"The Wealth Pre$ervation Company"

Joseph F. Blum CLU TEP

Practice Applications of Life Insurance Products 

A.       Stock Redemption. 

            In this form of agreement the Corporation is the buyer of the deceased’s interest and the estate of the decedent, is the seller.  If the deceased has a surviving spouse, it is important that she be the selling principle, so as to qualify the subject business interest for the marital deduction. (The spouse should be designated heir for the business interest; not a surviving shareholder or the children of the deceased.)             

The redemption agreement may be “funded” with a life insurance policy or the agreement may provide for a series of installment payments over a given number of years at a stated rate of interest.  (If no interest is specified, the IRS will impute an interest rate to the agreement.)  

  In the redemption agreement, the Corporation buys the stock from the estate and (in an insured agreement) turns the insurance proceeds over to the estate.  The stock may then be “retired” and the surviving shareholder, then being the only shareholder, essentially own 100% of the outstanding stock.  

            Should the surviving shareholder then sell the business, his basis for capital gain purposes remains unchanged from its original sum, since the Corporation bought the deceased’s stock; the surviving shareholder did not. 

Life insurance is recommended as a funding vehicle for this as well as for all other such forms of agreements for the following reasons: 

1.         100% of the dollars needed are provided simultaneous to the event that creates the need. 

2.         100% of the dollars required can be set aside in escrow by the annual payment of 2-6% (+ -) of the sum required (depending on the age and health of the insured). 

3.         Installment payments for a business interest are not a tax deductible expense to the Corporation / Partnership making the payments.   i.e.  If the business nets 5% on sales (post tax) and the purchase price of the deceased’s interest is $1,000,000, the Corporation will have to allocate 100% of the profit on $20,000,000 in sales to net a sum sufficient to buy in the stock ($1,000,000) and all this at a time when 1/2 of the business is deceased, and that half may have been the force driving the company. 

4.         The obligation represented by an installment payout must be posted to the Corporation’s balance sheet.  The portion payable in the year following the shareholder’s death is a current liability, the balance is a long term liability; if the subject Corporation had a book value of $2,000,000 prior to the shareholder’s death, and that death now creates a new $1,000,000 liability on the Corporation’s balance sheet, book value shrinks by 50%.  Such a dilution may have a serious negative impact on banking relationships and the willingness of suppliers to extend credit. 

5.         There can be no assurance that the business will remain profitable long enough to in fact complete a stream of installment payments, covering multiple years in the future.     

B.       Cross Purchase 

            In a cross purchase agreement, each shareholder commits to purchase the interest of any deceased shareholder. 

In an insured cross purchase agreement, each shareholder owns, pays the premiums, and is the beneficiary of a policy of insurance on the other shareholder’s life.  Upon death, the surviving shareholder, collects the proceeds of the insurance policy, pays the funds over to the deceased’s estate and receives in turn, the deceased’s business share.

The advantage to this form of agreement is primarily the step up in basis received by the survivor, when he buys in the interest of the deceased shareholder.   Since he / she paid for the interest with personal funds (received from the death proceeds of the life Ins. policy) his basis upon subsequent sale is stepped up to include his purchase price, thus reducing capital gain taxes, perhaps significantly.

In a cross purchase agreement, where 2 stockholders have significant age differences, it is sometimes problematic for the younger shareholder to pay premiums on his older shareholder This issue can be mitigated through the use of a Split Dollar arrangement, discussed elsewhere in the technical part of this presentation.

In S Corporations and Partnerships, the age disparity does not create the same problem since the premiums are allocated to the income accounts of the principles in direct proportion to their respective ownership interests.

C.       Wait And See Buy And Sell Agreement. 

In reality, the decision regarding the format of the stock purchase agreement is much easier made at some time following the death of a shareholder.  i.e.  An agreement executed today cannot possibly forecast the circumstances of the parties to the agreement when death triggers its provisions 10 or 20 years later. 

Enter the “wait and see” buy and sell agreement.  In many ways this agreement is similar to its counterpart agreements; cross purchase and stock redemption.  A specified price or formula is agreed upon and Life Insurance may be purchased to fund it, but that’s where the similarity ends, the buyer of the deceased’s interest is not identified.            

The Corporation will have an option to buy the deceased’s interest for 30 - 90 days.  If thereafter counsel feels that the option should be exercised, then a redemption will take place.  Should counsel feel that the Corporation should not exercise its option, the surviving shareholder will buy the decedents interest and a cross purchase will have occurred. 

If the Life Insurance was owned by, paid for and payable to the Corporation and it was determined that the surviving shareholder should make the stock purchase, the Corporation could loan the insurance proceeds to that shareholder.

Similarly, if it is determined that a redemption should occur and the shareholders owned policies on each other, they could then loan the insurance proceeds to the Corporation, following the first of them to die. 

It is even possible, in the “wait and see” buy / sell agreement to have a third party such as an irrevocable trust, own the insurance and buy in the stock to hold it for heirs who wish to ultimately participate in the business.  The trust could also loan the insurance proceeds to the surviving shareholder or to the Corporation, taking the stock as collateral for the loan assuming that the trustee felt the transaction was a prudent discharge of his responsibility to the trust’s ultimate beneficiaries.

II.                Key Person Life Insurance 

            Any policy owned by, paid for and payable to a business entity can be termed key person life insurance.  Generally speaking, the purpose of the policy is to indemnify the company for the loss of a key person both from the perspective of his / her importance to the profitability of the company, as well as the cost of hiring and training a replacement. 

            Examples of particularly key people are chemists whose discoveries drive the research and development efforts of a drug company or a dynamic sales manager who has single handily built the sales of the company. 

                        AMT 

            A C Corporation whose profits approach or cross over the AMT threshold will incur additional AMT tax upon the receipt of the proceeds of a key person life insurance policy since the policy cash value is subject to AMT tax in the year of death.  Note:  TRA97 exempts Corporations from AMT whose gross receipts average $5,000,000 or less in a 5 consecutive year period.  Once so qualified, AMT will re-appear if that Corporation has revenues exceeding $7,500,000 for 3 consecutive years. 

III.             Disability Insurance 

            Disability Insurance can be purchased on a group basis or an individual basis.             

1.      Group Disability Insurance: Short Term and Long Term 

A.     Short Term - generally available with waiting periods of 30 - 60 days and benefits payable for a maximum of 52 weeks at a rate not to exceed 66 2/3 of weekly pay to a stated dollar maximum.

B.     Long Term - benefits may start after 30, 60 or 90 days and are available for disabilities lasting to age 65 and amounts as high as $20,000 per month or more or 66 2/3 of pay which ever is greater.  Most group long term disability policies will offset any benefits collected by the insured from Social Security, Retirement Plan Disability benefits and other Wage Continuation Plans provided by the employer. 

Caution 

            Group disability premium costs are low because the definitions of disability are extremely limited.  The most commonly misunderstood product is group Long Term Disability.  Yes; it will pay benefits to age 65 but only if you cannot work at any occupation whatsoever.  During the first 2 years of disability you will be paid if you cannot perform the duties of your regular occupation.  Beyond 2 years, disability must be total to be eligible for benefit.  At this writing (6-98) we know of only one insurer that writes a group long term disability policy that will consider you disabled if you cannot perform the duties of your regular occupation.  This company is UNUM; (Union Mutual of Maine).                          

2.      Individual Disability Insurance 

            The best quality individual disability insurance policy available will have the following characteristics:

A.       It is Non-Cancelable regardless of the number of claims made by the insured, or the insurer’s claims experience with that series of policy.

B.       It is guaranteed renewable at the same premium costs established on its date of purchase.

C.       The policy will consider you disabled if you cannot perform the duties of your regular occupation.  Regular occupation is specified in the contract.  i.e.  Surgeon, Dentist, Trial Lawyer, etc.

D.       It has available a residual disability rider.  This rider assures payment proportionate to the degree of disability one is suffering.  i.e.  If you are 30% disabled you receive 30% of the benefit you purchased.           

            Unfortunately, “your occupation” policies are rapidly disappearing from the marketplace and are being replaced by loss of income contracts, which simply indemnify for loss of income, regardless of whether one can work at one’s occupation or not. 

Caution

            When determining eligibility for maximum amounts of individual disability insurance the amount provided under one’s group insurance plan is used as an offset.  i.e.  Assuming one qualifies for $3,000 per month of coverage and has $2,000 through one’s employer under a group plan, the individual carrier in that fact pattern, would only issue $1,000 of additional coverage.  

            Group carriers however do not offset individual coverage.

 Reversing the fact pattern, one could have $3,000 per month of individual coverage and still have $3,000 of group coverage if the group plan were purchased subsequently by the insured’s employer.  At claim time however, the total paid from both plans could not exceed 100% of the insured’s income immediately prior to disability.  Conversely, if one is currently covered by a group plan and then applies for an individual policy, the carrier will generally not issue coverage amounts which in total comprise more than 65 - 70% of the insured’s total monthly income. 

3.      Business Overhead Disability Insurance 

            These policies are generally available with long waiting period.  i.e. 60 - 90 -180 - 365 days and pay benefits for a short duration.  i.e.  One year - 18 months - 2 years.  All overhead expenses can be covered except the draw / salary of the insured.  These policies when combined with individual policies can provide sufficient sums of cash to allow a professional practice to continue during the time of disability of its principle.  Premiums for Business Overhead policies are low due to the long waiting period and the limited number of months of benefit. 

4.      Disability Buy Out Insurance 

            These policies are designed to pay out the value of a business interest following a period of disability, generally lasting one or two years.  The purchase price is then paid out over a period of years, 1, 2, or 3 years or in a single lump sum.  A purchase and sale agreement between the shareholders of the business will usually provide that the buy out trigger is the total disability of a shareholder.  The definition of disability written into the buy and sell agreement should mirror the definition of disability in the buyout policy.  This way, if the insurance company considers the shareholder disabled enough to receive benefits, the agreement will consider that same shareholder disabled sufficiently to trigger the buy out. 

5.      Jumbo Supplementary Disability Plans 

            Due to the disastrous claims experiences of the 80s most insurance companies either no longer offer non-cancelable disability policies or have formed strategic alliances with other insurers under which their agents market the policies of that strategic alliance carrier.  (Paul Revere Insurance Company is a primary example of that effort in that the company has strategic alliances with many large mutual life insurance companies.) 

            To fill the void, several indemnity carriers (Lloyds of London, Reliance Insurance Company, etc.) have entered the market by offering jumbo amounts of coverage on a conditionally renewable basis. 

            Baseball Clubs can now insure multi-million dollar contracts with star players; to provide compensation during a prolonged disability under a “no-cut” contract. 

On a more practical level an executive requiring $300,000 a month of disability coverage can obtain such a contract.  The usual provisions of the policy provides for a 90 - 180 day waiting period, with benefits payable for 5 years, under a contract renewable for 3 years only.  Every 3 years, evidence of insurability must be furnished, to continue the contract for a new 3 year interval. 

IV.              Life Insurance Products 

1.      Term Insurance 

            This form of life insurance policy derives its name from its purpose; to provide life insurance for a term of time,  i.e.  5 - 10 - 15 - 20 years.  It is particularly well suited to assure payment of financial obligations that have finite a duration, such as bank loans, mortgages, etc.  Its appropriateness in these situations assumes that the obligation is non-recurring.  If a business person will need bank lines of credit for as long as he / she is in business, term insurance will become prohibitively expensive at older ages.  Term insurance is not renewable beyond the original term of years selected 

            Term insurance is often touted as the “best kind of insurance” or the only kind one should buy; the theory being that the difference in premium cost between term insurance and other more costly forms of insurance (notably Whole Life) can be better invested by the buyer and for (certainly) higher returns than the cash value contained in these “high priced” forms of coverage. 

            This is a misconception of gross proportion, if one assumes that insurance coverage is to remain in force to the end of life expectancy.  Any premium (cost) savings available for investment is short lived.  By age 50 - 60 the cost of term insurance is equal to the cost of permanent insurance and the term rates rise geometrically from age 50 to mortality. 

2.      Whole Life Insurance 

            This plan design is intended to provide life insurance for the “whole of life”.  The cash value inherent on this policy form is not a savings account, an investment or a retirement fund (although it may be used for those purposes if one feels no need for insurance coverage at some point in time.) 

            These policy cash values are nothing more than a reserve, the earnings on which allow the insurance company to keep the premium level throughout the insured’s lifetime.  Absent that reserve, the insuror must continually increase the premium cost of the policy to keep up with the rising cost of insuring the risk, as the insured gets closer to the end of life expectancy.  These cost increases are required to make up for the absence of earnings on a policy reserve.  This is the reason that less than 1% of all term insurance policies “pay off” as a death claim.  They either expire (before the insured) due to unmanageable costs, or they are converted to permanent forms of insurance, either at the expiry date or, more commonly when the insured’s health fails and conversion to a permanent policy (usually guaranteed) is the only option to continued coverage.  

Note: 

Interest earnings assumptions are part of the calculation of all life insurance premiums.  It is the earnings on the reserve of all policies in force with a given life insurance company that defrays the cost of life insurance for any one individual insured. 

Consider, if you will, that a 40 year old female in excellent health can purchase $1,000,000 of permanent (Whole Life) insurance for approximately $12,500 per year.  Absent interest earnings, she would need to survive 80 years, and never miss a premium payment, in order to “pay in” as much as would be “paid out” by the insuror upon her death! Obviously no individual could afford to buy life insurance absent an interest earnings assumption built into the premium.  This 40 year old person has a life expectancy of 45 years, not 80 years.  Absent earnings on a reserve, term insurance is the alternative product and the mortality charge from age 60to age 85 is unaffordable. 

3.      Limited Payment Life Insurance 

            20 Pay, 10 Pay, Life Paid Up at 65, are all policy forms designed to compress mortality charge payments into shorter time spans than exist in Whole Life or Term Life Policies.  They can be useful as gifts from parents / grandparents to children / grandchildren or in business situations where earnings / profits are predictably high but for a limited period of years.  A 10 pay life policy guarantees that no more than 10 annual premiums will be paid.  This is not a projection but rather a contractual guarantee. 

4.      Universal Life

            Universal Life is a product born of the computer age.

Computers allowed the insurance companies to break out the mortality costs and the “cash value” element of Whole Life Policies.  Once having done that, interest could be credited to the policy cash value in a manner that created the appearance of an interest bearing investment.  Currently, interest crediting rates are 6 – 6.5% as of the time of this writing (200). 

CAUTION I

Reality Check - Universal Life 

A.                 Interest credits are stated on a gross basis before deduction of expenses which are: 

1.         Mortality charges
2.         Sales expenses
3.         Asset management fees
4.         Policy fees

            After deductions of these expenses, the actual net interest earnings on most Universal Life policies are substantially below the stated interest crediting rate in a given year. 

CAUTION II

Mortality Charges

            Most  insurance companies marketing Universal Life policies have the contractual right to increase the mortality charge of the policy to a certain maximum listed on a schedule inside the actual policy.  The maximum mortality charge may be a significant multiple of the  mortality charge at the time the policy is purchased.  Competition works to contain these charges.  It is however important for the advisor to be aware of the potential for dramatic increases in the cost of this policy component if mortality skews adversely for that chosen insurer.

            Universal Life Insurance as a concept is really nothing more than a term life insurance policy, with a premium that increases yearly along with a “side fund” to which interest is credited yearly at a rate decided upon by the actuaries of that particular life insurance company.  The hope is that the “side fund” will grow more quickly than the age adjusted premium will increase.  Generally, with a quality contract, this will work if a high enough premium level is selected by the insured with the help of his / her agent or broker.  The concept fails when the broker suggests a premium that is so low that it approaches term insurance rates.  At those low levels, the mortality costs eat up most, if not all, of the premiums being paid in, leaving few if any dollars on the table which earn the interest credits.  In this scenario, the death benefit will expire long before the insured expires.

            If you are advising your client on the purchase of a Universal Life Policy, you should request that the broker provide you with sales illustrations at several rates of interest; 1.  The current rate  2.  200 basis points below current rates  3.  The guaranteed rate.  Each computer run will show a point at which the death benefit expires.  These computer runs act as a useful guide to judging what amount of premium is required to maintain the death benefit in force to mortality; at least at the start of the policy. 

5.      Variable Life Insurance 

            Variable Life Insurance is built on the same chassis as Universal Life.  The major distinction is that the “cash value” portion of the premium is invested in mutual funds, a number of which are made available for the insured’s choice. 

            All of the considerations attendant to the Universal Life policy form are applicable to Variable Life, with one major exception, the amount of the death benefit is not guaranteed.  A $100,000 policy may not pay out $100,000 upon the insured’s death. 

            Some insurance companies marketing these policies do offer an option guaranteed to pay the amount of death benefit initially purchased.  Guarantee periods are available from 1 year to life expectancy.  The charge for the guarantee is significant and is deducted from the premium.  The balance remaining is then invested in mutual funds chosen by the insured.  At age 50, a 10 year death benefit guarantee on a $1,000,000 policy, into which the insured had chosen to pay $40,000 per year, would cost $8,000 over that 10 year period.  i.e.  The accumulated value of the mutual fund shares would be reduced by $8,000, because the death benefit of $1,000,000 was guaranteed for that 10 year period. 

            Variable Life Insurance is an excellent policy choice as a gift for a parent / grandparent, to a child, with the insurance being on the child’s life.  The mortality charge, sales loads and other expenses are so low, that the investment portion of the premium is maximized for its greatest potential return.