Private Placement Life Insurance

Take-Away: For the uber-wealthy, there is a growing interest in private placement life insurance as a means to escape the possible ‘wealth tax’ triggered on an individual’s ‘income’  that some in Congress continue to propose as a means to generate more federal revenue. While somewhat technical, the features of private placement life insurance might be considered by an investor who wishes to control his/her reported ‘income.’

Background: The concept of private placement life insurance has been around for decades, albeit off-shore. However,  it was only after a Revenue Ruling back in 2003 that the ‘green light was turned on’ with regard to this insurance product for domestic purposes. [Revenue Ruling 2002-3.] In that Revenue Ruling the IRS identified ways that a policy owner could add money managers to an insurance dedicated fund, or IDF, if specific guidelines were met. In effect, this Revenue Ruling was an extension of variable universal life insurance contracts.

The over-arching premise behind a private placement life insurance policy is that policy dividends are tax-deferred, and that the first distributions ‘out’ from a life insurance policy is a ‘return of premium,’ i.e. tax-free. With a universal life policy, the policy holder, not the insurance company, decides the amount of premiums paid towards the policy, and thus indirectly they also control the amount of the death benefit paid under the insurance policy.

Advantages and Disadvantages of Private Placement Life Insurance: The interest in private placement life insurance can be explained by some of its advantages, with only few qualifications. In essence, private placement life insurance is a variable universal life insurance policy which is purchased based upon the reasonable assumption that in the long-run, equity driven returns will be greater than interest driven returns on which traditional life insurance projections are based.

Advantages: A variable universal life insurance  type of policy- (i) Allows tax-deferred investment opportunities- policy dividends (i.e. investment returns)  are tax-deferred; (ii) The withdrawal of earnings are on a tax-free basis- distributions can be tax-free when the policy is structured properly since distributions ‘out’ from the policy are a tax-free return of premiums; (iii) The death benefit paid is usually income tax-free, as is most life insurance death benefits; (iv) As a ‘life insurance’ policy, it can be exchanged tax-free by its owner; (v) with many states, like Michigan, the investments held ‘inside’ the life insurance contract, i.e. the cash surrender value,  can be protected from the owner’s creditor claims; (vi) A private placement policy will often reflect lower internal policy costs than traditional life insurance, since the death benefit to be paid is ‘less important’ than the tax-deferred investment growth, resulting in lower mortality charges; (vii) typically there is little, to no, surrender charges compared to ‘traditional’ life insurance;  (viii) commissions are lower and often negotiated, perhaps 1-2% of the premiums paid, so that  there is more transparency associated  with the investments held ‘inside’ the insurance policy; (ix) unlike traditional life insurance where the insurance carrier writes the contract and imposes the policy terms, with a private placement life insurance contract, the policy can be designed with an advisor to meet the policy owner’s objectives while making the policy as economical as possible.

Insurance Dedicated Fund: With the emphasis on investment returns as opposed to the policy’s death benefit, a private placement life insurance policy could hold hedge funds and private equity investments. Some insurance carriers permit a separately managed account, or SMA. More important, however,  is the use of the insurance dedicated fund. Such a fund satisfies the diversity requirements for the contract to be classified as  ‘life insurance’ [IRC 817], which is then periodically tested. If the test ‘fails,’ the policy owner then has 60-90 days in which to correct the policy’s ack of diversification

Disadvantages: A private placement life insurance policy: (i) Is a ‘security’ for SEC purposes, and as such, the policy owner must be an accredited investor or accredited purchaser of the policy; however, there are different rules for trusts, LLCs, and individuals; (ii) The owner of a private placement variable universal life policy cannot exercise too much control over the policy, otherwise the policy will be ignored and it will be treated as if its assets were owned directly by the policy owner and subject to immediate tax on income and gains; (iii) While the policy owner can select the investment manager for the policy, the policy owner cannot have any control over the specific investments held ‘inside’ the policy; and (iv) Usually there is a minimum investment for amount of $250,000 for 4 years- though this ‘high cost’ can be mitigated to some extent through some form of split-dollar funding arrangement.

Investor Control: As noted earlier, this is perhaps viewed as a disadvantage to owning a private placement life insurance policy. The owner cannot exercise too much control. The insurer must be the owner of the separate accounts, not the policy owner. Nor can there be an arrangement or plan with the investment advisor on the availability of specific assets to be held in the policy. All investment decisions with regard to what assets are to be available for investment must be in the investment advisor alone. The policy owner may not communicate with the investment advisor with regard to the selection of any investments. The policy owner will have no legal or equitable interest in any assets owned by the insurance carrier. All decisions on the choice of investment advisor rest solely with the insurance company.

Possible Uses: While the death benefit to be paid is less important with private placement life insurance, it may be possible in the long run that the death benefit will actually be larger, since the policy performance (and ultimate death benefit) will be based on equity returns and not interest rate returns. These arrangements are sometimes used in connection with non-qualified retirement planning to increase retention of employees. They are often used with split-dollar arrangements due to the potential for increasing cash surrender values to the party who advances the premium dollars. They are also popular due to their premium flexibility: premiums may be more or less, skipped, started up again if (or when)  needed. A private placement life insurance policy also is an option to provide benefits to fund a ‘plan’ for top executives, perhaps giving them the ability to participate in investments they would not otherwise have been able to participate in.

Conclusion: For the wealthy who have assets to invest, a private placement life insurance policy, either for a single life or joint lives, is something to consider, either to avoid current taxable income through policy dividends, or to provide additional liquidity with which to perhaps pay higher federal estate taxes in the coming years. It is admittedly not for everyone, but it is just one more device to save taxes.