Matt Healy of Ascent Private Capital Management talks about how life insurance can play an important role in helping achieve the legacy and financial objectives of an individual or family – especially those with significant taxable estates and illiquid assets such as privately-held businesses and real estate.

Healy is a managing director of client risk management at Ascent, which is the ultra high net worth arm of U.S. Bank.

For those who have assets that exceed the federal estate tax-exemption thresholds - $5,430,000 for an individual and potentially $10,860,000 for a married couple in 2015 (both amounts indexed annually for inflation) - the concern is that a large portion of assets in the estate (meant for beneficiaries to be received in-kind) may have to be liquidated to pay estate taxes. Life insurance can help meet liquidity needs when selling assets is not the best choice.

Once it has been determined that life insurance is the ideal strategy to meet liquidity needs, it is of course important to carefully choose the appropriate amount of coverage and type of policy. Once the appropriate coverage is identified, the next step is to decide how to fund the premiums.

Cash may be available to pay for policy premiums, but you may want to avoid reducing available cash reserves. Selling existing portfolio positions is another option, but this approach is not always desirable. Certain assets are not easily liquidated, and, even when they are, doing so may have unfavorable tax implications. Selling assets to free up cash may also eliminate the opportunity to potentially generate additional returns from the assets that were sold, or, in the case of a business, may have an impact on its balance sheet.

As an alternative approach to funding a policy, you may want to consider the potential advantages of financing life insurance premiums, which may provide a policy owner with more financial flexibility. This approach involves leveraging existing assets rather than liquidating them. Premium financing may make the purchase of life insurance more convenient if assets are not readily liquid or if it is preferred that assets are retained and cash flow left alone. Premium financing may also provide certain tax advantages.

If financing is selected as the preferred funding option, the following steps should be taken:

• Identify collateral to back the loan: Specifying assets to a third-party lender that serves as collateral for the loan is a critical aspect of premium financing. The cash surrender value of the insurance policy can be used as security for the loan, but in the early years of the policy, additional collateral may be required;
• Determine an exit strategy: During the term of the loan, it may not be necessary to pay down the principal value of the loan. However, a strategic, viable source of repayment during the insured's lifetime must be identified at the time the loan is received. The borrower cannot rely on the policy's death benefits as a source of loan repayment; and
• Make interest payment: Periodic interest payments are required throughout the term of the loan, even though principal is not typically repaid at that time. In some cases, interest may represent a significant sum. If a trust owns the policy and the grantor of a trust must provide the funds to cover the interest costs, careful consideration should be given to potential gift-tax implications or how the gift will count against the lifetime unified gift and estate tax exemptions for the grantor.

No financial matter may be more personal than planning a legacy. With the proper due diligence and structure, life insurance premium financing can be an effective and efficient component of an individual's comprehensive financial, estate and tax-planning strategy.

Case study

Joe and Maria, both age 65, started their first grocery store 40 years ago. Through hard work and good fortune, they have expanded to 15 stores throughout the Southwest. Their four children are actively involved in the family business. The couple, whose net worth is nearly $60 million, desires to preserve the family business for future generations. Because the majority of their estate is illiquid, they are concerned with how estate taxes will be paid when the surviving spouse dies.

After considering a range of options suggested by their professional advisors, Joe and Maria concluded that life insurance offered the most immediate and effective solution to the cash liquidity needs of their estate. They decided to apply for a second-to-die policy and worked with their attorney to establish an irrevocable life insurance trust (ILIT) to own the policy. The couple could pay for the annual premiums out of the income from their business, but they are currently reinvesting the majority of that income to fund renovation and expansion projects. Joe and Maria faced a common dilemma: how to balance the need for liquidity with the opportunity cost of diverting income or assets from current investments.

The Ascent team suggested premium financing as an interim solution. Under this approach, the ILIT would borrow money from a third-party lender, such as U.S. Bank, to pay premiums. The loan would typically be interest-only for the initial loan term, with principal due at maturity. The policy cash-surrender value plus investment accounts held by Joe and Maria at Ascent would be pledged as collateral for the loan, so instead of needing to gift the entire premium annually to the ILIT, the couple's gift would be the annual interest on the loan.

Joe and Maria's decision to finance life insurance premiums would not be a sound one without a complete understanding of how the ILIT will repay the loan. Rarely, if ever, does it make economic sense to maintain the loan until the surviving spouse's death, particularly if interest rates rise. A variety of options exist to repay the loan during Joe and Maria's lifetime. A portion of the cash value of the policy may be withdrawn to repay the loan, but policy cash value growth is not guaranteed and may fluctuate. As an alternative or supplemental exit strategy, Joe and Maria could transfer ownership interests in their grocery business to the ILIT through a variety of wealth transfer techniques that would provide the trust with additional assets to repay the loan.

Life insurance premium financing offered Joe and Maria the ability to address the need for liquidity to meet their estate planning goals today without significantly disrupting their assets or business cash flow.