Life Insurance

The Flexibility of CAUL for Small Business Strategies
by Dick Kait, JD, LLM, CLU, ChFC, and Victor H. Gentner

Current assumption universal life (CAUL) is a dynamic product solution for the small business market. It combines the flexibility of premium payments and death benefits, with accessible policy cash values. (Cash values are not guaranteed, but reflect current assumptions and rates.) These features are especially effective in funding supplemental income benefits for the owners and key managers of any small business that has unpredictable or cyclical earnings.

Many U.S. households include one or more owners of a closely-held business or family farm. While the value of these businesses may be (and often is) the single biggest asset on the owner’s financial statement, their profits often fluctuate. The owners cannot always count on steady or increasing earnings. Some years are lean while others are exceptionally strong.

The earnings pattern of some businesses may be cyclical like real estate sales, home construction, and mortgage financing. Volatile earnings are seen in companies with revenues hinging on the award of competitive bids for industry or government contracts or businesses with earnings that are sensitive to economic conditions. And for start-up companies, earnings and profits are challenging during the early years as the business develops customers and reinvests revenues into growth.

Leading any business through hard times requires managing costs including outlays for strategies considered vital to the business’ survival. Many owners and their advisors understand the role of cash value life insurance as a tax-efficient vehicle for funding business arrangements and strategies, including the following:
• Business continuation plans (buy-sell agreements).
• Key person protection for valued employees.
• Bonuses to retain and reward key employees.
• Non-qualified deferred compensation for select management employees.
• Split-dollar arrangements for supplemental benefits to key executives.
Despite the efficiency of cash value life insurance for business strategies, premium cost can be a major hurdle in selling life insurance, especially in volatile economic times. The owner is simply uncertain whether the premiums can be paid during good times and bad.
The CAUL offers coverage lasting a lifetime with premium flexibility, adjustable death benefits, and accessible cash values.

CAUL is a life insurance product with five core features:
1. Premium flexibility
2. Current assumption
3. Adjustable death benefit
4. Withdrawal flexibility
5. Tax advantages.

1. Premium flexibility: To a large extent, the versatility of CAUL policies is in its premium flexibility. Level premiums are not required. The policy can be funded aggressively or conservatively, varying with the policyowner’s cash flow needs and financial circumstances over time. Premiums can even be skipped as long as there is enough cash value in the policy to cover policy costs and charges. But this cannot be carried to an extreme since underfunding the policy can lead to a forced lapse unless reinstated within a grace period.
2. A current assumption product: CAUL policies use current interest rates and M&E charges to calculate additions to cash values. This allows policyowners to participate in the carrier’s favorable investment, mortality, and expense experience. On the flip side, if interest rates decline, additions to cash value can also decline. In that event, increased premiums may be necessary to carry the policy.
3. Adjustable death benefits: The business owner may increase or lower the death benefit, within limits, as needs and financial circumstances change. The owner can place an emphasis on maintaining death benefit coverage or the potential growth of cash values and modify the focus over time. (Although most CAUL contracts permit the face amount to be lowered at any time, reductions in face amount within the first seven years may trigger the MEC rules. Doing so may trigger income taxes upon policy withdrawals and loans. While face amount increases are also generally permitted, they usually require evidence of insurability.)
4. Withdrawal flexibility: CAUL policies permit withdrawals of cash values without surrendering the policy or creating a loan obligation.
5. Tax advantages: CAUL policies enjoy tax advantages under current law including tax-deferred cash value build-up, tax-free receipt of death benefits, tax-free withdrawals of policy cash value to basis, and access to additional values through policy loans.

The Dynamic Flexibility of CAUL for Business Owners

CAUL contracts enable business owners to pre-fund the policy with a maximum premium amount. Large premiums, in the early years, can cause the cash values to support premiums in the future. Alternatively, the owner can pay minimum amounts (almost synonymous with term insurance). With bare minimum funding, the policyowner must pay premiums periodically, but this level may suit owners of newly formed businesses or any business that experiences a drop in business earnings. Premiums can be picked up later as sales and profits grow. Similarly, the face amount may be increased (subject to underwriting conditions) if the needs of the business grow, such as needing key person coverage for a top manager.

Four Business Scenarios

We compared four hypothetical premium scenarios to show the flexibility of CAUL as a vehicle for funding supplemental retirement income. In each scenario, a 45-year-old male in excellent health (preferred NT) pays premiums for a CAUL contract to age 65. At which time, level withdrawals from policy cash values are made for 20 years. The policy is assumed to have a current assumption interest rate of 5.4%. In each scenario, we assumed an initial death benefit of $500,000 with increasing Option B that switches to level Option A at age 65. In all four scenarios, the policy cash value is $10,000 at Age 121.

We focused on cash values at age 65, the level income steam starting at retirement age 65, and the total outlay over the 20-year period. The results may surprise you. Whether the premium funding was level or irregular, the policy achieved the goal of providing supplemental income on a tax-advantaged basis for 20 years.

Scenario I (max-funding)

What would the cash value and income payout would be for a max-funded policy? The maximum non-MEC premium ($22,280.14) is paid for 20 years to age 65 with a total outlay of $445,602.80. The death benefit increases to $1,207,511 at age 65 when the policy cash value is $707,511. At age 65, level withdrawals of $53,178 annually begin for a total outlay of $1,063,560 over 20 years.

Scenario II (nose-dive)

What if a business purchased the CAUL policy in a profitable year, but its earnings plunged and became erratic from years two through seven before returning to profitability. We assumed that the owner pays the maximum non-MEC premium ($22,280.14) in year one, but only minimum premiums ($120 and $150) for years two and three, respectively. As earnings rebound in year four, the owner pays target ($4,880), and then catch-up premiums of $40,000 and $35,000 in years five and six. Business drops again in year seven, so only a minimum premium ($2,449) is paid. Then the business returns to profitability and the owner pays $25,000 in annual premiums in years eight through 20. Total premiums paid to age 65 are $429,879. The death benefit increases to $1,131,522 at age 65, when policy cash value is $631,522. The level annual income from policy withdrawals is $46,716, starting at Age 65, or a total outlay of $934,320 over 20 years.

Scenario II (start-up business)

How would the premium design for a start-up business affect cash values and supplemental retirement income? We assumed that the owner could pay a level annual minimum premium of $2,449.92 for the first five years. Once business revenues grew, premium payments would increase to $4,880 (target) from years six through 10. With business booming after year 10, the owner max-funds the policy at $40,895 annually for years 11 through 20. The total outlay for 20 years is $445,599.60. The death benefit increases to $1,038,756 at age 65 when policy cash value is $538,756. The level annual income from policy withdrawals is $36,900 starting at age 65 or a total outlay of $738,000 over 20 years.

Scenario IV (cyclical business)

Our last scenario is a business hitting the bottom of the business cycle fluctuating over seven to 10 years:
1. The owner can pay minimum premiums of $2,449.92 from years one through four.
2. As the business rebounds, he pays a target ($4,880) in year five and max-funds the policy ($54,520.48) for years six through eight.
3. Earnings decline again in year nine, so the premium drops back to a target ($4,880).
4. With ongoing weak earnings, the premium is skipped for year 10 and minimum premium ($2,449.92) is paid for years 11 through 14.
5. The business rebounds again, so the owner pays a target ($4,880) for years 15 and 16, and finally pays $35,000 annually for the years 17 to 20.
The death benefit increased to $985,703 at age 65 when the policy cash value is $485,703. With this choppy, cyclical pattern, the level annual income from policy withdrawals is $32,054 starting at Age 65, or a total outlay of $641,080 over 20 years.

Summary of the Table

The table below summarizes these hypothetical case-study results. Naturally, max-funding produces the most cash value at age 65 and the greatest income stream for the 20-year period. Scenarios two, three, and four show declining cash value and outlays. A key point is how the total premiums paid for max funding, nose dive, and start up are roughly the same, but the income totals decline. This has to do with the timing of premium payments. With the cyclical scenario, the premium total was clearly less than the other three situations, but the income outlay bears a fair relationship with actual expenses for policy premiums. Again, none of these are winners or losers, but simply reflect the ability of the policy owner (the business) to achieve the goal of supplemental income with widely different funding patterns.

Observations and Conclusions

These four scenarios demonstrate the value of CAUL policies for business owners. Even a business that experiences a sudden drop in profits can maintain a supplemental retirement plan funded by life insurance, via catch-up premiums, without spending substantially more than the max funding scenario. While more total premiums are paid for fewer dollars withdrawn in the case of the start up scenario, the primary reason is obviously the timing of premium payments. Cash values do not grow when small premium amounts are paid in the first five years. That explains why the catch-up premium amounts in the start-up scenario are relatively costly. The up-and-down cyclical scenario resulted in the fewest dollars withdrawn, but still seems a fair result since the business owner was not able to commit to steady and level premiums. While the withdrawals were lower, so was the total premiums paid. Yet, the program still works despite the business’ cash flow uncertainties.
In summary, these scenarios provide a quick glimpse in how business owners can use a CAUL product for insurance-funded strategies. The product enables the owner to adjust premium payments to suit the financial condition of the business without compromising the goals of using the policy for pre-retirement insurance coverage and post-retirement supplement retirement income. q
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Dick Kait, JD, LLM, CLU, ChFC, is 2nd VP of Advanced Sales for West Coast Life and Protective Life where he leads the Advanced Sales Team. He is a graduate of Princeton University, Wisconsin Law School, and earned the Master of Laws in Taxation at the National Law Center of George Washington University. He is an active member of the LIMRA Advanced Sales Committee and AALU, and past President of the Society of Financial Service Professionals (Northern Virginia Chapter). He is a frequent author and speaker on business, estate and tax planning topics. He can be reached at 513-362-1537 or email: Richard.kait@protective.com

Vic H. Gentner, Director of Advanced Sales for West Coast Life and Protective, and has more than 30 years experience in the life insurance industry, including 17 years in advanced sales. He is a graduate of the University of Cincinnati, a member of the Cincinnati Chapter of the Society of Financial Service Professionals.