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Policies offer small business a credit lifeline

Advisers warn that life settlements are risky financing solution

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By Darla Mercado

December 14, 2008 6:01 am ET

Cash-strapped small businesses looking for a lifeline may find one in an unlikely asset — life insurance policies on the companies' owners.

While life settlement experts caution financial advisers that tapping into insurance policies is fraught with tax and estate-planning risks, some business owners may be tempted to sell their policies if other financing options are unavailable.

"The market for life settlements is small and illiquid, and using it puts an estate-planning tool at risk for very short-term liquidity issues," warned Kimberly Kitts, founder and president of Marquis Consulting LLC, an Orleans, Mass.-based company that specializes in working with business owners.

For one company, however, life settlements have proved helpful.

X-Rite Inc., a Grand Rapids, Mich.-based marketer of the Pantone color system — used widely in the publishing and printing industries —recently needed cash to pay down more than $340 million in outstanding debt and help fund a $175 million recapitalization.

With credit short and cash tight, the company looked at the life insurance policies it held on its founders, who are in their 80s. Annual premiums on the buy-sell policies amounted to $6.7 million, straining X-Rite's budget.

The company decided to sell the policies, and by early November received about $20.6 million through life settlements. "That is a significant amount of cash when you're talking about illiquid assets," said Robert Finfer, president and chief executive of Integrity Capital Partners, the Bethesda, Md.-based life settlements broker that helped X-Rite find purchasers for its policies.

WRITTEN CONSENT KEY

Having the founders' written consent to sell the insurance policies on the secondary market was a key component in the successful transaction, though those individuals were no longer involved in daily business operations, he said.

Without that consent, the estates of the decedents could bring a claim on the benefits, said Michael D. Myers, an attorney at McClanahan Myers Espey LLP in Houston. Notably, such a transaction would not be permitted in Texas, which requires that policy owners have an insurable interest in the insured for the duration of the policy.

Other minefields abound.

For one, the life settlement market has softened in the wake of the credit crisis. Sellers are likely to receive offers that are 10% to 15% below those of just a few months ago, said Doug Head, executive director of the Life Insurance Settlements Association in Orlando, Fla.

"Some of the decline is market-conditioned," he said, but there's also controversy over whether insurance policies being sold were based on accurate life expectancies.

Some mortality assumptions allowed policyholders to get more than what they should have when they settled the policies, said Matthew Schiff, president of Schiff Benefits Group LLC, a Blue Bell, Pa.-based benefits consulting company, who added that the secondary market may not be receptive if an insured is expected to live more than five years.

Perceptions about the morality of betting on life expectancies, along with the credit crisis, have led to "a backlash against the life settlements market," he said. "That will affect the settlements and the number of settlements done."

X-Rite itself ran into problems while waiting for bids, said David A. Rawden, interim finance chief of the company.

"We'd get an offer on a policy, and it would go away, partly due to the financial meltdown," he said. "Sometimes the buyers would have the cash, but shortly thereafter, they wouldn't."

Another factor that could hinder institutional purchasers is the "transfer for value" rule, which can trigger a tax on the policy's proceeds once the insured dies. This rule goes into effect when a policy's ownership is transferred in exchange for cash, a taxable event.

Similarly, the company selling a policy will pay ordinary income tax on the money received from the sale.

Depending on how much money a company needs, it may make sense simply to borrow against the policy, which wouldn't create a tax event, Ms. Kitts said.

In addition to tax issues, a corporate life settlement can pose estate-planning problems.

Insurance in a buy-sell agreement is intended to help surviving business partners purchase a deceased partner's ownership interest. But if that insurance is sold and the cash received is insufficient to cover the full cost of the decedent's business share, the surviving partners will have to scramble for funds to pay off heirs.

"Your business took the money from the life settlement because it needed the cash, but now where do you come up with the difference for the estate?" Ms. Kitts asked.

Perhaps that is why life settlements are rare among small businesses, Mr. Schiff said.

Even among larger companies, life settlements are unlikely to become a mainline financing technique, said Eric Wittenmyer, senior vice president of Chicago-based Aon Consulting Worldwide's executive benefits practice.

Large companies, he said, tend to own policies on a broad spectrum of key executives, and the policies are underwritten without evidence of insurability. To conduct a life settlement, a company would be put in the awkward position of having to ask retired key employees to undergo medical evaluations.

"It makes sense if the policies are on the company's owners," Mr. Wittenmyer said, but not if they are on retired executives.

"Remember that you're asking a retired person who might have some ties to the company to turn over medical records or take a physical, so you can sell the policy to a third party that has some interest in their dying," he said.

E-mail Darla Mercado at dmercado@investmentnews.com.

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