How to leverage life insurance for planning purposes

An IFA allows both the owners of corporations that have strong cash flow and high net-worth (HNW) clients to secure a loan from a financial services institution using the cash value of an exempt insurance policy as collateral. To employ this strategy, your client deposits sufficient funds in his or her policy to create an early cash surrender value (CSV) and applies for the loan. The amount that can be borrowed is based on a percentage of the CSV, and the funds are received tax-free.

The client pays interest on the loan each year, and can reduce the costs of funding the policy in two ways: by claiming an interest expense deduction (as long as the loan is used to generate income); and by claiming a collateral insurance deduction if the policyholder and borrower are the same person. The loan can be repaid at any time, including upon death, by using the insurance proceeds. For a corporate IFA, gross proceeds upon the death of the insured generate a credit to the corporation’s capital dividend account (CDA).

“The combination of a growing life insurance policy, the ability to invest the borrowed funds, the CDA credits and the tax deductions are all very appealing to a client,” states the team at Toronto-based Manulife Individual Insurance, Tax, Retirement and Estate Planning Services in an emailed response to Investment Executive’s request for information.

Bernard Larivière, certified financial planner with National Bank Insurance Firm Inc. in Montreal, says he considers an IFA for clients who aren’t risk-averse, have about $5 million to invest and can afford $100,000 in annual premiums. Clients who hold real estate can be good candidates because they have assets but lack liquidity, he says. He adds that specialists are required to set up and oversee the strategy to ensure compliance with the Income Tax Act.

Suitability

In addition to qualifying for the insurance, your client must qualify for the loan and benefit from an IFA’s tax efficiency for an IFA to make sense.

Specifically, the client must qualify for life insurance based on health as well as for underwriting based on income, net worth and premium-paying ability, the email from Manulife states.

Underwriting approval also involves ascertaining whether the death benefit is appropriate, given the client’s financial position. An IFA is not for someone who will borrow to pay premiums, Manulife’s email states. Qualifying also requires sufficient credit capacity, not just assets.

For tax efficiency, the IFA works best when a client is subject to high tax rates. For example, if the borrowed funds are used to generate investment income in a corporation (taxed at 50.2% in Ontario), the client’s internal rate of return on the IFA will be greater than would be the case if the funds are used to generate active business income that is taxed at the small-business rate (12.5%). The client must also have sufficient income that is taxed at the top rate to use tax deductions effectively, the email from Manulife states.

Although clients who own corporations or are HNW executives are ideal candidates, this strategy isn’t suitable across the board. These clients may take risks in business and be comfortable with leverage, but prefer to contain risk regarding their legacy, the email from Manulife suggests. In fact, for every 100 client conversations the Manulife team has about IFAs, only a couple of the arrangements go on the books. As a result of discussions about IFAs, the email states, “clients often realize borrowing is complex, and they really don’t need to borrow to enjoy the benefits of life insurance.”

Therefore, the discussion regarding IFAs often serves to promote insurance in general, with about 80 of those 100 client conversations resulting in policy purchases without using leverage.

Risks

Among the risks to consider is changes in interest rates, which will affect policy performance and interest expense over the term of the arrangement. And, as the email from Manulife notes, a rate increase applies immediately to the loan, which has a floating rate, but takes longer to be reflected in the dividend scale of a whole-life policy. When you project values over a client’s lifetime, you should use conservative assumptions, demonstrate the sensitivities affecting those assumptions, and discuss worst-case scenarios, the email suggests.

Kevin Wark, managing partner with Integrated Estate Solutions in Toronto and tax advisor to the Conference for Advanced Life Underwriting, says if rate changes result in the loan’s outstanding amount exceeding the policy’s cash value, the client will have to post additional collateral or repay a portion of the loan.

Another consideration, Wark says, is that the client may not be able to use the interest expense deduction fully over the life of the IFA if the client’s corporation fails to be profitable, which diminishes the strategy’s tax benefits.

You and your clients should discuss what happens if the investment undertaken using the loan fails completely, requiring the IFA to be unwound.

In such a case, the email from Manulife states: “The loan needs to be repaid, which requires liquidity.” If the client surrenders the policy to repay the loan, there may be a taxable income inclusion with no cash to pay the taxes.

Wind-down strategies also should be discussed, Wark says, because tax rules can change – a risk with all long-term planning. In recent years, the Department of Finance Canada’s rule changes often don’t grandfather existing arrangements, he adds.

Finally, a shareholder benefit can arise if the shareholder borrows personally and uses a corporate policy as collateral, because the corporation is guaranteeing the debt. That benefit can be managed if the shareholder pays the corporation a fee for that guarantee, but professional advice should be sought, Wark says. A benefit also can arise if the corporate policy’s proceeds go to the lender upon death; these proceeds must be managed so that the shareholder’s estate repays the loan.