Private Wealth Management Review, June 2001
PWMR asks whether offshore insurance should have a place in wealth management, what the products and opportunities are, where are to be found and importantly, the pros and cons.
For many people the word insurance means a necessary evil, and people generally would like to deal with insurance companies as little as possible. However, if you are a high-net-worth individual your advisor mat be trying to change your mind about that, as offshore insurance products are lauded as the next big thing.
The reasons that the world of off-shore insurance has recently risen in popularity and profile are three-fold – firstly, there is a growing tendency within financial institutions to offer clients a ‘wealth management’ package, including asset management, private banking, alternative investments, trusts, estate-planning and, insurance. Bank assurance – the tying of insurance and banking services/products – is growing in popularity as institutions strive to keep their clients custom of their assets, their plan, and their fees, instead of watching them use expensive insurance brokers.
The financial services industry sees insurance as presenting a considerable opportunity for a second reason. Over the next 20 years. Products for the distribution and transfer of wealth will expand – and life insurance serves as an optimal vehicle for achieving the common goals of tax mitigation, estate-planning and asset control.
A third factor is the changing off-shore environment, where in many jurisdictions the use of previously solid tax and estate – planning devices, such as trusts, is being eroded. Some jurisdictions (Such as where offshore insurance policies can offer opportunity and flexibility is the investment of the premium the UK and US) have created specific antiavoidance measures to render settlements inefficient, or the fiscal authorities regard them as artificial arrangements. Many jurisdictions do not recognize trusts due to their system of law, and in others the use of offshore holding companies is being increasingly frowned. As a side effect demand for life insurance products-which enjoy favorable tax status in most aggressive tax jurisdictions – has boomed.
The world of insurance contains a plethora of products. Providers, costs and terminology that confuse even the most sophisticated individual. Therefore, it is fundamental that an adviser has a working understanding of the features of the different types of product available to the client and which could be the most appropriate.
The product
Simply stated, offshore life insurance products are insurance policies based upon the life of a specified individual (the “insured”). Issued by an insurance company (the “insucer”) that is incorporated and conducting its business exclusively in an offshore jurisdiction. An individual a company or trustees of an offshore trust can own the policy. This idea is not new, but what are the refinements developed by insurers for servicing the needs of the international private client. Specifically, where offshore insurance policies can offer opportunity and flexibility is the investment of the premium. Traditionally, an insurer will offer a selected fund or group of group of funds, often through one of itw own affiliated companies. However, most high-net-worth clients have a structured and planned portpolio managed by a trusted advisor or banker. Therefore, many offshore insurers now offer clients the option to allow the investment managers, provided the advisor satifies the insurer’s requirements and any jurisdictional regulations and restrictions.
Alternatively, the client could use a ‘bond wrap’. This is when the premium consists of an existing investment portpolio held with the client’s private bank, which then holds the policy assets and becomes the “custodian” bank, the premium is simply transferred into the name of the insurance company (so as not to incur losses by having to luquidate the portpolio)and the client’s relationship with the bank remains undisturbed.
From a wealth management perspective, offshore life insurance can also be used as an estate planning tool. The beneficiaries of the policy are normally not the premium payers i.e., the individual who is paying for the life insurance normally uses the annuity or policy as a way to lock up assets until they are either retired or deceased, and can select to who or what the policy pays out its bounty. Thus the holder at their own discretion, the details of which are not a matter of public record, and thus confidential, can nominate beneficiaries. By going offshore, depending on the laws of each jurisdiction, one also can avoid paying gift tax and exchange control restrictions. In some domiciles legislation prevents forced heirship claims former spouses. Spendthrift heirs and other unwanted parties. The policy provider – the life insurance company – can in some circumstances alienate the assets within the policy by holding them itself. The policy can thus be separated from the premium payer’s accountable and taxable assets for wealth, inheritance and tax purposes.
What is an annuity?
An annuity is a contract between the client and an insurance company where their earnings are allowed to grow and compound without current taxes. All income taxes are deferred until maturing of the annuity. Capital gains and income accumulate tax deferred. This can be used to help the individual accumulate wealth for their retirement or other long-term financial goals.
The work annuity literally means annual payments and when an annuity is bought the insurance company agrees to pay the client an income for a specified period of time. Whether these income payments start right away, or at some future date, determines what type of annuity is chosen, the main two being deferred or Immediate.
With an immediate annuity income payments start immediately or within 12 months of purchase. The client chooses whether they want income guaranteed for a specific number of years or for their lifetime with the insurance company calculating the amount of each income payment based on their purchase amount and the life expectancy.
A deferred annuity has two phases the accumulation phase, where the money grows tax deferred until either the client takes it out, either as lumpsum or as a series of payments. They also have to decide when to take income from their annuity and therefore, when to pay the taxes. Gaining increased control over takes is one of the key benefits of annuities.
The payout phase begins when the client wants income from the annuity, normally during retirement. This can be in the form of partial withdrawals, completely payout of the annuity or converted into a stream of income payments (annuitisation). This last option is essentially the same as buying an immediate annuity.
Analysts predict the annuities will increase in popularity because high-net-worth individuals are seeking a steady income after retirement, hopefully locked away from the vacillations of inflation and the stock markets. Annuities can also offer the benefit of tax deferred income growth. Once money is invested in an annuity, all of its earnings – whether from interest, dividend income or capital gains – grow tax-free.
Advantages
For clients, a benefit of maintaining an offshore insurance product is that it can fit in with any existing structure already located in that domicile. This can smooth the administrative burden of introducing a new facet to the client’s portfolio and walth-plan. Being located offshore one has added security from changes in the relevant home jurisdiction, adverse tax changes, inflation, exchange control upheavals or political risks. All of these factors remain relevant concerns to the global high net worth individual or family.
If clients have a policy where funds paid into a life insurance policy accumulate income and capital gains tax free, there is no capital gains tax liability when the death benefit is paid nor any estate tax liability. It may be necessary or advantageous to have the policy owned by an irrevocable life insurance trust. From a purely tax perspective therefore life insurance policies can, in appropriate circumstances, offer a significant benefit, for example the life policy premiums may be tax deductible and therefore the client can disclose the policy to the fiscal authorities in their home jurisdiction. Repayments of premium based on a partial or total cancellation of the policy can count as non-taxable capital.
These products tend to be aimed at individuals or families with significant funds – most insurance companies look for commitments of at least US$1 million. What is important is the duration of the clients tax liability. Craig Macintrye, an associate at top Bermuda law-firm Conyers Dill & Pearman and insurance expert, explains: “If it is to be long term, in excess of 10 years, than the costs of the restructuring and ongoing insurance costs will be compensated by tax saving over time. Individuals expecting to be in a high tax jurisdiction for a limited number of years (such as international executives) may consider integration of a defined term modified endowment contract or an annuity contract, into their tax planning which can be unwound once they have left the high tax jurisdiction”.
Disadvantages
When the spheres of trust, insurance and tax collide, complicated issues arise. It should of course be checked that he product does not contravene any rules or regulations in the client’s home jurisdiction, as they will be less than happy if they find out what they are really buying is actually an expensive piece of litigation in their home jurisdiction against their revenue authorities, or for example, a disgruntled former spouse. Naturally the financial strength and reputation of the annuity or insurance provider is important, as is the stability and sophistication of the jurisdiction in which the firm operates, investment flexibility and competitive costs. Respected jurisdictions include Bermuda, the Cayman Islands, the Isle of Man, Ireland, Luxembourg and Switzerland. Likewise, the product itself must be utterly reliable.
However the main problems with annuities and other products are the costs involved. Offshore insurance, like most international products, does not come cheap. The fist two years of premium payments might be going just to pay commission costs, and the person selling you the policy normally will receive a substantial fee. In other cases 75% of each payment is deducted as a front – load. Annual fees on deferred annuities can exceed 3%. If a policy is cancelled before annuitisation, there can also be substantial penalties, as much as 3% of the balance.
Another problem is choosing the insurance company. As the popularity of these products increase, so does the range and quality of service providers diversity. Many of these companies are new and untested or are fresh offshoots of existing institutions. This situation is adroitly summed up by Urban Harju, head of advisory private banking for SEB Private Bank. Luxembourg who are also entering the life insurance market. “There are lots of inheritance and insurance products out there and often the only difference is how the insurance company presents it to the clients as all the products are relatively similar.
The future
There are four basic stages of the wealth cycle of which insurance can serve a valuable purpose in three. First is the accumulation stage as individuals build their wealth, second, the protection phase, when they seek to shield assets from taxes, inflation and declines in the financial markets; third, the distribution phase, when people retire and desire to lock in an income; and finally, the transfer phase, during which they pass their estate onto heirs and philanthropic causes.
The combination of “bond wraps”, flexible products and a highly dependable and well-regulated environment can produce some very attractive results for high-net-worth individuals. There are a variety of different products out there, from annuities to straight insurance, bond wraps, annuities and others that are still in development, such as the wrapped hedge fund. However, though useful from both an estate-planning purpose, through the use of beneficiaries, and tax planning, the costs must be balanced with care as should the choice of provider and jurisdiction . It is very important to took at the life insurance needs of the client, as the costs involved may tackle them inefficient for many segments of the market. Taxes are not the only reason to consider an offshore life insurance solution, and the need for offshore life insurance cover should only be offered when required.
Fixed or variable annuity?
The important differences between fixed and variable annuities are the way in which the products generate earnings and the amount of risk involved. When a client purchases a fixed annuity, the insurance company guarantees them a fixed interest rate for an initial period of time. At the end of this time the insurance company will declare a renewal interest rate for the life of the contract. In other words, regardless of market conditions, the insurance company can never set the interest rate below a stated floor (typically between 3% to 4%) Fixed annuities typically appeal to investors who feel more comfortable knowing exactly how much their money is earning. With a variable annuity, the client has more control over their investments. They are allocated funds among a variety of investment options with objective ranging from aggressive to conservative (insurance companies call these sub-accounts). The rate of return is tied to the performance of the underlying investments of the sub-accounts. Variable annuities typically appeal to investors who are willing to accept a higher level of risk in return for the potential for higher growth
What is variable life insurance?
A variable life insurance policy has two main features. First, it provides a death benefit similar to other life insurance policies. Second, it establishes an investment account that can be used as an investment account unrelated to insurance. Client who highly value the death benefit are able to obtrain this while maintaining an ability to influence the investments established by the policy. The client who, on the other hand, prefers the investment feature will be able to invest assets that grow free of income tax because of the investments classification as insurance.