Private placement life insurance (PPLI) is life insurance that has unique features not available for sale to the general public. PPLI policies are designed to appeal to high-net-worth individuals interested in funding insurance with a large, up-front premium payment to achieve high investment return on the amount transferred into the policy.
Let’s review how PPLI, specifically “on-shore” PPLI policies (that is, policies offered for sale and purchase in the United States through U.S. carriers), works and the planning opportunities and pitfalls that pertain to such products.
Popularity of PPLI
PPLI is an individually tailored variable universal life (VUL) insurance policy. Some of the reasons PPLI has become more popular in recent years include: (1) customized investment options; (2) a possible reduction in carrier costs; and (3) greater opportunity for investment in alternative investments like hedge funds, commodities and options, all of which are in combination with the beneficial tax treatment available to all policies. Further, PPLI carriers can offer more varied investment options than non-PPLI carriers, so long as they’re available only to “accredited investors.” As a result, PPLI carrier offerings often require a higher risk tolerance by carriers and the policyholders alike.
The additional investment options, which may provide greater returns, are potentially further improved by lower costs that can exist in a PPLI policy or be negotiated between the carrier and the owner of a policy. For example, a PPLI buyer may negotiate lower agent commissions or commissions that are based on growth in the value of the policy and taken ratably over the life of the policy, rather than a fixed, up-front commission charged against the initial premiums. Because agent commissions are paid by the carrier out of the premium, the lower the commission, the more the premium is added to the cash surrender accounts for the PPLI policy.1 Furthermore, because much of the policy premium is invested in cash surrender value (CSV) and not death benefit, mortality and expense (M&E) charges will be reduced. M&E charges are fees that the carrier charges within the premium for administration of the policy that account for the risk that the insured may not live long enough for the carrier to profit from the policy in light of the costs of maintaining the policy. This emphasis on growth in the CSV also results in smaller cost of insurance (COI) charges. COI charges are fees paid to the carrier within the premium for the pure investment risk it’s taking on by issuing the policy, and they’re based on the difference between the policy cash value and the policy’s face amount. Finally, surrender charges typically aren’t charged in PPLI products.
PPLI also has all of the same benefits offered by every VUL non-PPLI policy. The assets in the policy for investment are held in separate accounts, not the general account of the insurance carrier, thereby protecting the assets from claims against the carrier, and the payout of the death benefit isn’t subject to income tax under Internal Revenue Code Section 101(a) (subject to the transfer-for-value rules).2 In addition, IRC Section 72(e) provides that any amounts received from a life insurance contract are considered first to come from the policyholder’s investment in the contract and to such extent are income tax free.
While the emphasis PPLI puts on building the CSV as quickly as possible (taking advantage of its broader range of investments) is an attractive feature, it also raises concerns that funding the policy too fast will cause the policy to qualify as a modified endowment contract (MEC). A MEC is defined in IRC Section 7702A as a policy that’s over-funded during the first seven years of the contract period, which raised concerns that investors would acquire policies solely to avoid income taxation rather than for the death benefit.3 If a policy qualifies as a MEC, any distribution from the policy is treated as taxable to the extent there’s any gain in the policy at ordinary income tax rates.4 Only when such gain is fully recognized will the remaining distributions be considered a tax-free return on the policyholder’s investment in the contract. Furthermore, loans and dividends paid from a MEC will be considered distributions, as will dividends used by the carrier to repay principal or pay interest on a policy loan and, if the policy is pledged or used as collateral, that access to the financial benefits of the policy cash value by the policyholder may be deemed a distribution from the policy. Finally, if a policyholder accesses cash value from a MEC before attaining age 59½, a 10% tax penalty will apply to the distribution.
Regulatory Requirements
PPLI is a non-registered security under the Securities Act of 1933 and may only be made available to “accredited investors” (as defined under Rule 501(a) of Regulation D of the Securities Act of 1933), which exempts the sale of the policy from registration with the Securities and Exchange Commission.5 In addition to being accredited investors, prospective purchasers should also be “qualified purchasers” (as defined under the Investment Company Act of 1940), which will relieve the carrier from having to register as an investment company with the SEC.6
PPLI, like all policies, is subject to state law, and although each state has its own securities laws, most state rules mirror the federal rules governing PPLI. What may differ, however, is how each state regulates the business of insurance that takes place within its borders. Accordingly, PPLI must also satisfy the applicable state’s requirements on the policies, including the state’s approval of the product being offered (with its individually tailored provisions). The pricing of PPLI can also be affected by state insurance regulatory rules on premium taxes, solicitation and negotiated agent commissions.
Qualification as Life Insurance
Given the nature of PPLI with its focus on investment return, it’s important that PPLI be considered a life insurance contract and not an investment account. Even if the policy loses its tax-free build up under Section 7702(a) (discussed below), so long as it’s considered a life insurance contract, it’s still possible to obtain some of the tax-favored treatment of its death benefit under Section 101 (subject to the transfer-for-value rules).
The first requirement for the policy to be considered a life insurance contract is that it must be considered “life insurance” under the law of the state where the policy originates.7 There are both statutory and common law requirements for insurance policies. The common law requirements call for a certain amount of risk shifting (that is, risk of economic loss on the death of the insured transferred from the insured to the carrier) and a sharing of mortality risk among a group of insureds. These common law requirements exist under all jurisdictions,8 but the adequacy of risk shifting and risk distribution will vary among jurisdictions. The magnitude of risk is reflected in the amount by which the death benefit exceeds the premiums paid,9 and if the risk is so small as to be negligible, the contract won’t be considered insurance.10
Once the PPLI is considered a life insurance policy under applicable law, the question becomes whether the policy is a “life insurance contract” as defined under Section 7702(a), in which the carrier is taxed on the income realized in the policy accounts, or under Section 7702(g), in which the policyholder is taxed on that income. The policy must also satisfy one of two tests set forth in the Section 7702(a), both of which require actuarial calculations. The carrier will ensure the policy satisfies one of the tests and will continue to monitor premium payments to ensure compliance with Section 7702(a).
In addition to the tests under Section 7702(a), PPLI must also satisfy the diversification requirements of IRC Section 817, and the policyholder mustn’t engage in conduct deemed to be “investor control,” both of which were developed to address the Congressional concern that investors would use an insurance wrapper to achieve a better investment return than available outside of an insurance policy due to the tax-free build up available to life insurance policies. The investor control rules were developed by the IRS before the enactment of Section 817, and the IRS has continued to develop the investor control rules concurrently with Section 817.
Accordingly, there are several means of taxing the policy owner and not the carrier for the inside growth of a policy, including a finding that: (1) there exists no life insurance contract under state law; (2) there’s a life insurance contract, but it doesn’t satisfy the requirements of Section 7702(a) and is therefore taxed under Section 7702(g); (3) there’s a life insurance contract, it satisfies the requirements of Section 7702(a), but the owner of the contract has so much control over the investments inside the policy that it triggers the doctrine of constructive receipt;11 (4) there’s a life insurance contract, it satisfies the requirements of Section 7702(a) but doesn’t satisfy the requirements of Section 817, in which case the policy is subject to Section 7702(g); and (5) there’s a life insurance contract, it satisfies the requirements of Section 7702(a) and Section 817, but fails the investor control rules resulting in treatment of the policy as an investment account owned by the owner of the contract directly.
An exhaustive discussion of the Section 817 rules and the investor control rules is beyond the scope of this article; however, of the two sets of rules, the investor control rules are of more concern to PPLI given the greater flexibility permitted for investments held by a carrier and the often expressed desires of the owner of the contract to control those investments. In brief, Section 817 is a mechanical set of rules for which the carrier is typically responsible for ensuring compliance. With respect to investment of the policy cash value, Section 817 includes a strict set of diversification rules, providing that each asset account must contain at least five investments, and no one investment may represent more than 55% of the value of the account’s assets, no two investments may constitute more than 70%, no three investments may comprise more than 80% and no four investments may make up more than 90% of the separate account’s value.12
In addition to the diversification rules of Section 817, the IRS, supported by the U.S. Court of Appeals for the 8th Circuit, has taken the position that a variable life insurance policyholder who retains substantial control over the investment of assets underlying the policy may be treated as the owner of the underlying assets for federal income tax purposes, even if they’re adequately diversified under Section 817.13 In Webber v. Commissioner, the Tax Court confirmed this position by treating Section 817 and the investor control rules as two separate requirements for life insurance policies.14
In a nutshell, to ensure the policyholder isn’t considered to control the investments in the policy, they shouldn’t have control over specific investment selections. Further, there can be no arrangement, plan or agreement between the policyholder and investment manager (hired by the insurance company) regarding specific assets to be held, and all investment decisions must be made by the investment manager in their sole discretion. The policy holder may allocate premiums and transfer funds among available investment options, but they can’t select or recommend particular investments or investment tactics, communicate directly or indirectly with any investment manager regarding selection, quantity or rate of return of any investment or group of investments held in the policy. The policyholder may not have any legal, equitable, direct or indirect interest in any of the assets, and all assets are owned by the insurance carrier.
Managing PPLI
While there’s a great deal of flexibility in choosing the investments inside a PPLI policy, the insurance carrier is the owner of the assets in the separate accounts, and each investment manager managing assets for the insurance company must pass a rigorous due diligence test. PPLI policyholders may transfer cash values from one fund or fund manager to another based on the insurance company’s list of investments available, without taxation or costs, and as new funds or managers are added to an insurance company’s “platform,” policyholders automatically have additional opportunities for investment diversification.
Insurance dedicated funds (IDFs) are investment funds that are only available through the carrier, rather than the general public. Each IDF has an investment manager who manages the IDF in accordance with the investment strategies established by the investment manager and the carrier. The policyholder will select which IDFs the accounts will invest in based on the expressed investment strategies of each IDF. The investment manager looks through the IDF at its investments and certifies that the investments held in the IDF are sufficiently diversified to meet the requirements of Section 817.
Separate management accounts are also invested based on certain investment strategies managed by the carrier’s investment managers. The accounts themselves, when taken together inside the policy, must meet the diversification rules of Section 817. The policyholder will select the separate accounts managed by the investment managers, and the policy investment is then allocated among the separate accounts. As with IDFs, these separate accounts aren’t available to the general public.15
When to Consider
PPLI, with its potential for significant growth in cash value due to unique investment opportunities, can be very attractive in estate planning. With respect to premium payments, the cash value of a non-MEC policy may be used to meet premium payment obligations, as in the case of a split-dollar arrangement. The policyholder, perhaps an irrevocable trust, also could use the cash value of the PPLI policy to acquire other assets in the trust or other life insurance policies on the lives of beneficiaries and other family members.
While ownership in an irrevocable trust may be preferred from an estate tax planning perspective, it’s common for PPLI to be owned by an individual as an investment tool and, because it will also have a death benefit above the cash value, even if the PPLI is included in the policyholder’s estate, the overall wealth transfer will be more significant than without the PPLI. Also, in the case of an individually owned non-MEC policy, the unique tax treatment afforded to life insurance products, coupled with simple loan and withdrawal procedures, make PPLI an ideal supplement for traditional retirement planning, and it carries the added bonus of benefiting designated beneficiaries free from income tax, unlike traditional retirement accounts.
Given its particular benefits, PPLI should be added to an estate planner’s arsenal for use as an independent transaction for investment or retirement purposes or as a vehicle to support other estate-planning transactions. However, with the positive attributes of PPLI also come stringent requirements regarding investments and control, making PPLI best for clients who have an appropriate level of risk tolerance and otherwise meet the qualifications for being a PPLI policyholder.
Endnotes
1. Gerald Nowotny noted in his 2012 article, “Private Placement Life Insurance and Annuities 101-A Primer” (jdsupra.com, Aug. 28, 2012) that traditional variable life insurance products have a commission structure that “pays the agent 55-95% of the target (commissionable) premiums in the first policy year,” and commissions in subsequent years on premiums vary by carrier from 2-5% of the premium as well as .25-.35% of the policy’s account value.
2. Internal Revenue Code Section 101(a)(2).
3. IRC Section 7702A provides that a policy contract fails the 7-pay test and is deemed a modified endowment contract (MEC) if the accumulated amount paid under the contract at any time during the first seven contract years exceeds the sum of the net level premiums that would have been paid on or before such time if the contract provided for paid-up future benefits after the payment of seven level annual premiums.
4. IRC Section 77(e).
5. See 17 C.F.R. Section 230.501
6. The U.S. Investment Company Act of 1940.
7. See Private Letter Ruling 200919025 (May 8, 2009); see also Staff of the Joint Committee on Taxation, 98th Congress, 1st Session, “General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984,” at p. 646 (Dec. 31, 1984).
8. Helvering v. LeGierse, 312 U.S. 531 (1941).
9. See Notices 2009-47 and 2009-24, which established a safe harbor for contracts with a death benefit equal to at least 105% for certain policies. These Notices were made obsolete by Revenue Procedure 2010-18, 2010-34, which provided for safe harbors, but didn’t include the 105% requirement. The amount of risk in the policy affects the investment return: The lower the amount of risk the policy has to provide under applicable law, the lower the amount of the premiums that has to be paid to the carrier as cost of insurance and mortality risk expense, and therefore more of the premium may be retained in the cash value accounts of the policy.
10. See, e.g., Revenue Ruling 2005-40, in which the fact that only 10% of risk was shared by unrelated insureds and the remaining 90% was borne by only one insured/policyholder in a parent subsidiary relationship results in the holding that the arrangement wasn’t insurance.
11. See, e.g., Christoffersen v. United States, 749 F.2d 513, 515-16 (8th Cir. 1984), cert. denied, 473 U.S. 905 (1985).
12. See Treasury Regulations Section 1.817-5(b)(1)(i).
13. See, e.g., supra note 11, in which the court stated that:
[u]nder the long recognized doctrine of constructive receipt, the income generated by the account assets should be taxed to the [annuity holders] in the year earned, not at some later time when the [annuity holders] choose to receive it. This is the essence of Rev. Rul. 81-225, which we find persuasive.
14. See also Rev. Rul. 82-54, Rev. Rul. 81-225, Rev. Rul. 80-274, Rev. Rul. 77-85.
15. Webber v. Commissioner, 144 T.C. 324 (June 30, 2015).
16. Although see PLR 201105012 (Feb. 4, 2011) in which the assets were available to the general public, but the policy owner still wasn’t considered the owner of the account under the investor control rules.