Here are brief descriptions of some financial strategies using life or health insurance, which can improve the financial situation of a person and his/her legacy.
Financial obligation funding
Estate investment
Immediate financing arrangement
Charitable donations and life insurance
Insured annuity (back-to-back annuity)
Buy-sell agreement
Split dollar critical illness
Financial obligation funding
Many families or businesspeople face cash flow issues upon death. The taxes related to the deemed disposition of shares of a private corporation upon death, the funding of a buy-sell agreement, the fair distribution of the estate and the plan to ensure the financial security of a spouse are good examples. It is possible that the value of the capital on hand at death is theoretically sufficient to meet the future needs of the dependents, but that this capital is not "liquid" (for example, shares of a private corporation or commercial real estate). If there were taxes to be paid on these assets, the available cash would not be sufficient to cover them. It would be necessary to either sell the shares or the real estate or to borrow, measures which, in certain circumstances, may not be desirable or even possible. In this case, the subscription of life insurance to face the payment of this obligation is logical and coherent.
There are other cases where the heirs would not have liquidity issues in the event of the death of the insured person even after the taxes have been paid. For example, when liquid assets make it possible to meet the payment of these taxes. Despite this, life insurance remains useful as a tool to fund taxes at the lowest cost or as a profitable estate investment.
Estate investment
Permanent life insurance can be a very profitable as an alternative asset class.
A traditional investment involves two aspects:
-the effort: money must be invested;
-the fruit: the returns (interest, dividend, operating profit for a business, capital gain, etc.) and the return of capital.
Permanent life insurance follows this reasoning:
-the effort: the payment of premiums;
-the fruit: the collection of the death benefit.
The combination of this effort and this fruit can increase the value of the estate. A term 100, a universal life or a whole life (participating or non-participating) can be purchased to achieve the goal of preserving and maximizing the estate value.
The profitability of permanent life insurance is partly explained by its tax treatment upon death. Growth is tax-sheltered, the death benefit is not taxable, and when life insurance is purchased by a corporation, the death benefit will increase the capital dividend account (CDA) of the corporation and help pay tax-free dividends to the heirs. In this case, life insurance does not only allow to generate the sums to pay taxes on death, but also to reduce the tax bill.
Immediate financing arrangement
An immediate financing arrangement (IFA) is a strategy consisting of entering into a contract for an exempt life insurance policy (typically a participating whole-life or a universal life policy) and transfer funds to that contract. These policies have the potential to create significant cash surrender value (CSV) which could immediately (or soon after) be assigned as collateral to secure a loan. The loan is often structured as a variable rate line of credit repayable on demand. The borrower can request an advance whenever he/she wishes. The outstanding loan balance may not exceed a certain percentage of the CSV. Additional collateral may be required to gain access to additional fund advances. The loan amounts are used to invest in a business or property (real estate or investment portfolio) to generate income.
If the insured passes away before the loan is fully repaid, the outstanding loan balance is repaid using the death benefit amount and the remaining life insurance benefit is paid tax free to the beneficiaries of the policy. This strategy has two objectives. Firstly, it meets the need or wish of a client to establish an estate asset. Secondly, it reduces the cash outlay required to set up this estate. The policyholder has access to permanent life insurance without tying up significant cash. These objectives are reached through tax sheltered growth in the value of the policy, loans made and potential tax savings from deductions. If the arrangement is set up by a private corporation, the insurance proceeds generate a credit to its capital dividend account (CDA).
Charitable donations and life insurance
Several strategies use life insurance to donate to charities. In some scenarios, life insurance is the asset being donated. We thus take advantage of its multiplier effect. In other scenarios, life insurance allows for the replacement of capital used to fund a major charitable gift. Here are some important options.
1 The donor retains ownership of the contract (new or existing), names his/her estate as beneficiary and makes a donation in his/her will to a charity for an amount equal to the life insurance proceeds: no charitable tax receipt will be issued for the premiums paid during the lifetime of the donor. Upon his/her death, he/she will be entitled to a charitable receipt in his/her final tax return for the amount paid to the charity.
2 The donor assigns ownership of the policy (new or existing) to a charity and the charity designates itself as beneficiary of the contract (revocable or irrevocable): a tax receipt will be issued during the lifetime of the donor. Upon death, the donor will not be entitled to a receipt equal to the amount of the death benefit paid to the charity.
3 Inter vivos gift and replacement with a life insurance policy: the donor plans a series of living donations in cash or in securities. He/she then uses the tax savings applicable to donations to fund a permanent life insurance policy whose death benefit will often exceed the sum of the donations made. Thus, the total donations, increased by a return, will ultimately be recovered by the estate.
Insured annuity (back-to-back annuity)
The insured annuity is a very simple and very effective strategy in some circumstances. It includes the purchase of two contracts: a life annuity and permanent life insurance.
The combination of these two types of contracts creates the equivalent of a locked-in fixed-yield income investment vehicle, which is particularly attractive to older and more conservative investors. The goal is to provide a guaranteed income superior to the income of traditional fixed-rate investment instruments, while preserving the capital invested.
When the contracts are held by a private corporation, the insured annuity strategy is based on the same principles as those concerning an individual. However, some very interesting elements are added: upon death, the capital can be paid out with no (or very little) tax impact thanks to the capital dividend account (CDA), and the strategy makes it possible to reduce taxes upon death because the alienation of part of the capital for the purchase of an annuity reduces the value of the assets (and consequently the value of the shares of the corporation).
Buy-sell agreement
A properly funded shareholders' agreement guarantees shareholders of a private corporation that the seller has a market for his/her shares and that the buyer has a reliable source of financing to acquire them. Life and health insurance is relevant for certain aspects of the funding of a shareholder agreement, particularly with respect to death, disability and retirement.
It is accepted by most advisors that life insurance is an effective precautionary measure in the event of the death of a shareholder. Moreover, a significant and often overlooked risk, the potential disability of a shareholder, can also be covered with flexible living benefit products. Similarly, in some rarer cases, life insurance can also be useful in planning for retirement. Some products offer a guaranteed insurability option that allows the increase of the life insurance coverage without having to provide evidence of good health. With this option, it is sufficient to prove that the financial value of the corporation has increased.
The positioning of the life insurance policy in the structure is an element that requires planning. You should know that there may be several stakeholders for the same life insurance policy. First, there is the insured person, on whom the life insurance contract is based. Then there is the policyholder, who owns the insurance contract and who will make the decisions relating to the contract. There is also the premium payer, who is not necessarily the policyholder. Then there is the beneficiary, the person who will receive the death benefit at the time of death. Each combination of stakeholders will bring its own set of questions, tax and financial consequences, advantages, and disadvantages.
Split dollar critical illness
The split dollar critical illness insurance strategy calls for a critical illness insurance contract that includes a return of premium benefit upon termination after a few years (often 15 years) or upon expiry of the contract, if the basic critical illness benefit had not been paid before. A refund of premiums is also offered in the event of death.
The strategy applies mainly to the situation of a shareholder of a private corporation. The objective of the strategy is to provide the corporation with critical illness protection, either for business or personal protection purposes.
If no critical illness benefits have been paid at the time of termination or expiry of the contract, the shareholder will benefit from the refund of part or all the premiums paid by the corporation and by the shareholder, all tax free.
