Immediate financing arrangements re-emerge from the ashes of 10-8By Alain Thériault | September 29 2017 07:00AM
Diane Hamel and Christian Hubert
To fill the gap left by 10-8 programs, insurers have dusted off another leveraged loan solution that is making a strong comeback — Immediate Financing Arrangements.
“Insurance companies are talking about them more than ever, especially since financial arrangements called 10-8 were banned by the federal government in 2014,” says Claude Ménard, Senior Vice-President, Marketing, Canada, at PPI Advisory.
High cash surrender value
Immediate Financing Arrangements (IFA) let investors capitalize heavily on an insurance contract by paying premiums that exceed the insurance cost. “The IFA is a strategy involving a life insurance policy with high cash surrender value. Holders can offer the policy as collateral for a bank loan,” Diane Hamel, assistant vice president, Regional Tax, Retirement and Estate Planning Services, at Manulife says.
In a marketing document, the insurer explains that customers purchase a policy in which they deposit sufficient funds to accumulate major cash surrender value. They then use the policy as collateral for a line of credit at a bank. Customers can invest the amounts borrowed in a company or in an income-producing asset.
The immediate financing arrangement offers tax advantages, Hamel adds. “Transactions are generally structured such that interest and a portion of the premium are deductible in income calculation. The loan need not be repaid until death. The dividend account will be credited for the death benefit (portion of the death benefit that exceeds the adjusted cost base of the policy), and the company will have access to the insured capital that exceeds the loan balance,” she points out.
The IFA plan is not new, Hamel continues. When she joined Manulife in 1995, advisors already had immediate financing plans in place. Steven LaBarbera notes that Manulife Bank was one of the first banks to offer financing under the immediate financing arrangement. They deal with 10 other partners, including Manulife, he says.
Christian Hubert, senior tax advisor at National Bank Insurance, says that National Bank Insurance Firm (NBIF) usually partners with Canada Life and Sun Life Financial for this approach.
LaBarbera adds that immediate financing arrangements have gotten their second wind since the demise of 10-8. “It’s hard to pinpoint exactly what has caused the increase. In general, it appears that the market for IFAs has broadened, in part because more advisors and clients have become comfortable with it.”
Although immediate financing arrangements and 10-8s appeal to a similar clientele, the IFA is more aggressive tax-wise, he says. “The current market for IFAs is broader than the previous market for 10-8s. It would include clients who previously might have done a 10-8, as well as other clients who would never have done a 10-8,” La Barbera explains.
A market of millionaires
Sun Life describes its IFA as a leverage insurance strategy for high net worth clients. The immediate financing arrangement is tailored to clients such as the sole shareholder of a private, prosperous company that earns a large annual surplus. Most clients do not want to lock their money in an insurance contract.
Christian Hubert, of National Bank Insurance Firm, points out that leverage loan programs are not for everyone. “We target customers who have at least $5 million to invest. I often hear talk in the market of an entry level of at least $10 million.”
The Manulife document mentions that target customers need permanent life insurance protection and want to build wealth by investing in their business or investments. “The typical client of an immediate financing arrangement must have an insurance need and be interested in long-term strategies,” Diane Hamel says.
The strategy is more suitable for certain sectors. “Companies or individuals who hold real estate are often interested in IFAs. This approach also works for management companies, if they have taxable income to be able to benefit from tax deductions,” Hamel continues.
IFAs also benefit individuals who need to cover their tax costs at death, or have liquid assets that they want to transfer to their heirs, Christian Hubert adds. “Affluent clients don’t really need life insurance protection for themselves. They will use the policy strategically instead. They want to put in place estate values while reducing the tax impact. ”
The target clientele is sophisticated and well-informed, Hubert continues. Such clients seek legal, accounting, tax and other advice to make sure that they maintain the deductibility of interest, which is crucial to participate in the IFA plan, Hubert explains. “The rule of thumb is not to use more than a third of one’s net assets in the strategy, which is very applicable within a company.”
The target customer can afford to pay the premiums without having to contract a loan, Diane Hamel, of Manulife, adds. “If the funds borrowed are used to pay the premiums, the interest is not deductible in the income calculation. In fact, the typical clients must be able to structure their operations so that they can deduct this interest. Clients must also be able to deposit large sums and qualify for the loan, which is basically a business loan.”
Clients must also be able to benefit from the tax advantages the strategy offers. “To deduct interest, the entrepreneur needs taxable income,” Hamel explains. “It is not advisable to have an insurance policy and a loan in an operating company because it may be sold. This would probably mean having to repay the loan and transfer ownership of the policy, with the associated tax consequences. In real estate, it is generally the building that is sold, not the company that owns it.”
Cash surrender value
Christian Hubert explains that the loan is created when the insured invests liquid assets in the insurance contract. The loan takes the form of a line of credit whose rate is based on the future cash surrender value (CSV). To be able to deduct the loan interest, clients must reinvest the funds in their business or in a growth investment portfolio, for example.
For the concept to pay off, the financing must not exceed the permissible cash surrender value. It usually takes many years for the CSV to reach 100 per cent of the immediate financing, Hubert says. “If we want to finance 100 per cent of the CSV but it is less than the premiums invested, the lending institution will require other guarantees such as investments or real estate assets to fill the gap.”
For example, a real estate promoter purchases a policy that costs $10,000 per year, maximizes the CSV and minimizes the other guarantees. In the first year, the $10,000 premium may create value of only about $5,000; the usual bank financing rate, at 90 per cent, represents financing of $4,500. $5,500 is left for someone who wants total financing. “Around the 12th year, the CSV becomes equivalent to the premiums the insured pays,” Hubert explains.
Hubert adds that the bank linked to the immediate financing arrangement will usually lend 90 per cent of the value of a fixed-income investment such as the participating account in whole life insurance.
Manulife Bank will lend up to 100 per cent of the CSV value of a whole life policy, and up to 100 per cent of the premium if the holder provides additional collateral including CSV of another policy, a certificate of deposit, a non-registered portfolio, residential real estate asset, or a letter of credit from a bank, Steven La Barbera says.
IFAs are mainly associated with whole life policies. With universal life policies, Loan to Cash Surrender Value is lower and depends on the type of investment within the CSV, La Barbera says. “For example, if a UL policy is invested in Guaranteed Investment Accounts, we’ll fund 90 per cent of the CSV. If a UL policy is invested in equities, we won’t fund as much,” he adds.
Manulife Bank usually approves agreements up to 10 years in the future, which is unique in the market, La Barbera says. “Most banks, to our knowledge, will approve these two or at the most three years into the future. Like all banks, we do require an annual review before we lend back each year’s premium payment. The interest rate varies from deal to deal. ”