Trust departments are confronting substantial liability associated with the life insurance policies held by trusts under their management.

However, few banks recognize the potential liability they face. The stakes are huge, with a potential price tag of tens or even hundreds of millions of dollars.

At issue is the estimated $1 trillion in face value of life insurance policies held by irrevocable trusts.

Most of these policies were purchased to generate funds to satisfy federal estate tax liabilities. However, insufficient management of the policies and today's volatile insurance and financial markets have put the value of many policies at risk.

In addition, trust departments are solely responsible for managing assets in the best interests of the trust and its beneficiaries. If the policies under a trust department's control fall short, it will be difficult for banks and trusts to escape liability when beneficiaries contend that insurance policies were managed inefficiently.

Already, Crown Life Insurance Co. and New York Life Insurance have paid $50 million and $65 million respectively to settle lawsuits claiming vanishing premium fraud. In the suits, disgruntled policyholders contended that the insurers had promised that premium payments would end after a specific period. But when policies failed to perform as expected, insurers demanded additional premiums to keep policies in force. These consumer issues undoubtedly will spill over into trust management, and banks could be the focus of policyholders' wrath.

It is important to understand that trust officers at most banks and trusts lack the training to review or manage life insurance policies. In addition, over the past 15 years the life insurance industry has introduced a variety of products that make purchase decisions more complex.

Many trust officers try to minimize their liability by holding insurance policies from carriers with excellent credit ratings. However, it's just not that simple. The lawsuits being filed today are not claiming damages due to carrier failures; the basis for these lawsuits is policy performance.

Three scenarios most likely to expose banks and trusts to liability include:

*Failing to analyze the difference between vanishing premiums and level premiums.

*Holding inappropriate or obsolete life insurance policies.

*Failing to purchase enough life insurance for the premiums paid.

Beneficiaries and their attorneys could evaluate these issues to determine whether a policy has performed in accordance with its objectives.

One situation commonly overlooked by trust departments is adverse health ratings applied when a policy was first issued.

Assume that in 1988 an overweight nonsmoking male purchased a $5 million, 15-year level term policy owned by an irrevocable trust. Because he was overweight, the annual premium payment of $15,000 was 33% higher than the standard rate.

Now, seven years later, the insured - no longer overweight - would pay $10,000 annually for the same death benefit. Or he could maintain his premium at $15,000 but purchase $1.75 million in additional coverage.

When the insured dies and the trust begins distributing its funds, the beneficiaries review the policy and discover that the trust could have purchased $1.75 million in additional life insurance without increasing premiums. They decide to sue the bank or trust for mismanagement.

However, the beneficiaries do not seek $5,000 - the difference in annual premiums. They seek $1.75 million in damages - the difference in death benefit.

Considering that some banks manage as many as 4,000 trusts, the potential liability is staggering. This example represents one of the many potential issues banks and trusts confront.

However, today's prudent-investor laws provide these institutions with the ability to limit their exposure and liability - particularly if they obtain the necessary expertise to review the policies of each trust.

Banks and trusts can significantly reduce their exposure to liability through several steps.

Establish corporate policy. Banks should determine whether to absorb the cost of a policy review or pass the cost along to the trust. And if the risk associated with life insurance policies is too great to manage, they should get out of the irrevocable trust business.

Determine how often policies will be reviewed. Most banks review policies at least every two years.

Select an experienced insurance consultant or firm to assess the life insurance policies held by trusts. To keep the consultant's recommendations impartial, banks and trusts should prohibit consultants from selling life insurance policies to the trusts they evaluate.

Demand more service from insurance companies. Have them provide the ratings they receive from every service that evaluates them. Also, ask for information about the junk bonds and troubled real estate held in the company's portfolio as a percentage of its net worth.

Policy reviews can generate significant client good will. By conducting the reviews, banks and trusts help policyholders fully understand their specific policies, often for the first time.

The reviews also allow trust departments to demonstrate their active management of trust assets. Finally, reviews help banks and trusts reduce their exposure to liability.

It's a "win-win" situation for all parties involved.

Mr. Bernstein is president of Trustee Consulting Corp., a Chicago-based firm that advises on personal trust issues.

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