What are the biggest immediate financing arrangement (IFA) risks in Canada?

An immediate financing arrangement or IFA can be a convenient strategy for people with high incomes, but there are risks involved. While an IFA can offer liquidity, tax advantages, and long-term wealth benefits, it also has some complexities that may not suit every investor. Keep reading to find out what those risks are and how you can best avoid them.

What are the risks of an immediate financing arrangement?

Some of the biggest risks of using your life insurance policy for an immediate financing arrangement are:

Dividend scale fluctuations in the life insurance policy

Fluctuations in the dividends of a life insurance policy pose risks for an IFA by impacting the policy’s cash value growth. If dividends decrease or fail to meet the current projected dividend scale, the cash value may not accumulate as projected, potentially leading to insufficient funds for future collateral loan drawdowns. 

If the dividend scale decreases, the policyholder may also need to fund more premiums out-of-pocket to keep the policy in force and maintain the desired death benefit level. This can strain financial resources and disrupt long-term planning, requiring policyholders to adjust their access to cash flow from the IFA and potentially delay debt repayment strategies.

Growth fluctuations

Most IFAs come with the expectation that your business growth will pay for the interest charges you’re responsible for. The biggest risk arises if you end up having a lower rate of return than expected. If returns aren’t sufficient to cover your interest, you could have out-of-pocket costs for those fees, and that’s financial capital you could have put to better use.

Changing loan interest rates

If interest rates or floating loan rates increase, the bank will pass that on to you. Just like with growth fluctuations, increasing interest could also leave you paying out more than you are bringing in. This can have a fairly significant impact if the interest is being capitalized. Depending on your arrangement, your lender could potentially also ask you to provide additional collateral to make up for the higher interest build-up than the projections.

Change in lender terms

An IFA is offered through a financial institution like a bank or third-party lender, and they can change the terms of the agreement in the future at their discretion.

Lower death benefit

Most IFAs are made to be paid out of your death benefit when you pass. But you should keep an eye on this. Remember, the entire point of life insurance is to give your surviving family a lump sum they can use to offset estate taxes or for anything else. Be careful that the amount deducted from your death benefit proceeds doesn’t leave your family without enough funds for their purposes.

Unexpected changes in your financial situation

A sudden sickness, injury, disability or other unexpected event could impact your ability to earn income and keep up with IFA interest payments or other loan obligations. Some lenders ask for proof of sufficient income to justify the credit every year, and a sudden drop in your income could impact that.

Loss of collateral or assets

Sometimes, a bank or external lender may ask for additional collateral for your IFA agreement with them. If you are unable to pay in the long run, they could acquire those assets entirely.

Fees

Depending on which bank or third-party lender you choose, there may be fees associated with an IFA. You should ask about these upfront and read the agreement’s details to make sure you are aware of any possible charges, late fees, admin fees, etc.

Possible credit impact

When you apply for an IFA, it can appear on your credit report. This may impact your credit score or the creditworthiness of your business, or have other far-reaching implications.

Change in tax laws and CRA interpretations

Tax regulations undergo frequent changes, leading to variations in how loans, interest deductions, and life insurance policies are treated over time. With the General Anti-Avoidance Rules (GAAR) in place, the Canada Revenue Agency (CRA) has the authority to classify a collateral loan as a policy loan, resulting in distinct tax consequences.

Each loan possesses its own distinctive attributes, making it essential for the policyholder to thoroughly assess the reasons behind obtaining a collateral loan. Moreover, given the intricate and ever-evolving nature of the tax landscape, consulting with a tax advisor is strongly recommended before proceeding with the transaction.

Why do people get immediate financing arrangements?

High-income earners in Canada use IFAs as a convenient way to get the benefits of life insurance coverage while also getting liquid assets right away.

It’s especially useful for business owners, private corporations, and other high-net-worth individuals. With an IFA, they can access immediate access to capital without tapping into current income.

Common uses for an IFA

Most people use the proceeds from an IFA for:

• Recouping insurance premium payments
• Estate planning or estate equalization
• Instant cash flow (and the flexibility that affords)
• Business continuity planning
• Real estate purchases
• Investment opportunities
• Small business capital
• Funding a buy-sell agreement
• Other business purposes

In a way, an IFA lets you recoup the amount you paid in premiums, so you can use those funds for revenue-building ventures. You can then use those returns for interest payments on the agreement.

Is getting an IFA risky in general?

Yes, an IFA can be a risky and complex financial strategy for the reasons we highlighted in this article. But this is not uncommon. Many financial and insurance strategies come with varying degrees of financial risk.

The more important question is what your risk appetite is like, and where an IFA fits on that scale. This is why we always recommend that you speak with a professional before deciding to start an IFA. An experienced advisor can help you ensure your IFA works as planned and gives you maximum benefits.

Let’s understand this with a case study:

Situation:
Meet Alex, a high-income business owner who wants to provide his family with estate tax protection after his passing, while keeping most of his capital working in the business.

Insurance needs:
Alex chooses a high-value whole life insurance policy for long-term benefit and protection. However, he prefers not to have large annual premiums drain his company’s operating cash.

Risks associated with IFA:
Alex uses an Immediate Financing Arrangement (IFA), borrowing 100% of the premium from a bank using the policy as collateral. This delivers instant liquidity but also has some risks:

• If policy dividends fall short, cash surrender value or CSV may not grow as projected, and the bank could demand additional collateral or limit future loans
• Loan interest rates may increase, raising monthly costs unexpectedly and reducing Alex’s profits
• If lender terms change, Alex may have to post extra collateral or repay part of the loan
• If business revenues fall or Alex’s personal finances change, making loan interest payments can become difficult, risking the forced surrender of the policy

How to mitigate the risks: Here’s how he can mitigate the risks:

• Borrow less than 100% of premiums to deal with fluctuating dividend rates
• Keep a surplus in case the return is lower than expected
• Diversify investments funding interest payments to avoid over-reliance on single returns
• Set a target payoff date for loans to protect the net death benefit
• Use gains to support loan payments, but must closely monitor with a financial advisor to mitigate the risks associated with IFA