A Full Plate

In recent health insurance renewal cycles, agents have had a full plate of challenges.

Independent insurance agents may have felt like they are battling Goliath during the past two renewals, between reduced commissions and lower revenues. These issues have been due in part to the Patient Protection and Affordable Care Act minimum loss ratio thresholds, which require carriers to keep the total administrative costs at 15% for group health insurance (20% for individual health plans).

As a result, agency principals have looked to other sources of revenue for life and health producers to replace the lost commission revenue. One opportunity that leverages the agency’s commercial client base is focusing on the life insurance needs of commercial customers. While virtually every independent agency has someone on the staff with a life insurance license (or should), not many agencies have determined a focus and strategy to generate meaningful revenues on a systematic basis. So what is holding you back?

First, many p-c oriented agents may not feel comfortable dealing with issues associated in the life market, such as tax and accounting considerations, buy-sell concepts, estate planning and advanced underwriting. But don’t be deterred. Many insurance companies and MGAs have dedicated resources to assist agents in dealing with the myriad of related items, from proposals to binding policies.

“Our business model is built on assisting the independent agent from start to finish,” says Rich Shaeffer, CLU, ChFC, sales vice president for Crump National Accounts. “We understand the value that the agent brings to the equation because of the credibility that they have built in serving their clients’ needs.”

Talking it Over
So how should you start the conversation with clients? In the second quarter of 2012, there are a number of open income and estate rules that are up in the air. Unless Congress further extends the Bush-era tax cuts, people will see a reduction in their estate tax exemption from the current $5.12 million (e.g. the amount of assets that are excluded from estate taxes) and an increase in the current estate tax rate of 35%. If Congress fails to take any action by the end of 2012, these exemption levels will revert to $1 million in 2013, and the maximum income tax rate will be 55%. Portability will no longer apply; one possible scenario is that the exemption will extend to $3.5 million, with an estate tax rate of 35% to 40%.

It’s also important to remember that depending on the state in which the client resides, there can be significant state estate taxes, with lower exemption levels. Agents should be aware that the use of an irrevocable life insurance trust is a very effective way to eliminate the life insurance proceeds from the taxable estate. One hurdle, however, is that three years must pass before the transfer is deemed to be completed.

Even if a client believes that estate taxes will not be a problem, there is still the considerable issue of how to transfer the business—either at retirement, disability or in the event of a premature death. Using permanent life insurance as a secure, tax-advantaged vehicle is the prevalent way to accomplish these objectives (as well as using disability insurance for a disability buy-out). There are two primary methods that are used: cross-purchase, stock redemption or a combination of both.

Conquering Cross-Purchase
In a cross-purchase arrangement, insurance will be purchased on each business owner; the other owner(s) will pay the premium and become the beneficiary, the proceeds being used by the surviving owner to purchase the ownership of the deceased business owner. This approach works best with a few owners; otherwise, multiple policies will have to purchased, which can be cumbersome. The cross-purchase agreement will stipulate that a stockholder who wants to sell his shares during his lifetime must first offer to sell his shares to the other stockholders. If they decline, then the stockholder is free to sell his interest to other parties. If a stockholder dies, or upon the occurrence of other specified events, usually the agreement requires the shareholder or his estate to sell his shares (and the surviving stockholders to buy).

The family of the deceased owner will have a tax basis equal to the fair market value of the decedent’s stock at the date of death, avoiding any income tax consequences as a result of the sale. The fair market value of the shares should be defined by the buy-sell agreement. Also, the life insurance proceeds received by the surviving owners are not subject to income taxation. For newly-purchased shares, the corporate shareholders will be entitled to a tax basis equal to the purchase price. The stepped-up basis should reduce future income taxes if the surviving shareholders later sell their interests. The insurance proceeds are not subject to the corporate alternative minimum tax (AMT) and are also not subject to the claims of corporate creditors. The AMT avoidance and creditor protection exist because the proceeds are paid directly to the individual shareholders.

Stock Redemption Step-by-Step
A typical corporate stock redemption arrangement has the company purchase the policies on the lives of the business owners with the proceeds going to the business to redeem the deceased owner’s shares. The stock redemption agreement obligates the corporation to buy, and the shareholder to sell, his shares at the price or according to the formula specified in the agreement upon the occurrence of events that are set forth. Alternatively, the agreement may include a right of first refusal provision that requires a stockholder who wants to sell their share during his lifetime to first offer to sell his shares to the corporation at a predetermined price or formula specified in the agreement. Only if the corporation turns down the offer can the stockholder then sell to other potential buyers. When using a stock redemption agreement, it must also conform to any local law governing redemption of stock.

A significant disadvantage of the stock redemption form of the buy-sell agreement is that the remaining shareholders do not get the benefit of a step-up in basis when the corporation purchases the deceased shareholder’s interest. The continuing shareholders retain their original bases in the company. Compared to the cross-purchase agreement, the stock redemption structuring will create greater capital gains upon the ultimate disposition of shares if made before death. A shareholder who owns more than a 50% interest either directly or indirectly is deemed to control a corporation, under Internal Revenue Code section 267. In this situation, the shareholder is deemed to have an ownership interest in the life insurance policy due to the shareholder’s ability to designate a beneficiary, as well as other ownership interests. The fact that control exists over the policy in majority ownership instances would result in the proceeds being includable in the deceased’s estate. A C corporation may be subject to the AMT when it receives proceeds from a life insurance policy.

Assessing the Need
A need that many businesses haven’t considered is the impact of the death of a key employee on the businesses operations. This will be particularly true for smaller businesses where the key employee may have formed important relationships with clients, suppliers or other distribution partners. Agents should ask their business owner clients about the potential impact on their business should a key employee die. Also, many times business owners have made promises to particular employees but have not set aside the funds to provide the value of the stock of their closely-held business, which could be due upon the death of the employee.

In these challenging economic times, independent agents should be sure to focus on the basics of solving their commercial clients’ needs. Take the time to have a conversation with your clients, before someone else does.