The Essential Executor's Handbook: A Quick and Handy Resource for Dealing With Wills, Trusts, Benefits, and Probate (2016)

Chapter 12

The Insurance Agent and the Life Insurance Lotto

The Concept

There was a time when life insurance was thought to be a solution looking for a problem. Even worse, the thought that someone would receive a lot of cash because a loved one had died seemed somehow unethical—and to some, even immoral. But times have changed and now everything is expensive, even death. The average cost of a funeral is over $10,000. The cost of settling your decedent’s estate, including out-of-pocket expenses, court costs, professional fees, and your commission can consume up to 6% of total assets. Final medical bills that are not paid by health insurance can be enormous. And then you have the tax man, mortgage lenders, and noisy beneficiaries—all of whom cry that they need to be paid now. In short, the insurance solution has finally found its problem. And the problem is a need for immediate liquidity.

If you have never purchased life insurance or otherwise have no experience with it, rest assured that the concept is fairly simple. In fact, it’s very much like the lottery. Like the lottery, you are betting that you will pick the winning number and collect the pot. With life insurance, the only difference is that the number you are picking is your date of death and the pot is called the death benefit. Put another way, the insurance company is betting that you will survive the term of the life insurance contract but you are betting that you won’t. Because the insurance company has mathematicians called actuaries, they can calculate the odds of you dying during the term of the contract based on your age, weight, health, and habits. They then calculate how much you have to pay for the insurance in order to ensure that, in any given year, they will always make a profit. In other words, the house always wins.

For example, when I was 59 years old (last year), I agreed to pay my insurance company approximately $8,000 per year in exchange for a $1,400,000 death benefit. The term is 20 years. To ensure that I was not dying of anything neither of us knew about, they sent a nurse to my office to weigh me, take my blood pressure, wire me to an EKG machine, and draw blood. Turns out I am very healthy. If I survive the next 19 years, the insurance company comes out $160,000 ahead. If I die at some point in the next 19 years, my beneficiaries net a cool $1,400,000! But, from the insurance company’s point of you, there are enough people like me who survive the term to offset the few who don’t; and then some.

Types of Life Insurance

Level Term

Level Term life insurance is precisely what I purchased last year. I pay $8,000 per year (the premium) for 20 years (the term). If I die during that time, the insurance company pays my beneficiaries $1,400,000 (the death benefit, aka the face amount). At the end of the 20-year term, I have the option to continue the insurance contract for an astronomical premium (I will be 79, after all).

Whole Life Insurance

Whole Life insurance provides the insured with a cash reserve. A portion of each premium paid pays for the death benefit, just like Level Term life insurance. However, the remainder of the premium is invested with the insurance company. Over time, the invested portion (the cash value) grows. At any time, the insured can “cash in” the Whole Life policy, end the contract, and take the cash value. The annual premiums needed to purchase Whole Life insurance tend to be considerably higher than those needed to purchase Level Term.

Accidental Death

Contrary to what the media would have you believe, a surprisingly small percentage of deaths are the result of an accident. That is why there is a special type of life insurance that just covers accidental deaths. The death benefit can be very high even though the premium is relatively cheap. If life insurance were part of the gaming industry, accidental death would be right up there with Keno—cheap to play, big payout, but very poor odds of winning.

The Insurance Agent

As with securities, there are really two players in the insurance industry. There is the insurance agent and then there is the company who actually provides the insurance. The agent helps the consumer select a type of life insurance and, in return, the insurance company pays the agent a commission. Occasionally, you will come across an independent agent who can sell insurance policies from a myriad of insurance companies.

If your decedent owned life insurance, you may attempt to make a claim through the insurance company’s 800 number, but I wouldn’t recommend it. As with securities dealings, it is always preferable to work with an individual. More often than not, the agent will attempt to win future business from you by being as helpful as possible. For example, if you want to help a beneficiary file a claim with the insurance company, calling the 800 number will get you a blank form that you will need to fill out; sometimes the form comes with instructions and sometimes it does not. The agent, on the other hand, will provide the claim form, fill it out, and file it for you. After that, the agent will call to ensure that your beneficiary got the money. I would like to say that the two experiences are like night and day, but even that analogy doesn’t begin to cover the gulf of professionalism that yawns between a disinterested and disembodied voice and a really good agent—an agent who gives you a home phone number and sends you birthday cards.

This is important because people often own multiple insurance policies with multiple companies. My father owned four policies that were with four different insurance companies. He named his five children as equal beneficiaries on each policy. Every insurance company told me that I and each of my siblings had to file our claims separately. The upshot was that, since I was chosen to settle all of the estates, including the Contract Estate, I had to complete 20 claim forms and then forward them to my siblings for signature. Had my father had a single insurance agent working for any one of the companies, my load would have been lightened immensely. Alas, that was not the case. Any agent my father had ever dealt with had died or retired.

It is important to note that many insurance companies require that each claim be submitted with an original death certificate. Death certificates cost about $15 each. Had my father’s insurance companies required that each sibling send a death certificate with each claim form, it would have cost the estate an additional $300. Fortunately for me, each company only asked for one death certificate; so we got off light, for only $60.

Forms of Payment

As a rule, an insurance company will offer you multiple claims options. Of course, most beneficiaries will request a check for the entire amount that is due to them, known as a lump sum. However, insurance companies offer at least three other options: a checking account, installment payments, or an annuity.

Most beneficiaries are surprised to learn that the insurance company will be happy to hold onto the death benefit and simply give the beneficiary a checkbook. The beneficiary can then write checks for whatever he needs or desires until the checking account is empty. Whether or not the account pays interest is up to the insurance company and the state insurance regulators.

The second option is installment payments. The insurance company pays the beneficiary a fixed amount on a regular basis (monthly, quarterly, annually, etc.). This method has the advantage of giving the beneficiary a fixed stream of income for a predetermined number of years.

The third option the insurance company may offer is to give the beneficiary payment in the form of an annuity. Like the installment method, the beneficiary gets a fixed payment each payment period. The difference is that the payments are for life. In other words, the payments don’t end until the beneficiary does.

It is important to note that between the time that the insured dies and a lump sum payment is actually made, the insurance company has to pay interest on the unpaid death benefit. That is why you are rarely going to see a check that contains a round number; even if you are the only beneficiary. So, for example, if the death benefit was $100,000, the check that you receive will be more. If there is a lengthy delay (more than 60 days), state regulations may see to it that you receive a lot more.

Exclusions

In some case, the insurance company will not pay your beneficiaries. These are called exclusions and, quite frankly, they are common-sense escape clauses. Put simply, whenever the risk element has been removed, the insurance company is not required to pay. Just as a casino is not required to pay someone who has been cheating.

Suicide

In most states, an insurance company is not required to pay the death benefit if the insured committed suicide within one or two years after buying the policy. As an additional hedge against this risk, and especially in the cases of death benefits exceeding $1 million, many insurance companies will conduct a mental evaluation of the insurance applicant as well as the physical evaluation.

Murder

While homicide is not an excluded death per se, the insurance company will not pay someone who actually committed the murder. This is not so much insurance law as criminal law. Criminal law provides that a murderer may not benefit financially from his or her crime. This leaves open the question as to whether the insurance company will pay at all. In many cases, they will pay the estate of the victim and the estate will pay any beneficiary other than the murderer.

Fraud

When you fill out an insurance application, you answer a bushel basket of questions about your health, your health history, your family’s health, and their health history. Lie about absolutely anything and the insurance company can claim fraud. So, if you know that your family has a history of congestive heart failure and you lie about that, your family won’t be seeing any insurance proceeds when the big one gets you.

Failure to Pay

The Captain Obvious of the exclusions occurs when the insured has failed to pay the premiums. In most states (if not in all of them), an insurance company is required to give the insured notice that the life insurance policy is about to lapse unless an overdue premium is paid immediately. It doesn’t matter that the beneficiary is not at fault or had no knowledge that the insured stop paying. A life insurance policy is a contract. Failure to pay the premiums is a breach of the contract. And the insurance company’s recourse for the breach is to rescind the policy.

Uses for Life Insurance

The rule of thumb used to be that you need life insurance equal to five times your salary. I have no idea who came up with that rule or how they arrived at that amount, but it seems more than a little bit arbitrary. For executors, life insurance is simply an immediate source of cash. It spares you the dreaded decision of what to sell and what not to sell. With the exception of securities, executors almost always take a bath on the sale of estate assets. People seem to know that you are under pressure to sell and they will invariably take advantage of you. If your decedent had life insurance payable to the Probate Estate or to the Trust Estate, you don’t need to get stressed or get taken.

This, of course, begs the question of who are the beneficiaries. If the beneficiary of your decedent’s life insurance was not the Probate Estate or the Trust Estate, then the insurance will not be yours to use in any case. People are all too often comforted by the knowledge that they have life insurance to pay their bills when they die. But they don’t think it through. If the kids are getting the proceeds, they are unlikely to surrender any money to the executor. So, the one obligated to pay the bills is, once again, forced to liquidate assets. If this is the case with your decedent, you may prevail upon the beneficiaries to release their rights to the insurance money. Most life insurance policies that have no beneficiary to pay will pay the Probate Estate by default. Your insurance agent will provide the form or format for the release. It may be a long shot, but it is certainly worth the effort.

Assuming your decedent made the life insurance payable to the estate, or made it payable to a beneficiary who has died, or made it payable to a living beneficiary who has released all right to it, take the proceeds as a lump sum. Then, if you have not already done so, open a checking account for the estate and deposit the life insurance proceeds. Finally, add whatever other cash you have to the account and prioritize your expenses in the following order:

1.   Death Taxes: If your decedent’s Federal Gross Estate (i.e., the sum of all four estates) has a value in excess of $5,450,000, ask you accountant to project the estate tax due. If your state has an estate tax or an inheritance tax, have your accountant project that as well. There are major civil and criminal penalties for failure to pay taxes. Accordingly, death taxes, if any, will take priority when it comes to spending your available cash (including the life insurance proceeds). It is also possible that your decedent was liable for income tax as well for the period of January 1 up to and including the date of death. If the total projected tax liability exceeds the available cash, don’t use them for anything else. Begin considering what estate assets you can sell. If your cash exceeds the total projected tax liability, proceed to step 2.

2.   Administration Costs: Settling an estate can be expensive, especially the professionals that you need to hire. In addition, there are court costs associated with the Probate Estate. Also, if there is real estate, that too will be a source of expenses (mortgage payments, utilities, etc.). Your team and the court need to be paid or your efforts will stall. Mortgage payments need to be paid or foreclosure will ensue. Collect estimates of total fees from each team member. Ask your lawyer to estimate the likely court costs. Calculate real estate expenses for a year. Add all of the estimated administration costs, the total projected taxes, and the real estate expenses. If the resulting figure exceeds the available cash, begin considering what estate assets you can sell. If your cash is still the larger number, then proceed to step 3.

3.   Medical Bills: If your decedent was hospitalized or in a nursing home or assisted-living facility, there are going to be final medical bills, and lots of them. The billing practices of both physicians and hospitals can be woefully inefficient, with some bills arriving as late as a year after the date of death. And those that arrive sooner have often not been adjusted for health insurance payments. Therefore, don’t even consider using the proceeds for matters discussed in steps 4 and 5 until at least a year has gone by. If, after paying taxes, administration costs, and final medical bills, you project that you will still have cash on hand, proceed to step 4.

4.   Mortgage Payoff: Here is something I bet you didn’t know: Death is considered defaulting on your mortgage. That is to say that your mortgage company can foreclose on the house the instant you have breathed your last. They rarely do, of course. So long as they continue to receive mortgage payments—from anybody at all—they are happy. If you plan to sell the property, the mortgage will be paid off with the sale proceeds. If you plan to distribute the property to a beneficiary, the beneficiary will need to seek their own financing to replace the existing mortgage. However, if your beneficiary cannot replace the mortgage, you must pay the mortgage balance before you distribute the property. If that is the case, and you still have cash left over, proceed to step 5.

5.   Beneficiary Buyouts: There is always at least one beneficiary who can’t wait to get their share. The nagging, whining, and complaining, along with the threats and ultimatums, usually surface a few weeks after the death but have been known to commence as early as the funeral. In one instance, the youngest of three children called the executor, the court, and me every day for the entire duration of the probate process, which was three years. Sometimes, you just want them to go away. And with sufficient cash to satisfy their share, you can do just that. However, you will first need to get the agreement of the other beneficiaries in writing.

Taxes

One of the great advantages of life insurance is that it is not subject to income tax. You will not be receiving a Form 1099 and, more importantly, neither will the IRS. If you doubt me, have a look at your 1040 and you will see that there is no line for it, nor is it mentioned anywhere in the IRS instructions. You get to keep all of it. And yet, it can be used to pay deductible expenses such as mortgage interest. From an income tax point of view, it is the perfect asset.

On the other hand, life insurance may be subject to the Federal Estate Tax. And it’s not hard to find a line for it on the Federal Estate Tax Return; the IRS has dedicated an entire schedule to life insurance (Schedule D). The rule is that if the decedent owned the policy, then the death benefit (i.e., the insurance amount before the interest additions) is subject to the Estate Tax and most likely to your state’s death tax(es) as well. However, if the policy is owned by anyone else, the proceeds are exempt from the Federal Estate Tax.

This little quirk in the law gave rise to the Irrevocable Life Insurance Trust (aka ILIT) some 60 years ago. In an ILIT arrangement, a trustee other than the insured is both the owner and the beneficiary of the insurance policy. When the insured dies, the trustee then files the claim for the insurance proceeds and distributes them according to the terms of the trust. Most often, the trust specifies the exact same beneficiaries that your decedent would have named as the life insurance beneficiaries. However, the insured doesn’t own the policy; the trustee does. As a result, the exact same result is achieved but without incurring death taxes.

Of course, an ILIT is totally unnecessary if the life insurance is not pushing the Taxable Estate over the exemption limit (currently $5,450,000). So, for example, if a decedent had $3,000,000 in assets plus a $500,000 life insurance policy, an ILIT would be a wasted effort. On the other hand, if the decedent had assets worth $5,450,000 plus a $500,000 insurance policy, an ILIT would save up to $200,000.

Finally, the interest that is tacked on to the death benefit is taxed as income. It is not subject to the Federal Estate Tax.

Summing Up

Life insurance provides you, the executor, with much-needed liquidity. Most often, it takes the form of Term, Whole Life, and Accidental life insurance policies. Payments can be in a lump sum, installments, or even an insurance company checking account. And, although it is often difficult to claim, employing the assistance of your insurance agent greatly simplifies the process. The proceeds are most often used to pay taxes, administration expenses, medical bills, and mortgages. They can even be used to buy off an annoying, impatient beneficiary. Just be mindful of the major exclusions: suicide within two years, murder, fraud, and failure to pay the premiums. If an exclusion applies, there may be no insurance proceeds coming your way at all.

Things to Do

1.   Contact the decedent’s insurance agent and request the claim forms.

2.   Provide your lawyer with the forms and the information necessary to complete them (e.g., policy information, beneficiary information, mode of payment).

3.   Follow up to be certain that the claim has been filed.

4.   If the proceeds are payable to the Probate Estate or Trust Estate, be sure to provide your accountant with both the taxable and non-taxable portions of those proceeds.