Only 10 percent of issued Universal Life policies have turned into death claims in the 25 years that this policy form has existed, and Conning & Company found “…that more than 20 percent of the policies owned by seniors have life settlement values in excess of their cash surrender values.”  While it is not within the scope of this paper to further discuss life settlements, it is important to note a study conducted by Deloitte Consulting LLP and The University of Connecticut in which it asserts that “… the intrinsic economic value [of a policy held until death] always exceeds the life settlement value. ”

Scope of the market.  The most recent numbers (2007) indicate that the life settlement market processed approximately $13 billion of death benefit purchases. Before the economic downturn of 2008-2009, it was estimated that the settlement market would approach $160 billion by 2012.   However, with less investment capital available, the market may have at least temporarily plateaued.  Whatever the ultimate size of this secondary market for life insurance, life settlements are here to stay and represent a significant and often confusing opportunity for policy owners.

There are many life settlement companies, brokers and other resources - the potential overlap of which may overwhelm the public.  Further, there is little regulation to protect the consumer from some of the more aggressive life settlement approaches.   

Settle or surrender?  Often, life insurance policies are poorly maintained by their owners.  This  may be because they don’t fully understand the implications of the financial commitment they have made  at the time of purchase.  Frequently, the agent who sold the policy is no longer involved and the policy does not perform as well as the sales illustration suggested.  This is usually discovered when the insured receives a notice from the insurance company that a premium much greater than originally expected is due in order to prevent the policy from lapsing for lack of sufficient cash value or premium to sustain the policy further.  When faced with this decision, many policies are simply allowed to lapse.  Alternatively, as retirement resources dwindle and the policy owner determines that the policy is no longer necessary (or simply unaffordable), a permanent policy might be surrendered for its cash value.    This is often the point where the discussion of a life settlement option might begin, since the policy owner presumably seeks to maximize the benefit she can extract from discontinuing the life insurance policy.

A life policy’s death benefit is generally determinable at the point the insured dies (and assuming the policy is still “in force”).  If a third party is willing to “buy” the policy in advance of such death, and pay the premiums in exchange for receiving the death benefit in the future, the transaction could be beneficial for both seller and buyer.  Essentially, this is what a proper life settlement process would facilitate.

What is often problematic for the seller is the lack of transparency within the transaction.  As previously suggested, there is little regulation in this relatively new industry, and sellers are often unsophisticated about such technical issues as personalized life expectancy and usually have no idea what the right value of a policy is or should be in the settlement market.  Agents often receive significant compensation in transacting these sales - in the worst examples a settlement broker might receive more than the seller! - and no informed seller should consider moving forward with such a sale without the buyer’s transaction transparency, full disclosure, and maintenance of privacy.  It should be obvious that the seller must always be anonymous to the purchaser and vice versa.

Pricing.  The buyer - often a sophisticated financial institution - is making an informed investment decision based on the measured life expectancy of the insured. With a large enough pool of policies, actuarial certainty about the number of deaths that will occur should create predictable investment returns.  While it may be unnerving for the seller that someone is holding “a bet to die” on their life, if the net offer for the purchase of an unneeded or unaffordable policy is greater than the policy’s surrender value, the benefit should be obvious.  Less obvious is whether the offered value is the best possible offer, and retaining an independent (fee-only) consultant may be the best means of assuring the appropriateness of the presented “best offer.’

Charities and settlements.  Settlements can be a good solution for policy owners, including charities.  Some donated policies simply may fall outside of the parameters of the life insurance portfolio of  a given charity, whether at the outset of the policy donation or at some point in the future.   Settlement may provide a charity with needed cash beyond the cash value of a policy or it may relieve a charity of a premium burden that would be unsustainable.

Chapter 10

Whom do you trust?

Life insurance is generally marketed through a number of different channels which can be somewhat confusing to the ultimate consumer.  Further, the qualifications, ethics, reputation and expertise of any individual insurance representative must be evaluated before a charity transacts business with such a person.  Generally, life insurance is sold by either agents or brokers.  Agents typically represent just one major insurance company, i. e.  Northwestern Mutual.  Brokers, on the other hand, can, and often do represent many different companies. This does not make one group better or more proficient than another.  Nor does it suggest that there is a right or wrong way to offer life insurance.  In fact, the single biggest decision regarding the purchase of life insurance by charities is likely to be the trustworthiness and expertise of the person selling the insurance.  Further, charities must understand that while some insurance representatives may be known publicly as agents and others as brokers, technically they all operate under the rules of “agency” and their allegiance and responsibility is, and must be, to the insurance company they are representing, not to the individual(s) or institutions to whom they are offering to sell insurance.  While a broker may claim to be impartial as to which company he or she may be representing, he or she still owes a primary duty to the recommended insurance company.

It is very important that the life insurance representative be someone of the highest character and credibility who places the best interests of his clients before himself.  While there are many professional credentials available to life insurance agents, and while they carry some degree of importance in assessing the skills of a particular professional, character and background of the agent has the greatest importance.  Any representative worthy of consideration will gladly provide as much information and as many references as asked for.   The major professional designation for life insurance agents is CLU (Chartered Life Underwriter), along with academic degrees (MBA or Ph.D. in insurance), or exam-based certification programs such as FSA (Fellow of the Society of Actuaries).  Additional designations may include CIA (Certified Investment Analysis) or CFP (Chartered Financial Planner), but these designations are not as specific to insurance expertise and individuals with only these designations should explain their insurance expertise.

Of course the other key consideration when accepting (or purchasing) a life insurance policy is the life insurance company itself.  The financial strength of the company, its stability and ultimately its ability to pay its claims, are important factors to consider. Several ratings services exist and their opinions can be helpful in assessing a company. They also can be very different from each other. The four mainstream ratings companies are A. M. Best’s, Moody’s, Standard & Poors, and Fitch.  COMDEX is a third-party service whose reports are generally available from insurance agents, and these reports are helpful in reconciling “letter grade” differences between the agencies by providing a consolidated view of financial strength vis a vis all other carriers.  A COMDEX of 98 - an extremely high financial strength rating composite - indicates that the subject insurance company’s current financial strength is higher than 98% of all carriers who have current ratings from two or more of the traditional insurance rating agencies.

A charity may want to consider engaging an independent consultant to deliver a financial strengths report on an insurance carrier, as well as assessing underlying policy expense and growth factors (compared to the policy illustration or in-force report) when a significant amount of policy holdings exist or are being contemplated.  Recent economic history has demonstrated that large companies can fail very rapidly and diversification among various strong carriers is likely to be a good strategy so that over exposure to a single carrier is limited.

1. American Council for Life Insurance Fact Book, 2009.

2. Wikipedia: “Gross Domestic Product listed by the International Monetary Fund” at http://en.wikipedia.org/wiki/List_of_countries_by_GDP_%28nominal%29

3. Final Report of the Task Force for Research on Life Insurance Sales Illustrations under the Auspices of the Committee for Research on Social Concerns, Society of Actuaries, 1992

4. Ibid.

5. It is not the intention of the authors to provide tax advice, but rather broad concepts of income, gift, and estate taxation as it exists in 2011.  In all circumstances, those concerned about the tax effect of a transaction involving a charity should seek specific tax counsel.

6.  A Study of Real, Real Returns, Thornburg Investment Management, Volume 17, August 2010.

7. Asset Allocation, Roger C. Gibson, McGraw Hill 2000.  Third Edition.

8. Ibid.  Further: An example of potential  negative correlation could include certain periods of time when bond prices fall due to lower demand during a period in which equity values are rising (in part because of higher demand).  Again in this example, when stock values rise, all things being equal bond prices may fall since there is less demand for them compared to stocks.  Correspondingly, when stock values fall, new bond prices may rise as they become a “haven” for those selling out of their stocks.  An example of positively correlated assets might be a portfolio in which there are 1000 shares of Panasonic and 1000 shares of Sony.  While there might be modest diversification in the case of “bad press” about one or the other, market forces such as inflation spikes, labor union resolutions, and shifts in consumer attitudes are likely to affect both companies in the same way.

9.  A similar analysis was employed with the use of Par WL, UL, NLG-UL, and VUL with similar risk characteristics for the non-guaranteed portion of a policy.  The use of life insurance policy values used in this section are Par WL , which produced the best projected results of the various policy styles.

10. “Asset Allocation: Balancing Financial Risk,” Third Edition, by Roger  C.

11. Gibson, McGraw Hill, 1996; page 8.

12. The linkage of the accumulation of cash value and the potential for increasing death benefit over time exists in Participating WL because of the possibility that the insurer’s investment return above its cash value guarantee will provide an opportunity for a declared dividend, which in turn spawns the purchase of paid up additions and increased Death Benefit.  Universal life (both traditional and variable) may experience increased death benefits due to IRC Sec. 7702.  This Section requires an age-based ratio of death benefit to cash value, and when policy cash values approach the death benefit, the required “corridor” of death benefit will rise accordingly.  Unlike participating whole life, however, when the underlying asset value of the sub-accounts decline in a “down” market, previous death benefit increases may reverse back to the stipulated policy amount, since “corridored” death benefits fluctuate with the account (cash) value.

13. The actual quote is “A likely impossibility is always preferable to an unconvincing possibility.”

14. Capacity is the amount of life insurance an insured is allowed to purchase with respect to such factors as net worth, life expectancy, future earning potential, and avocation.

15. For example, a one-year LIBOR of 1.5% plus 250 basis points results in a loan interest rate of 4.0%

16. Deloitte Consulting LLP and the University of Connecticut “The Life Settlements Market: An Actuarial Perspective on Consumer Economic Value,” 2005

17. Ibid.

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