Corporate Insurance Strategy for Periods of Growth or Transition by Aaron Macdonald

Corporate Insurance Strategy for Periods of Growth or Transition How corporate life insurance can provide and protect

Period of Growth ↑

Expansion

↑  Increased Expenditures

↑  Potential for Higher Revenue

↑  Leveraged Capital

↑  Increased Demands

Period of Transition ▲  Change

▲  Phasing Out

▲  Replacement

▲  Purchase

▲  Income Stream

Growth or Transition = RISK

Risk – Growth Period •  Untimely death of o  Self o  Partner o  Key Employee

•  Serious Medical Condition •  Self •  Spouse •  Partner

•  Leveraged Capital may need to be secured •  Future financial commitments require protection

Risk – Transition Period •  Ensure funding is there for a buy out •  Erosion of retirement income •  Maintain ability to pay off any outstanding debts •  Adequate protection for transition of estate to heirs •  Increased capital gains liability •  Reduction in control of corporate assets

Insurance does not eliminate risk It helps to mitigate risk Insurance provides access to funds when you need it the most at the lowest possible cost

Corporate Life Insurance •  Fund a buy sell •  Replace a key person •  Secure a Line of Credit •  Provide a living buy out •  Ensure full value of corporation flows to heirs •  Reduce corporation’s exposure to risk

Corporate Life Insurance Basics •  Death benefit is always paid out tax free •  Premiums can be paid using lower taxed Corporate dollars •  CRA only allows a deduction if required as collateral for a loan •  The CDA credit for Corporate Life Insurance is equal to (Death Benefit) – (Adjusted Cost Base) •  Corporate Life Insurance is available as Term, Whole Life or Universal Life

Term 10 / 20

Term to 100

Whole Life

Universal Life

Death Benefit Only

Death Benefit + Funds

Rental Coverage for Short Term

Long Term Coverage

Low Cost Initially

Higher Cost

Flexible Cost

Many Insurers

Level Cost but higher then Term 10 or 20

Fewer Insurers

Priced to Lapse

Many Insurers

No choice in Investments

Choice in Investments

Expensive to Convert in Later Years

Fund Growth Dependent upon Insurer

Fund Growth NOT Dependent upon Insurer

Corporations want the lowest cost •  Understand the need for some permanent Corporate Life Insurance •  Want to pay with Corporate dollars •  Generally are interested in purchasing insurance at the lowest possible cost •  Term insurance is viewed as being the lowest cost •  If there is to be an investment component they want full control of all investment decisions

What is the most affordable type of Term Insurance available?

Term to 100 is the most affordable Male

age 50

$1,000,000 Tax Free

Term

to 100

Initial Premium

$1,810

$3,530

$11,104

1st 10 years

$18,100

$35,300

$111,040

next 10 years

$116,300

$35,300

$111,040

next 10 years

$350,300

$273,600

$111,040

Last 5 years

$395,050

$136,800

$55,520

Total Paid to age 85

$879,750

$481,000

$388,640

Term to 100 Payment of Premiums •  Is the most affordable type of insurance used to cover off a permanent risk •  Given the time value of money does it make sense to pay for a Term to 100 plan forever? No. •  If Corporate funds are available it makes sense to pay for the cost of Term to 100 insurance over the next 10 to 15 years. •  By prepaying the cost of insurance those same Corporate premium dollars can be used for more than just covering the cost of insurance.

Prepayment of cost of insurance •  If a Corporate has the funds available, it makes sense to pre pay for the cost of insurance on the life of the owner to life expectancy. •  Life expectancy is a reasonable time frame as it is likely the owner will remain active in the company and/or remain the owner of a Holdco for a lengthy period of time. •  Prepayment of insurance premiums is also prudent given the cost of insurance increases dramatically with age.

How much would it cost to prepay the cost of Insurance to life expectancy? For example letâ&#x20AC;&#x2122;s look at a Male age 50 Non Smoker with $1,000,000 of coverage

Pre Payment of Insurance Premiums •  Male age 50 NS $1,000,000 •  Term to 100 premiums from now to age 85 total $388,640 •  Using a Net Present Value discounted by 3% the total premiums are $245,746 •  Therefore it is reasonable for the Corporation to pay the premiums for the amount of coverage required ($1,000,000) at a rate of $27,970 per year for a period of 10 years. •  Again we are using the lowest possible cost of insurance as a basis for premium determination

What alternatives are available should a Corporation decide to prepay the cost of insurance?

Corporate Prepayment Options •  Deposit the premiums in an annuity to cover the cost of the Term to 100 premiums (taxation issues may arise in this case). •  Deposit the premiums into a Participating Life Insurance policy (dividends are not guaranteed). •  Deposit the premiums into a Universal Life Insurance policy (cost of insurance and investment choices would need to be determined).

Letâ&#x20AC;&#x2122;s consider the use of a Universal Life Insurance policy.

A Universal Life Policy •  Allows for the ownership of a UL policy to be split o  The Death Benefit can be owned by the Corporation o  The Fund Value can be owned by the Shareholder •  The cost of insurance can be based upon o  Yearly Renewable Term with surrender fees o  Level Term with surrender fees o  Level Term without surrender fees •  100% of the funds (less the cost of insurance and taxes) is guaranteed to be paid out at death

Universal Life - Details •  The face amount of coverage needs to be justified •  The cost of insurance can be level or Yearly Renewable Term – this would depend on the risk tolerance of the owner •  The growth of the funds can be illustrated at a guaranteed 4.2% annually or at market value plus a performance bonus of 2% (if 5% market value can be obtained) •  With prepayment of premiums, the Corporation’s costs are fixed over a 10 to 15 year period of time •  The Owner’s share of premiums will vary according to the cost of insurance and risk tolerance

Universal Life – Details cont… •  A YRT cost of insurance will create significantly greater fund value quicker than a level cost. •  In order for YRT to be effective the overfunding must start in the first seven years of implementing a policy •  YRT costs increase to age 85 when they become level and have a surrender charge for 7 years •  A level cost of insurance can be used for those more concerned with locked in guarantees

Why would an Owner pay premiums? •  If the policy is split then the Shareholder/Owner will be entitled to 100% of the Fund Value and the tax sheltered growth of those investments •  As such it would be reasonable to them to contribute some premiums towards the Fund Value •  The minimum amount required is normally a small % of the total premiums paid however it can vary according to the cost of insurance used •  The maximum amount allowable will be determined by CRA’s taxation guidelines on life insurance

•  The owner benefits by having full access to the tax deferred investment account – even though they have contributed only a portion of the total premiums •  They also have access to the investment account for living benefits such as a o  Policy loan o  Withdrawal o  Leveraging o  Disability •  It is also reasonable for the death benefit ownership to be transferred to the owner in the future (even though the owner did not contribute any premiums towards those premiums)*

Can the corporation pay all of the premiums? •  The corporation can pay the entire premium and T4 the owner for any excess premium paid by the corporation. •  If the owner is also a shareholder then the T4’d amount would not be tax deductible to the corporation (as it is a shareholder benefit). •  To avoid this the corporation should record the payment of the owner’s share of the premium as a loan to the shareholder which will be repaid at the end of the year from additional salary or bonus.

If the corporation prepays for the cost of insurance to life expectancy, what should happen if the owner dies before life expectancy?

•  If the pre payment for the cost of insurance was based upon a life expectancy of age 85, then the corporation should be reimbursed for those extra premiums paid if the owner dies prior to age 85. •  Basically there is a pre payment account that will calculate the amount due to the corporation should there be a premature death •  This account is a notional account •  The additional funds paid to the corporation will come from the Fund Value •  Interest is also credited to this notional account

Case Study #1 Mr. Entrepreneur Male age 50 Non Smoker with $1,000,000 of coverage

Mr. Entrepreneur •  The Corporation is interested in prepaying the cost of insurance to life expectancy. •  The Owner is interested on how he can benefit from additional tax sheltered investments but would like some control over those investments. •  As such we would propose a Universal Life policy with: Ø  YRT cost of insurance with surrender fees Ø  5% investment annual rate of return Ø  2% performance bonus rates Ø  Illustration with a transfer of the death benefit to the insured at age 85

Mr. Entrepreneur •  The Corporation will fund the policy at a rate of $27,971 over the next 10 years. •  The Corporation will contribute a minimum of $4,029 over the next 10 years on behalf of Mr. Entrepreneur. •  Mr. Entrepreneur can overfund the policy at any point.

What does the Corporation Own as a result of prepaying the cost of insurance over 10 years?

ABC Corporation Year

Age

Total Deposits

$27,971

$1,000,000

$991,023

$139,855

$1,000,000

$964,199

$279,710

$1,000,000

$956,986

$1,000,000

$1,055,875

$1,000,000

$1,052,379

$1,000,000

*Excludes prepayment account

Death Benefit Paid to Corp*

CDA Credit

Corporation also “owns” a Notional Account for Prepayment •  From conception to age 85 there is also a notional account required to keep track of the overfunding the Corporation has made (as it’s costs are based upon the NPV of Term to 100). •  Basically this grows at a rate of 3% per year until year 10 at which time it decreases until it becomes zero at year 35 (age 85 of insured). •  The money is not “lost” it simply means more or less will go to the Corporation or the Insured’s beneficiaries.

Prepayment Account Example Yr 1 •  If insured dies early, the corporation should be reimbursed for the excess payment, plus interest •  For example, in year 1; –  –  –  –  –

Corporation’s actual payment Minimum Premium Excess paid by company Interest on excess @ 3% Total prepayment

$27,970 11,104 16,866 506 17,372

•  In year 1, company should receive is $1,017,372

How does Mr. Entrepreneur benefit from the Corporation prepaying the cost of insurance over 10 years?

Mr. Entrepreneur Year

Age

Total Deposits on His Behalf

$4,029

$30,985

$20,145

$172,785

$40,290

$401,302

$624,022

$829,330

$823,233

$1,823,233

*Excludes prepayment account or surrender charges

Fund Value Owned by Mr. E*

Death Benefit Owned by Mr. E*

Summary at age 65 TOTAL Premiums paid by Corporation Death Benefit Owned by Corp at age 65

$320,000 $1,000,000

Fund Value Owned by Mr. E at age 65

$507,087

Death Benefit Owned by Mr. E at age 65

$507,087

Based upon a return of 5% plus a performance bonus of 2% Not including the prepayment Account

Summary at age 75 TOTAL Premiums paid by Corporation Death Benefit Owned by Corp at age 75

$320,000 $1,000,000

Fund Value Owned by Mr. E at age 75

$743,256

Death Benefit Owned by Mr. E at age 75

$743,256

Based upon a return of 5% plus a performance bonus of 2% Not including the prepayment Account

Summary at age 85 TOTAL Premiums paid by Corporation

$320,000

Death Benefit Owned by Corp at age 85 Fund Value Owned by Mr. E at age 85 Death Benefit Owned by Mr. E at age 85

$0 $823,233 $1,823,233

Based upon a return of 5% plus a performance bonus of 2% Not including the prepayment Account Alternatively you couldâ&#x20AC;&#x2122;ve paid a similar premium for T100 and still be paying premiums

What if the client is more conservative and wants guarantees?

Mr. Conservative •  The Owner is very conservative with his investments and wants guarantees. •  As such we would propose a Universal Life policy with: Ø  level cost of insurance with surrender fees Ø  4.2% guaranteed bonus rates Ø  Illustration with a transfer of the death benefit at age 85 •  In this case there would be less growth in the fund value however it would be guaranteed

Mr. Conservative Year

Age

Total Deposits on His Behalf

$4,029

$21,406

$20,145

$116,444

$40,290

$259,597

$255,587

$249,528

$1,245,420

*Excludes prepayment account or surrender charges

Fund Value Owned by Mr. C*

Death Benefit owned by Mr. C*

Other factors to consider

•  You can put a min funded UL Policy in force with the intent of beginning the overfunding via a Shared Ownership concept in the future. •  This only makes sense if you begin the overfunding in the first 7 years. •  If the situation changes you can stop the overfunding and restart it later. •  To be onside from a CRA perspective there should be a clear justification for the insurance and validation for the pre funding. •  This should not be presented as a means to strip out your Corporate cash tax free.

Is this concept acceptable by CRA?

Canada Revenue Agency •  CRA may want to see: –  Agreement –  Policy –  Transfers –  Calculations –  Other correspondence/documentation

Taxable Benefit??? Best advice for our clients is that the death benefit owner pay a premium relating as closely as possible to the cost of the insurance interest acquired based on the price for similar coverage on a stand- alone basis

Determining ACB of Separate Interests •  ACB for a life insurance policy is defined in Ss. 148(9) and typically equals premiums paid less the Net Cost of Pure Insurance (“NCPI”) •  NCPI is defined in Regulation 308

Determining ACB of Separate Interests •  Since the death benefit owner funds the entire mortality cost, only the death benefit owner’s ACB should be reduced by the NCPI during the period they hold that interest

Determining ACB of Separate Interests •  If the death benefit owner is a corporation, lower the acb the greater the amount that would be credited to the Capital Dividend Account •  If the savings element owner accesses the cash values while the policy is in-force, the tax consequences would be lessened if acb is higher