Risk Management: Protecting Assets When Home Ownership Is Transferred to
a Trust
December 2007
It is becoming more and more popular with
estate planning attorneys to try to reduce estate taxes on tangible property
by transferring ownership of that property from an individual to a trustee of
a trust.
by Jack Hungelmann
Corporate
4 Insurance Agency, Inc.
In the case of a residence ownership transfer, the former homeowner, the
"grantor" of the trust, is usually allowed to continue to reside at the residence
and use the personal property at his discretion for life. However, what may
be a good move for estate preservation from taxes exposes the entire estate
to some serious potential uninsured claims.
Bill and Mary's Story
Bill and Mary, in their mid-50s, have been through an estate planning session
with their attorney. He has recommended that they transfer ownership of their
$5 million in assets, including their $2 million home and their estimated $1
million in personal property including artwork, a sailboat, and canoe—to a trust
in their name. They follow his advice and do the deal. They appoint Mary's brother,
Joe, as trustee of the trust. No changes are made to any of the insurance policies.
The named insured listed on the homeowners and umbrella policies remains Bill
and Mary.
The following claims occur.
-
As the result of a defective electrical circuit, the house burns down,
destroying the building and all contents. The replacement cost of the property
is $3 million—the same as the insurance coverage. The insurance adjuster,
when delivering the $3 million check, requests a copy of the title. When
the adjuster sees that the title is in the name of Joe as trustee of the
trust and, on further investigation, discovers in the trust documents that
the household personal property is also owned by the trust, the adjuster
rips up the check.
The Reason? Neither the trust nor trustee
is an "insured" under the homeowners policy definitions. Therefore, the
trust property ownership of the home and personal property is completely
uninsured, and Joe and Mary probably will get paid only for the economic
value of their insurable interest—the additional living expenses for renting
a fully furnished home. The value of the estate including the trust assets,
however, has just been reduced by $3 million!
-
In the same fire, a neighbor, Julie, is trapped and suffers serious third-degree
burns over 70 percent of her body. Her medical bills run $600,000. She misses
5 years of work. She had been earning $70,000 a year. She sues Bill and
Mary and the owner of the defective wiring—the trust—for $2 million. The
homeowners policy and $2 million umbrella policy defends just Bill and Mary
(again because neither the trust nor the trustee are covered under the definition
of "insured" in the homeowners liability coverage part). So, the trust has
to spend $500,000 for its own defense costs. The jury awards Julie the full
$2 million—$1 million each against the trust and another $1 million against
Bill and Mary. Bill and Mary's homeowners and umbrella policy pay all of
their $1 million obligation but pay nothing on the judgment against the
trust. Julie's attorney successfully comes after $1 million of liquid investments
owned by the trust.
The Reason? The trust has no liability
coverage under Bill and Mary's homeowners or umbrella policies because the
trust is neither an insured nor a named insured under either policy. This
insurance gap drained the estate of $1.5 million—the $1 million judgment
plus the $500,000 defense costs.
-
Bill and Mary take their friends, Dave and Lisa, sailing on their 17-foot
catamaran sailboat. In a directional change while tacking, the sailboat
mast cracks, hitting Lisa in the head and knocking her in the water where
she drowns. David sues Bill and Mary and the sailboat owner—the trust—for
$1 million for negligent maintenance of the boat. Again, Bill and Mary's
homeowners and umbrella policies will defend just Bill and Mary because
the trust is not an "insured" under either policy. This time the jury rules
that the force of the wind—not defective maintenance—caused the mast to
crack. No damages are awarded. However, the estate once again had to spend
$500,000 to cover its defense.
The Insurance Industry Solution
The dilemma: how to protect the assets of the trust when the title to real
or personal property, or both, is transferred to a trust and trustee?
Insurance Services Office, Inc. (ISO), and the insurance industry have created
a specific homeowners endorsement for this risk called a "Residence Held in
Trust" endorsement (HO 05 43). [IRMI Online subscribers can find it here.
Personal
Risk Management and Insurance subscribers can find it on page 13.F.21.]
When using that endorsement, the trustee and trust are named in the Declarations
page as the "Named Insured."
The original owners who created the trust and still reside on the property
are shown in the Schedule section at the top of the Residence Held in Trust
form. Their status under the homeowners policy is changed to just an insured
rather than a named insured. The definitions in the form include other household
members as insureds as well.
The problem of being just an insured under the ISO form of this endorsement
for Bill and Mary is that coverage extends only for personal property (Coverage
C), living expenses (Coverage D), liability (Coverage E), and Guest Med Pay
(Coverage F). What about their insurable interest in the structures? Although
they are no longer owners, they typically have the right to occupy the home
rent-free for as long as they care to. If the home burns and is not rebuilt,
haven’t they lost something worth thousands of dollars?
The other problem I see with this Residence Held in Trust endorsement is,
if the trustee does not regularly reside at the residence premises, the form
limits liability coverage for the trustee and trust assets to the described
residence premises. (This poses a problem for liability coverage for personal
property being used off-premises, such as recreational vehicles or watercraft.)
I am concerned because this endorsement does not adequately protect all parties.
And I'm concerned about whether the umbrella policy sitting in excess of the
HO liability limit will, with the Residence Held in Trust Endorsement on the
underlying policy only, protect the trustee's and trust assets. I don't think
that it will. The definition of an insured, on the umbrella policy, also affords
no automatic coverage for trustees or trusts. There could be a congruence problem
too for Bill and Mary whose underlying homeowners policy now lists the trustee
and trust as the named insured. Bill and Mary are just insureds. If there is
a liability claim brought against Bill and Mary which is not covered by the
homeowners policy because they no longer are named insureds, will the umbrella
step down to the self-insured retention and afford primary coverage? Very unlikely
I think.
Applying the RIT Endorsement to Claims
To illustrate the shortcomings of the Residence Held in Trust Endorsement
(RIT), assume that the RIT Endorsement was attached to Bill and Mary's homeowners
policy in the three earlier examples. Joe and the trust would be the named insured
and Bill and Mary "insured" on the RIT schedule.
Claim #1
$3 million of home and contents destroyed owned by the trust. The policy
should pay the entire $3 million because the trust is the named insured.
Result—the trust assets are fully protected.
Claim #2
The homeowners policy should fully defend and pay all parties, but limited
to the Coverage E limit of $500,000. The umbrella policy will continue to defend
and pay claims up to its $2 million limits for Bill and Mary but not the trust
or trustee—neither of whom are an "insured" by definition on the umbrella policy.
The jury awarded $1 million against Bill and Mary and $1 million against
the trustee and trust interest. Each party incurred $250,000 in legal fees for
the primary coverage and another $250,000 each for the umbrella coverage. The
result is that the trust assets are depleted by $1 million (e.g., the $1.5 million
in claim and expense costs less the $250,000 in claim coverage under the homeowners
policy and less the $250,000 in legal fees covered by the homeowners policy).
[Note: Don't worry too much about how the numbers were arrived at. Focus
more on the point that with the RIT endorsement on the homeowners policy, the
trust still has no coverage under the umbrella policy.]
Claim #3
The homeowners Coverage E liability coverage will defend and pay judgments
up to Coverage E limits. But it will not defend or pay on behalf of the trust
and trustee because the nonresident trustee is only covered on the residence
premises. Remember, this liability claim originated from a sailboat being used
away from premises. The result here is that trust assets are depleted by the
$500,000 defense costs.
Am I certain that, with every insurance company, the interpretations will
be the same as those above? Of course not. I am sure there will be some claim
departments that will interpret liberally in favor of the insured and the trust.
But is that a risk you're willing to take or have your client take? I have one
cardinal rule when it comes to claims interpretations regarding coverage: never
ever assume a claim will be paid if coverage interpretation issues arise.
The Safest Solution
I think that the best possible long-term solution is to incorporate in the
definition of named insured under all personal lines policies the trustee and
trust owners of covered property. Until then, when a trust owns tangible property
like a residence, I think the only safe way to protect the exposures of the
grantor/resident and the property and liability exposure of the trust and trustee
is to list all parties as co-named insureds on both the underlying and umbrella
policies.
In the earlier examples, the named insured on the homeowners and umbrella
policies would be "William and Mary _______ and Joseph ______, as Trustee of
the William and Mary ________ Trust dated ____________." Not all underwriters
are willing to do this; the underwriting manager of each insurer will need to
be contacted in advance. Then, when a trust exposure arises, use only those
insurers. In my practice in the Minneapolis area, I use either AutoOwners or
Harleysville, both of whom are agreeable to this strategy.
If the agent for Bill and Mary had set up the named insured this way on both
the homeowners and umbrella policies, all three claims would have been fully
covered, including defense costs.
Opinions expressed in Expert Commentary articles are those of the author and are
not necessarily held by the author’s employer or IRMI. This article does not purport
to provide legal, accounting, or other professional advice or opinion. If such advice
is needed, consult with your attorney, accountant, or other qualified adviser.