Non-recourse Life Insurance Premium Financing Basics

by

Stuart A. Rader *

  Rader & Coleman , P.L.

2101 NW Boca Raton Boulevard

Boca Raton, Florida 33431

561.368.0545  raderandcoleman.com

*copyright 2007

NOTHING CONTAINED IN THIS ARTICLE SHALL BE CONSTRUED AS A COVERED OPINION OR THE RENDERING OF TAX OR LEGAL ADVICE OR AN ENDORSEMENT OF ANY PARTICULAR PREMIUM FINANCING PROGRAM OR AGENT.  ANYONE CONTEMPLATING A NON-RECOURSE PREMIUM FINANCE PROGRAM OR SIMILAR TYPE PROGRAM SHOULD SEEK COMPETENT LEGAL AND TAX COUNSEL

            I have recently received several inquiries on non-recourse life insurance premium financing programs as a potential investment. The programs are being marketed to high net worth individuals as free life insurance for generally two years, accompanied with the potential for a significant cash bonus after the two-year period.  The promoters of these programs believe that cash bonuses could conservatively range from 2% to 7% of the death benefit payable either: when the policy is issued, or at some time in the future if the policy is sold to an investor. The programs are usually complicated and unique to each promoter and lender. This article summarizes the general benefits and risks of a typical non-recourse life insurance premium programs.

Facts. 

Let's assume the person to be insured is a widow with a net worth of $7.5 million, who is 77 years old and healthy (Insured).  She has two adult children and several grandchildren. Her financial advisor proposes a non-recourse life insurance premium financing program to purchase a $5.0 million life insurance policy on her life. The first two years of premiums will totaling $800,000 will be paid by a third party lender.  At the end of the two-year period, the agent represents that he is willing to try to sell the policy to an investor and that Insured or her family could receive a cash bonus of at least $100,000. 

            How Will It Work?

• A third-party lender finances the $800,000 two year premium payment on the $5.0 million life insurance policy.
• The policy will be owned by irrevocable trust (Trust #1), with the Trustee selected by the lender.
• The beneficiary of Trust #1 is an irrevocable life insurance trust (Trust #2), created by the Insured that names her children and grandchildren as beneficiaries, and her nephew as Trustee.
• Insured signs a non-recourse loan for $1.0 million with interest at prime plus 3%, payable two years from the date the policy was issued. The lender's sole remedy upon a loan default is limited solely to the collateral pledged by the Trustee of Trust # 1, which is (1) the policy cash value, and (2) a $200,000 certificate of deposit (CD) funded from loan (collectively the Collateral).    
• On or about the maturity date of the loan, the Insured's advisor states that the $5.0 million life insurance policy can be sold to an investor for $1.2 million who is the highest of three bidders.  Assuming these facts, the advisor estimates that the net amount Trust #2 will receive from the sale would be approximately $300,000 itemized as:  $1.3 million proceeds minus $1 million loan principal equals $300,000; and the $200,000 certificate of deposit will be applied to pay $200,000 of accrued interest.  

Variables If the Policy is Sold.

• The Insured Dies within the Two-Year Loan Period.  If Insured dies during the two year loan period, the policy death benefits are payable to the Trustee of Trust #1.  After paying the lender the $1.0 million note (including accrued interest), the balance of the pledged certificate of deposit not applied to interest and the $5.0 million policy passes to Trust #2. 

• Fluctuating Interest Rate.   In our fact pattern, the interest rate is 3% above prime.  The interest rate fluctuates with changes in the prime rate. The difference is interest rates could l dramatically impact the net amount passing to Trust #2 upon death or a sale.  If the interest rate increases, the amount of money that Trust #2 could receive upon a sale will be adversely impacted.  There is no assurance that the policy could be sold of if sold, at an amount satisfactory to the Trustee of Trust #2. 

• Possible Sale of Policy.  Assuming there is even a market for the Insured's life insurance policy, the market price the investor could pay for the policy in two years is subject to market forces beyond Insured's control. The net amount to Trust #2 may be significantly less than the estimated return.  There is no assurances that the policy can be sold.  If that is the case, then Insured and the Trustee of Trust #2 will need to decide whether to continue the policy with the expensive premiums or to let it lapse.

• Examples of Variables.

Risk Factors.   

• The Total Amount of Life Insurance Available is Limited to an Insured¿s Net Worth.  

       If an Insured's family needs the life insurance benefit after the initial two-year period, then this program is not suitable. Among the reasons that the program is unsuitable is that an Insured's total available life insurance death benefits are limited to her net worth.  However, the Trustee of Trust #1 may be able to sell the policy to a third party investor without the Insured's consent.  Assuming that Insured's net worth is $7.5 million and the $5.0 million policy is currently the only policy in place, then the amount of additional insurance available to the Insured would be limited to $2.5 million. 

• The Life Insurance Company May Cancel the Policy within two years if there is Fraud or Misrepresentation.  

     Two years is the standard time period that most life insurance contracts allow an insurance company to rescind a policy, if there were fraudulent omission or misrepresentation of material facts on the application. If an insurance company determines that a policy is purchased with the intent of selling the policy for profit, rather than protecting one's family or business, the company may rescind the policy.  In fact, many life insurance companies do not publicly support non-recourse life insurance premium financing programs because these programs distort an insurer's actuarial assumptions.  The biggest assumption is that an insurance company assumes that a large amount of policies will lapse.  However, these lapses do not occur as often when a policy is owned by investors. This decrease in policy lapses likely will result in increased premiums for future policies. The impact of the cancellation is potentially more costly than a lost investment opportunity to Insured's family.  Additionally, if the policy was rescinded and a pre-arranged investor existed, the investor may institute a lawsuit against Insured and the Trust for the failure to deliver the benefit of the bargain as it originally anticipated. Generally, if the life insurance company cancels the policy, then the premiums are refunded to Trust #1 and will be returned to the lender and accrued interest due the lender is paid from the pledged certificate of deposit.

·         Is the Loan Truly Non-Recourse. 

The loan documents must be carefully reviewed to determine that the only recourse a lender has against the Insured is the two year policy amount, plus the value of the certificate of deposit.  If the loan documents state that the lender may require additional security or collateral, then the Insured may be required to pledge additional assets.  Although the loan technically remains non-recourse, the Insured must pledge and put at risk additional collateral at the lender's demand.  Any additional collateral would be an out of pocket cost to Insured from her personal assets.

·         Some States Prohibit Non-Recourse Life Insurance Premium Financing Programs. 

State laws govern life insurance contracts. Generally, the owner of the life insurance contract must have an insurable interest in a life insurance policy. An insurable interest is generally one where there is a close relationship by blood (such as a spouse, child, or trust for family members), or by law (legal contract such as securing a loan or a buy-sell agreement between partners).  The public policy argument against programs such as the one described in this article relates to an investor's insurable interest in the Insured--an investor makes the greatest return if the Insured dies substantially before her life expectancy.  It is critically important to verify that the choice of state law in the insurance policy broadly defines insurable interest to include investors.

·         There are Potential Income Tax Liability Issues

     The first income tax issue is discharge of indebtedness income.  If at the end of the two year term, no investor purchases the policy and the Insured surrenders the policy to the lender, then Insured risks paying taxes at the ordinary income rate, to the extent the loan balance exceeds the value of the collateral. This discharge of indebtedness income applies even when a non-recourse loan is excused. The theory is that after surrendering the collateral to the lender, the taxpayer is relieved of the duty to pay the lender the portion of the loan that exceeds the collateral's value.

     The second income tax issue is the taxation on the increased economic value of the life insurance policy. This value appears to be ordinary income and is reportable as set forth on the Form 1099 from the insurance company.

     The third income tax issue is the whether the gain on the sale of the policy to an investor is ordinary income taxed at graduated rates with 35% the maximum rate or as capital gain currently taxable at 15%.  Under the above scenario, the Trustee of Trust #1 will report the sale.  It is unclear under current law whether the gain, if any, is a capital or ordinary gain.

     Many commentators believe that the first two income tax risks are mitigated by having Trust #2 created as a grantor trust. Generally, a grantor trust is one where the grantor retains certain powers, which attribute  all income tax consequences to the grantor, notwithstanding that the transfers to the grantor trust are a completed gift and outside of the grantor's estate.  A transaction between a grantor and her grantor trust is a non-event for income tax purposes. This is based upon the principle that one cannot have a taxable transaction with herself.  Therefore, establishing Trust #2 as a grantor trust arguably eliminates the discharge of indebtedness and  the increase in economic value   income  liabilities. If, however, it is determined that there is no legitimate non-tax purpose for establishing Trust #2 as a grantor trust and the primary purpose was tax avoidance, then significant income tax risks remain. 

       ·                     No Specific Guidance Exists for These Programs.   

          These programs are relatively new.  There is not a large body of case law interpreting these transactions. There is uncertainty and no guaranty on how these transactions will be interpreted in the future.

Conclusion. 

The non-recourse life insurance premium financing programs appear to be creative way to provide a potentially large financial windfall to high net worth individuals who do not need life insurance. However, there are significant risks associated with the programs. Each individual contemplating entering into the transaction needs to assess the risks and decide whether the potential benefits out-weigh the risks prior to participating.