Eileen Gunn
10/01/2004
Michael Book, a managing partner at the New York financial advisory firm Lenox Advisors, recently sought to devise an investment plan that would shelter assets from taxes for one of his clients, a newly retired Wall Street executive in his mid-40s. The client has a tax-deferred retirement account that will continue to grow for several years before he starts drawing on it, and a portfolio of municipal bonds that generate a few hundred thousand dollars in mostly tax-free income each year to cover his living expenses. He also has about $4 million set aside to invest in alternative assets such as hedge funds.
| TOP VIEW Private-placement life insurance can offer us an attractive vehicle for investing in alternative asset classes, while securing a death benefit for our heirs. We must cede asset selection decisions to the insurance company in most cases. Costs and access to strongly performing funds vary significantly among insurance carriers, so it pays to research them carefully, and to negotiate the fees. |
Private-placement insurance policies are tailored to fit the needs of affluent investors, and, as their name indicates, are unavailable to the public at large. They are, essentially, variable insurance policies. Clients have some degree of choice over the assets they hold—at least when setting up these policies—and how well those investments perform determines the size of the death benefit. For example, the policy that Book arranged for his client starts out with a $19 million death benefit. “But,” Book notes, “we’re hoping the investments will grow to $30 million to $40 million.”
Private-placement life insurance is therefore a hybrid: half insurance policy, half asset-management tool. It is a valuable financial planning strategy for those of us who have enough liquidity to meet day-to-day expenses, and who want to invest a portion of our capital for long-term appreciation. For example, Anne Melissa Dowling, a senior vice president at MassMutual Financial Group in Springfield, Mass., recommends private placements for people who have recently had liquidity events, either inheritances or windfalls from selling a business or investment.
Many major financial companies, including New York Life, Massachusetts Mutual Life Insurance and Citigroup, offer these products. They have become more widespread as hedge funds have grown in popularity, primarily because of tax advantages. Any assets used to fund an insurance policy grow tax-free inside the policy, and the death benefit paid out to beneficiaries is also tax-free. Private placements are more flexible and less expensive than other types of insurance policies, making them attractive as investment vehicles.
“Still, people shouldn’t lose sight of
the fact that it is an insurance policy, and there are complications,” cautions
Douglas Moore, national director of estate and charitable planning at Citigroup
Private Bank in New York. For example, rather than investing directly in a hedge
fund, we pay a premium to an insurance company, which then invests the capital
for us. Private-placement policies typically have higher premiums than other
kinds of life insurance. This can work to our advantage, because it allows us to
put capital to work quickly. The premiums typically start at around $2.5
million, are spread over four or five years and can total as much as $10 million
to $20 million (there are limits on the extent to which we can insure
ourselves). The premium represents the initial cash value of the policy, and the
insurance company invests it in the hedge funds or other assets we choose. The
growth in its value partially funds the death benefit.
Circuitous Route“Some insurers have a wide selection of well-performing funds; others
don’t have as good a selection in terms of number or quality. I was
surprised by the discrepancy when I started looking into them for
our clients.”
There are other costs we will not bear if we invest in a
hedge fund directly. The federal and state governments levy taxes on insurance
policies. The insurance company itself will charge a commission and
administrative fees, and a management fee if the policy is big enough to require
its own asset manager. Advisors recommend factoring in all taxes and fees for
private-placement insurance when weighing it against direct investments. “We
assume a rate of return and run the numbers with all these fees, and with the
taxes we’d pay on the gains without the insurance policy. Then we see what the
consequences will be,” says Mark Watson, vice president of financial capital
services in the Orlando office of Asset Management Advisors. “Usually the
insurance product looks better.”
The fees that are charged for
private-placement insurance are generally smaller than those for other kinds of
life insurance, partly because these policies are far bigger, which gives a
client bargaining power, and partly because the companies offering them want to
make them appealing as investment vehicles. “On a good private placement policy,
the fees should be about 1 percent of the premium, capped at $50,000,” excluding
taxes, which will vary by state, Watson says. By comparison, on the more common
kinds of variable policies, he says, fees and commissions might total 9 percent
of the premium.
Fees can vary dramatically from firm to firm. “I’ve looked at
about 10 insurance carriers who do this, and I was surprised at the difference
in fees,” Watson notes. They can vary from 1 percent to a little over 2 percent
of the premium. If we like a carrier but it does not offer the lowest fees, we
should bear in mind that in many cases these may be negotiable.
| For those of us willing and able to abide by the restrictions, complexities and costs these policies can be ideal low-risk investments. |
Watson says it is important to research the private-placement carriers. “Some insurers have a wide selection of well-performing funds,” he notes. “Others don’t have as good a selection in terms of number or quality. I was surprised by the discrepancy when I started looking into them for our clients.”
| Essential Questions to Ask Your Advisor About Private-Placement Life Insurance: 1. Do I have enough long-term investment capital to consider funding a private- placement insurance policy? 2. Is my insurer willing to negotiate fees? 3. Should I have an independent policy that acts as its own fund of funds? 4. Does my insurance company have access to a wide selection of well-performing funds? |
If we purchase a large enough policy (at MassMutual, a minimum $5 million premium paid over four years) our possibilities for customization increase significantly. We can avoid the pooled investment funds altogether, and, in effect, have our policy act as its own fund of funds, with its own manager. This also gives us greater purview in our investment opportunities. Because we are already in an insurance-only fund (albeit our own), the manager can invest in funds available to the public. “The couture of it is attractive,” Dowling says. “Like a custom dress, it’s made just for you.”
Unfortunately, this does not mean we necessarily have more control over our investments. IRS regulations require that insurers, not policyholders, make asset management decisions. So we need to discuss our goals and risk tolerance with our insurance carrier, and make clear our perferred types of investments. Once we have purchased a policy, we cannot influence the choice of its assets. “Some clients see the lack of control as enough of a deterrent to decide against doing a private placement,” Citigroup’s Moore notes.
It is possible to extract some
capital from the policy while keeping the life insurance active and the
investment growing tax-free. The IRS allows us to withdraw the amount we
originally paid for the policy without penalty or tax. Beyond that, we can
borrow against the policy. If we choose not to repay the loan, at death it will
count against the benefit. But, we have to leave some money in the policy to
ensure it grows quickly enough to outpace the ongoing costs, including any
interest on the loan.
The Wall Street executive whom Book advises plans to
do just that. He will leave the assets to grow for eight to 10 years. “Then
he’ll probably take out the amount he initially put in, and then a little more
beyond that,” Book predicts. “We’ll invest the money we take out in something
else. And we hope what we leave in will grow to cover his estate
taxes.”
Indeed, the death benefit is perhaps the most overlooked aspect of a
private-placement policy. Clients tend to think it is irrelevant, advisors say,
because they expect their investments to grow strongly, ideally beyond whatever
the initial death benefit might be. Unfortunately, the IRS mandates that
insurance companies must bear at least some risk in the insurance policies they
sell. This means the death benefit always has to be larger than the policy’s
cash value by a minimum ratio that depends on our age and other factors. The
insurer charges us a “cost of insurance” fee—generally less than 1 percent of
the cash value—to bear that risk. That cost prompts many advisors, such as John
Dadakis, an attorney in the New York office of the law firm Morrison and
Foerster and a private placement specialist, to advise their clients to buy the
smallest death benefit allowable.
For those of us who are willing and able to
abide by the restrictions, complexities and costs of private-placement insurance
in exchange for long-term, tax-sheltered growth, these policies can be ideal
low-risk investments. “You don’t need to go into high-risk, high-return
investments that are up 30 percent one year and down the next,” Book says.
Because they provide tax- sheltered, compounded growth, “You can earn a steady
10 percent and make a killing.”