Question

ABC Manufacturing Company owns and pays the premium on a $10,000,000 whole life insurance policy on the life of the company's majority shareholder and principal, Navid, that was taken out thirty years ago.

Hasan, his son, is a minority shareholder and has been named as successor of the business if Navid retires or passes away. The intention of the life insurance policy has always been to facilitate the buying out of Navid's shares when his son, Hasan, takes over the business. If Navid passes away, the death benefit will be paid out to ABC Manufacturing Company, who would in turn would buy the shares from Navid's estate, leaving Hasan as the sole shareholder of the company. This way, Hasan is not sharing ownership of the company with the other beneficiaries of Navid's estate.
The adjusted cost basis (ACB) in the policy is significant. The total cash value is almost equal to the amount necessary to buy out Navid's shares. What, if any, is the best way to use this policy to buy out Navid if he retires?

a) Collaterally assign the policy's cash value to a bank
b) Take a policy loan directly from the policies cash value
c) Change the ownership of the policy to a bank, so they will lend out the full amount of the cash value
d) The policy cannot be used until Navid passes away

Answer 1

The question revolves around a cash-value life insurance policy and its potential use as collateral for a bank loan. The policy can be borrowed against, and this feature provides financial flexibility for the policyholder or the company that owns it. Banks can lend money using the policy as an asset on their balance sheet.

Step-by-step explanation:

The student's question pertains to the utilization of a cash-value life insurance policy that the ABC Manufacturing Company holds for their majority shareholder, Navid. Contrary to the common belief that these policies can only be leveraged after the insured's death, these types of life insurance policies have a cash value component that can be borrowed against during the policyholder's lifetime.

Life insurance companies often have large amounts of cash as a result of their operations, which they sometimes lend out. Similarly, policyholders can take loans against the cash value of their policies, providing financial flexibility. These loans must be repaid with interest. Thus, ABC Manufacturing Company has the option to change the ownership of the policy to a bank as collateral for a loan. This strategy can facilitate a loan for the company without having to wait for the death benefit.

In the context of insurance policy loans, when a bank lends money, it records the transaction as an asset on its balance sheet, expecting to generate income through interest. When the borrower deposits the money into a bank account, the lending bank's reserves increase, and they keep a fraction as required reserves while being able to loan out the rest.