Life Insurance

How Does Private Placement Life Insurance Work?

How Does Private Placement Life Insurance Work?

Private placement life insurance (PPLI) is a niche solution designed for wealthy individuals in high tax brackets who have a few million dollars available to commit.

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Many times, those for whom PPLI was designed want to invest in hedge funds, but hedge funds can carry significant taxes: If the wealthy individual invests in them in their personal 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 taxable at particularly high rates.

That's a serious issue at higher income levels, where combined federal and state income and capital gains taxes can easily add up to nearly 50% in some jurisdictions.

One increasingly popular solution: Hold these assets within a life insurance policy.

Who does private placement life insurance make sense for?

PPLI isn't for everybody. A good candidate for this strategy is someone with annual income in the millions, a net worth of $20 million or more or someone who controls a business that puts them in that category.

Life insurance comes with a number of important tax benefits, which can be major considerations for those in the highest tax brackets. But standard life insurance policies you can get from your neighborhood agent don't contain the hedge funds, funds of funds and other alternative investments that these investors require for their own diversification and investment needs.

That's where privately placed life insurance comes in: Wealthy families, family foundations, trusts, corporations and banks work with hedge funds and money management firms to create their own life insurance contracts, designed to reduce their tax burdens.

The idea is to combine the financial advantages of highly taxed hedge funds and similar investments with the tax advantages of life insurance. There are insurance and administrative costs associated with the life insurance contract, but the tax savings in a properly structured life insurance policy, plus the death benefit itself, more than make up for the additional insurance and administrative costs. And the insured can generally access most of the funds anyway, tax-free, via policy withdrawals and loans.

When a wealthy investor in a very high tax bracket wants to invest in hedge funds anyway, it often makes sense to create a privately placed life insurance policy to shelter the individual from taxes.

Qualifications to purchase PPLI

While anyone can buy a variable universal life insurance policy (as PPLIs are structured), PPLIs are an unregistered securities product. As such, agents can only present them to accredited investors.

Under current Securities and Exchange Commission (SEC) regulations, accredited investors are those with a net worth of at least $1 million (excluding primary residence), or income of at least $200,000 in each of the preceding two years. Married couples must demonstrate income of $300,000 in each of the preceding two years.

Ultimately, the owner is typically an individual or a trust. Holding the policy in an irrevocable trust allows the insured to keep the policy out of their taxable estate, possibly reducing eventual estate tax liability, though they give up rights to access the cash value prior to death.

In reality, the typical PPLI candidate or family has:

  • A high net worth
  • The ability to fund $1 million or more in annual premiums for several years, at least — $3 million to $5 million is typical
  • A desire for hedge fund or alternative investment exposure
  • Highly tax-inefficient investments
  • High state and local income taxes in addition to federal (advisors should be alert to the effect of any state premium taxes on the strategy)
  • A desire to shelter assets from creditors

It's important to be able to make a significant investment over the first several years as this initial investment of premium "primes the pump," meaning that, assuming the underlying investment subaccounts perform adequately, the insured's policy can become self-funding. That is, growth in its cash value covers the cost of insurance. At that point, the insured can cease committing premium if they choose.

Where to buy private placement life insurance

Professional wealth managers tend to recommend vendors. However, some of the most prominent providers of PPLI services and insurance-dedicated funds (IDFs) include BlackRock, Wells Fargo Private Banking, John Hancock, Zurich, Crown Global and Pacific Life.

How private placement life insurance works

Privately placed life insurance is generally structured as a variable universal life insurance policy, meaning:

  • Premiums are flexible. Policyholders can pay as much or as little premium as they like, whenever they like.
  • The cost of insurance is deducted from the cash value in the policy subaccounts each month or each year.
  • To keep the policy in force, the owner must pay enough premium to maintain enough cash value to cover the cost of insurance.
  • If the cash value reaches zero, the policy will lapse.

The agent who sets it up will usually structure the policy to maximize cash value accumulation while keeping the death benefit (and thus the cost of insurance) relatively low. The policy owner, working with their insurance professional, then pays as much premium into the policy as possible every year.

The client gets the benefit of the tremendous tax advantages of the life insurance contract:

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

Meanwhile, the insured still has access to accumulated cash values, which can be used for any purpose and accessed at any age. There are no penalties for accessing the cash value before turning age 59 1/2, as there are with annuities and with individual retirement accounts (IRAs). In addition, there are no required minimum distributions, as there are with annuities, IRAs and retirement accounts.

PPLI investments

As discussed, the best investment candidates for a PPLI policy are those that are tax-inefficient. They generate substantial current taxable income, imputed (phantom) income or capital gains unless they are held in a retirement account or life insurance vehicle that provides tax-free growth.

PPLI owners and their advisors either choose specific investments for their portfolios or carefully select money managers to manage their portfolios within the policies. Possible investments can include venture capital, real estate investment trusts, private equity funds, funds of hedge funds and commodity funds, or any fund with extremely high turnover rates that generate substantial short-term capital gains.

But that doesn't mean anything goes. PPLIs must still meet IRS standards for investor control, insurance and diversification.

Investor control. Individual policy owners and family offices are prohibited from exercising influence over the specific investment decisions of the fund managers. If the owner exercises too much control, the IRS may disqualify the tax advantages of the policy. Current case law requires managers to operate on an independent, discretionary basis. Assets held in PPLI policies are not designed to be separately managed accounts, and they should not be treated that way.

Insurance standards. The life insurance structure allows owners to sell insurance-dedicated funds within the policy as often as they like and replace them with other qualified investments, without tax consequences. IDFs are financial products that are designed specifically for the PPLI market. Hedge funds and funds of funds often create a version of their flagship offering as an IDF that uses all the same strategies and managers but is also managed to adhere to laws and regulations that govern insurance portfolios.

Diversification requirements. Investments must also meet diversification rules:

  • No single investment may make up more than 55% of the insurance subaccount portfolio.
  • 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 constitute more than 90% of the total assets of the account.

Therefore, the portfolio must, in practice, contain a minimum of five distinct investments in order to fully qualify as life insurance. Otherwise, the IRS will disqualify the policy, and the owner will lose the tax advantages of the life insurance structure.

Accessing your money in a PPLI

Policy owners can withdraw from their cash value or borrow against it at any time, for any purpose.

Withdrawals Withdrawals are tax-free up to the basis of the policies. So owners can get back their premiums, minus fees, without tax consequences — as long as their subaccounts' performance has kept up with the cost of insurance. If the cash value is greater than the owner's basis in the policy — that is, what they have paid in — then additional withdrawals in excess of 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 loan is secured by the policy's cash value. This makes the policy a solid choice for emergency funds. The loan does not have to be paid back, though the policy owner may want to replenish funds borrowed from the policy so as to maximize long-term tax-free growth.

Because the loans are secured by payments already made to the insurer, interest rates are often very low. Borrowers should be aware that interest does accrue, and borrowing will reduce any death benefits paid out unless the loan is paid back to the policy.

Contribution limitations and modified endowment contracts

The government imposes limits to how much premium the owner can contribute to the policy in a given year in order to help ensure life insurance is used for its intended purpose, as opposed to a tax shelter. The result of the contribution limit is the "seven-pay" test. If policyholders contribute so much premium to their policies that the policy would be paid up in less than seven years, it becomes a modified endowment contract (MEC). This will disqualify the policy from many of the tax advantages on withdrawals and loans:

  • One of the great things about insurance policies is that when you withdraw cash value from an in-force life insurance policy, you get the benefit of first-in, first-out (FIFO) taxation. This allows you to withdraw as much as you'd like, up to your basis in the policy (the amount you have contributed), tax-free. If your policy becomes an MEC, this advantage disappears. Instead, the IRS will deem you to be withdrawing interest first, not your basis. This interest is taxable.
  • Likewise, while the law allows you to take tax-free loans from a life insurance policy, once your policy becomes an MEC, those loans become taxable as income.
  • Additionally, once your policy becomes an MEC, any withdrawals prior to age 59 1/2 become subject to a 10% early withdrawal penalty, just as with a qualified annuity or a 401(k).

Your policy documents should specify the annual MEC limit.

Life insurance contract
PremiumsLimited by seven-pay testNot limited except by contract
LoansTax-free for life of policyTaxable as income
WithdrawalsTax-free up to basis (FIFO)Taxable until all interest/gains are withdrawn
Death benefitTax-freeTax-free
Death benefit amountUsually kept small in PPLI to maximize growth of cash valueUsed to maximize death benefit

How are PPLI policies different from retail life insurance?

Structurally, privately placed life insurance is identical to a conventional variable universal life insurance policy. What sets the PPLI apart is the assets held in the subaccount: An everyday retail customer will choose from a limited menu of subaccount investments offered by the life insurance company.

But when you buy a PPLI, you can customize your investment subaccounts. You can include nearly any investment imaginable — from index funds to hedge funds. Your registered investment advisor or wealth manager can help design the investments in your menu of subaccounts.

Tax and other benefits of PPLI

High-income individuals are very tax-sensitive. The ordinary income tax rate on incomes above $518,401 in 2018 was 37%, plus additional Affordable Care Act taxes on high-income individuals. When you add in state and local income taxes in some jurisdictions, the income tax bite for high-income families could add up to nearly 50%.

The heart of the PPLI strategy lies in the tax advantage. The PPLI essentially converts a very tax-inefficient investment, such as a hedge fund, into a very tax-efficient one for the high-net-worth investor.

Hedge fund held in personal account (typically)
Hedge fund held within a PPLI
Death benefitN/ATax-free death benefit
IncomeTaxable at 37%-50%Tax-free for life of policy
Short-term capital gainsTaxable at 37%-50%Tax-free for life of policy
Long-term capital gainsTaxable at 20%Tax-free for life of policy
Imputed incomeTaxable at 37%-50%Tax-free for life of policy
Transfers to other life policiesTaxable, gain over basisTax-free under IRC Section 1035
Transfer to annuitiesTaxable, gain over basisTax-free under IRC Section 1035
Creditor protectionNoneEnhanced
Estate tax treatmentTaxable unless in irrevocable trustTaxable in estate of owner unless in irrevocable life insurance trust
Tax loss harvesting strategiesInvestors can sell losers to offset capital gainsN/A, though losing policies can be surrendered
Treatment at deathSubject to probateBypasses probate — death benefit goes to beneficiaries in a matter of days

This strategy neutralizes the impact of current income by placing the assets within a life insurance policy, with tax advantages similar to a Roth IRA. Assets within the policy enjoy tax-free growth for as long as they remain in the policy.

In addition to the tax benefits that generally accrue to life insurance cash values, PPLI policies often provide a number of additional benefits:

  • Lower commissions. The cost of insurance and commissions is low compared to most retail life insurance products: Issuers are more interested in managing your money than in generating large upfront commissions.
  • No surrender charges. Because they don't rely on a commission-paid insurance sales force as traditional insurance companies do, they don't need to recoup commission costs by imposing surrender charges.
  • Phantom income is not taxed. Some investments generate a tax liability to the owner, even though there is no actual cash income distributed. For example, a zero-coupon bond pays no income until it matures, but the IRS forces taxpayers to pay taxes on imputed income as the bond approaches maturity. If the asset is held in a PPLI, the tax on imputed or phantom income is neutralized.
  • Tax compliance is easier. Tax reporting is a constant headache for hedge fund investors and those who hold interests in limited partnerships and master limited partnerships. By holding these assets within a PPLI, the taxpayer can eliminate having to deal with K-1 reports and other reporting requirements.
  • Creditor protection. Cash value life insurance is a proven way to shelter assets from creditors. Life insurance and annuities enjoy substantial asset protection in every state, and in some states, like Florida and Texas, creditor protection is unlimited. In some cases, PPLI life insurance assets are held offshore — placing these assets out of the reach of U.S. courts. No U.S. court can force a foreign company to release funds to a creditor.

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