How Does Private Placement Life Insurance Work?
Private placement life insurance (PPLI) is a type of universal life insurance that's only sold privately, not available to the public. It's primarily designed to help very wealthy people pay less taxes on their investments.
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PPLI was designed for people who want to invest in hedge funds but avoid the high taxes that come with those investments.
That's a serious issue at higher incomes. Combined federal and state income tax combined with capital gains taxes can easily add up to nearly 50% of a person's income in some places.
One increasingly popular solution: Hold these assets in a life insurance policy.
Who does private placement life insurance make sense for?
PPLI isn't for everybody. A good candidate for PPLI is someone with an annual income in the millions, someone with a net worth of $20 million or more or someone who controls a business that puts them in that category.
Life insurance comes with a number of important tax benefits, which can be major considerations for those in the highest tax brackets. But standard life insurance policies don't offer hedge funds, funds of funds and other alternative investments that these investors require for their diversification and investment needs.
That's where privately placed life insurance comes in. Wealthy families, family foundations, trusts, corporations and banks work with hedge funds and money management firms to create their own life insurance contracts to reduce their taxes.
The idea is to combine the financial advantages of highly taxed hedge funds and similar investments with the tax advantages of life insurance. There are insurance and administrative costs for a life insurance contract, but the tax savings and death benefit itself more than make up for it. And the insured person can generally access most of the funds, tax free, with policy withdrawals and loans.
When a wealthy investor in a very high tax bracket wants to invest in hedge funds anyway, it often makes sense to create a PPLI to shelter themselves from taxes.
Qualifications to purchase PPLI
Anyone can buy a variable universal life insurance policy, which is structured like a PPLI. But privately placed life insurance policies are an unregistered securities product. This means that agents can only present them to accredited investors:
Under current Securities and Exchange Commission (SEC) regulations, accredited investors are those with a net worth of at least $1 million (excluding their primary residence) or income of at least $200,000 for each of the two prior years. For married couples that income requirement jumps to $300,000.
The owner is usually an individual or a trust. Holding the policy in an irrevocable (can't be changed) trust allows the insured person to keep the policy out of their taxable estate. This can lessen eventual estate tax liability, but it means giving up the rights to access the cash value prior to death.
In reality, the typical PPLI candidate or family has:
- A high net worth
- The ability to fund $1 million or more in annual premiums for several years — $3 million to $5 million is typical
- A desire for hedge funds or alternative investments
- Highly tax-inefficient investments
- High state and local income taxes (advisors should be aware of the effect of any state premium taxes on the strategy) in addition to federal
- A desire to shelter assets from creditors
It's important to make a big investment in the first several years, because this initial investment "primes the pump." If the underlying investment subaccounts perform well enough, the policy could become self-funding. That is, growth in its cash value could cover the cost of the insurance. At that point, the insured person can stop paying the premium if they choose.
Where to buy private placement life insurance
Professional wealth managers tend to recommend vendors. However, some of the most prominent providers of PPLI services and insurance-dedicated funds (IDF) include BlackRock, Wells Fargo Private Banking, John Hancock, Zurich Insurance Group, Crown Global Insurance Group and Pacific Life.
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How private placement life insurance works
PPLI is generally structured like a variable universal life insurance policy. This means:
- Premiums are flexible. Policyholders can pay as much or as little premium as they'd like, whenever they'd like.
- The cost of insurance is deducted from the cash value in the policy's subaccounts each month or each year.
- To keep the policy in force, the owner must pay enough of a premium to maintain enough cash value to cover the cost of the insurance.
- If the cash value reaches zero, the policy will lapse.
The agent who sets it up will usually structure the policy to maximize cash value growth while keeping the death benefit (and with it, the insurance cost) relatively low. The policy owner, working with an insurance professional, then pays as much premium as possible into the policy every year.
The policyholder gets the benefit of the tremendous tax advantages of the life insurance contract:
- Tax-free death benefits to heirs
- Tax-deferred cash value growth
- Tax-free growth of dividends (if applicable)
Meanwhile, they still have access to accumulated cash values, which can be used for any purpose and withdrawn at any age. There are no penalties for taking out the cash value before turning age 59 1/2, as there are with annuities and individual retirement accounts (IRAs). Also, there are no required minimum distributions, as there are with annuities, IRAs and retirement accounts.
PPLI investments
PPLI policies are best for investors who are tax inefficient. People who generate a lot of current taxable income, imputed (phantom) income or capital gains, unless they're held in a retirement account or life insurance vehicle that provides tax-free growth.
PPLI owners and their advisors either choose specific investments for their portfolios or carefully select money managers to handle their portfolios within the policies. Possible investments can include venture capital, real estate investment trusts, private equity funds, funds of hedge funds and commodity funds or any fund with an extremely high turnover rate that generates large short-term capital gains.
But that doesn't mean anything goes. PPLIs must still meet IRS standards for investor control, insurance and diversification.
Investor control: Individual policy owners and family offices are prohibited from influencing the specific investment decisions of the fund managers. If the owner exercises too much control, the IRS may take away the tax advantages of the policy. Current case law requires managers to operate independently. Assets held in PPLI policies are not designed to be separately managed accounts and should not be treated that way.
Insurance standards: The life insurance structure allows owners to sell insurance-dedicated funds within the policy as often as they'd like and replace them with other qualified investments, without tax consequences. IDFs are financial products designed specifically for the PPLI market. Hedge funds and funds of funds often create a version of their main offering as an IDF with all the same strategies and managers. But it's also managed to adhere to the laws and regulations of insurance portfolios.
Diversification requirements: Investments must also meet diversification rules:
- No single investment may make up more than 55% of the insurance subaccount portfolio.
- No two investments may make up more than 70% of the portfolio.
- No three investments may make up more than 80% of the portfolio.
- No four investments may make up more than 90% of the total assets in the account.
The portfolio must contain at least five distinct investments to fully qualify as life insurance. Otherwise, the IRS will disqualify the policy, and the policy's owner will lose the tax advantages of the life insurance structure.
Accessing money in a PPLI
Policy owners can withdraw from their cash value or borrow against it anytime, for any purpose.
Withdrawals Withdrawals are tax free, up to the cash value (or "basis") of the policies. So owners can get back their premiums, minus fees and without tax consequences, as long as their subaccounts' performance has kept up with the cost of insurance. If the cash value is greater than the owner's basis in the policy, then withdrawals over the basis are taxed as a gain.
Policy loans The policyholder can borrow against the cash value of the policy with no underwriting or credit check. The loan is secured by the policy's cash value. This makes the policy a solid choice for emergency funds. The loan does not have to be paid back, but the policy owner may want to replenish any money borrowed from the policy to maximize long-term tax-free growth.
Because the loans are secured by payments already made to the insurance company, interest rates are often very low. Borrowers should be aware that interest does accrue, though. And the loan will reduce any death benefits paid out, unless the borrowed money has been paid back to the policy.
Contribution limitations and modified endowment contracts
The government sets limits on how much an owner can contribute to the policy in a given year. This ensures that life insurance is used for its intended purpose, as opposed to a tax shelter. The result of the contribution limit is the "seven-pay test". If a policyholder contributes so much premium to their policy that it would be paid up in less than seven years, it becomes a modified endowment contract (MEC). This disqualifies the policy from many of the tax advantages on withdrawals and loans.
- One of the great things about insurance policies is that an owner who withdraws cash value from a life insurance policy that's in force gets the benefit of first in, first out (FIFO) taxation. This allows the policyholder to withdraw as much as they'd like, up to their basis in the policy (the amount that has been contributed), tax free. If the policy becomes an MEC, this advantage disappears.
- Instead, the IRS will deem the owner to be withdrawing interest first, not the basis. This interest is taxable.
- Likewise, while the law allows tax-free loans from a life insurance policy, once the policy becomes an MEC, those loans become taxable as income. Also, any withdrawals from an MEC before age 59 1/2 have a 10% early withdrawal penalty, just as with a qualified annuity or 401(k).
The policy documents should specify the annual MEC limit.
Life insurance contract | MEC | |
|---|---|---|
| Premiums | Limited by seven-pay test | Not limited, except by contract |
| Loans | Tax free for life of policy | Taxable as income |
| Withdrawals | Tax free, up to basis (FIFO) | Taxable until all interest/gains are withdrawn |
| Death benefit | Tax free | Tax free |
| Death benefit amount | Usually kept small to maximize cash value growth | Used to maximize death benefit |
How are PPLI policies different from retail life insurance?
Structurally, private placement life insurance is identical to a conventional variable universal life insurance policy. The assets held in the subaccount are what set PPLIs apart.
An everyday retail customer will be offered a limited menu of subaccount investments by the life insurance company. But with a PPLI, the policyholder can customize their investment subaccounts. This can include nearly any investment imaginable, from index funds to hedge funds. A registered investment advisor or wealth manager can help design the investments and the menu of subaccounts.
Taxes and other benefits of a PPLI
High-income individuals are very tax sensitive. The ordinary income tax rate on earnings above $518,401 in 2018 was 37%, plus Affordable Care Act taxes. Combined with state and local income taxes, that could add up to nearly 50% in some jurisdictions.
The heart of the PPLI strategy lies in the tax advantages. The PPLI essentially converts a very tax-inefficient investment, such as a hedge fund, into a very tax-efficient one for a high-net-worth investor.
Hedge fund held in personal account (typically) | Hedge fund held within a PPLI | |
|---|---|---|
| Death benefit | N/A | Tax-free death benefit |
| Income | Taxable at 37%–50% | Tax free for life of policy |
| Short-term capital gains | Taxable at 37%–50% | Tax free for life of policy |
| Long-term capital gains | Taxable at 20% | Tax free for life of policy |
| Imputed income | Taxable at 37%–50% | Tax free for life of policy |
| Transfers to other life policies | Taxable, gain over basis | Tax free under IRC Section 1035 |
| Transfer to annuities | Taxable, gain over basis | Tax free under IRC Section 1035 |
| Creditor protection | None | Enhanced |
| Estate tax treatment | Taxable, unless in irrevocable trust | Taxable in estate of owner, unless in irrevocable life insurance trust |
| Tax loss harvesting strategies | Investors can sell losers to offset capital gains | N/A, but losing policies can be surrendered |
| Treatment at death | Subject to probate | Bypasses probate; death benefit goes to beneficiaries in days |
This strategy offsets the impact of current income by placing the assets in a life insurance policy with tax advantages similar to a Roth IRA. Money within the policy grows tax free for as long as it remains in the policy.
In addition to the tax benefits, PPLI policies often provide a number of additional benefits:
- Lower commissions: The cost of insurance and commissions is low compared with most retail life insurance products. Companies are more interested in managing money than in generating large up-front commissions.
- No surrender charges: Because companies don't rely on a commission-paid sales force (as traditional insurance companies do), they don't need to recover commission costs with surrender charges.
- Phantom income is not taxed: Some investments result in a tax liability to the owner, even though no actual cash income has been taken out. For example, a zero-coupon bond pays no income until it matures, but the IRS forces taxpayers to pay taxes on imputed income as the bond nears maturity. If the asset is held in a PPLI, the tax on imputed (phantom) income is canceled out.
- Tax compliance is easier: Tax reporting is tedious for hedge fund investors and people who hold interests in limited partnerships and master limited partnerships. By holding these assets within a PPLI, the taxpayer doesn't have to deal with K-1 reports and other reporting requirements.
- Creditor protection: Cash value life insurance is a proven way to shelter assets from creditors. Life insurance and annuities offer major asset protection in every state. In some states, like Florida and Texas, creditor protection is unlimited. Sometimes PPLI life insurance assets are held offshore, keeping them out of the reach of US courts. No US court can force a foreign company to release funds to a creditor.
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