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Private-Placement Variable Universal Life Insurance

Awareness--and demand--is growing.

Judith A. Hasenauer, 03/12/2009

It now appears very likely that the estate tax will return in all of its previous glory. As a result, the use of life insurance to ameliorate income taxes on investment gain, combined with the need for liquidity to pay estate taxes on the schedule demanded by the Internal Revenue Service will probably be reinforced. For those who have experienced a degree of financial success and can make the qualification standards, private-placement variable life insurance can provide a useful form of the product to meet these taxation needs.

PPVUL is a relatively new product in the life insurance field. It has only been readily available for the past 15 years or so, and even today there are only a handful of insurers that offer the product. Rarer still are the insurance agents and financial advisors that have made the jump from traditional life insurance to these new products. PPVUL products tend to be dramatically different from traditional products--even traditional variable universal life insurance. This difference is primarily a result of the degree of sophistication required of the purchasers of PPVUL. In order to be eligible to purchase PPVUL, a purchaser must be financially sophisticated enough to meet the qualification requirements for any type of product that is exempted from the registration and regulatory requirements of the federal securities laws. Thus, the product appeals to the more affluent among us. We have noted that rich people rarely got to be that way by being stupid; moreover, even if they are stupid, their financial advisors rarely are. As a result, PPVUL products tend to be simpler, more streamlined and less expensive than is the case with more-traditional products--even those traditional products designed for the affluent market.

Interestingly enough, the primary impetus for sales of the PPVUL product comes, not from life insurance agents or even financial planners, but from investment advisors--primarily hedge fund managers who seek a more tax-efficient method to provide investment gain to their investors. Recent years have seen a growth in the use of the product by those we think of as "trusted advisors" to affluent investors. Attorneys and accountants are becoming more and more aware of the product and a number have joined with insurance agents to make PPVUL available to their estate planning and tax clients. This presents obvious challenges when it comes to licenses, payment of compensation, broker-dealer affiliations, and similar considerations, not to mention the ethical limitations imposed on lawyers and accountants. The revisions to the financial services industry that will come as a result of the current meltdown may loosen or tighten how these products are sold. Whatever happens, it is unlikely that the selling of financial products will remain the same.

Since PPVUL products are both "securities" for purposes of federal securities laws and "life insurance" for purposes of state insurance laws, the products and sales methods must conform to the requirements for both. PPVUL enjoys exemptions from the registration requirements of the Securities Act of 1933 so long as the product is sold to people possessing the necessary qualifications specified in the law and applicable regulations. Likewise, the separate account of the insurer is exempt from the registration and regulatory requirements of the Investment Company Act of 1940 so long as sales are made only in the manner specified in the rule providing the exemption. However, PPVUL is a security--albeit an "exempt" security. It still has to be sold under the auspices of a broker-dealer that it regulated by FINRA.

PPVUL products enjoy a wide variety of underlying investment options. As we have said, some of the more exotic types of investments are the ones that usually appeal to sophisticated purchasers. And, since the sales impetus frequently comes from investment managers who have a relationship with prospective purchasers, the underlying investments tend not to be the garden-variety of mutual fund offered with traditional retail variable annuities and variable life insurance.

PPVUL products, when purchased by American taxpayers, are subject to all of the same requirements that apply to all variable insurance products--variable annuities and variable life insurance. Thus, PPVUL has to meet the definition of "insurance" as specified in Section 7702 of the Internal Revenue Code. Moreover, the separate account that holds the reserves for the policies must be "adequately diversified" in accordance with Section 817(h) of the Code. All of the requirements, published and unpublished that relate to diversification, public availability of underlying investment entities and investor control apply to PPVUL in the same manner as to any other variable insurance product. Likewise, a PPVUL product may be a "Modified Endowment Contract" as defined in Section 7702A of the Code. If so, distributions of contract values other than on death may subject the distributee to taxes on investment gains and even tax penalties for distributions prior to age 59 ½. We have notices, however, that most PPVUL products tend to be non-MEC products in order to permit tax-free borrowing from cash values prior to the death of the insured. This is a major advantage of life insurance policies that are designed as non-MEC products.

A number of insurers domiciled in jurisdictions outside of the United States have begun to offer what amount to PPVUL products. Bermuda, the Channel Islands and certain of the Caribbean countries have insurers that sell life insurance policies on what amounts to a private placement basis. Many foreign insurers have elected to be taxed as though they were domiciled in the United States. This presents advantages to U.S. taxpayers in that they can avoid payment of the excise taxes otherwise payable when life insurance is purchased from a foreign insurer while, at the same time avoiding payment of the premium taxes that would apply if the product were purchased from a U.S.-domiciled insurer.PAGEBREAK

Obviously, foreign insurers cannot sell their products in the United States unless they have qualified to do business here. Virtually none of the foreign insurers offering these types of products have qualified in the United States. Therefore, purchasers of these products from a foreign insurer must make the purchase in a place where such a purchase is legal. This may mean a trip to Bermuda or the Caribbean to make the purchase and take delivery of the policy, but there is a thriving business in people or their representatives making such trips.

Selection of a foreign insurer and its site of domicile is critical. Most of the foreign jurisdictions that have become centers for the sale of PPVUL have enacted laws that provide many of the features of the separate account laws that exist in the United States. Thus, a foreign insurer can establish one or more separate accounts that are "insulated" from claims of creditors of the insurer resulting from other business activities. In some instances, the laws of foreign jurisdictions are, in fact, superior to the laws of some of the states of the United States because they learned from the experiences of the U.S. regulatory system.

The federal tax laws applicable to life insurance policies purchased by U.S. taxpayers require that such policies have a substantial amount of pure insurance risk relative to the premiums paid or the cash values held under the policy. As a result, purchasers of PPVUL policies will usually have a substantial face amount of death benefit that they have obtained on a very tax-efficient basis. In essence, the pure insurance element is paid for with investment income on a pretax basis as opposed to other forms of life insurance that have to be purchased with after tax dollars. However, since the ownership of a PPVUL policy requires payment for an often substantial face amount of insurance protection, it is essential to be sure that the issuing insurer is financially sound enough to satisfy the needs for payment of death proceeds. Most foreign insurers issuing these types of products are small with little in the way of financial resources. Therefore, they must rely on reinsurance or other similar arrangements to provide policy owners with the security that the death proceeds will be available. There is no need to worry about the cash value element in a PPVUL product since the separate account mechanism provides insulation for such assets. However, purchasers of PPVUL products from non-U.S. insurers need to be more aware of reinsurance arrangements than is the case with more conventional types of life insurance.

PPVUL, both domestic and foreign is likely to be an increasingly important part of estate, financial and tax planning. It offers the ability to accumulate investment earnings of a tax-efficient basis; to access those assets via policy loans on a tax-free basis and to pass assets on to the next generation free from income taxes. Affluent Americans need to consider this important financial product and their advisors need to be able to discuss the products with their clients.

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