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Factors to Consider

Once you have decided to fund your buy-sell agreement with life insurance, you must choose the appropriate policies. What is considered appropriate will depend on factors including:

  • Time period to be covered by the buy-sell agreement--short-term or long-term arrangement?
  • Cash flow--company and individuals--what is affordable?

The answers to these questions (along with some others) will point to a type of policy that is most appropriate for your buy-sell agreement at this time. Check out the option features on the specific policies you are considering--it is possible that the policy type most appropriate today can be converted to a different type of policy to match your needs in the future.

Basic Policy Types Defined

The most basic characterization of life insurance policies is the duration of the coverage. Term insurance provides coverage for a specific amount of time. Other types of policies provide coverage for the person's entire (whole) life. Within these groups, some types of policies cover two or more lives but pay only one death benefit. The following discussions are intended to provide a brief overview of each major type of policy.

Policies on an Individual Life

Term Life

Term life insurance provides coverage for a specific time period (term) and is often referred to as "temporary" insurance. The face amount of the policy is paid if the insured dies during the term of the policy. When the person lives longer than the term of the insurance, nothing is paid.

Term policies are generally one of these types:

  • Annually renewable--coverage is for one-year period. Often, the coverage can be renewed for an additional year but only for a limited number of renewals. Some policies allow renewals up to age 90. The cost of the insurance increases each year. Most companies offer a guaranteed renewable policy that doesn't require evidence of insurability each year.
  • Periodically renewable--coverage is for a specific period, usually 5, 10, 15, or 20 years. If the policy is renewable, the premiums remain level for the coverage period but generally increase at each renewal date.
  • Term to a fixed age--coverage is provided until a certain age, usually 65 or 70. This is a longer-term temporary policy and provides protection during the usual income-producing years. With this type of policy, the premiums are level for the entire term.
  1. Purpose--Term insurance is designed to cover short-term needs, such as coverage during the working years or for the duration of a loan or mortgage. If you are considering term insurance, make sure the policy contains a renewability option, allowing renewal of the policy without a medical examination. Some term policies also contain a conversion privilege, which allows the insured to convert to a permanent policy without providing further evidence of insurability. Both of these features are very important.

Tip: You can start with term insurance in the early years of the buy-sell agreement, especially if the person to be covered is relatively young, say in their 20s or 30s. When cash is a little less scarce, use the conversion privilege to convert to permanent life insurance.

  1. Advantages
  • Flexible--can buy policy based on various terms
  • Low cost (at least in the younger years of life)
  • Policy with conversion feature can allow you to extend the coverage period and achieve a fixed premium amount
  • Policies available that provide coverage up to age 90
  1. Disadvantages
  • Premiums increase at each renewal--gets more expensive with age
  • Most policies not issued after age 65 or 70
  • Most people will outlive the term of the insurance
  • Increasing premium costs can make it expensive for long-term needs

Whole Life

Whole life insurance is called "permanent" protection, meaning the coverage (and the premiums) lasts for your entire (whole) life (i.e., as long as the premiums are paid). The premium amount often remains the same throughout the life of the policy (depending upon the specific policy chosen), and the death benefit is a guaranteed amount. When you pay the premiums on a whole life policy, part of the money accumulates as a cash value, sort of a savings account within the policy. The cash value may be borrowed against. Policy dividends (if any) may be withdrawn without affecting the guaranteed death benefit amount.

Caution: Accessing policy cash values could have tax ramifications. Consult with your tax professional before doing so. Guarantees are based on the claims-paying ability of the insurance company issuing the policy.

There are different types of whole life contracts:

  • Ordinary Level Premium Whole Life (or continuous premium whole life)--the premiums are calculated on the assumption that they will be paid for the insured's entire life. In many cases, policy dividends can be used to pay up the premiums in a shorter period of time.
  • Limited-Payment Whole Life--the premiums are paid for a specific number of years, but the coverage is for the insured's whole life. The policy is identified by either the number of annual payments (e.g., 7, 10, 20, or 30 annual payments) or the age at which it is paid up (e.g., paid-up at age 60, 65, or 70).
  • Current Assumption Whole Life--the premiums are subject to change based on the experience of the insurance company. The premium is capped with a guaranteed maximum, but the insurer often charges less. It is possible for the premiums to increase (up to the maximum) or for the cash value to be lower than projected. The premiums for an ordinary whole life policy are based on the assumption of a longer payment period, so they are generally lower than the premiums on a limited-payment policy. The premiums on current assumption whole life could increase based on insurance company experience. When used for funding a buy-sell agreement, the choice between the types available will depend on personal and business circumstances and preferences. A. Purpose--The purpose of whole life insurance is to protect against long-range or permanent needs. The coverage extends over the insured's entire lifetime, not just the average working lifetime. It accumulates a cash value (sometimes referred to as a savings fund), which can be used during the insured's lifetime.

Tip: If the owners of the business intend to work beyond age 65 and transfer the business at death under the buy-sell agreement, then whole life insurance will likely serve the purpose better than term insurance.

  1. Advantages
  • Cash values accumulate and can be used during lifetime
  • Premium amount doesn't increase with ordinary whole life
  • Mutual insurance company pays dividends--can be paid in cash, used to decrease premium, increase death benefit, or a combination thereof (called a participating policy)
  1. Disadvantages
  • Initial premium cost higher than term insurance (although in the long run can be less costly than the increasing premiums on term insurance)
  • Cash values could be subject to claims of creditors

Variable Life

Variable life policies have a fixed premium amount with a guaranteed minimum death benefit. The cash values are invested in an underlying investment portfolio chosen by the policyowner and fluctuate with market values. The cash values are not guaranteed. A. Purpose--A variable life policy allows the policyowner to choose the investments the cash values are invested in. In theory, the policyowner can participate in favorable returns, with favorable investment earnings added to the cash value of the policy. The policyowner also assumes the risk associated with any investment and could lose the total cash value of the policy with a downturn in the market.

  1. Advantages
  • Fixed level premiums
  • Guaranteed minimum death benefit
  1. Disadvantages
  • Few guarantees with these policies
  • Cash values fluctuate with market values--could be eroded due to market conditions and choice of underlying investments
  • Cash values are not guaranteed
  • Cash values could be subject to claims of creditors
  • Can be higher in cost than traditional products

Caution: Guarantees are subject to the claims-paying ability of the insurer.

Caution: Variable life and variable universal life insurance policies are offered by prospectus, which you can obtain from your financial professional or the insurance company. The prospectus contains detailed information about investment objectives, risks, charges, and expenses. You should read the prospectus and consider this information carefully before purchasing a variable life or variable universal life insurance policy.

Adjustable Life Insurance

Adjustable life is a special whole life policy with fixed premiums. The policy provides the same guarantees of death benefit and cash values as a traditional whole life policy. What makes the adjustable life policy special is that, at specific intervals, the policy allows the policyowner to request upward or downward adjustments of premium, death benefit (face amount), or cash value. Increases in the death benefit above a certain percentage or amount usually require evidence of insurability (i.e., medical proof).

  1. Purpose--Adjustable life insurance policies allow changing life insurance needs over long periods to be met by a policy with flexibility. Changes in the policy are often requested at the time of family events such as a child entering private school or college, the primary breadwinner's loss of employment, or the start-up or failure of a business. The most common adjustment requested is a reduction of premium during a family's period of decreased income or increased expenses.

Adjustable life insurance can combine funding for a buy-sell agreement with flexibility through the ability to adjust the death benefit and/or cash value. This can provide a growing business with a funding method that can keep pace with increases in the value of the business without the need to get additional policies. In an economic downturn, it can also provide flexibility through the premium adjustment feature. It has been used in cases when the parties to the buy-sell agreement are of different ages.

Example(s): Let's say that you and Ron own a business. You are 35 years old, and Ron is 45. You want to use life insurance to fund your buy-sell agreement. One possibility is for you to buy $100,000 in life insurance covering Ron. Likewise, Ron buys $100,000 in insurance covering you. Due to your difference in ages, a conventional policy covering Ron costs you $2,500 yearly, but the policy on you costs Ron only $1,675 a year. Or you could buy adjustable life policies with premiums of $1,750 that provide $100,000 in insurance on each of you. How can this be? The difference is the term of protection--the policy on Ron provides coverage to age 68, while the policy on you provides coverage until age 81.

  1. Advantages
  • Provides policyowner with flexibility and discretion selecting the premium payment schedule
  • Cash values accumulate and can be used during lifetime
  1. Disadvantages
  • Adjustments must be formally requested in advance
  • Adjustments may be allowed only at certain dates or intervals
  • Adjustments of premium payment or death benefit could lead to adverse tax consequences
  • Cash values could be subject to claims of creditors

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Universal Life

Universal life insurance is even more flexible than adjustable life insurance. Universal life provides for completely flexible premiums and even allows payments to be skipped after the first policy year as long as the cash value is large enough to cover policy expense charges. Additions to cash values are based on current interest rates as well as mortality and expense charges.

The cash values can be borrowed or withdrawn without a repayment obligation. The death benefit can also be adjusted, although increasing it may require evidence of insurability.

  1. Purpose--Universal life is generally best suited for long-term needs. Large premium payments in the policy's early years (or at other times when cash is available) can reduce or eliminate the need for premium payments at other times. The ability to change the death benefit provides versatility within the policy, allowing it to adapt to changing needs and circumstances. Universal life insurance has been used in funding buy-sell agreements when flexibility is needed. The ability to fund the policy when cash is available and to skip it when cash is tight can allow the premium payments to keep pace with the business cash cycles.
  2. Advantages
  • Maximum flexibility--premium payments can be skipped as long as cash values are sufficient
  • Skipped premiums do not create a policy loan
  • Cash values accumulate and can be used during lifetime
  • Policyowners benefit when insurance company has improved trend in mortality experience or expenses
  1. Disadvantages
  • Premium payment flexibility can easily lead to policy lapse
  • Policyowners bear more risk if insurance company encounters adverse trend in mortality experience or expenses
  • Adjustments of premium payment or death benefit could lead to adverse tax consequences
  • Cash values could be subject to claims of creditors

Policies on More Than One Life

Joint Life First-To-Die

A joint life first-to-die policy insures more than one life under one insurance contract. While a joint life policy can cover an unlimited number of lives, insurance companies usually limit the number of people covered. The death benefit is paid at the first death. A. Purpose--A joint life policy can provide a higher death benefit than might be possible under multiple individual policies.

For example, a joint life policy covering two lives with a death benefit of $500,000 would be less expensive than two individual policies, each with a death benefit of $500,000. Business owners sometimes use joint life policies to cover the lives of all owners, with the death benefit amount equal to the largest interest held. At the first death of an owner, the insurance benefit is paid to the surviving owners, which is used to buy the interest of the deceased. Some life insurance companies have even designed policies especially for funding buy-sell agreements.

  1. Advantages
  • Less expensive than multiple individual policies with the same face amount
  • Coverage can generally be continued after the first death by buying either another first-to-die policy or individual policies
  • Especially valuable for the two-owner business--policy provides cash when needed for buy-sell agreement at the first death
  1. Disadvantages
  • After the first death, the policy terminates--the remaining owners could be left without insurance and may be uninsurable
  • If continued coverage is allowed for the surviving owners, premiums are based on attained age, so it could become expensive at that point
  • The insured always has incidents of ownership in policy due to joint ownership--IRS could try to include proceeds in the estate of the first to die

Tip: When considering a joint life first-to-die policy, check for a guaranteed insurability rider that will allow surviving owners to buy additional coverage even if they have become uninsurable.

Second-To-Die (Survivorship)

Second-to-die or survivorship policies insure two or more lives under one contract. The death benefit is paid at the second death. Most survivorship life policies are whole life policies, although some are issued as term coverage. A. Purpose--Survivorship policies are generally used for funding estate taxes of high-wealth individuals. This type of policy is used in family and business key person coverage scenarios where the family or business could survive the loss of one person but not both. Because nothing is paid at the first death, this type of policy is probably not the best choice for use in funding a buy-sell agreement.

  1. Advantages
  • Less expensive than multiple individual policies with the same face amount
  • Can be used to insure multiple lives, and the policyowner can elect at which death the benefit will be paid (e.g., second, third, or later death)
  • Some policies feature an election whereby the face amount may be paid out more than once
  1. Disadvantages
  • Nothing is paid at the first death (so it may not help with your buy-sell agreement)

Comparison of Policy Types

The following table compares the types of insurance policies based on premium cost, length of coverage, and presence (or absence) of cash value accumulation:

Policy

Premium

Coverage (Assuming premiums paid)

Death Benefit

Cash Value

Term

Increases at each renewal

Most policies issued up to 65 or 70, but coverage may be to age 90+

Stated in policy

None

Whole Life (Ordinary)

Level, Fixed

For life

Guaranteed

Guaranteed fixed with a minimum interest rate

Current Assumption Whole Life

May change based on insurer's experience Policy usually has maximum guaranteed premium

For life

Guaranteed

Minimum guaranteed interest rate Cash value can fluctuate if assumptions change adversely

Universal Life

Completely flexible after first policy year

For life

Flexible

Must be kept at certain level to prevent policy lapse Varies depending on face amount and premium

Variable Life

Level, Fixed

For life

Guaranteed minimum

Not guaranteed, based on investment performance

Joint First-to-Die

Level

Ends at first death

Guaranteed

Yes

Second-to-Die (Survivorship)

Level

Until second death--nothing paid at first death

Guaranteed

Yes

Adjustable Life

Flexible, requires formal request

For life

Guaranteed, adjustable

Yes Varies depending on mix of premium and death benefit guaranteed minimum

Caution: Guarantees are subject to the claims-paying ability of the insurer.

How Do You Choose a Policy for Your Buy-Sell Agreement?

There are many factors to consider when deciding on a type of policy for your buy-sell agreement. There is no standard answer as to what type of policy should be used to fund any particular buy-sell agreement. Work with your insurance representative to choose the policy that will work for you now and in the future.

Business Stage

Consider what phase of development your business is in. The stage of growth will affect the cash flow and reserves available, which will influence the type of policy that makes the most sense. The following table shows some major stages in a company's life and an appropriate type of life insurance for each stage.

Company Life Stage

Characteristics

Policy

Reason

Start-Up

Little or no cash flow or reserves

Term

  • Smaller premium payment than permanent
  • Can generally be converted to permanent policy

Joint life first-to-die

  • Lower cost than individual policies with same face amount
  • Can be written for two or more lives
  • Cash values accumulate within policy
  • Usually includes feature allowing policy to be split into individual policies

Growth

Increasing cash flow; start of reserves

Permanent

  • Coverage for longer time period
  • Cash values accumulate within policy

Mature

Ample cash flow and reserves

Permanent

  • Coverage for longer time period
  • Cash values accumulate within policy

Time Frame

Another consideration is the expected time period to be covered by the buy-sell agreement. In the early stages of a company's life cycle, you might expect the buy-sell transaction to be some time in the future, say 20 or 30 years (or more) from now. A term policy may be for only 10 years, but if you use the convertibility provision, you can convert the term policy to permanent coverage. You may have big plans for your business (e.g., a public stock offering) that you expect to realize on a shorter horizon, say in 5 or 10 years. In this case, you may want short-term funding for the buy-sell, just in case a buyout is required before the big event. Even if the larger premiums of permanent insurance are affordable, you might want the less-expensive term coverage due to the time frame involved.

Ages of Owners

If the owners to be covered by policies are in their 20s, the premiums will be lower for permanent types of insurance than if the owners are in their 50s. The ages of the owners will affect the premiums--insurance is less costly when you are younger.

Ownership Percentages

If all the owners have relatively equal ownership shares and are of roughly the same age and health, the costs of policies on each will probably be pretty equal. However, if there is a majority shareholder who owns most of the business and who is quite a bit older than the other owners, there will be a difference in the amounts of insurance needed and the policy premiums. A younger owner may be faced with buying a large policy on the older owner, who may be considered a higher risk by the insurance company. To get the amount of coverage needed, there will have to be choices made so that the younger (presumably lower income) owner doesn't end up bankrupt over the insurance expense.

 

 

This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of  The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.

 

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