This article addresses many of the issues raised relative to life insurance in family law matters. Life insurance is not the most hotly litigated or negotiated issue in family law cases. In fact, life insurance is frequently an afterthought or a "throw away" issue. It is rarely considered significant in the divorce. Interestingly, a life insurance policy may ultimately be the most valuable asset of an estate. A more detailed understanding of the issues in this area will allow the practitioner to better protect a client's rights and expectations.
In family law matters, life insurance may need to be addressed as an ASSET, a SECURITY DEVICE, a component of a SUPPORT order and a source of unexpected TAX.
Defining Key Terms: Owner, Insured, and Beneficiary
For a full understanding of these issues as they relate to a divorce, it is necessary to understand the meaning of the terms of owner, insured and beneficiary.
The owner of the policy is the individual or entity who has the right to make decisions relative to the policy, such as changing the beneficiary designation, borrowing against the policy cash value, changing settlement options, canceling the policy, etc.
Careful consideration should be given to the designation of the owner of the policy in drafting a family law judgment. Policies are frequently owned by closely held corporations, business partners, irrevocable life insurance trusts (ILIT) or other third parties. Before allowing a policy to be awarded to your client in a divorce, confirm that either the husband or wife is, in fact, the owner of the policy. Be careful not to bargain for the ownership of a policy in a divorce that is owned by a trust, another entity or another individual. The policy may not be a community asset.
The insured is not always the owner. The insured is simply the person whose life is being insured. Certain policies insure more than one life.
The beneficiary is the person or entity that receives the policy proceeds upon the insured's death.
Types of Insurance
Life insurance is generally categorized as either term insurance or permanent insurance. Term insurance provides for the payment of a specific sum of money to the beneficiary upon the death of the insured. Permanent insurance is distinguished from term insurance in that the policy contains a cash value or investment component. Insurance products are designed in very imaginative configurations sometimes using a combination of different financial products. Each policy should be carefully analyzed for intricacies to avoid a misunderstanding of the benefits and restrictions before negotiating these issues in a divorce.
All term policies are not created equal. There are significant differences in term policies. Be certain to understand the exact nature of the term policy in question.
Term insurance is often referred to as pure protection. There is no accumulation of cash value. Some people refer to term insurance as temporary protection. Term insurance policies are sold for a specific term of years (e.g., 10 year term). The premiums may remain constant as in level term policies or the premiums may increase substantially with the age of the insured. this factor can be of critical significance for older parties in a divorce action.
Before the creation of guaranteed level term insurance, a very popular form of term life insurance was known as annual renewable term (ART) or yearly renewable term (YRT). This type of policy provides for the right to renew the insurance contract on a yearly basis without proof of insurability. The rate, however, increases as the insured's age increases.
Typically, an ART or YRT policy will set a guaranteed premium which provides a maximum premium for the insurance at a specific age. The spread between the current projected premium and the maximum premium can be very significant.
Below is a representative example of current premiums for a $1,000,000 ART or YRT policy for a 40-year old, non-smoking male:
|Year||Current Premium||Guaranteed Premium|
The above rates were obtained from a popular website. Term insurance premiums vary widely.
If a policy is a level term policy, the premium is fixed and cannot be increased during the specific level period selected.
Rates are relevant to any discussion regarding the use of life insurance as security for spousal support and/or child support in a divorce. Depending upon the age of the insured and cash flow, it may not be practical in a divorce judgment to provide for security based upon the annual cost.
Rates may also be relevant to a discussion relative to the value of a life insurance policy. If the replacement cost of a comparable term policy is substantially higher than the cost of the existing term policy, that factor may be relevant to the valuation question.
Most term policies include the right to convert the policy into a permanent policy without proof of insurability at a predetermined premium rate. This right can also be a very valuable right in that term policies expire at the end of the term and term policy premiums typically increase with the age of the insured unless the policy is a level term policy. The right to convert the policy to permanent insurance may allow the owner to keep the policy in force by converting the policy to a permanent policy and fixing the premiums. The purchase of permanent insurance may be the only practical way to maintain a policy of life insurance in later years in that the cost of term insurance in later years may become prohibitively expensive.
Permanent insurance falls into three general categories: whole life, universal life and variable life.
Whole life insurance premiums remain level. Whole life insurance policies have a base cash value that can be determined by reviewing the internal policy tables. The rate of the increase in the cash value is predetermined assuming the annual planned premium is paid. Some policies also pay an annual dividend. The owner of the policy selects one of several dividend options. The owner may receive the dividends, use the dividends to reduce the premiums, accumulate a dividend fund or purchase additional blocks of life insurance referred to as paid up additions. Cash value is defined as that portion of a life insurance policy equal to the accumulated premiums plus any earnings on the accumulated premiums less all expenses for the cost of insurance and administration.
Universal life policies provide the owner of the policy flexibility relative to several issues. The death benefit can remain constant or increase over time. The owner can determine within certain limits the amount of premiums paid, the frequency of payments and the duration of the payments. The insurance company deducts from the premiums an amount sufficient to pay for the insurance and administrative costs. The remaining portion of the premium is accumulated in the cash value account of the policy and increases in value based upon the returns on the investments of the insurance company. The return on the excess premium in a whole life policy is based on the company's declared dividend rate and the cash value schedule, but the return on a universal policy is a constantly changing rate tied to short term money rates, typically with a minimum rate of return.
Variable life policies can be either whole life or universal life and provide the owner of the policy with the opportunity to invest the cash component of the policy in one of several different investment options (bonds, growth stocks, high tech stocks, value stocks, etc.), somewhat like the traditional menu of investment options for a 401(k). The cash value changes with the performance of the investments selected.
The owner of a permanent policy can generally borrow the majority of the cash value from the policy. The amount of any policy loan should be confirmed with the insurance company before negotiating the award of the policy in a divorce. Outstanding policy loans bear interest at the policy contractual rate. The existence of, or amount of, any policy loan cannot be ascertained from reviewing the policy itself. This information is available from the agent or the life insurance company. The existence of a policy loan can materially impact the overall performance of a permanent insurance policy.
Permanent Insurance Valuation in Family Law
The reported family law cases deal with permanent insurance in a very basic manner. It would be error to analyze a permanent policy based only on the analysis set forth in any one of these family law cases.
In most situations, a permanent life insurance policy should be valued at the net cash value of the policy (i.e., cash value plus any dividends less any policy loans). In Re Marriage of Holmgren (1976) 60 CA3d 869.
Some permanent life insurance policies have a surrender charge. The amount of this surrender charge generally decreases with the age of most policies. The value of the policy, for family law purposes, should not be decreased to reflect this surrender charge. The surrender charge may never be paid in that the policy may remain in force long enough for it to be eliminated per the terms of the policy. A potential surrender charge is not immediate and specific unless the policy is being surrendered. Frequently, cash value refers to the cash value of the policy before the surrender charge. Net cash value often refers to cash value of the policy less the surrender charge. The issue is similar to real estate commissions being deducted from the value of real property only if the real property is to be sold. In Re Marriage of Stratton (1975) 46 CA3d 173, and In Re Marriage of Drivon (1972) 28 CA3d 896.
Ina family law matter, the policy value should be reduced to reflect potential tax only if the tax is immediate and specific. In other words, if the policy is not being cancelled or surrendered, there should not be a reduction in value to reflect any potential tax in a divorce. The tax is not immediate and specific. In Re Marriage of Fonstein (1976) 17 CA3d 738.
In a family law matter, the policy value should be more closely analyzed if the insured has experienced health problems or if there exists another issue that could bear on the insured's insurability. The insurability is not as simple as whether the insured is insurable or not insurable as it has been addressed in several appellate opinions. Insurance is frequently available at a wide range of premium levels depending upon health related issues ranging from preferred to standard to rated.
Additionally, it should be understood that the premiums charged to insure a 30-year-old are very different than the premiums charged to insure a 60-year-old. The difference in the premiums may affect the desirability of being awarded the policy. A client will probably not want to be awarded a policy in a divorce that carries with it a premium that is not affordable.
The amount of the life insurance premium may also impact the value of the policy itself if the insured can now only purchase a similar policy at a rated premium due to health issues.
Assume that the community has paid the premiums on a $1,000,000 whole life insurance policy for 30 years, the cash value is $100,000, the annual premium is and has been $8,000 per year. A similar policy purchased today (30 years later) might have a premium of $40,000 per year. One policy requires an annual payment of $8,000 and the other requires an annual payment of $40,000. The only difference is a cash value of $100,000. Could this set of facts result in the value of the older policy being a value in excess of the cash value? The analysis would involve many factors including, but not limited to, the tax basis of the policy, the projected return and the investment options of the $100,000, etc.
Term Insurance-Valuation in Family Law
The reported family law cases are inconsistent in their treatment of the valuation of term insurance. The inconsistency appears to be, in part, the result of lack of a basic understanding of term insurance contracts.
The court in In Re Marriage of Lorenz (1983) 146 CA3d 464, 468, held that term life insurance was not property for family law purposes. The Lorenz court reasoned that term life insurance is not property in that it does not have cash value. The family law court concluded that term life insurance only has value after the death of the insured and thus is not divisible in a family law matter.
This court's reasoning does not appear to be consistent with community property theory. A term policy may very well have value to a third party or a "life settlement firm." The insured may be uninsurable or may be insurable only at surcharge rates. The policy may simply carry a lower annual premium payment than a policy purchased at the insured's current age. Any of these issues could create value in the existing contract.
This court stated, "However, unlike whole life insurance, term life insurance is generally accepted as having no value, since once its term has expired it is worthless." In Re Marriage of Lorenz (1983) 146 CA3d 464, 469. The court does not provide support for its statement. At the expiration of a specific term (e.g., one year), the renewability guarantees of many policies allow for insurance to be renewed for additional terms (e.g., a series of one-year terms). This right is certainly not a worthless right in a divorce if the insured is no longer insurable.
The court in Modern Woodmen of America v. Gray (1931) 113 Cal.App. 729, 754 held that term life insurance was divisible property in a divorce action. In this case, the insured obtained insurance during his first marriage at the age of 42. When he married for the second time, he was 67 years old and would have been ineligible for insurance under the age requirements of many policies.
"It was only by virtue of his having obtained the certificate of insurance prior to his marriage to [the second wife] and his having regularly paid the premiums thereon in the meantime, that he was entitled to continue to enjoy the protection afforded by the certificate. While the right of his beneficiaries to receive the proceeds of the policy was dependent upon his continuing to pay the accruing premiums thereon, nevertheless he had acquired the right to have the contract of insurance continued in force by virtue of the payment of premiums from its issuance to him in 1899 until the date of his second marriage in 1923. This was a valuable right in the eyes of the law and it would be unreasonable to hold that the payment of the premiums after 1923 from community funds would convert the entire proceeds of the certificate of insurance into community property." Modern Woodman of America v. Gray (1931) 113 Cal.App. 729, 732.
The court concluded that where life insurance is paid partly with community funds and partly with separate funds, the proceeds of the policy should be apportioned in a divorce in the same ratio that the amount of community funds paid for premiums bears to the amount of separate funds paid.
The court in Biltoft v. Wooten (1979) 96 CA.3d 58, held that group term life insurance was divisible property. The action was one between the insured's daughter and his former wife. The court determined that the proceeds were to be apportioned between the community and separate property in a family law matter in the same ratio that the amount of premiums paid from the community property bore to the total premiums paid, even though the policy had no cash value. Group life insurance is insurance purchased at group insurance rates and incident to employment. This court rejected the argument that each premium payment constituted a completely new insurance contract. The court stated, "These benefits were derived from the contract which had its inception during the marriage and were preserved by the payment of the premiums out of community funds during the nearly 20 years of the marriage." Biltoft v. Wooten (1979) 96 Cal.App.3d 58.
The court in In Re Marriage of Gonzales (1985) 168 CA3d 1021, held that term life insurance was property. Gonzales addressed the issue of valuation and suggested that a court should examine face value, the amount of the premium, the insured's life expectancy, whether the policy is convertible to whole life insurance, the replacement cost and when, if ever, the policy vests and is deemed fully paid. Gonzales acknowledged that a term policy is difficult to value, but reasoned that this factor does not prevent the policy from being property in a divorce subject to valuation and division.
The court reasoned that the fact that the insured spouse could not have obtained new term insurance coverage at comparable rates required the insurance contract to be classified as property.
The court clearly explained its logical reasoning relative to the reference to replacement value. "[I]n Markey, California Family Law, Practice & Procedure, Section 24, - 45 [e], pages 24-25 and 24-26, the author notes 'Although there are no cases on the subject, it could be argued that policies are worth more than their cash surrender value, or in the case of term insurance, more than nothing, based upon their replacement value. Replacement value may be significantly higher than cash surrender value in situations where the insurability of the insured is lessened because of advancing age or declining health and the existing policy cannot be canceled or contains a guarantee of insurability.'" In Re Marriage of Gonzales (1985) 168 CA3d 1021, 1023.
The court in Bowman v. Bowman (1985) 171 CA3d 148, addressed the insurance issue in a missed asset case. The court reversed the divorce court and ordered that Mr. Bowman's first wife was entitled to 50% of the community interest in the group term life insurance policy as it existed on the date of separation. The policy had been paid for, in part, by Mr. Bowman's employer and in part by his earnings. The case did not reference any insurability issues.
"[T]herefore, the trial court must decide what life insurance benefits, if any, Rudy would have been entitled to had he terminated his employment at the date of separation. That percentage, if any, will constitute the community property portion of the life insurance proceeds. Celia's interest will be one-half." Bowman v. Bowman (1985) 171 CA3d 148, 161.
The court in Estate of Logan (1987) 191 CA3d 319, stated, in dictum, that term life insurance is property where the insured dies or becomes uninsurable at a time that was covered by a premium payment made by the community. The Logan court reasons that each premium payment is buying a new insurance contract. Thus if the policy was a yearly renewable term policy then each year would generate a new insurance contract.
The Logan court suggested that the factors listed in Gonzales relative to valuation were of questionable relevance. Logan suggested that the divorce court should look to the actuarial present value of the policy taking into consideration the shortened life expectancy of the insured.
The Logan court criticized Gonzales harshly in a number of areas. In footnote Eight, the court attacked the Gonzales list of factors that might be considered in valuing a term life insurance policy in a divorce. Logan was correct in stating that the reference in Gonzales to vesting and to the issue of whether the policy was deemed fully paid were errors. These concepts are not applicable to term life insurance. Term life insurance policies do not vest and they are never fully paid. However, the other factors referenced in Gonzales, such as: face amount, premium amount, life expectancy, convertibility options, and replacement cost could very well be relevant.
The court was specifically critical of the replacement cost reference. The court noted that the amount of the premium is a function of the age of the insured and the amount of coverage. It failed to fully understand the nature of the insurance contract. Its thinking relative to insurability and premium levels was wrong. All insurable individuals are not necessarily offered the same premiums for the same policy. As stated above, an individual is not simply insurable or uninsurable. Insurance companies offer different rates for different individuals based upon specific risks related to health.
In footnote Nine, the court addressed the issue of convertibility and implied that the feature is not overly significant. The court failed to understand the issue. The feature is very significant when the insured is uninsurable, insurable at surcharged rates, or at an age when term insurance may not be available.
The court continued its misunderstanding of insurance contracts when it stated, "With respect to the element of the right to renew coverage for additional terms, term life insurance has either a significant value or no value at all." In Re Marriage of Gonzales (1985) 168 CA3d 324.
The right to renew may have a value of zero, may be significant, or may be valued somewhere between those positions. Again, the issue is not so simplistically stated. The value is a function of the health condition and age of the insured as they relate to the premium that would be quoted to purchase insurance in the insured's circumstances at the later date.
The Logan court hinted that its reasoning may have been influenced by the belief that allowing term life insurance to be given the full status of property like other valuable assets would place a "roadblock in the way of simplified dissolution of marriage,…" In Re Marriage of Gonzales (1985) 168 CA3d 323. The court continued stating that fully addressing the issue would increase the cost of a dissolution by requiring each side to hire expert witnesses.
The court seemed to find it acceptable due process to deprive a party of a valuable right as a result of the potential cost of producing the appropriate evidence at the divorce trial. This analysis is inconsistent with family law principles. Interestingly, in many cases, the evidence might be simply presented to the family law court with the testimony of an experienced life insurance agent or the testimony of an agent from a life settlement firm. The cost to parties in a divorce could be minimal.
In 1985, the Gonzales court addressed the same issues raised in 1987 by Lorenz. "Why, then, should term life insurance be labeled a mere expectancy rather than property divisible upon divorce? If ease of valuation has something to do with the definition of divisible community property, as Lorenz suggests, the Mona Lisa could not qualify, because it is literally priceless. Yet it would be ludicrous to suggest such property should be awarded to one spouse without a corresponding credit to the other, however arbitrarily determined." In Re Marriage of Gonzales (1985) 168 CA3d 1025.
It appears that the Gonzales court was suggesting the use of an actuarial present value calculation using the factors listed. Except for the two factors listed above, the other factors listed by the Gonzales court could be relevant to a valuation based upon an actuarial present value calculation.
The court in In Re Marriage of Spengler (1992) 5 CA4th 288, held that term life insurance was property if the insured died during a period for which the premiums were paid with community funds. The Spengler court focused on renewal rights. It questioned whether a renewal right could be classified as property within the context of a family law matter. It suggested that the issue would be determined by answering the question: Is the right a contractual right or a mere expectancy. The term insurance policy in Spengler was a group term policy provided by the insured's employer. The Spengler court agreed with Logan's holding that an employment-related term life insurance policy is not a community property asset after the expiration of the term acquired with community funds/effort. However, Spengler disagreed with Logan's dictum, finding an exception where the insured becomes uninsurable during the marriage.
The court reasoned that the existence of the coverage depended on (1) continued employment and (2) the employer's continued willingness to provide for the coverage. The court emphasized that without a contractual right to the continuation of the coverage, the insured employee had no enforceable right relative to the coverage and, thus, the renewal right was a mere expectancy. The court acknowledged that, while the renewal right may have value, the characterization as a mere expectancy prevents the right from being characterized as property subject to division in a family law matter.
It would appear that this holding should, at least, be limited to family law cases involving (1) group term life insurance, (2) provided by an employer, (3) wherein the employee-insured has no contractual right to remain insured. Thus, a different result should occur if the policy is a private term insurance policy or a policy provided only in part by the employer or where the benefit is part of an employment contract (express or implied).
However, even in the set of facts that existed in Spengler, the court's reasoning seemed flawed for several reasons. Often the insured employee has a right to convert the term insurance to a private plan at the termination of employment or at such time as the insurance is terminated. It would seem that the existence of that conversion right would satisfy the court's objections related to the issue of mere expectancy.
In summary, one could argue a number of different positions relative to the value of a term life insurance policy in a divorce. Consideration of all the factors addressed above will result in a better reasoned analysis. Blindly following any one of the reported family law cases could result in a failure to properly represent a client. Woven into the reported opinions are long threads of flawed logic and a misunderstanding of the life insurance contract. Consultation with a life insurance professional is advisable in many, if not all, cases.
Family Law and Life Settlement Firms
Consulting an agent or a life settlement firm may assist in valuing an insurance policy (permanent or term) in a divorce. Life settlement firms buy existing policies. The value of a policy to a life settlement firm is quite arbitrary. If a policy is to be sold to such a firm, bids should be obtained from multiple firms and negotiations should be anticipated. These firms purchase life insurance policies from insureds who no longer have a need for insurance or from insureds who have medical issues that shorten their life expectancy and who have a need for immediate money. Conning & Co., a market research firm, estimated in their 1999 study that 75% of all term insurance policies insuring individuals over the age of 65 may be eligible for a life settlement purchase. The sale of the policy could also be useful to generate cash to the community, simplify the valuation question, and create more settlement possibilities in a divorce.
Financial Stability of Insurance Company
Analysis of the financial stability of a life insurance company itself may be important to a party in determining whether to seek the award of a policy in a divorce. Companies are rated for financial stability by A.M. Best and other services. Although governmental agencies do provide insurance to safeguard a portion of certain life insurance policy benefits, the bankruptcy of an insurance company could be a disaster for a client who was awarded a life insurance policy. The difference in premiums between a high investment quality company and an unstable company is usually not significant. Considering the risks, one should always insist on buying a policy issued by a company with an A.M. Best rating of "A" or above. If your client is being awarded a life insurance policy, care should be given to assess the financial stability of the insurance company. The ratings range from "A++" to "F." Note that all rating services differ in their rating categories. Other services rate insurance companies with top ratings described as Superior "AAA" or Excellent "AA." Between 1984 and 1993, an average of 70 insurance companies failed annually. While the failure of the insurance company is a major concern, the company's overall financial health is also relevant to the performance and return of some permanent policies which is a very relevant factor in deciding whether to seek the award of a policy in a family law matter.
Policy Splitting in a Divorce Settlement
An alternative to valuing a policy in a divorce is splitting the policy into two, separate and equal policies. Some insurance companies will agree to divide a policy. However, if the insurance agrees to split the policy, care should be given to confirm that the two policies are truly equal relative to cash value, terms, tax basis, etc. The splitting of a policy is typically easier if the policy is term insurance as opposed to permanent insurance. The practitioner should consult with the insurance company prior to proposing the splitting of a policy in a family law judgment to confirm the insurer's willingness to accommodate the request. Many policies cannot be split.
Family Law Spousal Support
Family Code Section 4360 provides the family law court with the authority to order a payor spouse to maintain the recipient spouse as a beneficiary to life insurance insuring the payor's life. The purpose of the insurance is to provide for the replacement of spousal support if the payor dies at a time when there remains a spousal support obligation.
"(a) For the purpose of Section 4320, where it is just and reasonable in view of the circumstances of the parties, the court, in determining the needs of a supported spouse, may include an amount sufficient to purchase an annuity for the supported spouse or to maintain insurance for the benefit of the supported spouse on the life of the spouse required to make the payment of support, or may require the spouse required to make the payment of support to establish a trust to provide for the support of the supported spouse, so that the supported spouse will not be left without means of support in the event that the spousal support is terminated by the death of the party required to make the payment of support.
(b) Except as otherwise agreed to by the parties in writing, an order made under this section may be modified or terminated at the discretion of the court at any time before the death of the party required to make the payment of support." Family Code §4360.
The level of insurance provided pursuant to Family Code Section 4360 should bear a reasonable relationship to the actual support obligation itself. In determining the amount of insurance, consideration should be given to a present value calculation of the stream of support payments and potentially to any tax savings to be experienced as a result of receiving life insurance proceeds as opposed to taxable spousal support depending upon the structure of the family law order.
Consideration should be given to transferring ownership of the insurance policy to the recipient spouse in a family law judgment. This transfer would not be taxable to the recipient per Internal Revenue Code Section 1041 if done incident to the property division and so long as there is not a violation of the complex transfer of ownership rules, which basically provide that the insured must live for three years after the transfer itself occurs. If the recipient spouse is the owner of the policy at the death of the insured spouse, the insured spouse's estate clearly will not incur any tax. Transferring the policy to the recipient spouse allows the recipient spouse to exercise all incidents of ownership of the policy and avoid concerns about the timely payment of premiums.
If the insured spouse is the owner of the policy, then the policy proceeds will be taxed to the insured's estate under Internal Revenue Code Section 2042. However, the estate would receive a credit due to the support obligation under Internal Revenue Code Section 2053 and there would be no net tax due in that it satisfies the spousal support obligation.
Consideration should be given to establishing an ILIT where life insurance is being used as security in a divorce.
Security for Child Support
California Family Code Section 4012 provides authority for the court to require a parent to provide life insurance as security for child support. "Upon a showing of good cause, the court may order a parent required to make a payment of child support to give reasonable security for the payment." California Family Code §4012. The security is in addition to guideline child support. The same considerations set forth above relative to security for spousal support apply here. Consideration should be given as to whether the beneficiary should be the custodial parent, the child, an ILIT or a revocable trust. If a trust is to be the beneficiary, careful consideration should be given to the selection of an appropriate trustee and the other terms of the trust. If the child is the beneficiary, consideration should be given to the tax consequences to the estate of the payor spouse. The naming of the child as the beneficiary would have the effect of causing the face amount of the insurance policy to be includible in the insured's estate at death. (Internal Revenue Code Sections 2042 and 2031). This designation is generally not the best solution in a family law matter.
As discussed above regarding spousal support, the amount of insurance should bear a reasonable relationship to the remaining total child support obligation. Consideration should be given to the use of a decreasing term policy or several different layered policies of different terms and amounts to provide for decreasing amounts of coverage to take into consideration the fact that the total support liability decreases as the child's age increases. For example, the order could provide for a policy of $500,000 for ten years, a policy of $250,000 for the first five years, and a policy of $125,000 for the last three years.
Application for New Insurance to Satisfy Needs in a Divorce
Under California Family Code Section 2010(d), the court may order the obligor spouse to cooperate in the application for a new life insurance policy. This code section gives the family law trial court jurisdiction to make orders "that are appropriate concerning … [t]he support of either party."
"In a proceeding for dissolution of marriage, for nullity of marriage, or for legal separation of the parties, the court has jurisdiction to inquire into and render any judgment and make orders that are appropriate concerning the following:
(d) The support of either party." (California Family Code §2010(d)).
Beneficiary Designation After Entry of a Family Law Judgment
The effective way to revoke a beneficiary designation after the family law judgment is entered is through direct action between the policy owner and the insurance company. Do not rely on general boilerplate waiver language in the divorce judgment to revoke the designation. However, general language of waiver was held to effectively waive a prior beneficiary's interest in a policy in Life Ins. Co. of N. America v. Cassidy, (1984) 35 C3d 599, 608-609. Better practice is to provide for a specific waiver relative to a specific policy in the divorce judgment. Set out the name of the insurance company, policy number, and face amount of the policy. Additionally, the insured should complete the appropriate new insurance beneficiary designation form for each respective insurance policy.
Military Policies and Family Law
A life insurance policy issued by the United States government is characterized as the separate property of the insured spouse. Wissner v. Wissner (1950) 338 U.S. 655. The asset should be confirmed to the insured spouse without offset to the other spouse in the family law judgment. The Superior Court does not have jurisdiction over the asset due to the federal supremacy clause.
There are often questions about whether the community is entitled to reimbursement in a divorce if community funds are used to pay the premiums on a separate property policy of life insurance. Reimbursement should be determined on a case-by-case basis. Issues that should be examined include the following:
- Whether the policy is separate property.
- Whether the policy is a permanent insurance policy that was acquired prior to the date of the marriage.
- Whether the cash value increased in an amount in excess of the policy premiums during the marriage.
- If the policy is term insurance and the insured spouse died during the marriage, whether the proceeds would have been deemed community property.
- Who was the beneficiary during the marriage.
- Who wrote the premium checks. Whether there were any agreements between the spouses regarding the payment of premiums.
- Whether the premiums were paid with community funds.
A right to reimbursement might be found by analogy to the approved family law formulas set out in In Re Marriage of Moore (1980) 28 CA3d 366 and In Re Marriage of Marsden (1982) 130 CA3d 426. If community funds are used to maintain a separate policy, the community could receive reimbursement of all or part of the premium payments and/or a right to a pro tanto share of any increase in the value of the asset. The life insurance policy may have experienced an increase in the cash value and/or dividends. A life insurance policy may have experienced an increase in value due to the other factors related to the insured’s health or age.
In the appropriate case, it could be argued that the reimbursement should be equal to the amount of premiums paid, the amount of premiums paid plus interest, a portion of the cash value determined by a formula calculated to achieve equity under the specific facts of the case, a portion of the increase in the value of the policy, etc.
Policy Loans in a Divorce
Permanent insurance policies allow the owner of the policy to borrow a predetermined percentage of the cash value from the policy. The principal and interest on the policy loan are payable to the insurance company on predetermined terms. If the owner dies with all or a portion of the loan outstanding, the amount due will be deducted from the face amount of the policy prior to the payment of insurance policy proceeds to the beneficiary. For example, if the policy face amount is $1,000,000 and the insured dies at a time when the outstanding policy loan is $100,000, the proceeds payable to the beneficiary would equal $900,000. The amount of any policy loan is deducted from the cash value to arrive at the net cash value.
If an asset, existing as of the date of separation, was purchased with the proceeds from a policy loan taken against one spouse's separate life insurance policy, the asset could be characterized as that spouse's separate property in a divorce if the source funds can be traced and other tracing burdens are satisfied.
The existence of a policy loan can significantly impact the policy performance and original assumptions regarding the value of the policy. Careful expert analysis is needed relative to valuing permanent policies in family law when they have outstanding loans or policies that previously had policy loans.
Tax Deductibility of Premium Payments in a Divorce
Life insurance premiums payable pursuant to a family law court order "as and for additional spousal support" on a policy owned by the insured payor spouse designating the recipient spouse as the beneficiary are not tax deductible to the insured/payor spouse as spousal support. The insured/payor spouse has the incidents of ownership which prevents the deduction Rev. Rul 57-125, 1957-1 CB Stevens v. Commissioner (2) Cir 1971) 439 F2d 69.
If the owner of the policy and the beneficiary of the policy are the recipient of spousal support, the insurance premiums paid by the payor spouse are tax deductible if the payments are payable pursuant to a Court order as and for additional spousal support. Rev. Rul. 70-218, 1970-1 CB19. This rule applies to both term and permanent insurance policies. Private letter ruling 8710089 (12/11/86 released 3/6/87).
If a policy of life insurance is owned by an ILIT, the premiums payable as spousal support will not be tax deductible as spousal support regardless of what the family law court order says. The premium payments made by the payor spouse to the ILIT will be deemed gifts to the ILIT.
Income Tax and Family Law
To the extent that the cash or investment value increases to a value in excess of the tax basis of the policy, a potential taxable gain is created.
If the policy is cancelled or lapses prior to the death of the insured, any tax will be recognized by the owner. If the policy is cancelled at a time when the tax basis is less than the gross cash value of the policy and a policy loan exists, the owner could be faced with phantom income. In other words, upon cancellation or lapse of the policy, the owner could receive less cash from the policy than is owed to the federal and state taxing authorities.
As an example, if the gross cash value at the time of cancellation of a policy is $60,000 and the outstanding loan (principal and interest) is concurrently $50,000, the net cash value payable to the owner is $10,000. If the tax basis of the policy is $20,000, the taxable gain would be $40,000 ($60,000 less $20,000). Such a gain could have been created by an increase in the cash value based upon the internal investment of the policy cash value. The owner could then be taxed on $40,000 of ordinary income while only receiving $10,000 of actual cash from the insurance company.
Recognition of any unexpected tax would be a very unhappy surprise for a client who was awarded a policy in the divorce. Recognition of phantom income would be far less pleasant.
Before negotiating the award of a life insurance policy to a client in a family law matter, the practitioner should carefully investigate the cash value, outstanding loans and any tax consequences that would result from the ultimate cancellation of the policy.
A party could be awarded a $1,000,000 policy with a net cash value of $50,000 at a value of $50,000 only to later learn that a cancellation of the policy would result in substantial and unexpected tax that exceeded the $50,000 cash value.
Investigating any potential tax consequences relative to a life insurance policy is critical in the property analysis of a divorce.
Tax on Death – Proceeds Payable to Child of Marriage
If a spouse maintains a policy of life insurance on his life, being the owner of the policy and designating a child of the marriage as the beneficiary of the policy, the proceeds will be received by the child income tax free. However, the amount of the policy will be includable in the parent's estate and potentially subject to estate tax. The estate may not receive a deduction similar to Internal Revenue Code Section 2053 deduction available for payment to an ex-spouse. This fact should be understood before the family law settlement is negotiated.
ILITs and Family Law
The use of an Irrevocable Life Insurance Trust (ILIT) can be beneficial to both the payor spouse and the recipient spouse.
The recipient spouse has a desire to be certain that she receives the life insurance proceeds and the benefit of the family law judgment that was negotiated or ordered. If the life insurance policy is held in an ILIT, the owner of the policy will be the ILIT. The ILIT will have a trustee. The trustee will direct that the life insurance proceeds be paid to the beneficiary of the trust. The recipient spouse will thus be guaranteed to receive the directed portion of the insurance policy proceeds. The payor spouse will not have the power to change the beneficiary. The trustee can be directed by the trust terms to notify the beneficiary if the policy premiums are not paid and, thus, avoid any policy lapse.
If the life insurance policy is owned by an ILIT, the payor spouse will have no control over the policy and, thus, will have no incidents of ownership. As a result, upon the death of the insured, the insurance proceeds will not be included in his estate.
Incidents of ownership refer to the power over decision making regarding a life insurance policy relative to such matters as changing the beneficiary designation, the right to cancel the policy, the right to obtain a policy loan, etc.
If the ILIT is the owner of the policy, the payor spouse may want to negotiate in the divorce settlement, prior to the formation of the ILIT, terms that provide that the amount of insurance proceeds payable to his former spouse will never exceed the outstanding spousal support obligation and that any excess proceeds shall be payable to his church, children, etc.
Parties frequently purchase life insurance in an ILIT during the marriage as an estate tax tool. This trust is not a community asset. It is an irrevocable trust. Typically one spouse is the insured and the other spouse and/or minor children are the beneficiaries of the trust. The trust is the owner of the policy. The ILIT generally is established as a part of an estate plan. At the time the ILIT is established, the parties typically are not planning on a divorce. The family law court will not have jurisdiction over the asset. The asset will not be awarded to either party in a divorce.
If the policy owned by the ILIT is permanent insurance with a substantial cash value, the non-beneficiary spouse may feel that the other spouse has received a substantial windfall.
Care should be given to analyze the terms of the ILIT to determine whether the language of the trust provides for any remedies to the insured spouse. Does the language relative to the description of the beneficiary open the door to a probate petition? Is there any trust language that provides for a modification of the trust in the event of unforeseen circumstances? Does a divorce constitute (or amount to) such a circumstance? If the terms of the trust provide potential benefits to the beneficiary spouse prior to the insured's death relative to invading the policy cash value for specific purposes, could those rights be valued as a community asset?
If policy premiums are not paid on the insurance policy owned by the ILIT, the policy will simply lapse. If the policy is permanent insurance with substantial cash value, the cash value can be used to pay the premiums until it is exhausted or, alternatively, the cash value can be used to pay for a reduced amount of paid up insurance.
Second To Die Policies of Divorce
Insurance companies issue so-called second to die or survivorship policies. Some insurers structure this arrangement in a second insured rider. Always check to determine a policy's riders and limitations. These policies are designed to provide that the insurance policy proceeds are paid on the death of the last of the two to die. These policies are typically used in estate plans. In a divorce, this type of policy can be awarded to either party. The value should be addressed in a divorce in a manner consistent with the comments set forth herein. Insurance companies are not likely to divide these types of policies between the parties.
Some insurance policies are sold with a disability waiver. The waiver may be included as a rider to the policy for an additional fee. The owner of a policy is relieved of paying the premiums of the policy if the insured becomes disabled. If such a rider exists this can be a valuable right relative to a large policy of permanent insurance if the insured is disabled. Such a rider could impact the valuation of the policy and decisions relative to a family law settlement.
Split-Dollar Life Insurance
Split-dollar life insurance is an asset that may be easily overlooked in a family law matter. The insured may fail to disclose the asset, may simply not recall its existence, or may even fail to recognize it as an asset. Split-dollar life insurance is an executive benefit. Formal discovery may be needed to determine the existence of this and other executive benefits. The split-dollar concept has two different structures. Both concepts have the employer and the employee splitting the cost of the premium and splitting the cash value or policy proceeds. In one scenario, the employer is the owner of the policy and it assigns a portion of the policy proceeds to the employee. In the other scenario, the employee is the owner of the policy, where the employer loans the premiums to the employee, which are repaid in one of several different methods. The employer is assigned a portion of the cash value or policy proceeds. The laws were changed in 2003 to make these arrangements less beneficial to the employee. These policies should be analyzed carefully to determine the community interest and the value.
Reservation of Jurisdiction
Consideration should be given to using specific language providing for continued divorce court jurisdiction over all issues pertaining to insurance provisions. If jurisdiction is not reserved, the family law court may not have the power to address issues and resolve disputes in the future.
As an example, if the family law judgment provided that the payor spouse was to maintain the recipient spouse as the beneficiary to a specific policy of life insurance and that the recipient was to pay the insurance premiums and later it was learned that the specific policy was not owned by the insured spouse but rather a corporation that employed him, the divorce court may not have the power to make new orders or may not be inclined to do so. The problem would be simplified with proper verification of the ownership of the policy prior to the entry of the family law judgment and/or specific reservation of jurisdiction language.
If the family law judgment provided that the payor spouse was to maintain (other than as part of a spousal support order) the other party as the irrevocable beneficiary on a specific policy of life insurance and it was later learned that the policy was a group term life insurance policy that had been cancelled by the employer and replaced with a new and different policy, the family law court may not have jurisdiction to make orders regarding the new policy without continued jurisdiction.
Drafting Tips in a Family Law Judgment
Family law Judgments frequently provide generally that the payor spouse is to provide for life insurance, but do not specify the details of the obligation. In order to avoid potential litigation after the death of the obligor spouse, care should be given to be very specific about which insurance policy is to be used as security. The name of the insurance company, policy number, face amount, and owner should all be referenced in the family law judgment. Current records from the insurance company should be reviewed to confirm the existence of the policy, the details of the current status of the policy, the existence of any policy loans, etc.
If a spouse becomes the owner of a policy of life insurance insuring the life of the other spouse at a time when there is an insurable interest, a family law court cannot order the owner spouse to terminate the policy after the support obligation ends and insurable interest ceases to exist unless jurisdiction is specifically reserved for this issue. If the insured spouse objects to the former spouse owning a policy after the support obligation terminates, consider seeking a divorce court order that limits the duration of the policy specifically to the term of the existing spousal support order or to the period when an insurable interest exists. Care should also be given to reviewing the convertibility provisions to prevent the former spouse from converting a term policy to a permanent policy if the insured objects to continued coverage. The use of an ILIT with the appropriate language could also address this issue in the family law judgment.
If the life insurance that is to serve as security in the family law court order is group term life insurance provided through the insured's employment, attention should be given to enforceability of such an order if you represent the beneficiary spouse. Enforcement of orders relative to employee group term life insurance is controlled by the terms of Employee Retirement Income Security Act. (29 USC §1144(a)). The Employee Retirement Income Security Act requires that the order take the form of a Qualified Domestic Relations Order for enforceability. [(29 USC §1056(d) and IRC §414(p)]
If the life insurance is group term life insurance, provide in the divorce court order for the probability that the employer will switch insurance companies several times during the term of the coverage and for the probability that the insured will change employers. Provide that the insured shall maintain the former spouse on the specific existing policy and all future replacement policies.