Crypto Millionaires and the Estate Planning Quandary: Using Traditional Life Insurance Policies to Hedge Downside Risk

The rapid inflation in blockchain-based asset values has contributed to a new generation of “crypto-millionaires.” As of the date of this article, there were 7,046 active addresses with greater than $1.0 million in BTC assets. Back in August 2018, there were approximately 24,000 addresses with greater than $1.0 million in BTC assets. Estimates at the height of the market range from 10,000 to 200,000 addresses with greater than $1.0 million of BTC1. Assuming BTC values grow over the next 2 decades, I expect for this figure to exponentially grow.

A key question for these millionaires is how to create liquidity using BTC (in a world where common goods cannot be purchased without BTC) in a tax efficient manner. Today, utilizing BTC for the purchase of goods and services would require two levels of taxation: (i) income / capital gains tax on the appreciation of BTC and (ii) sales tax. Another unforeseen tax is the estate tax, which is a unique consideration given that many crypto-millionaires had a low cost basis when entering their positions.   

While many structures will likely exist in the future to facilitate tax expediency with blockchain-based assets, I propose a strategy using a traditional universal life insurance policy and loans acquired through a crypto service provider as a means for an investor to both protect against steep declines in blockchain-based assets and boost returns.

Life Insurance Structure

Before going through the math, I wanted to start with an overview of the structure. The graph below depicts the mechanism in 3 stages. The blue boxes represent a crypto service provider activities, the green boxes represent activities of the investor / grantor, and the pink boxes represent activities of a life insurance company.

The first step in the process is for the investor to post their crypto collateral to a crypto service provider. A crypto service provider then secures the assets in their cold storage wallet with multi-signature functionality and lends fiat currency against the crypto collateral. The fiat currency is then used to facilitate a single-premium universal life insurance policy and an 8-year annuity (this is the max allowable LTV based on the math below). The selected universal life insurance policy is structured to provide a return linked to the S&P 500 with a floor / cap of 0.0% / 8.0%.

The investment thesis is to provide a greater rate of return on $5.0 million of BTC while protecting against downside risk. Below, we detail the steps in the process and the sensitize the resulting economics to the investor.

Exhibit 1: The Structure

The Math

The first step in the process is to obtain a loan from a service provider. Currently, you can take out a fiat-based loan against 50.0% of the value of your BTC assets. For example, if you have $5.0 million in BTC, a crypto service provider would offer a loan up to $2.5 million. While the lowest rates offered are around 6-7%, we used 8% in our analysis. The loan proceeds are granted by an investor to an ILIT to avoid the proceeds being counted as part of the owner’s estate.

The amount of the loan required to facilitate the strategy would be $2,347,852. This amount is calculated as 14.5% LTV for the fiat loan (in order to finance the premium payment) plus the amount required to finance an annuity that covers interest payments on the total loan balance ($2.4 million) for the longest period possible (in this case, 8 years). We estimated that the insurance premium for a $5.0 million universal life insurance policy to be roughly $725,0002. Assuming a time to liquidity of 20 years (i.e., death), the annual loan payment would be roughly $240,000.

Exhibit 2: Loan Payment Calculation

Exhibit 3: Financing the Annuity3

Note that the total debt ($2.4 million) was established at a 47.0% LTV.

Phased Approach

In terms of the change in value of BTC, we assumed no growth. Later, I sensitized the results on both the upside and downside. In order to understand the strategy, I broke it down in the following phases:

  • Phase I: Annuity Payments cover interest payments through the initial 8 years. Increasing the number of years would take above the LTV target. These payments would be made at the beginning of the year / period. The annuity payments have another function in that they defer the risk for the underlying collateral base – if BTC has 8 more years to gain liquidity (and one is a believer in the growth story), the annuity offers a valuable strategy to defer the holding cost of holding BTC.
  • Phase II: Annuity payments have ended; therefore, future interest payments would be funded either through liquidation of BTC (given LTV is more favorable as a result of the PI structure of interest payments) or accessing the cash value (discussed below).
  • Phase III: Exit and distribute proceeds to trustees of the ILIT. For the purpose of the below analysis, we assumed that the ILIT would immediately distribute the proceeds on the date of death.

Cash Value

A key component of life insurance policies is the cash value. The cash value represents an internal account within a whole / universal life insurance policy that could be accessed by the owner on a tax-free basis. For a whole life policy, the cash value usually turns positive beginning year 4 or 5. For a universal life insurance policy with a single premium, approximately 25.0% would be kept by the insurance company for fees, and the remaining balance would be deposited as an immediate cash value balance. That amount could be accessed by the grantor for whatever reason, like paying interest due. Day 1, the cash value would cover about 2.3 years of interest ($725k * 75.0% = $534.8k / annual interest). Assuming a long-run growth rate of 5.0% for the S&P 500 over the next 8 years on an annualized basis, the cash value account would be worth $803.4k, covering 3.4 years of payments.

Exhibit 4: Cash Value Calculations

Remember, any loans taken from the balance would be drawn 1 for 1 against the ultimate life insurance payout. In addition, there is no need to take out any funds from this account for the strategy to work, it just provides additional value.

Exit

We assumed an exit at the end of 20 years to estimate the net distribution. At exit, the total distribution would be $5.0 million. The remaining payments after the annuity include the loan’s interest ($2.9 million) and tax liability (for the purpose of this analysis, we assume that the cost basis was $25,000 – resulting in a large tax liability of $995,000).

At exit, the trustees would receive the net distributions plus the BTC. Assuming the mechanics above and no growth in BTC, an additional $1.1 million would be added to the value of the estate.

Exhibit 5: Exit Waterfall4

Sensitivities

I sensitized the performance of the investment strategy based on growth rates of BTC. Assuming a decline in the value of BTC, the portfolio outperforms given the uncorrelated hedge built into the life insurance policy. Furthermore, the tax liability would be reduced. The net benefit of the strategy works better as we sensitized lower performance. In a worst-case scenario where BTC goes to $0, the insurance policy is still fully paid for.

Assuming an increase in the value of BTC, I note that the portfolio return is greater due to the tax-free distribution from the life insurance policy covering a portion of the increased tax liability. The gains are diminishing if greater rates of return are achieved, without performance drag as a result of the policy.

Exhibit 6: Sensitivity Tables

Conclusion

The wave of crypto-investing we all experienced the last couple of years will need to be monetized in some fashion as investors consider their exit strategies or look to diversify their portfolio. The structure described above can be combined with other mechanisms to either increase the hedge or increase exposure to the underlying crypto. We note that improvements in crypto liquidity in futures markets may one day enable a low risk hedging option for investors that want less asset volatility but still wish to participate on the upside. Additional liquidity would also enable dynamic tactical hedging strategies informed by burgeoning asset management services in the crypto space.

Any strategy focused on providing liquidity to crypto holders should consider optionality for repayments. The approach above considers 4 sources of liquidity: (i) growth in the BTC asset, (ii) cash value principal + growth, (iii) annuity stream, and (iv) deferring a large tax liability5.

Footnotes:

  1. Source: https://bitinfocharts.com/top-100-richest-bitcoin-addresses.html
  2. Source: https://termlifeadvice.com/single-premium-life-insurance-the-pros-and-cons-2018/
  3. The annuity was “back-solved” so that the resulting annuity distribution equals the interest on total debt.
  4. Interest after annuity represent the remaining interest payments on debt. We assume they would be paid lump-sum on exit but note they would be paid periodically over the life of the loan. No PIK options currently exist on crypto-based lending platforms.
  5. No transaction fees were considered in the analysis (except the large haircut required for the annuity stream).

Disclaimer: I am not a financial advisor, none of the information contained in this blog post should be considered investment advice.

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