Happy New Year!
I’d like to start out the year with a quick reminder of something I have discussed before. I am referring to how often we see and catch mistakes from home offices. I’m talking about legitimate, serious mistakes on behalf of carriers which few people would recognize, let alone know how to deal with if they thought something was up.
Most recently, I had a situation which incorporated multiple mistakes, each one unrelated to the other. I was introduced to a family to analyze a handful of policies in the irrevocable trust. Some of the policies where dramatically underperforming due to a significantly reduced dividend rate over the years and how that affected this particular policy design. In the end, it was decided to cash in a couple of the policies.
After an intentionally tortuous process implemented by the carrier to hang on to money as long as possible, a check finally came. The problem was that it was light by the tune of six figures, which was a significant percentage of the gross cash value. I informed them of this and they commenced an “investigation” (after assuring me the number was correct). In relatively short order they acknowledged their mistake and sent the remainder of the funds.
Previous to surrendering the policy I had made sure to understand any tax consequences of the action and calculated that there would be no gain. However, after surrendering the policy, the carrier sent the owner a basis calculation which showed a six figure taxable gain. Looking closely I noticed two things, each of which was quite amazing.
First, the calculations of “qualified premiums” was incorrect. It was close but it was shy by one year of premiums. Usually this is a pretty straight forward calculation so I was wondering if I was mistaken or the policy owner related something to me in error. Was a premium skipped? Was a premium paid by dividends? Realizing that the non-forfeiture provision was “reduced paid up”, it lead me to believe this was not the case. I closely reviewed a recent in-force ledger and it had a line which summarized the premium history which was one premium short as well. At this point I got on the phone with customer service to discuss and came away with a “fun” discovery.
When talking to the rep, we agreed the policy was put in force in 1992 and surrendered in 2015 with the most recent premium paid in 2014. The ledger stated 22 premiums and she did the math and corroborated this. After all, 2014 less 1992 is, in fact, 22. The problem is, that’s not the right answer. I’ll admit I reverted to my tendency to count on my fingers and when I did so, I came up with the 23 premiums I knew to be the correct answer. The issue is, you can’t use a calculator for this math because the simple subtraction problem is not inclusive of the first and last year of premium, it simply gives you the difference and this is not the correct answer.
Not being able to get any acquiescence on the matter, we were forced to pay $100 to order a premium history which we were told would take three months to complete. When it finally arrived, I was proven right and the gross premium was factually greater than the ledger reflected.
I mentioned that there were two issues at hand with the gain calc. The second issue was that the company insisted on reducing the basis for “dividends distributed”. This would reduce the basis under IRC Section e(1)(B) … if that was the entire story. However, no dividends were ever distributed from the policy in cash and all dividends were used to purchase paid up additions in the policy’s failing attempt at converting the term portion of the policy into whole life insurance. (IRC Section 72(e)(6)(A)) The bottom line is that we have a policy with no gain associated with the surrender and the insurance carrier is providing startlingly inaccurate documentation which would result in significant taxation. This happens more often than people would like to believe.
As you might expect, this has resulted in another “investigation”. Given my experience with a number of carriers miscalculating basis, gain, surrender value or guarantee formulas, the moral of the story is to remember that, while home office based calculations and data are usually on target, we can’t always count on the materials we receive being accurate and it might be worth a second opinion if something seems fishy… or even if it doesn’t.