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How Does Private Placement Life Insurance Work?

Private placement life insurance (PPLI) is a specialist option developed for high-income customers with a few million dollars to invest.

Many of those for whom PPLI was designed want to invest in hedge funds, but hedge funds can be taxed heavily: if the wealthy individual invests in them in their own name, in a taxable account, or in a trust, every trade the manager makes can generate a capital gains distribution, and any ordinary income is taxed at extremely high rates.

At higher income levels, where combined federal and state income and capital gains taxes can easily sum up to nearly 50% in some jurisdictions, this becomes a severe concern.

One frequent method is to keep these assets under a life insurance policy.

Who does private placement life insurance make sense for?

PPLI is not suitable for everyone. A strong candidate for this method is someone with a million-dollar annual income, a net worth of $20 million or more, or who owns a firm that puts them in that category.

Life insurance provides a number of significant tax advantages, which can be significant considerations for people in the highest tax brackets. However, ordinary life insurance policies available from your local agent do not include hedge funds, funds of funds, and other alternative assets that these investors seek for diversification and investing needs.

• This is where privately placed life insurance comes into play: Wealthy families, family foundations, trusts, corporations, and banks collaborate with hedge funds and money management organizations to build their own life insurance policies in order to lower their tax liabilities.

The concept is to combine the financial benefits of highly taxed hedge funds and similar ventures with the tax benefits of life insurance. There are insurance and administrative costs involved with the life insurance contract, but the tax benefits of a correctly structured life insurance policy, as well as the death benefit itself, more than offset the additional insurance and administrative costs. And, in most cases, the insured can access the majority of the cash tax-free through policy withdrawals and loans.

When a wealthy investor in a high tax bracket wishes to invest in hedge funds anyhow, it often makes sense to set up a privately arranged life insurance policy to protect the individual from taxation.

Qualifications to purchase PPLI

While a variable universal life insurance policy (as PPLIs are constructed) can be purchased by anybody, PPLIs are an unregistered securities product. As a result, they can only be presented to accredited investors via agents.

Accredited investors, according to current Securities and Exchange Commission (SEC) standards, are individuals with a net worth of at least $1 million (excluding primary residence) or income of at least $200,000 in each of the previous two years. Married couples must have earned at least $300,000 in the previous two years.

In the end, the owner is usually an individual or a trust. Holding the policy in an irrevocable trust allows the insured to keep the policy out of their taxable estate, potentially reducing future estate tax burden, but they give up rights to the cash value prior to death.

In actuality, the average PPLI applicant or family possesses:

• A high net worth
• The ability to fund at least $1 million in annual premiums for several years — $3 million to $5 million is common
• A desire for exposure to hedge funds or alternative investments
• Investments that are extremely tax-inefficient
• High state and local income taxes on top of federal income taxes (advisers should be aware of the impact of any state premium taxes on the approach).
• A desire to shelter assets from creditors

It's critical to be able to make a considerable investment over the first several years since this initial premium investment "primes the pump," which means that if the underlying investment subaccounts perform well, the insured's policy can become self-funding. In other words, the increase in its cash worth covers the expense of insurance. At that moment, the insured has the option to stop committing premium.

Where to buy private placement life insurance

Professional wealth managers frequently make vendor recommendations. BlackRock, Wells Fargo Private Banking, John Hancock, Zurich, Crown Global, and Pacific Life are among the most renowned providers of PPLI services and insurance-dedicated funds (IDFs).

How private placement life insurance works

Privately placed life insurance policies are typically designed as variable universal life insurance policies, which means:

• Premiums are adjustable. Policyholders are free to pay as much or as little premium as they want, whenever they want.
• Each month or year, the cost of insurance is withdrawn from the cash value in the policy subaccounts.
• To keep the policy active, the owner must pay enough premium to keep the cash value high enough to cover the cost of insurance.
• The policy will lapse if the cash value reaches zero.

The agent who sets up the policy will normally build it to optimize cash value accumulation while keeping the death benefit (and consequently the cost of insurance) as low as possible. Working with their insurance expert, the policy owner then pays as much premium into the policy as possible each year.

The client benefits from the life insurance contract's significant tax advantages:

• Tax-free death benefits to heirs
• Tax-deferred growth of cash value
• Tax-free growth of dividends (if applicable)

In the meantime, the insured retains access to accumulating cash values, which can be used for any purpose and accessible at any age. There are no penalties for withdrawing the cash value before reaching the age of 59 1/2, unlike annuities and individual retirement accounts (IRAs). Furthermore, unlike annuities, IRAs, and retirement funds, there are no mandatory minimum distributions.

PPLI investments

As previously stated, tax-inefficient investments are the ideal candidates for a PPLI program. They generate significant current taxable income, imputed (phantom) income, or capital gains unless they are held in a tax-free retirement account or life insurance vehicle.

Owners of PPLI policies and their advisers can either select particular investments for their portfolios or carefully select money managers to manage their portfolios under the policies. Venture capital, real estate investment trusts, private equity funds, funds of hedge funds, commodity funds, and any other fund with exceptionally high turnover rates that create significant short-term financial gains are all possible investments.

But that doesn't mean anything is off limits. PPLIs must continue to meet IRS requirements for investor control, insurance, and diversification.

Investor control. Individual policyholders and family offices are not permitted to exert influence over the fund managers' specific investment selections. If the owner exerts too much control, the IRS may reject the policy's tax benefits. Current case law requires managers to act independently and discretionarily. Assets held under PPLI policies are not intended to be managed independently, and they should not be viewed as such.

Insurance standards. The life insurance structure allows policyholders to sell insurance-specific funds inside the policy as often as they choose and replace them with other suitable investments without incurring tax penalties. IDFs are financial instruments that are specifically intended for the PPLI industry. Hedge funds and funds of funds frequently construct an IDF version of their flagship offering that uses all of the same strategies and managers but is also managed to comply with insurance portfolio laws and regulations.

Diversification requirements. Investments must also meet diversification rules:

• No single investment may account for more than 55% of the portfolio of insurance subaccounts.
• No two investments may constitute more than 70% of the portfolio.
• No three investments may constitute more than 80% of the portfolio.
• No four investments may account for more than 90% of the account's total assets.

As a result, in practice, the portfolio must comprise a least of five unique investments in order to completely qualify as life insurance. Otherwise, the policy will be disqualified by the IRS, and the owner will lose the tax benefits of the life insurance arrangement.

Accessing your money in a PPLI

Policy owners can withdraw or borrow against their cash value at any time and for any reason.

Withdrawals Withdrawals are tax-free up to the policy limit. So owners can recoup their premiums, minus expenses, without incurring tax implications – as long as the performance of their subaccounts has kept pace with the cost of insurance. If the cash value exceeds the owner's basis in the policy — that is, what they paid in — then any additional withdrawals in excess of the basis are taxed as a gain.

Policy loans You can borrow against the cash value of the policy with no underwriting or credit check. The cash value of the policy serves as collateral for the loan. As a result, the policy is an excellent choice for emergency cash. The loan is not required to be repaid, but the policy owner may wish to refill funds borrowed from the policy in order to maximize long-term tax-free growth.

Interest rates are frequently quite low because the loans are backed by payments already made to the insurer. Borrowers should be advised that interest does accrue and that borrowing reduces any death benefits given out unless the loan is repaid to the policy.

Contribution limitations and modified endowment contracts

To help ensure that life insurance is used for its original purpose rather than as a tax shelter, the government limits how much premium the owner can contribute to the policy in a given year. The "seven-pay" test is the outcome of the contribution limit. A modified endowment contract (MEC) is formed when policyholders contribute so much premium to their policies that the policy is paid up in fewer than seven years. This disqualifies the policy from various tax breaks on withdrawals and loans:

• When you remove cash value from an in-force life insurance policy, you receive the benefit of first-in, first-out (FIFO) taxation. This permits you to withdraw as much as you want, up to your policy's base (the amount you deposited), tax-free. This benefit is lost if your insurance becomes a MEC. Instead, the IRS will consider you to be withdrawing interest before your base. This is taxable interest.
• Similarly, while the legislation enables you to obtain tax-free loans from a life insurance policy, those loans become taxable as income if your policy becomes a MEC.
• Furthermore, if your insurance becomes a MEC, any withdrawals made before the age of 59 1/2 are subject to a 10% early withdrawal penalty, exactly like a qualified annuity or 401(k).

Your policy documents should specify the annual MEC limit.

How are PPLI policies different from retail life insurance?

Privately placed life insurance is structurally equivalent to a traditional variable universal life insurance policy. The assets held in the subaccount distinguish the PPLI: A typical retail consumer will select from the life insurance company's limited menu of sub account investments.

When you purchase a PPLI, however, you can tailor your investing subaccounts. You can incorporate almost any type of investment, from index funds to hedge funds. Your registered investment advisor or wealth manager can assist you in developing the investments in your subaccount menu.

Tax and other benefits of PPLI

Individuals with high incomes are extremely tax-conscious. In 2018, the ordinary income tax rate on earnings over $518,401 was 37%, with additional Affordable Care Act taxes on high-income persons. When state and local income taxes are factored in, the income tax bite for high-earning households can reach nearly 50%.

The tax benefit is at the heart of the PPLI strategy. The PPLI essentially transforms a highly tax-inefficient investment, such as a hedge fund, into a very tax-efficient investment for the high-net-worth client.

This technique mitigates the impact of current income by putting assets in a life insurance policy with tax benefits similar to a Roth IRA. Assets held within the policy grow tax-free for the duration of the policy.

PPLI plans frequently give a variety of additional benefits in addition to the tax advantages that normally accrue to life insurance cash values:

• Lower commissions. In comparison to most retail life insurance plans, the cost of insurance and commissions is low: Issuers care more about managing your money than they do about making big upfront commissions.
• No surrender charges. They do not need to impose surrender charges to collect commission costs because they do not rely on a commission-paid insurance sales force like traditional insurance companies.
• Phantom income is exempt from taxation. Even if no cash income is distributed, some assets incur a tax liability for the owner. A zero-coupon bond, for example, pays no income until it matures, but the IRS requires taxpayers to pay taxes on imputed income as the bond approaches maturity. The tax on imputed or phantom income is offset if the asset is held in a PPLI.
• Tax compliance is simplified. Tax reporting is a perennial source of frustration for hedge fund investors and those with limited partnership and master limited partnership interests. The taxpayer can avoid dealing with K-1 filings and other reporting obligations by holding these assets within a PPLI.
• Creditor protection. Cash value life insurance is a tried and true method of protecting assets against creditors. In every state, life insurance and annuities provide substantial asset protection, and in certain states, such as Florida and Texas, creditor protection is infinite. In other circumstances, PPLI life insurance assets are stored offshore, making them inaccessible to US courts. No US court has the authority to compel a foreign corporation to release funds to a creditor.