If there's one R05 topic that candidates consistently underestimate, it's writing protection policies in trust. It appears straightforward on the surface, but the CII tests it because it sits at the intersection of protection planning, estate planning, and taxation. Candidates who skip over trusts in their revision often find themselves staring at a multi-mark question they can't answer.
Here's everything you need to know to handle trust-based protection questions with confidence.
Why writing a policy in trust matters
When a life assurance policy is NOT written in trust, the proceeds on death form part of the deceased's estate. This means:
- The payout goes through probate. This can take months, leaving the family without funds when they need them most
- The proceeds may be subject to IHT, if the estate exceeds the nil-rate band, 40% tax applies to the excess
- The policyholder's will determines who receives the money, which may not reflect their current wishes if the will is out of date
When a policy IS written in trust:
- The payout bypasses probate. The trustees can pay the beneficiaries within days of the claim
- The proceeds are outside the estate for IHT, provided the trust was set up correctly and survived the 7-year rule for transfers
- The policyholder specifies exactly who benefits, through the trust deed, independently of their will
For a client with a £500,000 life policy and an estate already at the nil-rate band threshold, writing the policy in trust could save the beneficiaries £200,000 in IHT. That's the kind of practical impact the CII wants you to understand.
Types of trust used for protection policies
Bare trust (absolute trust)
- The beneficiaries are fixed and cannot be changed
- The beneficiaries have an absolute right to the trust property
- Simple to set up and administer
- Best for: straightforward situations where the policyholder knows exactly who should benefit (e.g. a spouse)
- Limitation: inflexible, if circumstances change (divorce, for example), the trust can't be amended
Flexible trust (discretionary trust)
- The settlor nominates a class of potential beneficiaries
- The trustees have discretion over who receives what and when
- More complex to set up but much more adaptable
- Best for: situations where the policyholder wants to keep options open, for example, naming 'my children' rather than specific individuals
- Limitation: subject to the relevant property regime for IHT purposes (periodic and exit charges), though these rarely apply to protection policies since the trust fund is the policy itself, which typically has no value until a claim
Split trust
- Separates the critical illness benefit (paid to the life assured during their lifetime) from the death benefit (paid to the beneficiaries)
- Best for: policies that include both life cover and critical illness cover
- Why it matters: without a split trust, if the CIC benefit is paid into a discretionary trust, the life assured might not be able to access it for their own use
The IHT implications
This is where the exam marks concentrate. The key rules:
Gift with reservation of benefit (GROB)
If the settlor (policyholder) retains any benefit from the trust, the policy remains in their estate for IHT. For protection policies, this is rarely an issue because the settlor typically doesn't benefit from their own death policy. But it can be relevant for:
- Joint life policies, if the surviving policyholder is also a beneficiary of the trust, GROB may apply
- Critical illness policies, if the CIC benefit is paid into the trust but the life assured wants to use it, GROB could be triggered (hence the split trust solution)
The 7-year rule
If the policy has an existing surrender value when placed into trust, this constitutes a transfer of value. If the settlor dies within 7 years, the transfer may be subject to IHT. For new policies with no surrender value (most protection policies), this isn't an issue.
Chargeable lifetime transfer
Placing a policy with value into a discretionary trust is a chargeable lifetime transfer. If the value exceeds the nil-rate band, there's an immediate 20% charge. Again, for most protection policies (which have no or minimal surrender value), this doesn't apply.
Premium payments and IHT
Here's a subtlety the CII loves: even though the policy itself may have no value, the premiums being paid could be transfers of value. Each premium payment is potentially a gift to the trust.
However, most premiums qualify as normal expenditure out of income. An IHT exemption that applies if:
- The payments are regular (habitual)
- They're made out of income (not capital)
- The settlor retains sufficient income for their normal standard of living
If the premiums qualify under this exemption, they're immediately exempt from IHT. No 7-year rule applies.
The exam trap:
A wealthy client pays £500/month in premiums for a large life policy in trust. The exam asks whether the premiums are transfers of value. The answer depends on whether they qualify as normal expenditure out of income. If the client earns £200,000 and maintains their standard of living comfortably, £6,000 per year in premiums almost certainly qualifies.
Common exam scenarios
Scenario 1: Married couple, both working, joint mortgage
Recommend two single life policies (not joint life first death) each written in trust for the other spouse. This keeps both policies outside both estates and allows quick payout on either death.
Scenario 2: Business owner with keyman insurance
The policy should NOT be written in trust. It needs to pay the business, not individual beneficiaries. The proceeds will be used to recruit a replacement or cover lost profits. This is a common trap. Candidates reflexively recommend trusts for everything.
Scenario 3: Divorced parent with children from two relationships
A flexible (discretionary) trust is ideal here. The parent can name all children as potential beneficiaries, and the trustees can distribute based on need and circumstances at the time of claim. A bare trust naming specific children would be too rigid.
Trust-based protection is one of those R05 topics where a small amount of focused revision pays disproportionate dividends. The CII tests it because it demonstrates whether you understand the purpose of protection planning, not just covering a risk, but ensuring the money reaches the right people, at the right time, in the most tax-efficient way. Learn the trust types, understand the IHT rules, and practise the scenarios. You'll be glad you did.