The PPLI Solution

Delivering Wealth Accumulation, Tax Efficiency, and Asset Protection Through Private Placement Life Insurance

Kirk Loury

• Publisher: Bloomberg Press
• Year: 2010
• Print ISBN: 9781576601730
• eBook ISBN: 9780470884973
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

Private placement life insurance (PPLI) was once the exclusive domain of wealthy investors willing to tackle the logistical challenges of the offshore insurance market. The investment portfolio, tax, and estate-planning applications, and ongoing investment potential of these policies made the effort worthwhile. In recent years, though, a number of U.S.-based insurance companies have developed similar policies that meet all U.S. insurance, investment, and tax regulations.

PPLI is becoming a fundamental component of effective tax, trust, and estate planning, but few sources have been available to detail the best practices—until now. The PPLI Solution can serve as a resource for effective execution. Written by leading practitioners, the book will position advisers to capitalize as PPLI expands further into the high-net-worth market and becomes available to individuals with an investable net worth as low as $1 million.

Few investors—whatever their net worth—will want to venture into the PPLI market without guidance. The PPLI Solution addresses the needs of investment managers, consultants, attorneys, and accountants who want to achieve the broad understanding of PPLI's applications required of those providing advice. It can serve as an authoritative source for anyone—including investors—seeking to know more about PPLI's nearly perfect tax efficiency, solid creditor protection, and powerful means of creating wealth.

PART ONE

THE MULTIPURPOSE POLICY

In wealth management—as in any professional-services business —there’s really only one performance standard: Do the solutions executed truly meet client needs? If so, business grows; if not, business shrinks.

That’s why the chapters in this section don’t merely address how private placement life insurance (PPLI) works; they describe the wide range of benefits it can deliver. As John Lawson explains in the opening chapter, PPLI’s initial success arose from a problem-solving approach to a client’s needs for tax management and asset protection.

It’s safe to say that every affluent client is likely to have financial concerns that require personalized solutions for risk management, tax management, asset protection, estate planning, and trust management. PPLI can play a role in all of those areas. And for corporate executives, an extremely valuable PPLI application has emerged in executive benefits. The chapters in this section map the territory and provide clear direction on how PPLI functions to address critical wealth-management needs.

CHAPTER 1

An Introduction to PPLI

JOHN B. LAWSON

The road private placement life insurance (PPLI) has traveled to t come into its own has been a bumpy one and hardly straight. But what was once a shadowy side business is now a legitimate market, with a foundation solid enough for growth. PPLI is the most recent innovation within the life insurance industry for superaffluent investors (individuals with $10 million or more in liquid net worth). It is a variable universal life (VUL) insurance transaction that occurs within a private placement offering. Private placement adds the flexibility to VUL’s product construction, pricing, and asset-management offerings. Because the product is sold through a private placement memorandum (PPM), every transaction can be individually negotiated and custom designed for the investor. The tax benefits it offers to policy owners are available from few other investment vehicles, particularly since they accrue without the need for complex trust structures.

To fully understand PPLI policies and the advantages they make possible, we must look to the basics of life insurance itself.

Life Insurance: Where It Starts

Of the two basic types of life insurance available—term and permanent coverage—term is considered the most cost-effective way to purchase a life insurance death benefit for a relatively short period. But it’s the permanent contract that provides buyers with the unique tax benefits that have helped create the PPLI market.

The key distinguishing factor of permanent coverage is that it has a cash value that accumulates on a tax-favored basis inside the product. The policy is funded over one or more years and is intended to last the entire lifetime of the insured. The premiums are typically much higher than they are for a term policy for the same death benefit, but the value of the product is to front load or level the premium amount so that the coverage lasts at least until the insured reaches age 100. This difference is important because it lays the foundation for the tax benefits that come with permanent life insurance products. These benefits help the policy owner grow the cash value that covers the higher costs of insurance charged as an insured ages, without a corresponding increase in premium payments.

The larger early premiums combined with tax-free growth make it possible to pay lower total premiums over the lifetime of the insured. This is especially important considering what cumulative term costs would be over an insured’s lifetime. If term were the only option available to buyers, there would be very little coverage purchased that lasts through life expectancy.

Permanent life insurance has a long history in the United States as a tax-advantaged long-term wealth-creation, savings, and investment vehicle. As long as a permanent contract complies with U.S. tax rules, it’s entitled to preferential tax treatment. The Internal Revenue Code (IRC) sets forth the testing required for a permanent policy to ensure that it qualifies and remains compliant as a life insurance contract under U.S. tax law.

With a properly designed and legally compliant contract, which is typically assumed as a given when working with the larger, more highly respected U.S. life insurance companies, a policy owner can accumulate tax-deferred investments by paying premiums into a policy. The ultimate death benefit on that policy will one day be paid to the beneficiary free of all income taxes. Once the premiums are paid (often referred to as the investment amount in a policy), these investment benefits accrue under decades-old tax laws as follows:

• The cash value of the policy can grow free of current taxation, and investment income credited under a life insurance contract is not subject to current taxation.

• The policy owner retains tax-free access to the cash value through the use of withdrawals up to basis (basis being the amount of paid-in premium) and/or low-cost loans from the carrier, which uses the appreciated cash value as collateral. This tax-preferred access to liquidity is available only from a nonmodified endowment contract (see chapter 2).

• The death benefit amounts, including any accumulated investment income, received by a beneficiary of a life insurance contract are not subject to income tax.

As a planning tool, life insurance in some states offers an additional benefit in that the cash value (and in some instances, the death benefit) of a life policy is considered an “exempt asset,” which means it is statutorily protected in the event of bankruptcy and cannot be claimed by creditors if a judgment is awarded against the owner or beneficiaries (see chapter 4). This unique feature varies by state but is an additional benefit of owning a life insurance policy in about 20 states.

Finally, permanent policies can be written on more than one life, which is the so-called second-to-die or joint-and-survivor contract. With this design, the investment horizon is substantially extended because the contract will not pay a death benefit until the death of the second insured under the contract.

Private placement deferred annuities (PPDA) have been more popular than PPLI to date mainly because they are so simple to implement. They typically involve only a one- or two-page application, and no physical or financial underwriting is required. PPDA tax benefits and asset-protection issues are similar to the benefits of life insurance in that the investment amount grows free of current income taxation. At some point, however, assuming the contract has an investment gain, either the annuity contract owner or the beneficiary will be required to pay income taxes on the gain at the short-term capital gains rate. That makes PPDA an attractive mechanism for deferring current taxation, but it does not have the preferred lifetime access to cash value on a tax-deferred basis or an income tax-free death benefit as do life insurance contracts. For this reason, informed investors typically prefer the PPLI transaction when the ultimate goal is current tax deferral with future access to cash value during the investor’s lifetime.

Whole Life and Universal Life Insurance

The architecture of a permanent life policy, often referred to as the chassis, typically takes one of two forms. The first is a whole life contract; the second is a universal life contract. The whole life chassis is the older of the two and is somewhat antiquated for today’s market. It has a fixed death benefit, a fixed premium amount that must be paid each year, and stated guarantees with respect to the coverage and a portion of the cash value. With whole life, if the stated premium is paid every year, the policy owner is guaranteed to have the stated death benefit to contract maturity (often defined as age 94 to 100).

One problem with whole life coverage is that it is extremely inflexible. But the more important drawback of whole life policies when considered for purchase by sophisticated investors is the lack of disclosure to the buyer of the underlying costs of the policy—a problem often referred to as the “black box.” Basically, it’s impossible for anyone to break out the costs of the policy, making it hard to determine whether the insurance company is pricing the product fairly. The insurance company declares an annual dividend, and the policy performs based on this unilateral declaration by the insurance company. Although whole life does include guarantees that might be important to some buyers, there are newer products that make the whole life chassis obsolete for the affluent buyer (people with a liquid net worth exceeding $5 million).

The second type of permanent contract, universal life (UL), was created to address many of the complaints buyers and insurance agents expressed regarding the black box. UL products were not widely available until it became possible to arm the agent with point-of-sale computing power. Older whole life products were designed so that an agent could simply consult a rate book to determine an annual premium amount. But with UL, which was built to have flexible premium payments and simplified death-benefit changes, premiums could not be illustrated or modeled without the use of a personal computer. This new and updated product provides much more flexibility and allows the purchaser to see the explicit charges in the contract.

This kind of transparency provides the buyer clarity regarding the amount the company is charging, as well as full disclosure regarding the guaranteed maximum the company can charge at any future time. The sophisticated investor gains the ability to analyze all elements in the contract and make informed cost comparisons. Although UL products do offer many levels of guarantees, they are not the rigid guarantees that whole life products provide. Therefore, the product is more flexible and requires more knowledge to understand, transact, and service after the sale. Despite the increased complexity, most clients quickly understand the economics of a UL product, whereas they never understood the black box associated with a whole life policy. The greatest benefit to working with UL products is the flexibility and the transparency of costs associated with the policy.

Most illustrations represented as computer printouts for UL contracts include a ledger of all costs and the assumed earnings on cash value in the contract, typically shown on a year-to-year basis. This makes it easy to explain and illustrate what happens to the money in the contract, and showing how different assumptions affect the performance of the policy over time is a simple matter (see chapter 11). UL performance depends heavily on a factor called the crediting rate, or the earnings rate attributable to the cash value within the product. This rate tends to track long-term corporate bond yields.

Often, when UL contracts are sold, insurance agents illustrate what happens to the contract at the current crediting rate, at the minimum guaranteed rate, and also at a midpoint on the scale. This is done through a sophisticated software program that produces a policy illustration and shows what can happen if certain assumptions occur after the policy is purchased. But there is no way to predict exactly what will happen to interest rates, mortality experience, or carrier profitability after a contract is sold, so the illustration is simply an assumption (see chapter 11).

Within a universal life illustration, it’s common to look at different premium streams as well as changes in the death benefit. Premium payments can be increased, decreased, or left unpaid based on the policy owner’s discretion with no prior consent from the insurance company. For this reason, a universal life product is often referred to as a flexible premium chassis because it provides the maximum flexibility to investors. The policy owner may determine the frequency and amount of premium payments, subject to minimum policy requirements that there be enough in the cash value account to pay the policy charges and the maximum premium guidelines to keep the contract within the definition of life insurance under IRC § 7702.

The maximum premium guidelines are driven by one of two tests under IRC § 7702—either the guideline premium test (GPT) or the cash value accumulation test (CVAT). Under both tests, there is a maximum amount of premium that can be paid into a contract without creating a modified endowment contract (MEC). Although slightly different, both tests are based on factors such as the age, sex, and health status of the insured and the amount of death benefit in the contract.

The transparency inherent in a UL policy requires the insurance company to closely monitor the disclosed charges in order to remain competitive in the marketplace. If a company’s charges become uncompetitive, the policy owner can exchange the p...

Table of contents

• Praise
• Title Page
• Copyright Page
• Dedication
• PREFACE
• Acknowledgements
• ABOUT THE CONTRIBUTORS
• PART ONE - THE MULTIPURPOSE POLICY
• PART TWO - A VITAL INVESTMENT VEHICLE
• PART THREE - UNDER THE HOOD—THE ESSENTIALS ON PPLI
• PART FOUR - SETTING UP SHOP
• Continuing Education Exam
• INDEX
• ABOUTBLOOMBERG