A collection of insightful and informative articles from Myerson Wealth's “Recipes for Success” newsletter
When I meet with ultra-affluent clients and/or their advisors, at the very top of their list of concerns is tax-reduction planning. This has always been the case but seems now to be of greater urgency as clients begin to consider the mountain of national debt that has no visible ceiling, and equally recognize the need for additional tax revenue to deal with this debt. For these clients, of particular concern is income generated by their investments, especially those assets in tax-inefficient vehicles.
While some have never heard of the potential solution of Private Placement Life Insurance (PPLI), others may know the term – but not exactly how it works.
At its core, PPLI is a type of universal life insurance policy offered privately to accredited investors. Unlike retail insurance products that are available to anyone who might need them, PPLI is obtainable only by individuals or entities who are allowed to deal, trade and invest in financial securities and satisfy one (or more) requirements regarding income, net worth, asset size, governance status or professional experience.
PPLI enables policyholders to take advantage of investment products not available in retail insurance, like private equity funds or hedge funds, and defer (or potentially eliminate) all the income tax that would otherwise have been paid on the realized gains on those assets. To allow for that tax deferral on the build-up of cash value, PPLI policies (like their retail counterparts) are carefully designed to meet Section 7702 of the Internal Revenue Code (IRC). IRC §§7702 requires that the policy meet a series of tests, which confirm the policy is not solely created for investment purposes but also meets the definition of life insurance.
PPLI policies are issued by a limited number of U.S. Domestic carriers and Offshore carriers alike. In the past, Offshore carriers were considered preferable due to the much lower premium tax charged in the carrier’s jurisdiction, as compared with up to 200 basis points (bps) domestically. However, over the last several years, in a concerted effort to generate new business, a number of states have significantly reduced their premium tax (for example: Alaska 10 bps; S. Dakota 8bps). It’s important to remember, no matter where the carrier resides, all assets deposited into a PPLI policy remain segregated in separate accounts, secure from creditors of the carrier.
Compared to traditional retail insurance products, PPLI offers significantly more extensive investment and management options. Investments are made through insurance managed accounts or insurance dedicated funds (IDFs). These allow policy owners to invest in generally tax-inefficient assets like private equity funds, hedge funds and venture capital – all through the tax-efficient wrapper of life insurance. Asset managers are then carefully selected by policy owners and their advisors to manage those portfolios within the policies.
In addition to the aforementioned tax provisions, the IRC also requires PPLI to meet certain diversification requirements outlined in IRC §§817. Stipulations include the life insurance contract contain five or more investments, with no one investment accounting for more than 55 percent of the value of the separate account assets. Additionally, no two investments can make up more than 70 percent, no three can make up more than 80 percent, and so on.
Finally, the policy owner must not have any control over the investment choices. However, it is common to see policy owners having indirect involvement in the selection of assets through the use of an investment policy document.
Beyond these regulatory limitations, the only other constraint would be the insured’s personal “insurable capacity.” Insurable capacity is determinative of the insured’s current and future projected net worth less existing coverage they might already have in force. As most carriers have retention limits of the risk they will retain, all excess above retention is passed onto “reinsurers” who parse out the risk to their investors. Between the major U.S. carriers’ own retention limits and the excess limitations of the five major worldwide reinsurers, individual insurable capacity is possibly between $250 million to $300 million.
As with other life insurance contracts, PPLI policies pay out death benefit proceeds to the beneficiaries’ income tax-free. A PPLI policy can be structured either to maximize the death benefit (for purposes of wealth transfer) or structured to maximize the internal accumulation value for the policy-owner’s living benefits, with the death benefit being secondary to this objective. However, in the case of the latter structure, it’s important to bear in mind that the policy must be carefully engineered to avoid becoming a Modified Endowment Contract, or MEC. If an MEC, the policy will lose much of its exceptional tax efficiency on policy withdrawals.
An MEC is created if too much cash is deposited into the contract over too short a time period. That would not be problematic to those policy owners who simply want to transfer wealth through the death benefit, as MEC status does not impact the tax-free nature of the death benefit. However, for many who may want to withdraw or borrow from the cash value, an MEC would mean that any inherent gain in the policy will be forced out first, and taxed as ordinary income regardless of the underlying nature of the investment growth.
Although still a relatively unknown solution, PPLI has been in existence for several decades. Typically, PPLI utilizes Annually Renewable Term Insurance (ART) for determining the charge for the life insurance wrapper surrounding the cash value. Over time, as the insured ages, this can become very expensive.
A new type of PPLI structure is now available to minimize mortality charges, and further reduce other policy costs and expenses, including asset management charges. The result? Significantly lower long-term costs and maximized asset value to the policy-owner. With the associated tax-deferral, for the ultra-high net worth investor, this policy engineering is exceptionally powerful.
If you have a client for which PPLI may be suitable, or you have questions on the tax, financial or legal aspects of PPLI, we would be happy to further discuss.