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 HO 05 43 10 00. Personal Risk Management 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.
$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.
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.]
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, and other articles written on various issues.
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