IMMEDIATE FINANCING ARRANGEMENT

Immediate Financing Arrangement ( IFA ) Strategy

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.

The main benefits of an IFA are getting life insurance without tying up cash flow from your business and getting tax deductions on the loan interest when investing the loan proceeds into a business or investment portfolio. Additionally, an IFA can be used for estate planning, charitable giving, and business succession planning. 

        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. If he has to wait 15 or 20 years to start financing the interest, this strategy may become less attractive because he would want a way out in case his circumstances change. The graph below shows total deposited premiums of $2.5 million by the fifth year (blue). The loan balance remains at $2.5 million until the end of the ninth year because he’s paying annual loan interest (yellow) until year 10. The collateral required to get 100% of the premium back (light green) increases, but does wind down by the 10th year. And starting in the 10th year, he decides to finance the interest, which results in the loan balance capitalizing. The cumulative net annual outlay (dark green) represents the cost of the loan interest minus the tax savings. The UL death benefit (brown) represents the insurance proceeds before the loan repayment; the net death benefit (red) is the proceeds of the insurance policy left for the shareholder’s estate after loan repayment. Fast forward to age 90 (year 40), when he’s exceeded normal life expectancy. There’s a conservative 4% rate of investment return assumption in the guaranteed market-indexed account and a 5% loan interest rate. Projected proceeds on death are:

Key points to remember for Micheal

1. The $2.5 million of retained earnings he deposited into his policy over five years was immediately loaned back and reinvested into both his business and alternative investments, which will generate an attractive internal rate of return.

2. Assuming he financed his loan interest starting at year 10, the cumulative net outlay or carrying cost of the coverage is $472,500, considerably less than buying a level-cost, minimum-funded insurance policy for that same death benefit.

3. By using the guaranteed market indexed account in the universal life policy, the client can participate in the upside of an equity index (e.g., S&P/TSX 60 or S&P 500) but guarantee a floor of 0% in the event the index has a negative return in a given year. Any gains from previous years are locked in and can carry forward. As a result, the client’s able to mitigate market risk, inflation risk and interest rate risk in the universal life policy by using the guaranteed market-indexed account.

The strategy allows the client to experience the benefits of life insurance in his lifetime via the loan reinvestment. He also gained the financial security of having death benefit proceeds paid to his corporation’s capital dividend account. This can cover other liabilities, provide working capital to surviving shareholders or be paid out to his estate. As with any kind of leveraged investment, you’ll have to manage client expectations. Your client must be prepared for full financial underwriting by the lender, and to understand that lenders do not solely lend based on assets (borrowers must have the appropriate income to service the debt). You’ll also want to make sure they’re fully aware of the risks of borrowing to invest.