Introduction
We’ve written in the past about the mistakes agents and clients can make related to personal or business life insurance.
It’s time to revisit that list because several court decisions and rulings in the recent past highlight the consequences of such errors. We have not made any changes to the items on the list but have added updated examples of real-world problems created by failure to address the oversights.
The mistakes generally have two things in common. First, each has potentially serious consequences in terms of expense and aggravation. Second, each can be avoided or, if found in time, corrected quickly and inexpensively.
Who profits from these mistakes? In some cases, it’s the IRS. In others, it’s the probate courts and probate lawyers. In still others, it’s the insured’s creditors.
Who loses when the mistakes are made and not corrected? In most cases it’s the group the insured cares most about—close family members, business partners, friends, and charities. If those close to the insured feel they’ve been cheated because of oversight and neglect on the part of the agent, at best they’ll feel less inclined to continue to work with that professional. At worst, they may be able to successfully sue the agent for substantial damages.
For insurance and other financial service professionals, it is imperative to be alert to spot these life insurance mistakes—whether they are made at the policy’s inception or develop later on.
Mistakes Made During the Process of Buying Life Insurance
Mistakes in Beneficiary Designation
The single biggest category of common life insurance mistakes is related to beneficiary designations. While the beneficiary errors discussion centers around life insurance, each of the beneficiary designation observations could also apply to some extent to pension accounts, IRAs, or nonqualified annuities.
MISTAKE 1: THE INSURED’S ESTATE HAS BEEN NAMED BENEFICIARY
Few life insurance applications explicitly name “estate of the insured” as the beneficiary of the death benefit. However, most life insurance companies default to the insured’s estate when no specific beneficiary is listed.
If the decedent has no valid will at the time of death, the intestate rules of the state of residence at the time of death will dictate who will be entitled to the death benefits at the end of the probate process. Will the state’s default provisions match the decedent’s intentions? In many cases the answer will be no.
If the estate is the beneficiary, the access of the heirs to any money associated with the financial product is delayed because the money must go through probate. With probate, in some cases, the delay can be a year or more.
Any asset forced through the probate process becomes part of the public record, so privacy is lost.
Perhaps most importantly, in most jurisdictions the life insurance death benefit payable to the estate becomes subject to the claims of creditors of the decedent’s estate—a situation that does not exist where there is a named beneficiary.
In an appeals court decision from Arizona, Woerth v. Reese (In re Estate of Tobin), 250 Ariz. 104, 475 P.3d 1144 (Ct. App. 2020), making the estate the beneficiary of a life policy allowed the decedent’s creditors to have access to the death proceeds.
The court’s decision turned primarily on the language of Arizona Revised Statutes Section 20-1131(A):
If a policy of life insurance is effected by any person on the person’s own life or on another life in favor of another person having an insurable interest in the policy, or made payable by assignment, change of beneficiary or other means to a third person, the lawful beneficiary or such third person, other than the person effecting the insurance or the person’s legal representatives, is entitled to its proceeds against the creditors and representatives of the person effecting the insurance.
The appeals court decided that since there was no named beneficiary in this case—but that the insured’s estate was the default beneficiary instead—the protection provided by Arizona law was not available. Therefore, the decedent’s creditors could claim access to the life insurance proceeds.
MISTAKE 2: THE POLICY HAS NO NAMED CONTINGENT BENEFICIARIES
A substantial percentage of life insurance applications have no named contingent beneficiary or beneficiaries.
Why is that a problem?
If no contingent beneficiary is named, and if the primary beneficiary has predeceased the insured, in most cases the insured’s estate will be the default beneficiary. That leads to all the drawbacks described in mistake 1.
The best practice, in our opinion, is always to name contingent beneficiaries. Some more sophisticated producers even go so far as to name a second set of contingent beneficiaries in case both the primary and contingent beneficiaries have predeceased the insured.
MISTAKE 3: MINORS OR OTHER IMPAIRED PERSONS HAVE BEEN NAMED BENEFICIARIES
One typical example of this kind of situation is where young parents name their minor children contingent beneficiaries under their life insurance policies. In the event both parents die unexpectedly while the children are still young, the minor beneficiaries will not be old enough to exercise legal control over the money. In most cases a court-supervised guardianship or conservatorship will need to be created for the benefit of the minors.
While a surviving parent generally automatically qualifies to be the guardian of the person of a minor, the same parent would not typically be guardian of the estate of the minor.
In the Tennessee appeals court case of Dunnivant v. Mitchell, APPEAL NO. 01A01-9310-CV-00473, 1994 Tenn. App. LEXIS 259 (Ct. App. May 11, 1994), the court was asked to decide if a guardianship proceeding was necessary for the surviving mother of two minor children. The court concluded that a guardianship proceeding was necessary because the children were entitled to collect more than $200,000 in life insurance proceeds as a result of their father’s death.
The process of creating a guardianship or conservatorship usually requires a legally responsible adult to file a petition with the court to seek permission to act. If family members are not in agreement with regard to who should act, the court proceeding could be contested. The cost of a family fight could deplete assets otherwise available for the minor.
Once selected by the judge, the guardian or conservator will have numerous duties and responsibilities with regard to taking care of all of the minor’s needs. The fiduciary will likely have to seek the court’s prior approval for many actions, increasing costs and creating delays.
What are the alternatives?
It is possible for the parents in this example to create one or more testamentary trusts inside their will or living trust documents. Then that trust may be named contingent beneficiary of the life proceeds. If no such trust has been created, the parents may decide to use a ready-made custodianship under the Uniform Transfers to Minors Act (UTMA).
Some clients will suggest an alternative shortcut and try to name the adult relative they have identified as the kids’ successor caregiver as the direct contingent beneficiary of the life insurance. That strategy might backfire if the named beneficiary decides to keep the money while failing to perform the desired task. There are a number of court cases involving situations where a life insurance beneficiary refused to keep an implied promise to take care of the minor children.
It is up to a professional agent to be the voice of caution when a client insists on pursuing a course of action that has inherent risks that the client has overlooked.
MISTAKE 4: THE BENEFICIARY LANGUAGE IS WRONG OR UNCLEAR
One of the advantages of having a named beneficiary of a life insurance policy is that the payment of the death proceeds to the beneficiary usually involves no drama.
What happens when the beneficiary designation is unclear?
In the Tennessee appeals court case of Stonebridge Life Ins. Co. v. Horne, No. W2012-00515-COA-R3-CV, 2012 Tenn. App. LEXIS 805 (Ct. App. Nov. 21, 2012), the parties ended up fighting over the insured’s intention with respect to a beneficiary change form.
The insured purchased life insurance in 1999, leaving the default beneficiary designations intact. The default provision was for beneficiaries to be paid in the following order:
- Surviving spouse
- Children
- Parents
- Insured’s estate
The insured subsequently married in 2000. After the date of the marriage, the insured sent a beneficiary change form to the insurance company which
- Expressly revoked prior beneficiary designations,
- Left the new primary beneficiary designation area on the form blank, and
- Named the insured’s mother the contingent beneficiary.
The insured’s mother and surviving spouse both claimed the proceeds. The appellate court determined that the trial court would need to hear evidence to determine the insured’s intent in order to decide who was entitled to the proceeds. The court proceeding added expense, delay, and uncertainty over the $75,000 death benefit.
Mistakes in Amount of Coverage Purchased
A professional agent needs to help a client decide how much coverage is needed to meet the client’s family and business objectives.
MISTAKE 5: FAMILY NEEDS ARE NOT ADEQUATELY ADDRESSED
Most of our clients and prospects never realistically calculate the true cost to maintain survivors’ standard of living. Perhaps the most important life insurance-related question to be asked is this: Is there enough liquidity to maintain the current lifestyle for a surviving spouse and other family members?
The amount of coverage is not the only issue that needs to be considered with regard to family needs. For many, a permanent insurance policy is designed to perform double duty—protect the family in the event of death and also provide the possibility of supplemental retirement income from the policy’s cash value. Where a life policy is designed to achieve both objectives, the agent needs to help the client pay close attention to the cash--value policy’s performance. When the client’s expectations are not met, the policy may fail, and the agent and carrier may get sued.
In the case of C&C Family Trust v. AXA Equitable Life Ins. Co., No. 14-CV-62 (N.D. GA Aug 28, 2014), a policyowner sued the agent and life insurance company when the policy failed to perform as expected. In 2005, pursuant to the requirements of a divorce decree, the insured established a trust to own insurance on his life. The trustee purchased a permanent policy through an agent from AXA. When the policy was delivered, the trustee asked the agent about the difference between guaranteed and projected policy performance. The trustee believed the agent represented that the policy was guaranteed to stay in force if the scheduled premiums were paid.
In 2012, AXA informed the policyowner that additional premiums would be required to keep the policy in force. The trustee sued over the unmet expectations.
While the ultimate disposition of this case is not clear, agents and carriers do not want their customers to be unhappy over policy performance. The best way to make sure permanent policies meet family needs is through regular, consistent, and objective communication.
Mistakes in Ownership
MISTAKE 6: THE WRONG OWNERSHIP IS CHOSEN FOR THE PROBLEM TO BE SOLVED
Sometimes the parties make a mistake about who should own a life insurance policy.
For example, questions often come up regarding proper policy ownership when the insured is a business owner. Many clients will prefer that their business be listed as the owner for the life policy. This is often done under the mistaken belief that the premium for a business-owned policy is income tax-deductible. Code Section 264 makes clear that the premium is not tax-deductible.
The error is compounded by the fact that if the business owns the policy—and if the insured client wants to have personal access to the policy’s cash or other lifetime benefits—there may be tax or practical consequences of moving money controlled by the business to the client.
The wrong ownership is also sometimes chosen when the parties are required to buy insurance as part of a divorce. Often, marital settlement agreements have provisions specifically related to life insurance or annuities.
Unfortunately, because many divorce attorneys are unfamiliar with how insurance products work, the direction given may be unclear or inadequate. For example, what if the settlement agreement contains the following language?
Husband shall maintain $500,000 of insurance in force on his life for the benefit of Wife.
Based on the foregoing language, who should own the policy on the husband’s life? Let’s say that the husband decides he should own the coverage. Should the wife be granted a collateral assignment against the policy? What are the consequences if the husband names a trust for his children’s benefit as beneficiary, instead of the wife? What if he fails to pay the premium and then passes away?
If the wife is named the owner instead, will she be able to keep the policy in force forever? How long must the husband be required to help her pay the premiums? Will she be required to eventually transfer the policy back to the husband?
Because of these types of ambiguities, an agent should take a proactive role in helping to decide on proper policy ownership for a divorce-related policy.
MISTAKE 7: THE OWNERSHIP CHOSEN CREATES A TAX PROBLEM
In general, if the insured owns a life insurance contract, the insured can name anyone he wants as the beneficiary of the contract, while still keeping the death proceeds income tax-free.
If a third party owns the contract, the third party must name itself the beneficiary of the policy. A mismatch creates tax trouble.
For example, say Ben’s company owns a life insurance contract on Ben’s life. The company names Ben’s wife the beneficiary of the policy’s death benefit. At Ben’s death, the death proceeds will be treated as a taxable distribution to Ben’s wife. See Golden v. Comm., 113 F.2d 590 (3rd Cir. 1940) and Revenue Ruling 61-134.
In a personal situation, assume Cathy owns a life policy on her husband Paul’s life. Cathy decides that in the event of Paul’s death, she doesn’t need the death proceeds. Cathy names their son Brandon as the beneficiary.
At Paul’s death Cathy will be considered to be making a taxable gift of the death benefit to Brandon. While that doesn’t expose the death proceeds to income taxes, it does make them subject to gift taxes. See Goodman v. Comm., 156 F.2d 218 (2d Cir. 1946).
In the modern estate and gift-tax environment, a gift-tax issue is not the end of the world for most clients. Most states do not impose a gift tax, and individuals have a $13.99 million federal estate and gift-tax exemption in 2025—meaning that most will not be affected by gift-tax drama. However, agents should be prepared to discuss the possible gift-tax consequences associated with third-party ownership.
The safest rule of thumb for the professional advisor is that if a third party owns a life contract, the same third party should be the beneficiary.
MISTAKE 8: SECTION 101(J) REQUIREMENTS HAVE BEEN NEGLECTED FOR A BUSINESS POLICY
Under Revenue Code Section 101(j)—created by the Pension Protection Act of 2006—life insurance death benefits payable in a business situation are income taxable.
The tax-free death benefit can be preserved by a business if proper notice and consent forms are obtained and if the employee has the kind of substantial connection to the business described in the Code. Under the language of Section 101(j), the notice and consent requirements must be fulfilled prior to the issuance of the policy. If the requirements are not met, the income tax taint on the policy appears to be permanent.
Because of the great risk associated with the new rules, we recommend that Section 101(j) procedures be followed in every case where there’s any chance a business might be thought to benefit directly as a beneficiary or indirectly from a life policy.
In Private Letter Ruling (PLR) 201217017, the IRS was asked to consider a case where the insured business owners of business-owned life policies had satisfied the notice and consent requirements of Section 101(j). Under the facts presented, the insureds had not signed any stand-alone notice and consent paperwork prior to policy issue.
However, the company-owned policies purchased under the facts of the PLR were designed to fund an entity purchase buy-sell arrangement. The insureds had signed a buy-sell agreement prior to policy issue obligating the insureds to apply for business-owned life coverage. The IRS ruled that under the facts of the PLR, the executed buy-sell agreement met all the notice and consent requirements listed in Section 101(j) of the Code, and thus the death proceeds payable in the future to the business would be tax free.
What is the lesson of PLR 201217017? Even though the IRS ruled in favor of the business owning the life insurance policies, it affirmed that the requirements of Section 101(j) had to be strictly complied with in order to preserve the tax-free death benefit. Professional agents should make it part of their process to secure the insured’s signature on a separate notice and consent form for every business owned life insurance case.
Mistakes Made After the Life Insurance Policy Has Been Issued
Financial professionals need to keep in touch with their life insurance customers after a policy has been sold because a change in circumstances may cause a problem later.
MISTAKE 9: BUY-SELL FUNDING POLICIES HAVE NOT BEEN PROPERLY REVIEWED
Even the best buy-sell life insurance funding arrangement can fail if the subsequently drafted buy-sell agreement leaves important issues unresolved. It’s up to professional agents to work as part of the team that includes business attorney and CPA to make sure buy-sell plans actually protect the business.
In the case of Lynn v. Lynn, 202 N.C. App. 423, 689 S.E.2d 198 (2010 N.C. App.), the owners of a company failed to make sure the insurance policies they owned integrated with their buy-sell planning.
Under the facts of the case, brothers Kenneth and Gregory were the owners of a company. They entered into a shareholders’ agreement under which the company would buy their shares in the event of either brother’s death.
Instead of having the business own and be beneficiary of the $750,000 contracts, the brothers opted instead for cross-purchase funding, with Kenneth owning the policy on Gregory’s life and vice versa. The policyowner was listed as beneficiary.
The brothers subsequently purchased additional insurance on their lives. Shortly after doing that, they each became the owners of the policies on themselves. They named personal beneficiaries on the policies—including the policies originally intended to fund the buy-sell obligation.
The messy fact situation became even more complicated when one of the brothers got divorced and the other brother subsequently died unexpectedly. The parties ended up in court arguing over who was entitled to the insurance proceeds and whether the ex-wife was obligated to transfer her shares of the business.
When a professional agent does a good job of helping a business-owner client with buy-sell planning, the life insurance is only part of the solution. Making sure the funding coordinates with sensible buy-sell terms—and that funding, agreement, and valuation method are updated as needed—are important parts of the process.
MISTAKE 10: POLICIES HAVE NOT BEEN REVIEWED AFTER DIVORCE (OR OTHER LIFE EVENT)
Every week a new court case seems to appear where an insured’s heirs are fighting over the beneficiary designation related to a decedent’s life policy. Many cases end up in court related to uncertainty in the insured’s beneficiary objectives after a divorce.
In Volk v. Goeser, No. DA 14–0747, 2016 WL 888859 (S.Ct. MT, March 8, 2016), the Montana Supreme Court was asked to decide if the named beneficiary or the insured’s children should receive more than $2 million of life insurance coverage. As part of the insured’s divorce, the divorce court ordered him not to change the beneficiary on his existing life policies, in order to protect the rights of his dependent children. In apparent violation of that court order, the insured subsequently named his sister the beneficiary of his life insurance policies.
After the insured’s death, the sister-beneficiary collected the death proceeds. When the decedent’s ex-wife found out, she sued to have the money turned over to a trust for the children’s benefit. The Supreme Court of Montana decided that the ex-wife’s request should be granted and directed the life insurance death proceeds to be turned over by the sister-beneficiary to be used for benefit of the insured’s children.
In the federal district court case of Am.United Life Ins. Co. v. Broatch, No. CV-13-00956-PHX-DLR, 2014 U.S. Dist. LEXIS 188005 (D. Ariz. Aug. 28, 2014), Deborah Broatch owned a $400,000 insurance policy on her life. When she divorced her husband Thomas in 2012, she executed a change of ownership form that was intended to transfer the policy to him.
Thomas simply filed away the form instead of sending it to the insurance company.
After Deborah died later in 2012, the company sent Thomas a death claim form—since he was still listed as beneficiary under the policy. During the process of trying to collect the death proceeds from the carrier, Thomas’s attorney sent in the previously unrecorded change in ownership form.
The insurance company recognized that Thomas might not be legally entitled to receive the death proceeds because
- The change in ownership form was not effective because it was not submitted to the company prior to Deborah’s death, and
- Arizona has a revocation-on-divorce statute that has the effect of removing a spouse as life insurance beneficiary if the parties divorce.
The carrier notified the contingent beneficiary—Deborah’s mother Lynda—of her potential right to collect under the policy. The company ultimately deposited the death proceeds with the federal district court, asking it to determine who was entitled to the death benefit.
The court determined that Thomas’s attempt to change ownership of the policy was ineffective, as it was not sent to the carrier prior to Deborah’s death. It also ruled that because the parties divorced after Thomas had been originally named beneficiary, Arizona’s revocation-on-divorce statute applied. The court concluded that Lynda—the contingent beneficiary—was thus entitled to receive the death benefit.
Inattention to detail ultimately led to litigation. Litigation is expensive from both a financial and an emotional perspective, and the result is uncertain. Would our clients, given a choice, be willing to put the decision about the ultimate payout of their life insurance death proceeds in the hands of strangers?
Conclusion
Clients expect financial professionals to get the client’s life insurance structured correctly. At the policy’s inception, that means making sure the policy is owned by the right party, the beneficiary designation is consistent with the client’s objectives, coverage is adequate, and tax objectives have been optimized.
After the policy is in force, the responsibility is to make sure the policy not only matches the client’s original intentions but also to adapt existing insurance to changing personal and business goals.
Not every life insurance agent is vigilant about avoiding the ten most common life insurance mistakes. For those who try to do things the right way, there’s an opportunity to find those prospects who haven’t been served well, fix the things that need to be fixed, and begin a mutually beneficial professional relationship.