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.
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.
Jack Hungelmann's book Insurance for
Dummies, contains much of this information and is available at your
favorite bookstore or
online. For more information on his risk management and insurance business,
go to www.JackHungelmann.com where you can check
out sample newsletters, brochures, other articles written on various issues.
For background information, see Mr. Hungelmann's biography.