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Life insurance is making headline news. The explosive growth of the life settlement industry, where portfolios of life insurance policies are traded for profit on the secondary market, has caught the attention of insurance and securities regulators, as well as the media. Amid these highly publicized developments, the life insurance companies have been cultivating a very different type of investment-oriented insurance product, which has been maturing quietly without any recent controversy. This is private-placement life insurance (PPLI). The primary advantage of a PPLI policy is that premium payments can be invested flexibly in the securities markets and other assets, and accumulate free of income tax for the benefit of the policy owner. This presents a valuable income tax planning opportunity for people who are comfortable with the risks inherent in such investments, and whose income tax savings from the policy investments could outstrip the costs of creating and maintaining the policy. Furthermore, the policy owner may, within certain limits, borrow from the cash value of the policy. To understand what PPLI is, and what it does, requires an understanding of its two fundamental components: the “term” insurance component and the segregated investment account component. Term insurance is the simplest and most basic form of life insurance, in which the policy owner pays premiums for a specified term of years for a set amount of financial protection known as the “death benefit,” in the event of the insured individual’s death. Term life insurance premiums are less expensive than other life insurance products because they are actuarially keyed to pay only a set sum in the event of death during a specified time period. If the insured survives the term, then nothing will be paid. In other words, the premiums do not build up any cash value during the insured individual’s life, and the policy has no value as an investment vehicle, except for the death benefit. All of the more sophisticated “permanent” insurance products, including PPLI, offer a segregated, income tax-free investment account component in addition to the term insurance death benefit. Among these products, PPLI offers the most flexible investment options, with potentially higher rates of return and attendant risks. PPLI has evolved from variable universal life insurance, a type of product in which the cash value is held in a separate, segregated account, and is invested in a restricted group of mutual funds and money market accounts preselected by the insurance company. Unlike standard variable universal life products off the shelf, however, a PPLI policy is designed from scratch for the policy owner and the insured individual. The PPLI policy’s cash value can be managed by an investment adviser selected by the insurance company, and can be invested flexibly in stocks, bonds and hedge funds, among other assets, subject to the diversification rules and the “investor control” rules discussed below. Because the insurance carrier can make no guarantees as to investment returns-which also affect the death benefit and the required amount of premiums-PPLI may be offered only to wealthy, sophisticated, “accredited” investors who are deemed to be capable of bearing the risk of loss of their entire investment in the policy, under applicable securities laws. A discussion of the federal and state securities laws pertaining to the insurance carriers is beyond the scope of this article, but it is important to note that reputable carriers offering this type of policy must be licensed to do so, and typically provide an accompanying private-placement memorandum fully disclosing all material information regarding the policy and its risks. This is why such policies became known as “private-placement life insurance.” The insurance carriers issuing PPLI policies were initially located in offshore jurisdictions. This was due primarily to the fact that domestic state insurance laws restricted many types of policy investments, which was a key issue for most owners. Now, several states, including South Dakota and Alaska, have revised their laws to be more competitive, and the reasons to go offshore are less compelling for U.S. individuals. Since the insurance regulatory laws vary in different states and countries, it is important for the policy owner to get professional advice to confirm what each relevant jurisdiction requires, depending on the domiciles of the insurance carrier, the policy owner and the insured individual, if different, as well as where the contracts are negotiated and executed. Who should be the owner? One important threshold decision is whether the policy owner should be the insured individual or a trust. An individual owner does not have to pay any gift tax on payment of the premiums to the insurance carrier, and may borrow back a portion of the premiums paid, subject only to the terms of the policy and no-lapse considerations. However, the death benefit would be in his or her estate at death and subject to estate tax. If the individual lives a long life and the cash value has substantially increased, then the estate tax could be quite burdensome, even if Congress were to raise the ceiling on taxable estates and/or decrease the rate. If a trust serves as the policy owner, then whoever pays the premiums to the trust will likely be subject to gift tax. Some financial institutions and advisers have developed premium financing methods involving commercial loans to insurance trusts, and even intergenerational split-dollar arrangements whereby the entire family invests in the policy, but these are beyond the scope of this article. Since the PPLI provides an investment strategy as well as a death benefit, careful attention needs to be paid to the question of who the insured should be. If the death benefit is not the primary focus, then the premiums paid to insure a young and healthy family member will be allocated less to the death benefit, and more to the income tax-free investments. The owner’s investment in the PPLI policy should be sufficient for the income tax savings to outstrip the policy costs. Although there are differences of opinion, insurance carriers typically recommend that the premiums should be, at a minimum, an aggregate of $2 million or more over the first several years. In vetting the policy costs, the factors that the policy owner, the insured individual and their advisers must carefully consider in selecting a carrier include the following: the carrier’s reputation and stability; “loads” or commissions to be charged at inception and going forward; cost of insurance going forward; mortality and expense charges going forward; investment charges, if any; loan interest rates in the event the owner wishes to borrow funds from the policy cash value; flexibility of the carrier’s investment platform; and credit ratings of the carrier’s reinsurance companies. It is important to obtain “in-force illustrations” comparing the different carriers’ projections of cash value and death benefit based on the same premium payments for the same insured individual. These comparisons reveal the different carriers’ charges and costs. One of the reasons that PPLI policies are not as commercially popular as they might otherwise be is that they are labor-intensive and there are no standardized commissions built into them. One way of getting the best value from different carriers is to build a transparent and fair commission into the policy, to compensate the agent for the time and effort to structure the policy, and then solicit bids from competing carriers. In paying the premiums, the policy owner should also be careful to do so over the number of years required for the policy to avoid being characterized as a modified endowment contract (MEC) under � 7702A of the Internal Revenue Code. If a life insurance policy is an MEC, then all policy loans and withdrawals are fully subject to income tax, and additional penalties may apply as well. A life insurance contract can become an MEC at any time during the policy’s first seven years if the policy owner’s premiums exceed certain statutory limits. A discussion of the premium limits and actuarial computations applicable to life insurance policies, whether to qualify as life insurance policy premiums or to avoid triggering the MEC rules, is beyond the scope of this article. The policy owner should work closely with his, her or its advisers and the insurance carrier to ensure that the premium amounts qualify as life insurance premiums, and do not trigger the MEC rules, since the policy owner’s ability to “borrow back” the premiums is one of PPLI’s benefits. Investor control One of the most important aspects of PPLI is the extent to which the policy owner may control the investments in the policy. Following a long line of precedent regarding the “investor control doctrine,” which treats the person controlling the investments of the variable contract as the owner for income tax purposes, Congress enacted � 817 of the Internal Revenue Code. This statute provides that the segregated asset accounts of variable life insurance contracts must be “adequately diversified” to be considered life insurance contracts. Its attendant regulations provide “look through” treatment for partnerships and investment companies if public access is available exclusively through the purchase of a variable contract. In other words, the variable policy may be invested in only one partnership yet retain its adequately diversified classification, provided that investment in the partnership is available exclusively to variable-contract owners and not to the general public, and that the partnership’s investments themselves are adequately diversified. About 20 years after the enactment of � 817, the Internal Revenue Service issued Revenue Ruling 2003-92, which clarifies the “look through” rule, and Revenue Ruling 2003-91, which clarifies the owner’s rights as to variable policy investments. Specifically, the owner of the insurance policy may allocate premiums among the insurance company’s subaccounts, and may transfer and reallocate funds among them as well, but cannot direct or select particular investments. The insurance company must have sole discretion regarding investment decisions and the selection of the investment adviser. The subaccounts in the facts of the ruling offered a broad array of different investment strategies, including money market funds, bonds, small and large cap and international stocks, mortgage-backed securities and funds in various industries including health care, emerging markets, telecommunications, energy and financial services. The owner has no direct interest in these assets, but rather a contractual claim to collect cash from the insurance company. In the wake of these revenue rulings, the life insurance carriers have responded with investment platforms available exclusively to PPLI owners that are as flexible and diverse as those available to the public. Furthermore, many of the major brokerage firms that provide investment advisory services to the general public have also developed investment products for the insurance industry for purposes of managing PPLI portfolios. The PPLI policy investments have unlimited potential for income tax-free growth, although, like any other securities investments, there is no guarantee that they will perform well. One possible risk is that the investment returns will fall short of policy costs and lose money. Another is that these types of insurance policies are expensive to unwind. If the policy owner surrenders the policy prior to the death of the insured, any amount by which the proceeds, including amounts used to repay any policy loan and unpaid loan interest, exceed the policy owner’s basis in the policy will be includible in income as ordinary income. While PPLI has been slowly and quietly maturing, it has generally managed to avoid the regulatory onslaught that often follows when a product gains popularity that has unintended, but significant, tax benefits. The prognosis is that it should become even more popular in the future, as other investment-oriented insurance arrangements become more highly regulated. The legislative and regulatory reforms now targeted to combat life settlements may ultimately provide even more stability for PPLI, by creating more licensing and reporting responsibilities for insurance companies and brokers, and by providing greater transparency of fees for consumers. Carol Perrin is a principal shareholder at Greenberg Traurig’s Los Angeles office, where she heads the tax, trusts and estates department. She has extensive experience with life insurance and other wealth-management tools. Grace Chung is of counsel to the same office, where she practices tax law.

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