Viewing the Fiduciary Risk of Unique Assets Through a Different Lens
Wealth management clients continue to accumulate unique or “hard-to-value” assets within fiduciary accounts contributing to their overall net worth. In a recent IRS study, the number of estate tax returns filed (Form 706) by high-net-worth
taxpayers, illustrates that more than half of their estate portfolio composition consists of illiquid assets such as real estate, closely held businesses, and other asset classes.
As a result, fiduciary organizations have aligned with the expertise (internal or external) to manage unique assets while trying to minimize their risk serving as Trustee. Are the controls you have in place “good enough”, or are there opportunities to #bebetter by looking at your unique asset portfolio through a different lens?
Unique Assets Defined
Unique assets mean different things depending on the context of the conversation. For this article, unique assets are assets held in a fiduciary account that are generally “illiquid in nature” often classified as “hard-to-value”. According to the OCC Unique and Hard-to-Value Asset Handbook published in August 2012, some examples listed are a) real estate b) life insurance c) collectibles and many more!
Fiduciary Risks Managing Unique Assets
Unique assets present risks and oversight challenges when held and managed in fiduciary accounts such as irrevocable trusts. The OCC outlines risk categories such as “Compliance” and “Operational” risks and provides specific examples of when a unique asset is held in a fiduciary account. Some examples are 1) Maintaining the physical upkeep on property such as real estate and 2) Proper transactional processing for income and expenses pertaining to mineral interests. Another important risk is the reputation risk the trust organization takes on when it chooses to manage unique assets. Trustees decide whether they will have the internal expertise that is qualified to administer these unique assets, or partner with an external third-party vendor to align with that expertise. If an external vendor is engaged, the Trustee still has liability since they are serving in a fiduciary capacity and a comprehensive due diligence process should be utilized to select a vendor. The level (or severeness) of risk can be dependent on factors such as:
Account type that is holding unique asset
Investment authority (asset or account level)
Fiduciary capacity being served
Governing document and applicable laws
Competence of the staff (or vendor) managing the unique asset
Economic conditions that may impact asset
Adequacy of systems and controls in place
Some factors impact risk more than others. Most (if not all) trust accounting systems, internal proprietary systems, and other third-party software solutions capture necessary asset information to help Trustees review and manage unique assets in fiduciary accounts. Some examples are major/minor asset type, taxpayer EIN, shares held, and the list goes on. In addition, Trustees may have access to robust reports and “built in” processes to help them review the information at an account level to monitor the fiduciary risk. Some automated process examples to help fiduciary organizations monitor these assets at an account level are annual administrative reviews and Reg 9 reviews.
Controls and Monitoring Tools
In addition to the examples above, other controls are needed to minimize the fiduciary risks of unique assets managed in trust accounts. Effective policies alone will not ensure a Trustee’s risk is minimized. There are additional controls and procedures that must accompany sound policies/procedures. Some examples of these controls/tools are illustrated.
These controls (and others) are commonly utilized by Trustees to manage/oversee their unique asset risks. They are usually reviewed by internal audit departments, fiduciary committees, and externally by regulatory agencies during examinations. Given the higher risks pertaining to unique assets in fiduciary accounts, they are often a focus on examinations and closely scrutinized. In addition to the above examples, some fiduciary organizations have created an internal process to assign a “risk rating” for fiduciary accounts. This varies within the industry, but weighing factors used to determine the risk level could be the account type, investment asset types such as unique assets, any concentrated position holdings, and other factors. Rating the risk at the account level is another tool to help analyze the “highest” risk accounts in a fiduciary organization.
So, you have aligned yourself with the proper internal and external resources and established controls to mitigate the risks at an asset and account level. Is anything missing?
Before we view the fiduciary risk of unique assets from a different lens, let’s take a short quiz. How easily (and quickly) can you retrieve the following information pertaining to your unique asset portfolio when the following situations occur?
An insurance carrier’s financial strength has deteriorated, and you want to identify the exposure in your life insurance policies to communicate this risk with clients.
A catastrophic flood took place near Naples, Florida and you want to quickly assess how many trust clients holding real estate in the surrounding area will be impacted and need help.
An unexpected pandemic occurred severely impacting the restaurant sector. You need to identify the closely held entities you manage associated with the restaurant industry.
How easily could you filter your unique asset portfolio to gather the necessary information from this quiz? If the answer is “easily” (internally or through a vendor), congrats! You seem to be in the minority of trust organizations. However, if you have a few hundred real estate properties or manage 87 mineral interests in fiduciary accounts, this level of detail might be more challenging to retrieve in a reasonable timeframe. If these situations are challenges for your organization, maybe you should consider adding additional controls to further help you identify and monitor your fiduciary risk. Consider viewing your unique asset risk from a different lens.
Monitoring the Fiduciary Risk of Unique Assets by the Asset Category/Type
If you admit you have challenges managing aggregate risk, have you considered creating additional processes to further monitor these by asset category or type? Below are 3 ideas that can help you assess and minimize your unique asset risk.
Create (or leverage) a database to view, analyze, and filter unique assets based on a specific “asset type”
Although fiduciary systems contain important information at the asset and account level, sometimes other critical data may not be stored which is needed to further analyze the fiduciary risk of a unique asset.
Example: Let’s say you have a closely held entity in a trust and you have access to basic information. Some information is more challenging to store and often systems “cannot talk to each other” to maintain critical data in one place. For this same example, where would the following information be stored, if at all?
Closely held entity type (LLC, S-Corp., etc.)
Trust ownership % of closely held entity
Related industry (Manufacturing, Retail,)
Current valuation and last appraisal date
Identifying and reviewing some of these asset components (in aggregate) might help you further evaluate the asset risk.
TIP: Leverage information stored by a third-party vendor. You might be partnering with a vendor that has this information available to you (through software or reports). If that is the case, there is no reason to create a database if you can access the information stored (or delivered) by your vendor. Ideally, it is beneficial to have as much pertinent asset detail “in one place” to be able to effectively manage the risks of unique assets.
What if you do not have all the information that you need to monitor these assets effectively?
You could consider creating a database/spreadsheet for a unique asset type that you a) determine is a higher risk and b) want to monitor more closely.
Select an asset type
Start populating a spreadsheet (or alternative) with info you have.
Determine other important asset components you want to capture for this asset type to further assess and monitor the risk
Populate the spreadsheet with the supporting detail and set up a process to ensure the data is current
Filter and analyze the information as needed
Adding this additional information in one location provides easy access and an ability to organize and filter information at the asset type level (in aggregate) by high risk factors.
By doing this, below are some examples which would allow you to quickly identify:
How many closely held entities in your portfolio have a majority ownership?
The number of insurance policies that will lapse in less than 5 years.
Which oil and gas leases will be expiring soon?
There are other examples depending on how you might want to sort and filter the data. The “key” is to identify (and organize) the asset components that are a higher risk to your firm.
2. Apply a risk rating to unique assets by asset type
Another idea related to monitoring your unique assets at an aggregate level would be to apply a risk rating model at the asset type level. This tool would help you assess your portfolio based on specific asset components that your organization feels are “higher risk”.
Example: If you created a list of information associated with your insurance policies, what level of detail do you have and monitor? You would have the policy name, insurance carrier, and maybe even the premium amount (if applicable). However, to manage the risk of your insurance portfolio properly, other asset components should be evaluated. For example:
Policy death benefit
# of years before policy lapses
Cost of insurance policy
Maturity date
Insurance carrier rating/strength
Insurance policy type
So, how would you develop a risk rating process? First you would want to determine which unique asset types you want to apply a risk rating model toward. Next, you would choose the asset categories that will be assigned a risk rating
Example: ILIT risk rating example (Illustration below)
I chose 3 insurance policy components to apply a risk rating toward a) policy death benefit amount, b) year(s) to a policy lapse, and c) insurance policy type. NOTE: These were chosen randomly and are not meant to be reflective of which categories the author feels are the highest risk.
Establish a point system - As illustrated below, a risk point system is established ranging from “1 to 4” , with a score of “4” indicating the highest risk and a “1” equating to the lowest risk. The higher the risk rating total (adding the categories for a specific unique asset), the higher the potential risk for that asset according to the model. So, a policy death benefit above $1M has the highest risk point or would be assigned a risk rating (or score) of “4” in this case.
Next, apply this risk rating model to your ILIT portfolio - see illustration below where 4 insurance policies (ILITs) are rated based on the selected categories and their total risk score per policy is calculated.
Note: The example above does NOT weigh each asset category by the level of risk which can be taken into consideration. It also does not assess the risk at the account level. You may feel that some asset categories may have a higher risk “weighting” than others. For example, in this case, the insurance policy type to some organizations may not be deemed as “risky” as the number of years before a policy lapse. Your risk rating model could take into consideration category risk weightings to reflect the risk more accurately for your unique asset type.
The risk rating model is not meant to take the place of other controls, but to compliment them. Applying a risk rating model to your unique asset portfolio may help you monitor the risk more effectively!
3. Review unique asset performance trends
The last idea to consider is analyzing the performance trends of your unique assets over time. What steps do you take if the performance of a unique asset changes dramatically? The following are examples of changing performance situations:
A privately held bank suspends quarterly dividends for the year
A life insurance premium cost increases by more than 20% from last year
The appraisal of a real estate property declines by 40%
If examples like these happen, will you be able to identify these risks and are there procedures to further monitor the asset and take any necessary actions? What can you do?
👉 Start small and identify some performance trends you want to measure for higher risk unique assets. Establish some milestones that trigger additional monitoring and potential reporting to a fiduciary committee.
Examples of performance trend milestones that could be established and further reviewed are:
Partnership (or other entity) recurring dividend decreases greater than 40%
Oil royalties that decrease year over year by 30%
Real estate appraisal decreases 30% since last appraisal
These are just a few examples and there are more! You can choose what targets make sense to monitor and make sure the changes are meaningful to avoid creating unnecessary monitoring. Your policies can be adjusted to incorporate these additional monitoring tools to help you better monitor risk “over time”. Properly assessing performance trends allows you to be proactive and stay ahead of future risks.
Conclusion
In summary, I hope these ideas help you view your unique asset risk from a different lens. I realize resources are limited and it may not be easy to create additional monitoring processing in addition to what you currently have. However, for higher risks in your unique asset portfolio, it may be worth it to implement additional tools to minimize your fiduciary risks and avoid unpleasant surprises! You never know what can happen in this ever-changing fiduciary industry. If you have any questions or comments, reach out at patrick.alyward@trustworthyconsultants.com
