Cash Private Placement Contract by apr33488


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   The Lure of Private Placement

   It offers more flexibility and dramatic savings
   when a large amount of coverage is needed

                        Over the past couple of years, there have been numerous articles and
                        presentations at professional seminars on the use of private placement
                        life insurance and annuity products. The primary focus has been the
                        overall tax benefits of investing in a tax-neutral holding vehicle. In many
                        situations, the required life insurance coverage is simply considered a
                        “cost” of getting the tax deferral. However, as a practical planning tool,
                        life insurance coverage for death-benefit purposes is needed in many
                        instances. The possible scenarios include second-to-die policies for
                        estate planning, buy-sell agreements for partnerships/corporations, key
By Grant R. Markuson,   person life insurance or employee benefit-planning arrangements. And
   managing member,
                        private placement life insurance (PPLI) can be used as an alternative to
 Markuson & Neufeld,
             Chicago    retail policies in such traditional planning arrangements.

                        PPLI DEFINED
                        Private placement life insurance contracts are variable universal life
                        insurance products that focus to a greater degree on the tax-deferral
                        aspects of life insurance than on the death-benefit coverage of pure life
                        insurance. A PPLI contract, depending on the internal options offered
                        by a carrier, allows the policy owner to have a greater selection of
                        investment options than a traditional retail life insurance contract. In a
                        traditional variable contract, the carrier may offer 10 to 20 mutual funds
                        of varying styles that the policy owner can allocate his cash value
                        among. In PPLI, an individual will often designate a manager to cus-
                        tomize the investments of a given policy. Generally speaking, this
                        means that the policy owner will pick up more investment flexibility

   58                                    TRUSTS & ESTATES /                      MAY 2003
                                                                  COMMITTEE REPORT: I N S U R A N C E

with fewer costs. The cost reduction is due to       charge, there is a normal and expected effi-
the “non-fund” setting that sometimes occurs         ciency with larger cases. PPLI contracts have
in the PPLI marketplace.                             break-point fees, while smaller retail con-
    The true insurance coverage amount in a          tracts have flat fees. As with any policy, there
PPLI contract is usually the minimal amount          are normal reporting and administrative costs
needed according to one of two tests                 in simply keeping the policy in force. There
detailed in Internal Revenue Code Section            are few additional incremental expenses
      4                                                                                                 With PPLI,
7702. In either one of these tests, the long-        (such as those relating to personnel, comput-
term amount of insurance can be quite small          er systems or general administration) to           there’s a
and still allow the policy to qualify as life        maintain a $100,000 face policy as opposed
insurance. Because of the focus on the tax-          to a $1 million face policy.                       higher level
deferred nature, and the fact that minimal               Thus, as the cash value of the contract
                                                                                                        of disclosure
amounts of insurance will be purchased,              increases, there is a potentially greater prof-
most of the insurance companies’ profits are         it level for the larger policies in the retail     regarding
derived from the mortality and expense               market. However, the carriers’ actuaries and
(M&E) costs, the true administrative costs           marketing and sales professionals have a           costs, and
of the policy, rather than the cost of insur-        fairly good idea of the number, and the aver-
                                                                                                        there are
ance (COI), the actual cost to buy the term          age size, of the retail cases that will be sold
insurance coverage of the policy. It is this         each year. Without a doubt, the average            few, if any,
fact that opens up the opportunity for dif-          retail case has premiums of thousands of
ferent types of insurance-oriented planning          dollars, not millions. Yet these smaller cases     hidden fees.
for PPLI, especially when large amounts of           must remain profitable. Actuaries price
coverage are needed.                                 products so that all size cases will be prof-
                                                     itable but don’t necessarily adjust the costs
SAVINGS                                              for the larger policies.
The marketing and sales-related costs of PPLI
vs. retail contracts are a key difference            MORE DISCLOSURE
between them. Retail contracts by their              One of practitioners’ biggest complaints is
design are structured to be sold through an          that it is difficult to understand the various
established agency system. This is by far the        pricing constraints of a retail contract. Every
most effective way for a carrier to distribute       planner has seen different premium quotes
its products. Although most agents are paid          from the same company for the same amount
only on commission, there are various fixed          of death benefit. Nothing is free and some-
costs that must be absorbed in the costs of the      thing must be given up, be it investment gains,
policy. First, marketing and distribution costs      underwriting standards, costs or commis-
are much more pronounced for retail con-             sions. With PPLI, there’s a higher level of dis-
tracts. You won’t see any ads in magazines or        closure regarding costs, and there are few, if
on television for PPLI contracts. Furthermore,       any, hidden fees to have a substantial impact
a $5 glossy brochure is proportionately more         on policy costs.
costly for a $1,000 premium than a similar              Because PPLI policies normally don’t have
brochure is for a $1 million premium. All            surrender fees, amortization of fees is rare, so
things being equal, certain fixed costs of sell-     one does not have to factor in this cost.
ing a policy can be substantial for small poli-      Producers and distribution sources will nor-
cies, while effectively being a nominal cost for     mally mark up the M&E but not the COI. This
very large policies.                                 leaves those who are seeking the insurance
    The second element to consider is the fact       death benefit with an opportunity to take
that the average retail contract is substantial-     advantage of this “wholesale” fee structure.
ly smaller than a PPLI contract as measured             It is for these reasons that PPLI can actual-
by premium. Because many of the fees from a          ly be a much more advantageous structure
variable contract are asset-based, either via        than a retail contract. Keeping the COI, while
the asset-management fees or via the M&E             keeping the drain on the cash value at a min-

MAY 2003                                           TRUSTS & ESTATES /                             59

imum, helps support a larger death          dollars of cash value, it represents a    even with the same issuing company,
benefit with smaller premiums.              substantial percentage difference in      PPLI can result in dramatic savings to
                                            that year and each subsequent year.       the client. There are also variations
COMPARING PRODUCTS                                                                    among PPLI companies, but the
One of the driving elements of any         CASE STUDY                                 average result is that with a premium
insurance product, especially for          Let’s compare a retail and PPLI con-       of perhaps $500,000 per year for
those products where a large amount        tract from the same carrier, taking a      five years, the $15 million of coverage
of insurance is required, is the COI.      54-year-old male seeking $15 million       can be maintained (also assuming
Of all the costs, this is by far the one   of insurance coverage for a buy-sell       normal fees and commissions for this
that is least understood by the plan-      arrangement. Further, let’s assume that    type of product).
ning community and is also the hard-       straight term insurance is not the best        The overall savings in premium
est to compare.                            fit. Finally, assume that the client wish- outlay ranges from around 20 percent
    In a variable life insurance con-      es to purchase the insurance from a        to 50 percent at these growth rates.
tract, an insurance company will           “major” life insurance company.            With larger growth rates, the savings
purchase, on a monthly basis,                                                               would be even more pro-
the net amount of risk required                                                             nounced. Finally, in a PPLI
for each policy. The net amount                                                             arrangement with larger premi-
of risk is defined as the differ-       In a PPLI contract,                                 ums, the administrative fees
ence between the face amount                                                                shrink quite dramatically. In other
of the contract (the stated             most carriers’ cost of                              words, the larger the policy, the
death benefit) and the cash                                                                 more efficient PPLI becomes.
value of the contract (the
                                        insurance is only                                       This is the scenario that best
investment element).                    slightly above the true emphasizes the cost savings:
    In a PPLI contract, the COI                                                             Clients who need $10 million or
of most carriers is only slightly       reinsurance cost of                                 more of death benefit for any
above the true reinsurance cost
of this risk. Although some car-
                                        this risk. Many carriers reason always wantbest compa-
                                                                                            est policy with the
                                                                                                                   the cheap-

riers have substantial markups,
                                        mark up the costs by                                ny. Estate planners find it much
as much as 250 percent, many                                                                easier to conduct transfer-tax
carriers mark up the costs by           less than 10 percent.                               planning on $500,000 than for
less than 10 percent. The differ-                                                           $1 million. Money managers
ence is even more pronounced                                                                would much rather manage the
between retail and PPLI con-                                                                money than lose it to an insur-
tracts. What this means is that if the          Traditionally, the client would       ance company. Obviously, there is
true cost of $1,000 of coverage for a      seek the advice of his insurance           benefit for almost everyone except
particular individual is $10 for a par-    agent, who would obtain various            the retail policy salesperson who
ticular year, the range of costs           quotes from the required carriers.         won’t sell the PPLI version.
among carriers could be anywhere           For the sake of this article, we               But that doesn’t mean that the
from $11 (a 10 percent markup) to          obtained illustrations from several        retail salesperson shouldn’t use PPLI.
$25 (a 250 percent markup).                insurance companies in order to            For those unusually large cases that
Although this may not seem sub-            establish a baseline. Furthermore, we      he may come across, a sale may never
stantial, these numbers become             assumed that the individual has a          occur with a retail contract if a PPLI
quite important for large cases.           preferred rating and that the gross        contract is also offered. For larger
    If, for instance, $10 million of net   growth rate on the account will be 6       cases, PPLI is logically one of the best
risk coverage is needed, a policy may      percent. Obviously, different insur-       ways to go.
incur a COI cost in that year of           ance companies have different cost
between $110,000 and $250,000,             assumptions, and different crediting       APPLYING THE SAVINGS
depending on the carrier. Multiply         rates. The range is about $750,000 to      The key benefit to PPLI in a tradi-
this difference over a 20- or 30-year      $1 million of premium for five years       tional insurance-needs situation is
period, and substantial savings may        to support this coverage to age 100.       that more death benefit can be
be realized. More importantly, this        This assumes normal fees and com-          bought for less money. This be-
may only be a difference of $150,000,      missions for this type of product.         comes especially important when
but as measured against a few million           In a similar case and sometimes       one is dealing with transfer taxes

60                                          TRUSTS & ESTATES /                                  MAY 2003
                                                        C O M M I T T E E R E P O RT: I N S U R A N C E

where mitigation of the costs is         lapse. The use of PPLI in conjunc-          that an actual insurance need exists.
important. In employee-benefit sit-      tion with premium financing helps           Too often insurance is used to fill a
uations, the company can provide         to stabilize some of the uncertain-         gap that adequate income or estate-
the same or a better benefit at a        ties of the program. Due to the cus-        tax planning could have reduced
lower cost. And finally, for any other   tomization of the policy, and the           from the beginning. Therefore, it is
insurance-needs situation, the client    ability to have lower costs, especial-      critical to bring a large insurance con-
can effectively maintain the preva-      ly in the first years, the policy           tract into the big picture only when it
lent philosophy of “buying term and      owner has a greater possibility of          provides the most efficient and man-
investing the difference.“               making the program work. What all           ageable solution for the client.       ❙
                                                these programs need is the
                                                ability to stabilize the interest
                                                rate over a longer period of
                                                time rather than the normal
Customization of                                period of three to five years.
                                                                                     1. David S. Neufeld and Grant R.
                                                                                        Markuson, “Tax Planning with Private
PPLI contracts can                              With break-even points often            Placement Life Insurance: Practical
                                                in the 10- to 15-year time              Considerations and Real World Uses to
help smooth out                                 horizon, policyowners take              Achieve Tax-Free Investment Returns,”
                                                substantial risks of fluctua-           Vol. 4, Asset Protection Journal 48
fluctuations in                                 tion in their account values            (Summer 2002).
                                                                                     2. For a detailed discussion of the tax rules
account values and vs. even more fluctuation in                                         and practical aspects of private place-
                                                future interest rates.                  ment life insurance, see Grant R.
interest rates.                                     Once again, the customiza-          Markuson, “Private Placement Life
                                                tion of PPLI contracts can be           Insurance: New Insights for an
                                                adapted to help smooth out              Enduring Technique,” a special advertis-
                                                these fluctuations. By keeping          ing supplement to Trusts & Estates
    If the client were to obtain the     overall fees low and by converting             (December 2002).
                                                                                     3. It is important to understand that the
investment flexibility of a PPLI con-    heavy up-front commissions to a
                                                                                        client cannot have too much control
tract and earn more in doing so, this    smaller trailer-based fee, the spread          over the underlying assets and thus
efficiency would help in making each     needed between the interest rate               violate the Investor Control Doctrine.
dollar go further. Depending on the      and growth rate of the cash value              For a detailed discussion of this sub-
amount of additional death benefit       can be compressed.                             ject, see David S. Neufeld, “The
required, an increase in the growth                                                     ‘Keyport Ruling’ and the Investor
rate by 1 percent to 2 percent can       STILL LIFE INSURANCE                           Control Rule: Might Makes Right?,”
                                                                                        The Insurance Tax Review, March
effectively fully cover the costs of     The key thing to remember is that
                                                                                        2003, p. 383.
these policies. In addition, this 1 per- PPLI contracts are still life insurance     4. See IRC Section 7702. For a detailed
cent to 2 percent could actually be      contracts. For those individuals who           discussion of the testing under IRC
the average annual tax savings on the    need life insurance coverage in                Section 7702, see Howard M. Zaritsky
investments within the policy. Once      excess of $10 million, substantial             and Stephan R. Leimberg, Tax Planning
again, the overall efficiency of PPLI    cost savings can be incurred by                with Life Insurance: Analysis with
can oftentimes cover, and even           using a PPLI contract over a tradi-            Forms (Warren, Gorham & Lamont,
                                                                                        2nd ed., 1998).
exceed, the hard costs of the mortal-    tional retail contract. This is not to
                                                                                     5. It is important to note that for market-
ity coverage.                            say that some clients will not be well         ing purposes, some carriers start out
                                         served by retail contracts. For those          with very low COI markups but gradu-
PREMIUM FINANCING                        who seek simplicity, don’t desire              ally increase them over the years.
Many premium financing programs          flexible investment options and                Unless one is specifically looking at
have been tested and established         don’t mind paying a little bit more,           COI incremental shifts, it is very easy
over the years. Unfortunately, many      retail contracts will fit the bill.            for a carrier to increase these costs
of them assume a substantial spread      However, for the sophisticated client          without anyone noticing. For pure PPLI
                                                                                        products where minimal death benefit
between growth rates and interest        who earned his money the hard way,
                                                                                        is needed, these incremental costs are
rates on the financing, regardless of    and has a tendency to be a tough               not that important. However, if one is
some foreign hedging with various        negotiator on fees, PPLI offers a              looking to buy additional mortality, the
currencies. If the assumptions don’t     comfortable home.                              cost of the product becomes much
hold up, the whole program can col-          The key issue in this analysis is          more pronounced.

MAY 2003                                        TRUSTS & ESTATES /                                       61

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