Tony Mudd: Which trusts are right for care cost protection policies?

The development of protection policies that will pay the sum assured on a whole of life product, or a percentage of it, in the event of the life assured requiring funds to meet care costs has been long overdue. Vitality was the first to enter the market, followed more recently by Zurich and AIG.

Whether marketed as life assurance policies that pre-pay a benefit in the event of care or as care policies that in the event of no claim will pay on death should make little difference. In either case it increases the value and attractiveness of protection, which in itself must be welcome.

There is, however, one technical flaw brought about by S3 of IHTA1984 worth noting. All life assurance policies should be placed into trust and there are inheritance tax issues that need to be considered: principally, that a gift with reservation of benefit will arise where:

  • A reduced payout as a result of a care claim does not bring the contract to an end, and
  • Where the care payment is optional and there is an omission to exercise the right to claim.

The first point does not apply as the plans of all three current providers do or can come to an end in the event of either payout. This leaves the second point, which can be dealt with in most situations. This is best explained by looking at the trust options with broad client scenarios.

A discretionary trust with no carve-out 

Such a trust should ensure monies paid out remain outside the settlor’s estate for IHT purposes. The downside would be that any payment in the event of a care claim could not be made to the settlor. The settlor would be entirely reliant on the beneficiaries of the trust using the funds to pay for their care needs through third party top-ups.

Meanwhile, with an option, the beneficiaries would be able to take advice as to whether to claim the care benefit or defer on the basis of receiving 100 per cent at a later date. Any care needs arising in the meantime could be funded from the beneficiaries’ own funds.

Discretionary trust with carve out (client has no IHT liability) 

Where the clients are unlikely to have an IHT liability, even including the value of the sum assured, the existence of an option and therefore the inclusion of the value of any sums not paid out in the settlor’s estate would not be relevant. For a married couple their chargeable estate would have to be in excess of £650,000 (perhaps even £1m looking further ahead) and the transferrable nil rate band means in practice it does not matter whether the individual assured is first or second to die.

Discretionary trust with carve out (client has an IHT liability) 

There will clearly be some clients for whom IHT will be an issue, under which circumstances failing to exercise the option in the event of a potential care claim will give rise to an IHT liability.

Under these circumstances, in the event of death, payment will be made free of IHT. Where a claim is made for care and monies are paid out, then, to the extent the monies are used to fund the settlor’s care needs and are spent, they will not be aggregated with the balance of the settlor’s estate and therefore broadly will again be free of IHT.

This leaves the only situation that in practice could cause a problem: where the settlor becomes eligible to make a care claim but no claim is made. This will be a gift for IHT purposes, equivalent broadly to the full value of the sum assured. Failure to survive seven years from the date of failure to exercise this right would result in an increase in the settlor’s IHT liability by 40 per cent of the sum otherwise payable.

The question for advisers is what, if any, other mitigating factors can be introduced. There may be no perfect solution. It could simply be accepted there is only one scenario that causes a problem and that it will only apply to a very limited number of clients:  those who choose the trust carve-out route, that have an IHT problem and that are able to make a care claim but choose not to exercise their right to do so.

Despite this, these new protection policies certainly deserve a closer look. The trust issues simply reinforce the importance of advice and undermines the view that protection is simply about price.

Tony Mudd is divisional director of tax and technical support at St James’s Place