There are many ways to fund an insurance program. In most cases, the funding source is the checking account of the client or trust. However, what do you do when your client’s funding needs outpace their available liquid assets or gifting capacity?
Reading the title of this article would lead most to conclude that the focus is on clients who borrow funds from a bank to pay annual insurance premiums. That is not entirely wrong. However, when the team at Highland thinks of financing life insurance premiums, we think in terms of premium funding strategies. That includes commercial premium financing, but also private finance, split-dollar, sales to intentionally defective grantor trusts, and dual loan strategies.
There’s no free lunch
You may be familiar with the phrase, popularized by the award-winning economist, Milton Friedman, ‘there’s no such thing as a free lunch’. Commercial premium financing is no different, this is a pay me now, pay me later proposition. While the initial interest cost is very low, at 5% of the 1st year premium, the cost to simply service the funding escalates quickly reaching 50% by year ten. Not to mention the increasing collateral exposure the client must plan for annually. This simplistic example below assumes a static interest rate environment. An increasing cost of borrowing only serves to increase the ongoing servicing cost, or the outside collateral exposure.
While commercial premium financing is often an attractive funding approach for large transactions, due to the low strain on the client’s cash flow, it may not always be the best approach. Commercial or third-party financing is complex and contains additional risks which must be managed annually, at minimum.
You might have a client in mind but are unsure of where to begin. Start by completing one of our fact finders, either the Estate Planning Fact Finder or the Premium Financing Fact Finder and send it to the Highland Advanced Planning Team at firstname.lastname@example.org. The following chart can help you consider and compare which strategy may be most appropriate to your client’s situation.
How does third-party financing work?
The current economic and product environment is ideally suited for designing, implementing and managing commercial premium financing programs.
✓ Borrowing cost at near-record lows
✓ Record high asset values
✓ Powerful Fixed Index Universal Life products
The most common use of commercial premium financing is to fund coverage owned by an irrevocable life insurance trust (ILIT) for estate planning purposes. The trust borrows each annual premium from the commercial lender, which can be a bank the client has a relationship with or one of many specialty lenders. Although there are many alternatives, including fixed-rate loans, loan interest varies based on a benchmark interest rate, which today is typically the London Inter-Bank Offering Rate (LIBOR), plus a spread. While it is possible to accrue some or all the loan interest, interest payments are commonly paid in advance via cash gifts from the insured or from existing cashflow or assets held in the ILIT.
The lender will always require that the loan is 100% secured. This may be accomplished by pledging a combination of the underlying policy cash surrender value, cash, a letter-of-credit, marketable securities, and other assets accepted by the lender. The loan may be settled in multiple ways, or combinations, including gifted assets, policy distributions, GRATs, proceeds from sales to a defective grantor trust, charitable lead trusts, or through policy death benefit proceeds.
The following diagram illustrates the operation of a commercial premium financing transaction for a trust-owned life insurance policy.
Carefully designed and well-executed commercial financing plans can be very beneficial for affluent clients, affording them the ability to put in place valuable insurance planning. This helps protect their wealth and ensure the client’s financial plans can be optimized today as well as tomorrow, with little initial impact on their current cash flow.
Awesome, right! So, what’s the catch?
Commercial financing is a highly complex strategy that involves a unique set of risks. These risks must be carefully reviewed and planned for annually. They include:
✓ Policy performance risk
✓ Interest rate risk
✓ Collateral call risk
✓ Gift tax risk, and
✓ Income tax risk
For these reasons, and others the Highland team created a best practices guide when it comes to designing and implementing third-party financing cases so that the plans you put in place today have the greatest chance of being successful. Download now!
Click below for the Premium Financing Best Practices Guidelines.