Life Insurance Panel Reveals Key Tax and Risk Issues
This year’s Heckerling conference featured a special session, “From Soup to Nuts: Life Insurance Fundamentals – Risks and Products, Income and Transfer Taxes,” a life insurance panel featuring Donald O. Jansen, Mary Ann Mancini and Lawrence Brody.
Lawrence opened the discussion by addressing a core, but often misunderstood, reality of modern permanent life insurance: Most policies contain meaningful investment, credit and pricing risk and therefore can’t be treated as “buy and hold” assets, but rather must be approached as “buy and manage” assets. Many permanent policies issued today offer limited guarantees with respect to returns and insurance costs. As a result, long-term performance is highly dependent on variables such as investment returns, crediting rates, dividends, mortality experience and carrier expense assumptions. Lawrence emphasized that the greater the inherent investment risk, the more critical ongoing policy monitoring becomes, particularly when policy performance is expected to offset rising mortality costs, fund premiums or support strategies involving term riders or policy loans.
Over-Reliance on Illustrations
A recurring theme of Lawrence’s presentation was the danger of over-reliance on policy illustrations. He explained that most illustrations project decades of performance based on static assumptions that simply can’t hold true over time. Illustrations frequently fail to reflect the impact of lower-than-expected investment returns and rising insurance costs. As a result, a policy that appears to be the “best” or least expensive option at inception may ultimately underperform over a 30- to 50-year horizon. Lawrence stressed that illustrations should be viewed strictly as hypothetical modeling tools, rather than promises, and should be regularly stress-tested against actual policy experience using more conservative assumptions.
He concluded by outlining a practical framework for managing in-force policies across universal life, variable universal life and equity-indexed universal life products. His guidance emphasized periodic re-illustrations using conservative return assumptions, current expense structures and funding levels designed to carry coverage well beyond life expectancy. He encouraged diversification across carriers and policy types in larger cases, selection of financially strong insurers with durable product lines and proactive overfunding when feasible to create a margin of safety. His overarching message was clear: In today’s environment, much of the long-term risk of permanent life insurance rests with the policy owner rather than the carrier, making ongoing management essential.
The presentation then shifted to Donald Jansen, who examined why life insurance continues to receive favorable tax treatment under the Internal Revenue Code, while emphasizing that those benefits are subject to numerous exceptions and can be easily lost if policies are structured or transferred improperly. He began with the general rule that death benefits paid by reason of the insured’s death are typically excluded from a beneficiary’s income but quickly underscored the many statutory limitations to that rule. He gave particular attention to accelerated death benefits for terminally or chronically ill insureds, viatical settlements and policies that fail to qualify as life insurance under federal tax law, including modified endowment contracts (MECs). Donald highlighted how common missteps (such as failing the 7-Pay test under Internal Revenue Code Section 7702A, violating diversification requirements for variable contracts or engaging in certain ownership transfers) can convert what clients assume to be tax-free proceeds into partially or fully taxable income.
A central focus of Donald’s discussion was the “transfer for value” rule and its increasing relevance in modern planning. He explained how sales, assignments and even certain gifts of life insurance policies can spoil the income-tax-free treatment of death proceeds, and he walked through the limited statutory exceptions for transfers to the insured, to partners or partnerships, to corporations in which the insured is an owner or officer and transactions that qualify for carryover basis treatment. He cautioned that even routine ownership changes must be carefully evaluated, as entity restructurings or planning-driven transfers can inadvertently trigger adverse tax consequences.
Donald also addressed employer-owned life insurance (EOLI), an area subject to especially strict statutory limitations. He reviewed the general rule that death proceeds from EOLI are taxable to the employer to the extent they exceed premiums paid, unless specific exceptions apply. These exceptions generally require that the insured be a director, a highly compensated employee or a member of a permitted employee class and that stringent notice and consent requirements be satisfied. He concluded by reinforcing the importance of understanding how cash value grows on a tax-deferred basis, when distributions become taxable and how MEC status fundamentally alters the taxation of loans and withdrawals.
To finish the panel, Mary Ann Mancini addressed the transfer tax consequences of life insurance, focusing on how ownership, funding and trust design decisions directly affect gift, estate and generation-skipping transfer tax outcomes. She began by emphasizing the threshold question: Who should own a life insurance policy? This must be analyzed in light of the insured’s family dynamics, business relationships and the purpose of the coverage. Mary Ann cautioned that lapse rates approaching 85–90% raise legitimate questions about whether using the lifetime exemption to fund premiums is an efficient transfer-tax strategy, noting that sometimes individual ownership may be appropriate (such as when a policy is viewed as an investment or short-term asset). Alternative ownership structures, including spouses, children and irrevocable trusts, carry distinct risks, such as exposure to divorce, creditor claims, family conflict or unintended estate inclusion, underscoring the need to align ownership with long-term planning objectives.
A portion of Mary Ann’s presentation focused on funding irrevocable life insurance trusts (ILITs) and the technical requirements for qualifying premium gifts for the annual exclusion. She walked through the use of Crummey withdrawal powers, highlighting the Internal Revenue Service’s focus on proper notice, timing and the existence of meaningful withdrawal rights.
Mary Ann concluded by addressing estate tax inclusion risks and valuation challenges unique to life insurance. She reviewed how retained incidents of ownership, entity-level control, transfers made within three years of death or death benefits payable to the insured’s estate, can cause policy proceeds to be pulled back into the taxable estate.
Overall, the presentation reinforced that while life insurance remains a powerful and flexible planning tool, its effectiveness depends on careful structuring, strict compliance with complex and evolving rules and ongoing coordination among legal, tax and insurance advisors.
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