Dark Side of the Moon

The Peculiarities of the Alternate Investment Diversification Testing Method for Variable Universal Life Insurance


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I was never a Pink Floyd fan growing up. My older brother Willy liked Pink Floyd along with Jimi Hendrix, Led Zeppelin. I liked all of the horn bands – Chicago, Blood, Sweat and Tears and Tower of Power. The one thing that we agreed on, and the rest of the Canal Zone was the band Rare Earth. He bought me the albums that he liked as Christmas gifts and I did the same. These days we both agree on Salsa even though neither of us is a great dancer. It’s a Zonian thing, Spanish after the fact!

In later years I was even less of a fan of Pink Floyd after hearing that Roger Waters, the front man, was very anti-Semitic. For the record, I am very Philo-Semitic. I too had to look that up the first time to see if that was a good thing or a bad thing. Nevertheless, I think that the title of an album, “Dark Side of the Moon”, is pretty catchy.

I have previously written about the two sides or philosophies of PPLI. One side of the industry sees the PPLI industry as an extension of the retail variable life insurance and corporate owned life insurance industry but with institutional pricing and customized investment funds managed by large institutional money managers. The other side of the industry sees PPLI as tax advantaged, institutionally priced policy with investment options designed to migrate tax-sensitive investment and low basis capital assets. The traditionalists see the latter as the dark side of the moon laden with investor control tax risks. The investor control doctrine essentially says that if the policyholder retains too much direct and indirect control over policy investments, the tax-free inside build up is forfeited and immediately taxable.

The traditionalists say that the PPLI business was never meant to be the latter, i.e. the Wild West of the life insurance industry. Who has the correct view of the World? The answer to this question may not be as straight-forward when you look through the lens of the Treasury Regulations and the alternate investment diversification testing for life insurance. Viewed through this lens, a discussion of the investor control doctrine and congressional intent does not seem as straight-forward as it might otherwise seem.

The investor control doctrine is a tax rule that effectively says that if a “policyholder” retains too much control directly or indirectly of the policy’s investments, the policyholder forfeits the tax benefits of treatment as life insurance. The inside buildup of the cash value is immediately taxable. In the Webber Case, the taxpayer was not assessed tax penalties for the determination that the policyholder had violated the investor control doctrine.

Nevertheless, the alternate diversification testing method stands in direct contrast to the proposition that the only “good” and viable insurance policies are ones that feature large commingled funds managed by institutional quality money managers.

This article makes the case that the non-traditionalists were wrong in thinking that Congress never intended for alternative assets and asset classes to be owned within life insurance, let along large concentrated holdings.

The Investment Diversification Rules

The basic rules dealing with investment diversification in variable life insurance and annuities can be found in IRC Sec 817(h) and Treas. Reg. 1-817-5. Generally, the rules provide that no single investment can represent 55% of a fund; two investments 70 percent; three investments 80 percent; four investments 90 percent; resulting in a portfolio of at least five investments.