December 13, 2013 WHEN A LIFE INSURANCE LOSES STEAM Dear Clients and Friends: A settlor may establish

an irrevocable trust to hold a life insurance policy on that settlors life or a joint and survivor policy with a spouse. Often the premiums on the trust policies are paid by annual exclusion gifts from the settlor. The policy proceeds can provide liquidity to pay the estate tax or purchase a business interest, or other administration expenses without being included in the settlors estate. The settlor views the irrevocable trust as straightforward. To the trustee, however, the administration of an irrevocable life insurance trust is anything but straightforward. The trustee has a fiduciary duty to administer the insurance trust in accordance with its terms and the settlors intent, and owes fiduciary duties to the beneficiaries. The fiduciary duty to preserve the trust property and to invest it prudently applies even when that property consists only of life insurance policies. A policy that was a prudent investment at the inception of the trust does not excuse the trustee from reviewing its economics in future years. Settlors may find annual contributions to the trust to pay policy premiums a burden. The increased federal estate tax exclusion may eliminate the projected tax savings that justified establishing the insurance trust. The settlor may decline to make further contributions, having determined that the policy is no longer necessary or that the present premium cost outweighs any potential future tax savings. The absence of contributions may leave the trustee with no funds to pay the policy premiums or other trust expenses. The trustee may have to choose among (1) allowing the policy to lapse, leaving the trust estate with no assets; (2) surrendering the policy for its current cash value; (3) exchanging the trust policy for a single premium paid up policy with a likely reduction in the policy proceeds; or (4) borrowing against the policy to pay the premiums. A recent case in Indiana, Cochran v. Key Bank, N.A., provides guidance to trustees in making these difficult choices. In Cochran the settlor created an irrevocable life insurance trust to own an $8.0 million policy. He named an independent bank as trustee, and his daughters were the

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trust beneficiaries. The trust had continued for several years when the settlor informed the trustee that he would no longer contribute funds to pay annual premiums. The trustee retained an insurance consultant to review the options. The trustee investigated the options, received advice from the consultant, and reviewed the settlor-insureds health condition. The trustee then exchanged the trust policy for a paid up $2.5 million policy. The settlor died unexpectedly within the following year. The settlors children, as the trust beneficiaries, sought to hold the trustee liable for the loss in the death benefit payable on the life insurance policy. The appellate court found that the trustee did not breach its duty to the beneficiaries in exchanging the life insurance policy. The trustee acted prudently in investigating available alternatives and selecting the replacement policy based on an analysis of objective factors under the circumstances known at the time of the exchange. The court held that even though the process of reviewing the policies was not perfect, the trustee was not liable for choosing between two acceptable options recommended by the insurance consultant. The Cochran case highlights the importance of a trustee using due diligence in deciding among alternatives for life insurance policy that is no longer economically viable. The trustee built the evidentiary record that supported its decision to exchange the trust policy. The court found the trustee acted reasonably in exchanging policies. A trustee may delegate investment functions to outside consultants, subject to reasonable care in selecting the consultant. The court in Cochran held that hiring an independent insurance consultant was a proper exercise of the trustees duty to invest the trust assets prudently. The prudence of an investment decision is determined at the time it is made, and not in hindsight. The trustee investigated the settlors health status and had no reason to suspect the settlor would die within a year. The trustee in Cochran was not liable for the unforeseen death of the settlor shortly after the decision to exchange the trust policy. A prudent trustee will need to consider as part of its ongoing responsibilities the viability of the policy when it fails to meet economic projections or available cash cannot satisfy the annual premiums. A careful trustee may also consider communicating the alternatives to the beneficiaries and obtaining their consent. Attention to this process should provide the evidentiary support for a court to conclude the decision of the trustee was consistent with the trustees fiduciary duties and find no liability to the beneficiaries.

4 Orinda Way, Suite 250-B, Orinda, CA 94563 |

Tel: (925) 253-1717 |

Fax: (925) 253-0334 |

info@hartogbaer.com |

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Please feel free to communicate with us if you have any questions or concerns regarding the administration of a life insurance trust.

Very truly yours, HARTOG & BAER A Professional Corporation

By: JOHN A. HARTOG

4 Orinda Way, Suite 250-B, Orinda, CA 94563 |

Tel: (925) 253-1717 |

Fax: (925) 253-0334 |

info@hartogbaer.com |

Top 100 Lawyers