Investing in Insurance

The Financialist • Issue 90 • October 2006
 
BY CORY HILL 

In financial planning, insurance is typically used as a way of protecting one’s assets from a traumatic event, such as death or disability. Assets can be defined as one’s employment income or portfolio of investments.

At or near retirement, life insurance is used quite often to help protect one’s estate from taxation, or to create an estate that  an be left to one’s heirs in a tax efficient manner.

A more advanced and somewhat specialized use of insurance is as a long-term savings vehicle. This can be done on an individual basis, or, in the case of this article, on a corporate basis.

Let’s assume that we are dealing with an individual who owns small company called ABC Co. ABC is an operating company, owned by John Jones, who is the sole shareholder.

Over time, ABC Co. has grown to the point that the income earned by the company is significantly higher than the expenses each year. ABC Co. pays tax on the excess earnings at a lower corporate tax rate than Mr. Jones’ personal income tax rate), and these earnings remain in the company as retained earnings.

Retained earnings can stay in ABC Co. to be invested, they can be paid out to shareholder(s), or they can be used to fund future expenses of the company. Depending on the situation, these may not be the most advantageous uses of retained earnings.

One alternative is to invest some of the retained earnings for the future benefit of a shareholder. Typically, if one wants to invest retained earnings from their small business for the future benefit of its shareholder(s), it is usually advantageous to set up a holding company. A holding company is another corporate structure that becomes an owner of the operating  company.

Let’s assume that Mr. Jones sets up a holding company called XYZ Holdings. Now, ABC co. is partly owned by Mr. Jones, and partly by Mr. Jones’ holding company, XYZ Holdings. As shareholder, XYZ Holdings is entitled to dividends paid out of retained earnings. The share structure can be complicated, so, suffice it to say, dividends paid from one company to another can be done on a tax-free basis if structured properly.

Now, XYZ Holdings has cash in the bank from the dividends from ABC Co. Now what?

Within the holding company structure, investments can be made just as one would invest as an individual. Usually there is a mixture of short-term liquid assets, medium term income-oriented assets, and long-term growth-oriented assets.

Mr. Jones, as the shareholder of XYZ Holdings, decides to take out a life insurance policy, which would be considered a long-term investment asset. The policy is based on the life of Mr. Jones, but the owner and beneficiary is XYZ Holdings. In this example, the policy is for $500,000. The cost for the insurance is $3,000 per year. Rather than simply paying $3,000 per year for the insurance, the policy is structured so that additional amounts can be contributed – a type of policy called Universal Life.

In this example, XYZ Holdings contributes $30,000 per year.  With $3,000 of the $30,000 invested paying the premiums for the $500,000 of insurance each year, the remaining contribution, approximately $27,000 per year, is invested within the policy and left to grow over time.

As long as the policy follows certain prescribed limits to contributions set out by CRA (Canada Revenue Agency), the insurance death benefit, investment account and growth together are deemed an insurance contract and therefore considered tax free to XYZ Holdings when paid out as a death benefit.

At a future point, typically at Jones’ retirement, XYZ Holdings may take some or all of the accumulated savings within the policy and pay it out to shareholder(s), namely, Mr. Jones.

Another, somewhat more complicated approach would have XYZ Holdings enter in to an agreement with a bank whereby XYZ assigns the policy to the bank as collateral security for a loan. Based on this assignment, the bank would then lend XYZ Holdings money, usually as a line of credit, up to a certain percentage of the policy’s value (a combination of the death benefit and accumulated investment account value).  XYZ Holdings agrees to pay the interest on the loan (line of credit), but no principal payments are made.

When Mr. Jones passes away, XYZ Holdings receives the tax- free death benefit from the life insurance policy. XYZ Holdings then uses a portion of the death benefit, made up of the face amount of $500,000 plus all the money in the investment account, and pays off the loan. It would then flow the remainder to Mr. Jones’ estate as a dividend on a tax free basis. The exact amount of the dividend to Mr. Jones’ estate is determined by a number of factors. There are corporate tax implications to consider that are beyond the scope of this article.

As you can see, there are some very interesting and advantageous uses of insurance in corporate situations. If you are an owner of a small business, or know someone who is, ask your Rogers Group Financial advisor about this concept at your next progress meeting.