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Captives and Life Insurance

Michael Mead | July 1, 2012

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Many practitioners and captive folks are not aware that captives can be used with life insurance. In this piece, I will share some thoughts on the subject.

At first view, the two insurance entities may seem completely unrelated, but upon closer study, there are at least two main areas in which they intersect.

Life Insurance as an Investment

The first is as an investment for the captive. One reason for establishing a captive, or at the least a side benefit of establishing a captive, is the ability to select investments that may produce a higher return and that may not be available in the traditional market. One such investment is ownership of a life policy insuring the life of another person, so-called stranger-owned life insurance or company-owned life insurance.

These policies work to provide death benefits to the owner of the policy, the captive, upon the passing of the insured, who may have little or no relationship to the captive owner. The public or some regulators often view these policies unfavorably as being essentially speculative in nature. They evolved from purchasing coverage on key personnel whose passing could financially impact a company. Thus, a death benefit could financially assuage a loss through hiring a replacement or otherwise covering costs that didn't exist without the death.

Today, the captive can decide that owning a life policy on a third party can potentially provide a greater return than other investments in some situations. As with any investment by the captive, the regulator must approve it in advance and since, as mentioned, some regulators don't like this investment, it may not be approved. However, some regulators will approve such an investment, and the return may or may not be better than other investments. I don't address those issues in this article. As always, consult your investment professional if you are considering such a course.

Trust-Owned Life Insurance

The other primary use of a captive with life insurance is when a life policy owns the captive. This is seen primarily in estate planning and wealth management scenarios. In this practice, a life policy is purchased by an entity, usually an irrevocable life insurance trust, which in turn purchases a life policy. This policy is often issued by a non-U.S., or offshore, life insurance company established for this purpose. The principal reason for a non-U.S. situs is to avoid U.S.-based life insurance investment restrictions. In most states, there is no law against an insurance company choosing a life policy as an investment, but traditional life insurers shy away because of the many accounting and regulatory reporting issues.

Following specific Internal Revenue Service guidelines, the investment portion of the policy (as the policy usually takes the form of a universal whole life policy with investable assets) can be the shares of a captive. Thus, any profits generated by the captive become assets of the life policy, payable to its beneficiaries. There are many nuances on this structure, which can be easily tailored to the specifics of an estate planning exercise.

In the estate planning field, the above described structure is known as trust owned life insurance (TOLI). In TOLI, as in all other whole life structures, the life policy itself is a very complex legal document, which is rarely understood by people outside of the life insurance industry. While many of you will be repelled, I cannot stress enough the importance of building these structures with the input of a qualified life insurance specialist.

Many whole life policies sold in the 1980s and 1990s used current illustrations of ultimate payouts based on then best available investment return data. As with the recent housing/mortgage crisis, the investment assumptions have been proven to be overly generous. So? So, the value of these whole life, universal TOLI policies is usually in immediate danger of being out of money. You should note that life illustrations given at the time of purchase of the policy are not guarantees of ultimate payout.

Life premiums that have not been adjusted since purchase may now be so low that the insurer has paid itself the necessary premium increases and accounted for the payment as a loan taken out by the policy owner. With everything else that you must keep up with, checking the up-to-date value of a life policy purchased 20 years or more ago is probably way down the list. It should not be so. As with so much else in insurance, it is vital to be dealing with experienced professionals who will give you objective advice.

Captives and life insurance can be successfully paired, but the success is built into the details at the very beginning.

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