As the worst financial crisis since the Great Depression grew in magnitude in recent weeks, many small businesses struggled, often desperately, to fund operational expenses by securing credit from suddenly loan-averse banks. Others took the easy (and frequently overlooked) route: tapping into their permanent life insurance policies’ cash values.
“Being able to tell business owners that they can access the cash value for whatever business purposes they see fit is important,” says William Bell, a director in the advanced design unit at Pacific Life, Newport Beach, Calif. “Especially, in today’s tough economy, knowing there is ready source of liquidity is a point that many businesses owners will be excited about.”
They may also be interested to learn that securing access to funds is a fast and painless relative to alternative funding sources. “It’s quick cash,” says David Smucker, a senior consultant in advanced sales at Nationwide Financial Services, Columbus, Ohio. “There is no loan underwriting. You don’t have to make an appointment with a loan officer. You just have to call the carrier and ask for money.”
That could be music to the ears of millions of small business owners. But no-hassle access to cash is not the only reason businesses are turning to their life insurance policies to meet short-term liquidity needs.
The cash values inside such policies, which are purchased to informally fund long-term commitments, such as an executive compensation arrangement or a buy-sell agreement between business partners, can generally be tapped on favorable terms, in part because of the product’s tax-efficiency.
A business owner can borrow or withdraw against a permanent life insurance policy up to basis (the total of premium payments) without incurring income or capital gains tax. What is more, values grow inside the policy tax-deferred, while death benefits come out tax-free. If the business does not own the policy, as in the case of an executive bonus arrangement, premium contributions are also tax-deductible.
Another big benefit: low loan interest costs. Sources say carriers generally charge significantly less than their bank counterparts. The going rate at Nationwide, says Smucker, is 3.9%. Contrast this with bank interest rates averaging between 6% and 8% for business loans. Add to this the fact that businesses are in effect paying themselves back–recapitalizing the cash value they own–when they retire a policy loan.
If, adds Rich Wessel, an advisor and principal of Wessel Capital Group, Jeffersonville, Pa., the policy is a non-direct recognition contract, then cash values continue to grow–earning interest and (potentially) dividends–as if the business had not taken out a loan or withdrawal against the policy.
“We can also buy business owners time before they have to start retiring a loan,” says Wessel. “Policy owners can pay back a loan according to a schedule that best suits their cash flow needs, whether over 5 or 10 years. That can be extremely valuable in an economic crisis or slowdown.”
The market for such borrowing is huge–and growing. Contract loans totaled $113.4 billion in 2007, according to Highline Data, an affiliate firm of The National Underwriter Co. and a unit of Summit Business Media. This compares with $109.7 billion and $106.4 billion in 2006 and 2005, respectively.
What are businesses using the cash for? As with bank loans, commercial paper and other sources of credit, businesses employ the money to meet any number of short-term liquidity needs: purchasing inventory for resale; replacing aging manufacturing equipment; or (particularly for severely cash-strapped firms) covering basic overhead costs, such as payroll.
Bob Smith, an investment advisor representative for Nationwide Securities LLC, Columbus Ohio, recalls that one of his clients, a building materials dealer, borrowed a total of $320,000 last July against 4 contracts: two universal life policies and two variable UL contracts used to fund buy-sell contracts and non-qualified deferred compensation plans for the company’s two partners. The funds enabled the partners to honor a $3.5 million bid to supply materials for a commercial job.
This firm’s connection with the construction business doesn’t surprise Wessel, who observes that clients of his practice that have also taken out policy loans are active in this space, as well as the real estate and mortgage businesses. He cites a profitable construction rental equipment firm that resorted to a policy loan because the company was unable to get favorable financing to buy a -mounted backhoe. Another client, a real estate company that was refused a bank loan, tapped its whole life policy to meet immediate business expenses.