Leveraging life insurance* (see AER, September 2014) has a lot of appeal to affluent clients. After all, leveraging a policy allows the policy owner to benefit from the life insurance protection, along with using the capital they’ve built up in the policy for lifestyle or income purposes.
Back-end leveraging strategies, commonly referred to as Insured Retirement Plans (IRPs), are designed to supplement RRSP or RPP income. Front-end strategies, or Immediate Financing Arrangements (IFA), let clients deduct the interest cost since they are investing the proceeds of the loans into stocks, real estate or another qualifying vehicle with a reasonable expectation of profit.
A high-level view of the IFA process seems straightforward:
- Apply for life insurance.
- Get the policy approved.
- Get a loan from a lender or establish a line of credit.
But there’s more to the process. Let’s explore the finer points so that you can manage client expectations and inform all parties, including clients, their centres of influence and the lending partner.
What clients need to provide
Clients must provide net worth statements on the bank’s standard form, three years of personal and/or corporate income tax returns, financial statements prepared by their company accountant and supporting IFA/insurance illustrations. They should treat this no differently than applying for a mortgage or a business loan. Likewise, there is no guarantee the loan will be approved.
Clients often think they don’t need to qualify for the loan and that banks lend solely on the cash value in a policy, but they need to apply for the loan just like any other lending product. On paper, the client must have enough income to service the loan, which can be a challenge if the client’s accountant has structured it so the client has low earned income for tax purposes. Lenders will check your client’s total debt servicing ratio before approving a loan. With that said, exceptions can be made for clients who have a recession-proof business, such as a medical practice.
Another misconception is that the lender will automatically allow for the loan interest to be capitalized, which helps with cash flow. This is most common for back-end strategies where the line of credit supplements retirement income or lifestyle purposes. In general, capitalizing the interest cost is not part of most lenders’ loan programs. However, exceptions may be made on a case-by-case basis. If so, lenders may ask the client to pledge other securities, lending up to 90% of the cash value.
The 5 Cs and 4 Ms of assessment
Put yourself in the shoes of the lender for an idea of whether to expect a loan approval. John Turner, director of program development with BMO Private Banking, says: “Getting the lender involved early in the process is key to having [it] run smoothly. Just having the cash value in the policy does not ensure the lender will approve the loan, since they will want to review other factors like past credit history, income level/history and the client’s ability to repay the loan.”
The 5 Cs and 4 Ms can help you do a preliminary assessment on your client:
Character—their credit history, job profile, family situation
Capacity (total debt service ratio)—available income to support debt obligations, ability to repay
Capital—what if the business fails?
Collateral—what’s securing the loan besides the policy?
Conditions—what industry or market factors impact them and their business?
Money—their financial ratios (current, quick, DuPont) and audited financial statements
Management—ownership structure of their business, succession plans, strengths, weaknesses
Markets—industry size, competition set, power of suppliers/consumers, barriers to entry
Material—collateral types, business inventory/assets, profitability, turnover ratio
The loan program setup
The life insurance policy owner can be a corporation or an individual. When structuring leveraging strategies, corporate-owned policies can be important financial planning tools for a few reasons, including the tax-free flow of the death benefit through the company’s capital dividend account. The borrower can either be the corporation or the business owner/shareholder. If the strategy involves a corporate-owned policy with a personal borrower, make sure the shareholder pays the guarantor fee to the corporation to avoid any shareholder benefit issues.
The authorized minimum line of credit or revolving demand loan can vary. Given the fees involved in setting up leveraged life insurance strategies, a minimum loan of $500,000 to $1 million makes sense from a cost-benefit perspective. Here are the typical costs involved:
- Interest. The rate is either a floating rate (prime or BA notes) or a fixed rate (30 days to seven years). Interest payments are usually calculated monthly.
- A set-up fee or annual review fee. This is charged by the lender. The loan term sheet will detail all terms, conditions, covenants and costs.
- Other professional fees. These include legal fees and those from the client’s advisors.
In order to secure 100% premium financing in an IFA, the lender will ask for collateral. In general, here’s what to expect:
- assignment of the policy (critical in order to properly deduct the net cost of pure insurance, if applicable);
- other collateral, as required, if securing 100% premium financing on an IFA;
- a maximum of a 90% loan-to-cash-value ratio on a universal life policy or whole life policy; and
- up to 80% of first mortgage on the principal residence or cottage,
- up to 95% on government or pledged corporate bonds,
- up to 75% on equities,
- up to 100% on money market,
- up to 60% on commercial property.
Borrowing to invest is not suitable for everyone, so evaluate your client’s level of comfort with the strategy. When misapplied, leveraged investments may increase financial risk to your clients’ overall financial well-being and result in unexpected losses.
So, how do we manage uncertainty of good and bad risk?
- Default risk—if your client defaults, the lender will likely go after his or her other assets and turn them into collateral before attempting to access the life insurance policy.
- Funding risk—if your client stops funding the policy, how flexible is the life insurance product? Perform a stress test and review how stopping deposits earlier than planned might impact the strategy.
- Tax risk—if your client paid a guarantor fee in the case of a personal borrower of corporate policy, how will they pay off the loan on death with personal assets (since the death benefit is a corporate asset)? Either way, did the client re-invest the borrowed funds in a qualified investment that will allow them to deduct the interest cost?
- Additional collateral requirement risk—on a whole life policy, can the client provide more collateral if needed dividends are lower than expected?
- Interest rate risk—what happens when prime rates go back up? Has the lender done a stress test at a higher rate to see if the debt ratio is still acceptable?
- Investment risk—how long will the 30-year trend of declining dividend scales in whole life policies continue? Is the client reinvesting the loan proceeds into safe or risky assets?
- Interest rate relationship—what is the spread between the annual cash value growth of the policy and the loan interest? What if that spread widens?
More robust planning
While not an exhaustive guide to leveraging life insurance policies, this article has provided you with insight and questions to ask. The more prepared you are, the faster you can respond to questions during the planning process and offer clients a much more robust planning solution.
- Ensure the leveraging strategy is suitable for your client and her overall financial objectives
- Make sure she is adequately informed about the structure and risks associated with such a plan
- In the event of a corporate-owned policy with a personal borrower, have the shareholder pay a reasonable fee to the corporation to avoid any shareholder benefit issues
- Connect the lender, accountant and lawyer
- Reinvest where there is a reasonable expectation of profit, such as shares, business income, securities, real estate (income property), so the client can safely deduct interest
- Use leverage insured annuities (also known as triple back-to-backs), since the Department of Finance has taken away many of the tax benefits
- Use the death benefit proceeds to pay off the loan balance in the event of a corporate-owned policy with a personal borrower; be prepared to use or pledge personal assets
*Note: The availability and terms of the loan programs mentioned in this article are subject to change at the discretion of the lenders and are not guaranteed.
Pierre Ghorbanian, MBA, CFP, FLMI, the Advanced Markets Business Development Director at BMO Insurance.