Life Insurance Wrappers

An insurance wrapper is an insurance contract wrapped around capital to protect against loss or damage by a contingent event. Insurance contracts are risk-management tools. Financial advisers recommend that clients exposed to the risk of fire, theft, accident, and liability purchase adequate insurance to protect against those risks. The products we're discussing here use either a life insurance contract or an annuity contract as the wrapper. The question the informed client deserves to have answered is, Does this wrapper, the insurance contract, provide enough value in the form of protection against loss of capital to justify its cost? Advisers sometimes fail to understand that once one of these contracts is wrapped around a block of capital, the legal nature of that capital changes in many important ways. Advisers need to understand the costs and features of insurance wrappers and to be able to explain them to clients so that they can make informed decisions about whether to use them.

Managing client money tax-efficiently has many challenges, and investment theory on how to provide the most efficient after-tax, after-expense rate of return continues to evolve. As a starting point for a decision, advisers need to determine what it costs to manage taxable portfolios in their practice. figure 10.1 presents a set of cost assumptions that can be adjusted according to your own information.

The gross return of 10 percent assumes an asset allocation with a large proportion of equities, which means that tax-free municipal bonds may protect the bond portfolio from some taxation but leaves the equities exposed to taxation. Indexing can minimize the cost of outside managers, but to the extent it's successful in an asset-allocated account and some rebalancing is used to stay within risk parameters, income taxes could at times exceed the average of 2 percent per annum. (Advisers who are able to keep their clients' tax burden under 2 percent per annum will want to adjust Figure 10.1.) Although many advisers are moving from charging for assets under management to charging retainers, we translated the adviser's long-term compensation—be it an asset-management fee, retainer, or commission—to about 1 percent.

If this capital is moved into an adviser-managed variable life insurance policy, how is the cost structure likely to compare? (See figure 10.2.)

To answer that question, the critical adviser will ask:

figure 10.1

TAXABLE PORTFOLIO

ADVISER-SPECIFIC TAXABLE PORTFOLIO

ADVISER-SPECIFIC VARIABLE LIFE INSURANCE

Gross return

10%

Income taxes

-2%

Management fees

-1%

Adviser fee/commission

-1%

Cost of life insurance

N/A

Net to investor

6%

1 Can you find a variable universal life policy with subaccount management fees and mortality and expense (M&E) charges of 2 percent or less?

2 Can you keep adviser-management retainers, fees, or commissions down to 1 percent of policy capital?

3 Is there a possibility of keeping the monthly applied administration fees and the cost of life insurance down to 1 percent of policy capital per annum?

The answer to question one is yes, although it may take some contract hunting and subaccount selection. Typically, low-load products without surrender charges are more acceptable to advisers. The answer to question two is adviser driven and, with substantial capital in a life insurance contract, appropriate fees can be a great deal less than 1 percent of the capital in the policy. As for question three: In a single-life policy designed to retain all of the income tax benefits of life insurance, getting the monthly deducted cost of insurance and administrative expenses down to 1 percent of policy capital on an annualized basis is not likely to happen in the first years of the policy because of the government constraints on how much can be put into the contract during those years. With survivorship, or second-to-die, policies it will happen earlier because the costs of insurance are about a tenth of what they are for a first-to-die policy. Also, more money can be put into the contract, relative to the death benefit, in the early years of a contract if the policy owner is willing to forgo the ability to withdraw cost basis or take

figure 10.2

TAXABLE PORTFOLIO

TAXABLE PORTFOLIO EMBEDDED IN VARIABLE LIFE

Gross return

10%

10%

Income taxes

-2%

0%

Management fees and M&E

-1%

-2%

Adviser fee/commission

-1%

-1%

Cost of life insurance

N/A

-1%

Net to investor

6%

6%

policy loans from the policy without incurring immediate income taxation to the extent of gain in the contract and 10 percent Internal Revenue Service penalties on gain removed before age fifty-nine and a half.

In the single-life policy, retaining all of the tax benefits including the right to withdraw cost basis without taxation and to take policy loans without taxation, it would take five years for a sixty-five-year-old insured male to embed $500,000 in a $1 million policy. Whereas if the income-tax-free withdrawal/loan feature was not needed and modified endowment contract (MEC) status was acceptable, $500,000 could be put into the policy in year one. The MEC case could drive the cost of insurance and administrative costs down to 1 percent in year two, whereas in the slower five-year funding method, it could take five years to get to that point, depending on investment returns on the capital. Capital losses can drive up the cost of the life insurance, whereas capital gains can drive down the cost of the life insurance as a percentage of the capital in the policy.

Once cost questions are adequately addressed, the next questions have to do with how the life insurance wrapper around this capital changes the nature of the capital and whether those changes have positive or negative value for the particular client situation under study. The comparison table "How Variable Life Insurance Differs From Taxable Portfolios" (see Web address www.bloomberg.com/thinktank) may be helpful in determining the applicability and the positive or negative value in basis points of various variable life insurance features. To be as complete as possible, the list is extensive. Some features, of course, may be marked "not applicable" (N/A) for an individual client.

The adviser can use the blank portions of this table to evaluate a specific client situation, putting a check in each box, indicating positive, negative, or no value. Tallying the checks will indicate whether there is a preponderance of negatives or points of no value, so that further consideration is not required. If there are a significant number of positive checks, however, quantifying the value of the positive features versus the negative features may be warranted.

0 0

Post a comment