Building Wealth: Using Premium Financed Indexed Life Insurance (PFIUL)

Building Wealth: Using Premium Financed Indexed Life Insurance (PFIUL) - - - -

INTRODUCTION What is Premium-Financed Indexed Universal Life Insurance and how is it used in various wealth building strategies implemented by Momentum Advanced Planning? In order to understand its applications to planning for affluent families and profitable businesses, let s break down the name in reverse order life insurance, universal life insurance, indexing and finally, premium financing. LIFE INSURANCE - TERM & PERMANENT There are two major kinds of life insurance, term and permanent. Term life insurance is a fixed premium for a fixed duration (e.g., 10 years). A term life insurance policy has no cash value or any type of account balance within the product. As a result, 100% of the premiums paid by the policyholder for the duration of the policy (10 years in this example) go to the insurance company in return for the death benefit of the policy. If the policyholder does not die within the term, then all of the term life insurance policy payments are 100% sunk costs and lost. In contrast, permanent insurance is built to last for the policyholder s entire life. It has two components, a death benefit and an account balance (a personal account inside the policy that the owner can access) designed to accumulate completely taxfree earnings for the policyholder. There are, in turn, two types of permanent insurance, whole life and universal life. The key differences between whole life and universal life insurance policies are in the growth of the account balance and the manner in which the annual cost (as a percent of the total premium) is calculated. Both of these differences are further explained below. PERMANENT - WHOLE LIFE INSURANCE The annual cost of whole life insurance (as a percent of the total premium paid by the policyholder, with the rest going to the account balance) is calculated by taking the cost to insure the policyholder each year individually from now until 100, the age the typical policy is designed to last until (i.e., calculated as if it were a term life insurance policy), averaging it, and charging that amount each year. The growth of the whole life account balance is tied directly to the dividend of the company placing the policy (e.g., Mass Mutual). Whole life carriers adjust the dividend rates as a result of overall company performance and market conditions. Dividend rates typically track up and down with federal funds rates, but the variability is typically very low. PERMANENT - UNIVERSAL LIFE INSURANCE The annual cost of universal life insurance is calculated by taking the cost of insuring the policyholder in the current year (i.e., at the policyholder s then-current age) and charging it against the premium in that year. As a result, in the early years of owning the policy, the cost of the insurance portion of the policy (as a percent of the total premium) is dramatically lower in universal life than whole life. This is because the cost of the insurance is less when the policyholder is younger, with a theoretically (and actuarially) longer remaining life expectancy. So, whereas the whole life policy premium is based on the average of the annual costs to insure the policyholder until 100, the universal life lower costs in the early years for insurance means that far more of the premiums paid early on are allocated to the capital appreciation or growth portion of the policy i.e., the account balance. The growth of the account balance in a universal life policy is tied to either a fixed rate (determined by the particular insurance company underwriting the policy), or some type of index (e.g. S&P 500, Hang Seng, and EURO STOXX). This raises a few questions. Why use the account balance portion of permanent life insurance for growth? And if you do, which insurance company should you use? Before answering these questions, it s important to keep in mind that life insurance has a benefit that doesn t exist for any other income the death benefit is 100% free of any income tax. Keeping that in mind, then first, the growth question: all of the growth and income from a permanent insurance policy is tax deferred, and very importantly, as long as the policy is never canceled before the insured dies, all of those proceeds are completely tax free. Each insurance company has a minimum size death benefit that a life insurance policy can be reduced to in order to maintain a non-mec and stay inforce most are between $150,000 and $250,000. This is because any monies received by the policyholder from an insurance policy are defined first as withdrawals of the basis (i.e., up to the total premiums paid by/for the policyholder) and then as loans (advances on the policyholder s death benefit). BUILDING WEALTH USING INSURANCE 1

Thus, permanent universal life insurance functions in a similar way as a Roth IRA (without the much lower cap) that is, after tax dollars are used for contributions, and all growth and income are tax-free (just as the insurance policy death benefit is). Also, under historic and current law, when structured correctly in context with your estate planning, all death benefit proceeds are free not only of any income tax, but also estate, gift and/or generation-skipping taxes. As a prelude to the choice of the right insurance company, it s instructive to define how insurance companies manage their own risk (a policyholder s death). There are three (3) types of insurance company underwriting for a death benefit amount: 1. Internal retention is the amount of death benefit for which an insurance company will reserve on its own balance sheet (the industry average being $10,000,000); Once the total additional amount being sought from the potential provider is identified, a comparison is made between the competing insurance companies by considering: 1) an insurance company s internal retention (see above), and 2) its autobind capability, or agreements under the company s reinsurance treaties. Once that list of qualified insurance companies has been created by the broker, it should then be cross-tested with each insurance company s risk pricing for the policyholder (including health class and age). The results of that cross-testing will likely reduce the potential insurance company count to a short list (generally between two and four companies). From this point on, the choice is more directed at the financial strength of the company and its ownership type ( mutual or policyholder-owned or stock or shareholder-owned). By the end of the process, only one or two insurance companies typically compete for the best fit for a particular individual. 2. 3. Auto-bind is the amount of death benefit that an insur ance company can impose on their reinsurance partners due to their mutual treaties (the industry average being $50,000,000); Facultative reinsurance is any amount above an insur ance company s auto-bind amount, as well as any unique underwriting requirements that cause the insurance company to want to off-load all the risk on a particular case. The process of navigating the product and insurance company landscape is crucial for large case insurance market and premium financing in particular. Families and institutions that purchase significant policies typically have policies with multiple insurance companies, spanning multiple product lines in order to manage risk and diversify. The above high-level overview in life insurance tax advantages and in life insurance company underwriting sets the stage for a discussion on the correct choice of carrier for any particular policyholder. It s important to understand that every insurance company prices their risks (health classes and ages) somewhat differently. As a result, carrier selection occurs after some pertinent data collection from the policyholder. Initially, a complete health profile is compiled. Secondly, a broker or consultant (whomever is procuring the policy) should define the total insurance line being sought for the policyholder (i.e., any current in-force insurance + any additional amount being sought = total insurance line ). The total insurance line is key to the insurer(s) since it represents the total financial risk they are taking on, collectively, for an individual policyholder. BUILDING WEALTH USING INSURANCE 2

INDEXED UNIVERSAL LIFE INSURANCE (IUL) While the tax treatment is obviously advantageous, the method of growth inside the permanent policy is another major factor in using it for growth of assets. For illustrative purposes, indexed universal life insurance will be featured. It s worth noting that every insurance company providing indexed universal life insurance has different design specifications. But in this class of insurance, two types of growth exist fixed and indexed. Fixed allocations in an IUL fluctuate on an annual basis, but are tied to the general account of your insurance carrier. Currently, most vary between 4.5% and 5.5% annually. The fixed allocation has historically averaged an amount 2% above LIBOR (currently 3.5%). The indexed allocation has multiple indexes as options for the policyholder, but for simplicity, it s worth focusing on two types of S&P investment allocation. PREMIUM FINANCED INDEXED UNIVERSAL LIFE INSURANCE (IUL) With the descriptions of insurance in contained in this document, the favorable tax treatment that the account balance enjoys, as well as the explanations of the hedged upside that indexed universal life insurance provides, it s appropriate to consider the reasons that affluent families and businesses alike both finance (borrow) money from a bank to make the premium payments on these policies. This is referred to as premium-financed indexed universal life insurance (PFIUL). These policies are optimally designed so that they are fully funded over 7-10 years, with no premiums to be made thereafter, in order to maximize the account balance and minimize the fees as a percent of the premiums paid. HOW IT WORKS The first type has a floor (the least an account balance can achieve in a given year) of 1%, and a cap (the most an account balance can achieve in a given year) of 13%. In this type, participation would be 100%, meaning the account earns precisely what the market returns in that year (subject to the floor and cap). The second type has a floor of 1% and a cap of 11%, with 150% participation. For example, if the S&P returned 5% in a year, the account would receive 7.5% in this type of allocation (still subject to the floor and cap). Another important point to make on the growth of an account balance is that it is NOT cumulative return based (meaning it isn t a return over multiple years) it is year-by-year. For example, in an ordinary investment account, if the market went down 10% one year and recovered 13% the following year, the account would have been nearly flat cumulatively. In an IUL policy for the same period, it would have earned 1% the first year and 13% the next year, for an average annual return around 7%. These types of hedged policies offer a tremendous advantage during periods of volatile markets.. BUILDING WEALTH USING INSURANCE 3

A VERSATILE, POWERFUL SOLUTION Since 1986, (when data was available for LIBOR, Fed Funds and the S&P) LIBOR and Fed Funds rates have performed below a hedged (1% floor and 13% cap) indexed insurance account by 3.68% and 3.06% respectively (Appendix p4) As a result, banks are comfortable lending to IUL policies (in the form of making premium payments for the policyholder) on favorable terms. Additionally, insurance policies provide double collateral for premium financing lenders the cash surrender value (account balance net of surrender fees) and the policy s death benefit. Consider the cash surrender value first. Assuming a contribution of $200,000 in the first year, with a supplemental loan of $1,500,000, the cash surrender value would be approximately $1,300,000 (due to early-year surrender charges rendered by the insurance company only if the policy was cancelled in those early years). In order to secure the $1,500,000 loan, approximately $200,000 of outside collateral (existing insurance, stocks, bonds, cash, real estate, etc.) would be used to supplement the cash surrender value collateral to the lender. Alternatively, an additional $200,000 in premium (reducing the loan to $1,300,000) could be contributed to the policy by the policyholder to avoid having to pledge collateral other than the policy. Since the policy owner receives the death benefit net of any outstanding loans, the policy is designed as an increasing death benefit (meaning the death benefit increases each year by the amount contributed that year by the policyholder and/ or the bank) during the years that premiums are paid (typically years 1-10), and then levels out from year 11 onward. Again, when lending for Premium-Financed Indexed Universal Life Insurance, the bank s loan is collateralized with the insurance account balance (and personal collateral cash or other assets whenever the insurance account balance is less than the total loan) as well as with the death benefit of the policy. The final discussion point is loan repayment. The most obvious way involves the death of the insured, with the net proceeds passing to the beneficiary, completely tax-free. Additionally, during any year after the funding phase (typically years 1-10), the policyholder can access their account balance in the form of withdrawals (up to their basis, which is the total premium paid by the policyholder and the bank combined) and loans, which are characterized as an advance of the policyholder s death benefit (which are also tax-free). The loans are available in two forms wash loans and select loans. For wash loans, the rate of interest is exactly equal to whatever the policy returns on that money in that year, having no negative impact on value, but providing no arbitrage either. In contrast, select loans utilize a fixed interest rate (i.e., 5.5%) but the policyholder receives the growth on the cash value in the policy that is in excess of the 5.5% loan rate on the amount they borrow. For example, using a select loan, if there is $10,000,000 of cash value in a policy and the policyholder borrows $500,000, if the market earns 8% that year, the account earns the 8% on the entire $10,000,000 cash value (i.e., $800,000) and owes 5.5% on the $500,000 borrowed (i.e., $27,500). Furthermore, the cash value grows to $10,800,000 (which continues to earn in future years from this value) and a debt accrues of $527,500. The debt can be paid back from the death benefit proceeds, and is shown assuming that in the illustrations from carriers. In the case of the market going down in a given year (leaving only a 1% floor return), the account would earn 1% on the $10,000,000 (i.e., $100,000) and owe 5.5% on the 500,000 (i.e., $27,500) for a net gain on the account balance of $72,500 (i.e., $100,000 less $27,500) with an accrued debt of $500,000. The net death benefit (gross death benefit minus loan) would be reduced by $500,000 if the insured were to die. While the impact of loans and withdrawals of basis (i.e., the total amount paid into the policy by policyholder and the lending bank) can seem complicated at first glance, they are the manner in which to best utilize the tax-free build-up of a permanent insurance account balance. In practice, assuming average market conditions, withdrawals and loans are used to take money from the account balance of the policy on an annual basis starting typically in years 8 or 11 (i.e., after the premium payment stage ends), pay down the loan principal and interest, as well as generate completely taxfree income for the owner. For example, using the same numbers above, assuming you had interest due of $200,000, the policyholder could withdraw $500,000 (using either method), pay $200,000 towards loan interest, $100,000 towards loan principal and take $200,000 personally (or provide it to a trust depending on the ownership of the policy).. BUILDING WEALTH USING INSURANCE 4

Using withdrawals and loans, the policy owner pays down the bank loan over time, until it s either paid off through annual withdrawals and loan payments, or with the death benefit upon death of the policyholder. The only reason to pay down or pay off the loan prior to death is to reduce the impact that interest rates can have on the policy. Some policyholders never pay down/off the loan until death, others pay it off as quickly as the policy will allow. However, it is not necessary to pay off the loan in most cases if you believe in the long-term arbitrage of the strategy. In summary, Premium-Financed Indexed Life Insurance does the following for the owner: 1. 2. 3. 4. Utilizes a permanent, universal life insurance policy to take advantage of low early year insurance costs as a percent of premiums paid. Takes advantage of the completely tax-free accumulation, income, and wealth transfer benefits provided by permanent insurance and fueled by hedged (floor and cap) access to investments in the S&P. Leverages the benefit of low interest rates (and historical arbitrage of over 3% i.e., market returns > loan interest payments see Appendix) by financing all or a portion of the premiums for the policy. Receives dramatically higher living income than could reasonably be achieved in any taxable investment, while paying down/off the loan and efficiently transferring assets to heirs, again, completely taxfree. BUILDING WEALTH USING INSURANCE 5

Appendix LIBOR, Federal Funds, S&P And Hedged IUL Rate History BUILDING WEALTH USING INSURANCE APPENDIX