Best Practices for Insured Leveraging Programs

CALU Practice Note

Best practices for insured leveraging programs Part I

Introduction

The purchase of a life insurance policy with the intention to borrow against the policy has become increasingly popular in the Canadian marketplace. Leveraging an insurance policy can result in financial and tax benefits to the policyholder, particularly when the projected growth in a policy’s cash value exceeds the growth in the outstanding loan. However, such programs also pose a number of financial and tax risks that should be communicated to clients and managed over an extended period of time.

This Practice Note (Part I) will primarily focus on issues relating to marketing leveraged programs, client communications and disclosure, due diligence on lending arrangements and longer term management issues. A following Practice Note (Part II) will build on previously issued Practice Notes and focus on the key tax issues pertaining to leveraged insurance strategies. 1

The overall objective of this Practice Note (Parts I and II) is to provide guidance to CALU members on how to identify appropriate clients for insured leveraging programs and ensure they have the necessary information/advice so they can make an informed decision before implementation. Each client’s circumstances will of course influence the nature of the information that needs to be provided.

Background

Most lending institutions accept the cash value of a life insurance policy as collateral security for a personal, investment or business loan. This can be attractive from the borrower’s perspective as the assignment of the policy does not result in a policy disposition, 2 the policy values continue to grow on a tax deferred basis 3, and any loan outstanding on the death of the borrower can be repaid with part or all of the tax free life insurance proceeds. 4

1 Please refer to “Leveraged Insurance Arrangements Golini v. The Queen” (August 2016); “Corporate Owned Insurance Shareholder Borrowing” (September 2016) and “Leveraged Insured Annuities” (February 2017).

2 The assignment of a life insurance policy to secure a debt or loan (other than a policy loan) is not considered a disposition of an interest in the policy by virtue of paragraph (f) of the definition of disposition in subsection 148(9) of the Income Tax Act (the “Act”). Unless otherwise stated all statutory references in this Practice Note are to the Act.

3 An exempt life insurance policy is not subject to the income accrual rules by virtue of paragraph 12.2(1)(a)

4 The life insurance death benefit is tax free by virtue of paragraph (j) of the definition of disposition in subsection 148(9). Where a corporation is a beneficiary of a life insurance policy a portion of the death benefit is also credited to the corporation’s capital dividend account despite the assignment of the policy to the lender. This permits the payment of tax free capital dividends to Canadian resident shareholders (subsection 83(2))

The ability for a policyholder to leverage against the cash values of a newly issued insurance policy has become an increasingly popular strategy. By doing so the policyholder can replace a substantial portion of the capital/cash flow used to pay the insurance premiums and direct the borrowed funds towards investing or business purposes. 5 This can be particularly beneficial where the projected growth in policy cash values exceeds the projected growth in the outstanding loan. It can also be an attractive strategy in corporate ownership/shareholder borrowing strategies. 6 While recent increases in interest rates will impact the financial benefits of these lending strategies, it is anticipated that insurance leveraging strategies will continue to be of interest to a number of high net worth and business clients.

Who is the ideal client for a leveraged program?

Leveraged insurance strategies will be attractive to the following types of clients:

• High net worth individuals with a need for life insurance to cover tax and other liabilities that arise upon their death (or upon the second death of the individual and his or her spouse). The policyholder/borrower will have strong income flows and/or liquid capital that are available to fund the annual premiums and cover potential margin calls. As well, the policyholder/borrower shoul d have sufficient taxable income (preferably taxed at the highest marginal tax rate) to best utilize interest expense and collateral insurance deductions 7 that may arise from the borrowing arrangement.

• Business owners that may require life insurance to fund corporate and/or personal liabilities or contractual obligations arising on the death of the shareholder. The borrower should have strong income flows and/or liquid capital that are available to fund the annual premiums and cover potential margin calls. As well, the borrower should have sufficient taxable income (preferably taxed at the highest personal/corporate tax rate) to utilize the interest expense and collateral insurance deductions that may arise from the borrowing arrangement.

The amount of life insurance should be appropriate for the client’s estate planning needs and not determined primarily to achieve tax benefits while the life insured is alive. 8 For example, advisors should spend the appropriate amount of time to understand the client’s needs and objectives and determine the type of policy and required coverage before considering leveraging options.

The client should also be familiar and comfortable with leverage and understand that the financial/tax risks can be increased by the long term nature of the leveraged program.

5 It should be noted there are also insurance programs where the leveraging is expected to occur at a later date such as the retirement of a business owner. While many of the comments in this Practice Note also apply to deferred lending programs, this Practice Note will focus primarily on “immediate” financing arrangements

6 These strategies will be discussed in more detail in Part II.

7 Paragraphs 20(1)(e) and 20(1)(e.2) The requirements for these deductions will be discussed in Part II

8 Life insurance company underwriting practices should also ensure the amount of insurance coverage is suitable for a particular client’s needs and requirements

Professional advice

It is essential that the client has the support of a strong professional team with insurance, legal, credit, tax and accounting expertise. This group needs to work closely together during the implementation stage and while the leverage program remains in place. The advisors must be in a position to independently evaluate the leverage program and properly advise the client as to the risks and associated risk mitigation strategies. The client needs to understand there will be legal and other fees associated with reviewing and establishing the borrowing arrangement as well as potential costs for prematurely unwinding the leverage program such as insurance surrender charges, policyholder taxes, loan break fees and additional professional fees.

What insurance products are suitable for leverage programs?

Universal life (UL policies) and whole life 9 (WL policies) from a Canadian life insurance company are typically used as part of leveraged arrangements. WL policies have been the preferred product as policy dividends or performance bonuses/credits that are annually credited to WL policies have resulted in projected policy values growing at a faster rate than the associated loan balance. In addition, lenders may be prepared to offer higher leverage limits against the cash values of WL policies. Assuming interest rates continue to increase, UL policies may become increasingly attractive for leveraging purposes. However, it is important to avoid UL investment accounts which may be susceptible to significant market fluctuations, since declines in the policy’s cash values could lead to the lender requiring additional security or possibly calling the loan.

The use of foreign insurance policies for leveraging purposes can pose additional risks for the policyholder and for this reason are not ideal for leveraged arrangements. For example, offshore insurers are subject to different regulatory and capital requirements which may lessen financial protections for the policyholder. The insurance product may not qualify as an exempt policy under Canadian tax rules, which would subject the policyholder to accrual tax reporting. The use of an offshore lender may also expose the borrower to increased financial risks as they are not subject to the same regulatory rules as a Canadian lender. 10 As well, some offshore leverage programs involve the purchase of both insurance and annuity products. In this case the Canada Revenue Agency (CRA) could use the general anti avoidance rule (GAAR) to challenge the tax benefits of the arrangement on the basis that the products would not otherwise be available on an independent basis. 11

9 This includes participating whole life and guaranteed non par whole life policies.

10 For additional discussion of the risks see “Advisor/Client Considerations in Purchasing Foreign Life Insurance Policies”, CALU Practice Note (October 2021) In addition, a foreign lender would likely not qualify as a “restricted financial institution” for purposes of the collateral insurance deduction (discussed in Part II).

11 This was the type of arrangement in Golini v. the Queen (2016) TCC 174, where the CRA successfully assessed a taxable shareholder benefit to the taxpayer. This Tax Court decision is discussed in more detail in a CALU Practice Note supra Note 1

Marketing and promotion

It is important that marketing material and client communications appropriately describe and position the purpose of the insurance leveraging program to clients, their advisors and the general public. The benefits of having life insurance coverage as part of the client’s overall estate plan should be at the forefront of discussions and confirmed in documentation relating to the arrangements. It should be made clear that the purpose of leverage is not to fund the insurance premiums. Instead, the borrowing is to replace the liquid capital being used by the policyholder to pay the insurance premiums. In effect, the policyholder is using personal or corporate resources to pay the insurance premiums, and the leverage facility is used to the replace that capital, which in turn will be redeployed for business or investment purposes.

From a tax perspective, the borrowed funds must be traceable to a business or investment purpose. Otherwise, the Canada Revenue Agency (CRA) could challenge the policyholder’s claim for an interest expense deduction on the borrowed funds (as discussed in Part II). Terminology used in a website, marketing material and client illustrations indicating the client is “borrowing to pay the premiums”, doing “premium financing”, or is acquiring “free insurance” is not aligned with the tracing principle and could invite review by the CRA as part of an audit of a client’s tax affairs.

Where a corporation is participating in an insurance leverage strategy, it is equally important to properly describe the tax results that might arise from the overall structure. Marketing material describing the overall arrangement as a means for a sharehol der to strip out corporate surplus or create “super deductions” will invite closer examination by the CRA. On the other hand, it is quite appropriate to highlight the tax free nature of life insurance proceeds and the tax benefits arising from the corporation being entitled to a credit to its capital dividend account upon the receipt of the life insurance proceeds.

Policy illustrations vs. leveraging illustrations

For non guaranteed insurance products such as UL and WL policies, insurance companies require the policyholder to receive a policy illustration which assumes a lower policy dividend, performance bonus/credit or credited rate to illustrate that future results may vary depending on future product performance. This alternate illustration demonstrates that the performance of the policy is not guaranteed and shows the impact of lower credited rates on the growth of cash values and premium payment requirements. This also protects the advisor and the insurance company from potential client lawsuits should there be reductions in policy dividends, performance bonuses/credits or credited rates in the future.

It is equally important to provide clients involved in leverage arrangements with disclosure and/or illustrations which explain/demonstrate the impact of lower policy performance as well as future increases in interest rates, to ensure they understand the impact such changes can have on the security position of the loan. For example, alternate illustrations could be provided with different policy performance assumptions and loan rates for review with the client and professional advisors. It is recommended that illustrations extend past the life expectancy of the life insured to demonstrate policy/loan values at later policy durations. This may demonstrate

the potential need for the client to provide additional collateral in the future due to the loan/cash value ratios being exceeded if the client lives beyond expected mortality.

The illustrations should also disclose the consequences of surrendering the pol icy to repay the loan prior to death, either numerically, by showing the after tax cash surrender values of the life insurance policy at various policy durations, or through specific disclosure. This further reinforces the need for the client to have other sources of liquid capital available for collateral purposes or to repay the loan, should future events impact the viability of the loan program.

Where the interest deduction/collateral insurance deduction are being factored into the client’s cash flow analysis, the client should be made aware through disclosure and/or alternate illustrations that the cash flow benefits are dependent on the borrower’s marginal tax rate from year to year.

Terms of the loan

There are several financial institutions who currently offer lending facilities based on the security of a life insurance policy. While the client and advisors are responsible for ensuring the loan meets their requirements, you may be exposed to liability where you recommend an insti tution that ultimately fails to meet the client’s needs and expectations. The following should be considered as part of your own due diligence on a specific lending institution:

1. How long has the financial institution been involved in providing loans secured by life insurance policies?

2. How many staff are involved in this part of the lending business and what knowledge and experience do they have?

3. How much capital does the institution have available for insurance leveraging and how much is currently committed to existing loans?

4. Do you know other advisors who deal with this institution if yes, what has been their client experience?

5. What are the specific terms of the loan

a. interest rate setting policies

b. availability of fixed vs. floating rates

c. loan to cash value ratios (collateral ratios)

d. annual financial reporting requirement

e. loan covenants and default provisions

f. renewal rights and pre payment provisions

g. rules and protocols around advances

It should be reinforced with clients and professional advisors that the renewal of the loan is not guaranteed and interest rates applicable on renewal will depend on the market conditions at that time. Any new loan issued

upon renewal will also be subject to the lender’s continued participation in these types of loan arrangements and will typically be subject to requalification based on current loan underwriting requirements. 12

Managing and monitoring the loan arrangement

Given the complexity and long term nature of leveraged insurance strategies, proper maintenance and archiving of client communications (including emails and meeting notes), policy and leveraging illustrations, tax opinions, implementation step documents and other related material should be retained for an extended period of time. This could be of significant assistance to your client should there be a subsequent audit by the CRA and will also be of importance in the event there is a dispute relating to what information and advice was provi ded to the client.

It is recommended that staff in the advisor’s office be educated on the mechanics of leveraged insurance programs and ongoing administrative requirements. They can offer important “back office” client support and help manage ongoing policy and loan administrative requirements.

As part of your client service routine, meetings should be held with the client and professional advisors at least once a year to review the status of the loan arrangement. This meeting should include a discussion of what events may have occurred since the last meeting which affect the client’s personal, family or business affairs, the status of the policy’s cash values in relation to illustrated values, the status of the loan and future renewals, and ensuring the collateral position provided by the policy continues to be sufficient. This may also involve discussions with the lending institution to ensure the institution is not contemplating significant changes in their lending facilities that could affect the terms of the loan or ability to continue to offer collateral loans in the future.

Conclusions

As evident from these discussions, the marketing, implementation, client communications and ongoing management of leveraged insurance programs places additional requirements on the insurance advisor, client and other professional advisors. Proper steps should be followed to ensure the client is fully apprised of both the benefits and risks of entering into a leveraged strategy. As well, ongoing client communications and service is critical to ensure the outstanding loan is properly managed and the policy’s cash values continue to provide adequate security.

12 Lenders may choose to limit their ongoing participation in leveraged insurance arrangements by modifying their collateral requirements, increasing minimum loan advances and/or placing limits on total loan exposure to any one borrower.