The Wealthy Have Found A New Way To Cheat On Taxes

The life-insurance industry has enjoyed beneficial tax treatment for its products for nearly a century. Whenever Congress tried to change that, insurers always had a mantra at the ready: We protect widows and orphans.

Life insurance needs to be free from income taxes, the industry said, because of its special social function. It keeps survivors from a life of penury when a chief breadwinner dies.

But in a development all but unnoticed outside the industry, life-insurance companies gradually have shifted away from their broad historical base of middle-class households. Instead, statistics show, an increasing portion of insurers' business consists of selling large policies to wealthier Americans, often as part of complex estate-tax plans.

The shift means that a growing proportion of the tax benefits of life insurance goes to the well-off, not to the middle class that once was the industry's backbone.

The industry's safety-net role is eroding just as Congress is scouting for new revenue sources amid gaping budget deficits, raising concern among insurance executives that lawmakers could revisit the industry's tax advantages.

High-end policies for $2 million and up, which can carry annual premiums of $20,000 or more, made up nearly 40% of the face value of new whole-life and universal-life policies sold in 2007, according to an analysis done for The Wall Street Journal by Limra, an industry-funded research group. Such large policies accounted for just 10% a decade earlier, and 1% two decades ago.

Meanwhile, the percentage of American families owning life insurance continues to fall. Thirty percent have no life-insurance coverage of any kind, a four-decade high, according to a Limra survey.

Permanent life insurance has "become a tax shelter for the rich," said Charlie Smith, a former head of an international association of insurance managers, who in 2003 to 2005 was chairman of an insurance-industry task force on flagging middle-market sales. "If the industry no longer has a significant presence on Main Street, it loses its political clout in Congress and can't defend the tax benefits."

Whole and universal life's tax benefit could become still more important to affluent families if their income-tax rates rise, as they would under Obama administration plans to restrict the extension of the Bush-era tax cuts.

Meanwhile, middle-class families have been getting a smaller portion of the overall tax benefits, in part because they tend to hold less-costly "term" insurance, which provides coverage just for a designated period and doesn't involve a tax-advantaged investment account.

According to Federal Reserve survey data, 22% of assets accumulated tax-free in whole-life and universal-life policies were held by the wealthiest 1% of U.S. families in 2007—those with more than $8.4 million in net worth. More broadly, 55% of the assets in such policies were held by the wealthiest 10% of families. The bottom half by net worth held 6.5% of these assets.

Some of the largest life insurers, seeing the trend, are concerned about a failure to meet what some consider the industry's social mission to ensure that families have life coverage.

Prudential Financial Inc., which historically has focused on the middle class, says 31% of its new-policy sales in 2009 were to its most affluent slice of customers, households with investable assets over $250,000. That puts them in roughly the top 15% of U.S. households measured by financial holdings, according to Fed figures. A decade earlier, 19% of its policies in force were in that high-end segment.

"If all we do as an insurance industry is focus on the affluent, then I think we can lose sight of the original tenets of life insurance," said Mark Hug, a Prudential executive.

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