Case Study
A hedge fund principal with a net worth of $470 million dollars has $215 million in real estate and business interests. The client has discounted and frozen the value of the various real estate and business interests with a part gift/part sale of the assets to multiple intentionally defective grantor trusts. The client has also taken advantage of a charitable lead trust strategy to bring offshore hedge fund carried interest assets back onshore. This offsets income taxes due while benefiting charities and eventually heirs. What's important to note is that before life insurance for estate tax purposes is considered, all viable legal strategies should be employed.
The client, with his accountant and attorney, decided to obtain $150 million in life insurance to pay estate taxes. The premiums for this much life insurance were large and well beyond the annual gift exclusion that was available.
Meanwhile, the $5 million applicable exclusion was used with the intentionally defective grantor trusts. The primary reason premium financing was used was that the client determined he could invest the money and get a better return than the interest on the loan used to buy the life insurance.
The client chose a 30-day LIBOR loan with rates averaging under 2%, including the lender's fees. Using high-cash-value life insurance policies, he was able to secure the $150 million of coverage from multiple insurance companies, with business interests used as collateral for the loan.
The risks in this strategy are that the loan interest rate could increase over time and that the investments could underperform, particularly with multiple policies. Either of these situations could result in a need to post more collateral. To mitigate this risk, annual loan interest will be paid out of trust assets. Additionally, the policies' guaranteed cash value increases make it extremely unlikely that additional collateral will be required. This design provides a positive arbitrage over the borrowing costs, and any excess earnings and/or dividends enhance the arbitrage further.
In this situation, the client was well schooled on the risks involved. He recognized that additional funds would probably be needed for premiums because of the likelihood borrowing rates would increase. At the same time, the trust structures gave him the ability to move money among the different life insurance policies. With this arrangement, cash flows are available to pay the premium finance arrangement to keep it in balance, regardless of annual gifting limitations. Finally, the ability to move the loan among various lenders gives him the opportunity to lock in longer-term rates if rates start to increase.
When it comes to premium financing, it's essential to continuously watch and evaluate all the moving pieces. Additionally, when implementing such a transaction there needs to be a predefined way to exit if circumstances change dramatically. There always needs to be a way to unwind the transaction for the client.
Implications
Premium financing can be a very effective and worthwhile way to purchase large life insurance policies. However, when not done expertly, the approach can be disastrous for all involved. It's essential that the ultra-high-net-worth client and his or her advisors clearly understand the nature of the transaction and all the potential complications.
These transactions, like all life insurance transactions, need to be monitored carefully and continuously. Changes in the client's life, his or her economic situation, and the performance of the life insurance policies will all impact the effectiveness of the transaction. If the client stays on top of the situation, potential missteps are avoided.
Keith M. Bloomfield is president of the Forbes Family Trust multifamily office.
Frank W. Seneco is president of Seneco & Associates, an advanced planning and life insurance boutique.