Before a client is encouraged to leverage a life insurance policy, there are some key points that need to be analyzed
Borrowing against a cash-value life insurance policy is a useful strategy for helping a client access a new stream of capital. It is an effective financial planning tool that can free up funds for clients to invest in their businesses, fund retirement portfolios or finance other personal needs.
Before a client is encouraged to leverage a life insurance policy, there are some key points that need to be considered:
“Before you get to leveraging, you must help the client understand whether they have a life insurance need and then, if they do, look at the type of insurance that is appropriate for them,” says Chris Ireland, Senior Vice-President, Planning Services for PPI Advisory . “Then, look at whether they want to put additional funds into the policy. Only then should they start thinking about leveraging. It is a four step process to get there, and if that process is not followed the client may not understand clearly what they are doing and why they are doing it.”
By guiding the client through a thorough step-by-step process before leveraging you lay the groundwork for an effective financial strategy, today and in the future.. When the client looks at their leveraging arrangement two or three years down the road they will still understand the value of having the loan. There are moving parts that need to be managed every year and the client will be prepared for that.
“People ask ‘why am I doing this; why do I have this insurance?’”, Ireland explains. “Clients will be comfortable with the arrangement if they fully understand from the outset why they entered into the insurance contract and why they then leveraged.”
There are additional considerations before leveraging, which include sensitivity analysis of the interest rate and rate of return in the policy, the potential for deductibility of interest, and understanding the consequences if the loan is repaid while the borrower is alive.
“A sensitivity analysis is essential for anyone looking at doing a leveraging arrangement with insurance,” Ireland says. “The interest rate on the loan will vary, depending on the agreement, as will the rate of return on the policy. Over time, if those figures diverge the client needs to know what that means for them. They may have to put more money in the policy or add some more security to the loan. You can’t predict the future, but if you go through a few scenarios with the client they will better understand what could happen down the road.”
Ireland also encourages advisors to carry out ‘crash testing’ on the leveraging agreement. It’s an analysis that reveals all of the potential outcomes if the client decides they want to wind up the loan . In most life insurance leveraging arrangements, the cash built up in the policy is used to repay the loan.
“Doing this crash testing makes you consider if there is enough cash in the life insurance policy, if that cash is available to come out of the policy, if using the cash to repay the loan will result in a taxable gain, and whether the client needs to use other assets to pay the loan,” Ireland says. “The client needs to be prepared for all eventualities if leveraging is being considered.”
Leveraging a cash-value life insurance policy is an effective financial planning tool for clients, and it’s a strategy that all advisors should have in their arsenal, Ireland explains.
“Make sure you understand the lending arrangements and the differences between institutions,” he says. “Know the product you are presenting to your client and make sure you collaborate with a client’s tax and legal advisors – they are an integral part of the process and will help the client understand the economic benefits and considerations of this financial planning strategy.
