family-life-insurance-policy

There’s been significant change in the insurance industry. MGAs and insurers have consolidated, there are fewer products and features, and there have been proposed changes to exempt rules. Most recently, Budget 2013 closed the marketing of 10-8s and triple back-to-backs (leveraged annuities) to wealthy Canadians.

Notwithstanding these changes, strategies like the immediate financing arrangement (IFA) still work. The IFA doesn’t have the same appeal as the 10-8 because the loan interest and investment return assumptions are variable and are not linked to one another. But for the right client, it can still build wealth and protect against creditors, while reducing the carrying cost of life insurance.

Insurance policy options

People choose universal life policies for their flexibility and higher cash surrender value in earlier years, which minimizes the amount of additional collateral required to secure the loan. But there’s been renewed interest in whole life because of low Guaranteed Interest Account rates in universal life policies. In addition, the insured can deduct the Net Cost of Pure Insurance in a whole life policy because declared dividends are used to pay base premiums.

Whole life isn’t always ideal because of low cash surrender values in earlier years, and also because of declining dividend interest rates, which drag out the period of additional collateral required. An ideal IFA will have the minimum number of collateral years and the ability to finance the interest as soon as possible, so the client doesn’t feel committed for life.

Case study

Michael, a successful 50-year-old real estate developer, requires about $6 million of life insurance for short-term risk and approximately $2 million for capital gains taxation at normal life expectancy. Additionally:

  • his holding company has more than $3 million in retained earnings (cash and other fixed-income securities);
  • he wants to reinvest retained earnings in his business;
  • he’ll deposit $500,000 into the policy each year for the next 5 years;
  • he plans to leverage the funds back into his business via an immediate collateral loan through his bank; and
  • he wants a maximum loan ratio to cash value of 90%.

Assumptions:

  • 5% loan interest rate, and the loan interest will be financed as soon as possible;
  • universal life policy with a 4% return in a guaranteed market-indexed account, which allows for equity-like returns from an underlying market index, such as the S&P/TSX 60. There’s a contractual guarantee of no negative returns should the markets decline in a given year;
  • high loan rate of 5% for illustration purposes. Realistically, he could currently secure prime plus 0.50%.

Risk management

Like many business owners, he keeps a lot of wealth in cash. He doesn’t want to get locked into GICs with today’s record-low rates, a problem that’s magnified by inflation and tax. He’s also wary of equities, fearing volatility. But he is comfortable with alternative investments like real estate and mortgages because he understands the risk.

The strategy

To get the $500,000 first-year premium back as a loan, Michael requires additional collateral of $133,327, which can consist of real estate, securities or other assets. In this case study, the alternative investment that Michael will be investing into will be a land deal with a projected IRR in the 17% to 19% range. The tax-deductible loan interest in the first year is $25,000, and assuming a 46% corporate investment income tax rate, the tax savings is $11,500.

As a result, the net annual outlay for the program in the first year is $13,500 ($25,000 minus $11,500), which is good value for more than $6 million of insurance on a 50-year-old male non-smoker.

Fast forward to year 10. The corporation got back $2.5 million ($500,000 x 5 years) of premiums as an immediate loan, and there are enough funds in the policy that additional collateral is no longer required.

Michael’s stopped paying annual interest and will finance it going forward by adding the loan interest to the loan balance. This is important in the event he can’t deduct the interest because he no longer has the business income to support it. Flexibility in the structure is important, so he knows he isn’t committed to paying loan interest for life.

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