Insurance Trusts: Avoiding Potential Negative Consequences of Lump Sum Payouts

Insurance Trusts Avoiding Potential Negative Consequences of Lump Sum Payouts

The primary purpose for buying a life insurance policy is to provide a large sum of money to tide over loved ones for an extended period after the person dies. Apart from property assets, life insurance policies are arguably people’s most important assets to protect their loved ones, especially minors, in the event of their death.

As such, life insurance is another key tool for estate planning. The lump sum payments associated with life insurance policies are a godsend for loved ones. But what if this is mismanaged and the nest egg dwindles in size? Not many people take the trouble or have the foresight to put in provisions to ensure that their beneficiaries can manage the lump sum payout that they will receive after someone’s death. This is understandable as no one really anticipates that their life insurance policies will kick in until much, much later.

Let’s illustrate this with an example: Say, a businessman dies suddenly in a car accident, leaving his wife as well as three children who are all minors. His life insurance policy will pay out a hefty $500,000, which should help to cover his children’s needs at least until they start working themselves.

Now, many people who get a lump sum payout have never received that amount of money before.  For some, the natural reaction is to start splurging on luxury items like sports cars or expensive holidays. They choose instant gratification, instead of stopping to think about more practical long-term issues such as setting some money aside for retirement or allocating for their children’s university education.

Meanwhile, there is always a chance that a person who receives the payout is inexperienced in financial matters, such as knowing the value of paring down existing debt with the new funds, or making investments that can help to grow the nest egg in the longer run. This also creates a potential danger that the person who receives the payout might be advised badly or taken advantage of by nefarious parties, and lose the nest egg altogether.

More levels of protection

To safeguard loved ones from such scenarios, the person can add another layer of protection to his insurance policy by establishing an insurance trust. He appoints a trustee to administer the assets held by the insurance trust and states the terms under which the assets should be administered. In other words, the terms of payments associated with the insurance trust are set by the person who establishes it.

In this way, an insurance trust essentially functions like a living trust, though the only asset assigned to it is an insurance policy. Importantly, payment is staggered over a period of time. It is not unlike an annuity (which is also a popular product sold by insurance companies). However, there is more flexibility with payments from an insurance trust as they can be targeted at important life stage moments of beneficiaries.

Another advantage of setting up an insurance trust is that it avoids the complications that arise if a person has an estranged spouse or children who are minors. If he did not establish an insurance trust, the insurance payout will typically be given to the living parent of minors in the absence of a legal guardian, even though the relationship may be strained or non-existent after years of estrangement.

Meanwhile, setting up an insurance trust can also protect beneficiaries from creditor claims in the event of death. While the beneficiaries are waiting for the deceased person’s will to be executed or probate to go through, the insurance trust can settle any loans in his estate, staving off creditors. This will give the executor of the Will some time and space to sell the person’s assets rather than having to do a forced sale at a lower realised price.

Finally, an insurance trust also allows a person to extend protection to his parents, siblings or even a charity of his choice. If they don’t establish an insurance trust, the insurance policy will follow the nomination. The holder of a life insurance policy can typically only nominate immediate family members. Combining all these factors, there is thus a strong case for people to consider insurance trusts, especially when their children are still young.

This article was first published in our newsletter, The Custodian Issue 19 on Oct, 2021. Click here to access our latest newsletter.

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