The stock markets may be slumping, but the affluent market remains hot. What do we mean? Even though there is currently a great deal of volatility permeating the financial markets, private-wealth creation throughout the world is historically unprecedented. Simply put, the affluent market is booming. There are more wealthy people now than ever before, and they have more wealth.

Because the affluent market is hot, the competition for high-net-worth individuals has never been keener. And because managing the financial affairs of the affluent is a great business to be involved with on a risk-adjusted basis, it is increasingly competitive. To be successful in these times requires a sharply focused approach, a strategy that usually involves being able to provide high-net-worth individuals state-of-the-art solutions.

Right now, one of the most intriguing products to provide to an affluent client is private-placement variable life (PPVL) insurance. For a meaningful segment of the high-net-worth market, PPVL insurance is the answer to many of its needs and wants. Our research among affluent individuals who already have obtained the product shows that their evaluations are extremely positive. When we survey the affluent and ask about PPVL insurance, we inevitably find a high degree of interest. PPVL insurance is a technical product that must be sold by an expert advisor (it is not the sort of product that will drive buyers to advisors' doors). We find that there is increased interest among the affluent in alternative investments, as well as investment-oriented tax management, and it therefore follows that there will be increased interest in PPVL insurance. However, PPVL is not for all clients; advisors need to know that unless it is structured, executed and monitored properly, it can prove to be disastrous.

Life insurance has certain tax benefits that make PPVL insurance an excellent choice in the right situations. In general, life insurance possesses benefits such as a tax-free buildup of cash values and first-in, first-out accounting treatment of premium contributions and withdrawals. Also, there is the ability to mitigate estate taxes by incorporating an irrevocable life insurance trust and/or by setting up a private split-dollar plan.

These generic life insurance benefits are leveraged in the context of PPVL insurance. The key here is the private placement aspect of the policy. Because we are dealing with high-net-worth individuals, there is the opportunity to move beyond the types of investments found in traditional variable life insurance policies. The preferred option turns out to be alternative investments (particularly hedge funds) as the investment vehicle. PPVL insurance enables high-net-worth individuals to trade off paying income taxes on portfolio income and transactions for the much smaller costs inherent in PPVL. Thus, the taxes generated by high-turnover hedge funds, for instance, can be rendered moot.

Aside from the tax advantages of PPVL insurance, additional benefits also are available. For example, the assets placed in the policy can be made secure from creditors and litigants. Further benefits can be achieved, depending on the way the product is structured.

The financial services industry is taking a range of approaches to providing this product. At one end of the spectrum is a souped-up version of conventional variable life insurance. At the other end of the spectrum is a totally customized approach adapted to individual high-net-worth clients. In the middle is a panoply of variations.

Which is the best product for a wealthy client? Well, it is a function of the individual and the situation. According to the research, the most satisfactory approach is to create customized policies for high-net-worth individuals so that the affluent person has the opportunity to designate the money managers in the product. This customized approach may not always prove viable depending on the client and his/her situation.

The Potential For Disaster

While there are significant benefits for affluent clients by employing PPVL insurance, there is also the potential for significant complications and even the potential for unmitigated disaster. Within the process of providing PPVL, there are a number of possible land mines that can blow up the product, the client and, consequently, the advisor. Some of these land mines are major across-the-board problems; some are product-structuring problems; and some occur post-sale. To get a better feel for what can go wrong, let's briefly consider each category of problems.

The major across-the-board problems not only negate the benefits of PPVL insurance, but also can cause considerable difficulties for all parties involved. A few such problems include:

Disqualification of the product as life insurance. When this happens, all the income is taxable as it occurs. Thus, the benefits associated with the life insurance wrapper are eliminated.

Money must be taken out of the policy, and the result is a taxable event. This can happen, for example, when the investment performance creates a Section 7702 corridor problem and there is not enough life insurance available in reserve.

The policy runs afoul of the modified endowment contract rules. This can occur because of poor construction initially, or it can occur because the product changes over time.

The policy matures as an endowment or worse, lapses. In the case of maturity as an endowment, the gains are taxed as ordinary income. When the policy lapses, there is phantom income.

Improper structuring of the policy also may lead to problems. This doesn't mean that such a policy cannot be underwritten. All it means is that it will not work properly. Examples of initial structuring problems include:

The client's goals and qualifications are not accurately assessed. This is becoming more common in those cases in which PPVL insurance is a souped-up variable product. It can also occur when PPVL insurance is presented as a panacea - a tax-management strategy capable of mitigating most, if not all, tax consequences. PPVL insurance is a very powerful tool when used the way it was intended. Trying to make it something it is not is a sure-fire way to court disaster.

An inappropriate insurance company is selected to provide the wrapper. With the seeming attractiveness of the market, many insurance companies are creating private placement variable life products. However, that does not mean they will be able to develop the product and support system that works well.

Related to the above point, the situs for application and policy can make a very big difference to the affluent client, and few insurance companies are taking this into account. When considering such things as state premium taxes, as well as asset protection, the situs for application and policy can have a dramatic impact. It also is an issue when the decision is made to go offshore.

Post-sale problems arise because the policy is sold and then "forgotten." As with all financial products, there is a clear need to monitor carefully the performance of the product (and the situation of the client) and to be prepared to make adjustments as necessary. Unfortunately, a growing body of anecdotal evidence suggests that most agents today are marketing PPVL insurance as a one-time transaction. Post-sale problems can come from a number of sources:

The carrier's reproposal and monitoring systems are inadequate. For instance, there is limited in-force policy illustration capability. Another example is when there is limited in-force concept (i.e., split-dollar) illustration capability.

There is no or limited ongoing monitoring. Client situations change, investment performance impacts the product, and policy structures are affected. These and related issues must be considered.

Conclusion

PPVL insurance has the potential to be a very strong product for advisors and for clients. Without question, the product will broaden in appeal. More affluent clients will hear about the product and become enticed by its potential benefits. More advisors will look to market PPVL insurance to their clients.

If we reach one conclusion, however, it is the need to approach PPVL insurance carefully. This brief survey demonstrates the range of problems that can occur. With due diligence in client assessment, implementation and servicing, adverse results for all involved can be avoided. With care in mastering the intricacies of PPVL insurance, advisors will be able to compete more successfully for high-net-worth clients.

Russ Alan Prince is president of the high-net-worth consultancy Prince & Associates and co-author of eWealth (www.iihighnetworth.com).

Richard L. Harris CLU, AEP, is a principal of BPN Montaigne, a boutique financial-advisory firm specializing in developing unique solutions for high-net-worth individuals.