Avoiding Unpleasant Surprises—or Worse—with Your Life Insurance

Life insurance can potentially play an important, even prominent, role in your wealth planning efforts. But you have to be careful when using life insurance. Because of the somewhat esoteric and obscure nature of some types of life insurance, it’s possible to buy the “wrong” life insurance policy for your needs—or implement life insurance-based wealth planning strategies that are too aggressive (perhaps even illegal, in the worst-case scenario).

What to watch out for

There are a number of signs that should give you and your wealth managers pause when it comes to using strategies incorporating life insurance. These red flags indicate the need for significant due diligence on the part of your advisors.

Some red flags to watch for:

• Does the strategy have clear economic benefit? Every legitimate wealth planning strategy must have a substantial and material nontax business or insurance purpose. Clearly, any attempt at tax evasion in any shape or form is unacceptable.
• Is signing a nondisclosure agreement required? Some … shall we say … less scrupulous wealth planners and life insurance agents may not permit prospective clients to submit the wealth planning strategies they’re proposing to outside review by other professionals. If you’re asked to sign one of these agreements in order to be “privileged” to learn about a strategy, it’s a sure red flag.
• Is signing a hold harmless agreement required? This type of agreement says that the provider of the strategy is not legally responsible for what happens to you because of the strategy. Any formal agreement that limits the liability of the provider of a wealth planning strategy is a cause for serious concern.
• Does the professional proposing the strategy consistently avoid explaining it, instead advocating the need to just trust him or her? All legitimate wealth planning strategies are transparent.
• Where is the insurable interest? On a state-by-state basis, there are clear guidelines for defining an insurable interest. Consequently, when there’s not a clear and solid insurable interest as approved by the state in question, the strategy is highly suspect. This can also hold true for other types of jurisdictions, such as different countries.
• If the stated goal is to benefit a charity, will the charity actually benefit? Anytime a strategy has a charitable component, there must be a strong charitable intent from the policyholder. In the end, the strategy must meaningfully benefit the charity.

Let’s be clear here: In our experience, the vast majority of professionals do not take actions that create red flags. Still, such professionals do exist, and you need to watch out for them. Wealth planners and life insurance specialists should employ legal strategies and should push back against those strategies that are over the line. Any wealth planning strategy that may potentially compromise you in some way should be avoided at all costs.

The motivation to cross the line

Getting caught using an over-the-line insurance-based wealth planning strategy can result in penalties for the policyholder—including fines, interest, paying back taxes and (in some cases) the loss of significant assets. For professional advisors, getting caught also entails penalties—in some cases, the loss of their professional licenses. They may also be sued by their clients for malpractice.

What motivates some people to step over the line, given these types of consequences? In some cases we’ve seen, the policyholders don’t actually know that they’re being entrapped. The “professionals” they’re working with are exploiting them. Other times, the clients and professionals involved do a cost/benefit calculation and conclude that given the amount of money involved, the risk of being caught and audited is worth taking.

Ultimately, they’re driven by greed. Playing the “audit lottery” is a financial strategy for some people. And we have seen some wealthy people who do have more time, energy and mental firepower than the government can bring to bear against them.

While it’s unlikely that the consequences of getting caught will deter every single professional out there from stepping over the line, those who do act in overly aggressive or illegal ways out of greed are putting themselves in a position where their actions will come back to haunt them. It is up to your professionals, through their understanding of the legal consequences and their ethical grounding, to draw the line and not cross it.

The IRS cries foul

One question that is often asked with insurance planning strategies is this: “Just how aggressive is too aggressive?”

An example might be helpful. Consider the case of the now-discredited advanced estate planning strategy known as charitable reverse split dollar.

In charitable reverse split dollar, an affluent donor would make a contribution to a willing charitable organization for a certain amount of life insurance. The charitable organization would turn around and, in concert with the donor, pay the money to the insurance company as part of the premium for a policy on the life of the donor.

The donor then contributed the balance of the premium—which was an amount considerably less than the amount contributed by the charitable organization. Through a split-dollar agreement, the charitable organization owned the death benefit and the donor owned the cash value. The donor also could terminate the relationship on any policy anniversary so that the charitable organization would then receive nothing. With this strategy, the donor would receive a tax deduction as well as owned cash value and life insurance that were of much greater comparative benefit than what had been contributed.

The strategy was actively marketed by a company that provides products and services to the life insurance industry, and was accompanied by an opinion letter from an attorney with a prominent law firm. Inevitably, this inventive but questionable strategy attracted government scrutiny. In 1999, the IRS warned about adverse tax and penalty consequences. Subsequently, in the Tax Relief Extension Act of 1999, a law was passed to deal with personal benefit contracts that included provisions such that in addition to the taxpayer facing taxes, fines and penalties, there would be an excise tax imposed on charities that facilitated these transactions. Additionally, any charitable organization that had conducted such a transaction had to file a report with the IRS—and there was no grandfathering.

The reason for the IRS and the legislative responses was simple enough: The charitable intent on the part of the donor was not present. The strategy also employed an outdated IRS table that has been subsequently revised. Since then, the seemingly straightforward and altruistic relationships between many affluent donors and charitable organizations have been reconsidered—sometimes to the discredit of both parties.

Putting a solution to the test

When it comes to life insurance, a process called stress testing can be a powerful way to help you determine whether what you have implemented or what you are considering is likely to generate the results you’re looking for.

Essentially, stress testing challenges the wealth planning and life insurance solutions you have implemented or are considering, in order to assess the likelihood of their working as expected in different scenarios. If you are concerned about the viability of a solution—or even if you are not completely sure—a stress test can potentially be valuable.

There is a decidedly systematic way to go about stress testing.

1. Profiling

The process starts with smart questions. What are your specific goals and objectives? What are you seeking to attain? What problems are you looking to solve? What opportunities are you seeking to benefit from? Answers to these and similar questions should be the driving force behind the life insurance and legal solutions you employ.

2. Evaluation

Once your goals, objectives, concerns and limitations are clearly understood, the strategies and policies you are using or considering can be examined. This is where you “work the assumptions” to determine the probability that the strategies and solutions will accomplish your goals and objectives. Costs are also evaluated at this step.

3. Alternative solutions

Based on the evaluation of the existing or proposed strategies and products, alternative solutions might be considered. It can be very useful to conduct analytic side-by-side comparisons between the solutions you are currently using or that are being proposed and the alternatives.

4. Recommendations

At the conclusion of stress testing come the recommendations. If the life insurance solutions and wealth planning are on target, the recommendation may be to stick with the plan. Perhaps a little tweaking may be in order, but that’s it. On the other hand, if the stress test finds a “system failure,” the recommendation is to quickly take a different course of action.

There are variations on this basic process, with some wealth planners incorporating complex algorithms and structured analytic techniques into their methodology. That said, stress tests generally have the “look and feel” described above.

ACKNOWLEDGMENT: This report was published by the VFO Inner Circle, a global financial concierge group working with affluent individuals and families, and is distributed with its permission. Copyright 2025 by AES Nation, LLC.