For many years Premium Financing was used by the Property & Casualty industry to allow employers to finance hefty commercial liability premiums. Fast forward to the last two decades and Premium Financing has evolved to fund a client’s large life insurance needs.
Premium Financing refers to the funding of premiums through a third-party lender, like a bank.
Clients who need a large life insurance policy to create liquidity for estate planning, wealth transfer or business succession may consider establishing a loan for the annual premiums through a commercial lender. This type of loan is similar to other loans: the arrangement requires approvals from both the bank and the insurance company issuing the policy, a fair market rate of interest is charged, and collateral in the form of the life insurance policy and additional personal assets must be posted.
Generally, the profile of the client who is a good candidate for a Premium Finance plan includes:
- an insured with a need to finance at least $100,000 of annual premium;
- a sophisticated investor generally between the ages of 55-80 and insurable;
- has a minimum net worth of over $5M in the case of an individual, or $10M for a couple;
- has sufficient assets to post as collateral, including the policy’s cash value, trust assets, marketable securities, a Letter of Credit or cash equivalent assets — like CDs, money markets or fixed annuities;
- has a clearly defined loan repayment strategy, other than at death;
- has most of their cashflow reinvested in their business or other investments like real estate.
What Premium Finance Is Not
Premium Financing is not for clients who want free insurance with the intention of not paying the loan back. It is also not for clients who want to take an aggressive financing design by under-estimating the loan interest charges, assuming death as the exit strategy, and accruing interest for all years on a long-term note.
The best practices for designing a premium financing case include:
- Loan interest is best illustrated as paid annually, as opposed to accrued.
- Accrued interest may be considered in certain circumstances for a short period but may make the plan prohibitive over time.
- The loan interest rate illustrated should show a bump of at least 20bp annually to account for an increasing environment.
- A Modified Endowment Contract(MEC) should not be illustrated or taxation will occur when the loan is repaid during lifetime.
- Loan repayment during lifetime should be contemplated and illustrated.
- Life insurance should be fully underwritten by the insurance carrier before a financing request is submitted to the lender.
- The policy should be stress-tested:
- IUL Policy – Include a rate equal to or less than AG49 Basic Index Account (BIA) x 85%
- UL Policy – Include a rate equal to or less than 85% of the current account rate
- WL – Show dividend scale equal to or less than 85% of the current dividend scale
- Registered products are not suitable for premium financing because they are subject to the margin loan rules relating to securities that limits the amount of the loan that can be secured with the policy cash values.
- Term policies are not suitable for premium financing since they do not offer cash value.
Mechanics of a Premium Financing Plan
Loan interest is typically tied to the 1-month or 12-month LIBOR or Prime Lending Rate, plus a spread, and is often paid annually as cash, or under the right circumstances and design, can be accrued.1
Length of Loan Term
The shorter the term of the note the less likely the loan will become problematic. Often, premium financing terms are for 15 years or less. A 3-5 year note is ideal as it is more manageable and may lend itself more easily to refinancing, if needed.
Repayment of Loan
The loan should be designed so that it is paid during lifetime, by the end of the loan term. The policy can be designed so that the potential cash values can be used to fund most, if not all, of the outstanding loan if the policy performs as illustrated. However, consideration should be given to repaying the note other than from policy values. Repayment may come from:
- cash gifts equal to the annual exclusion or lifetime exemption amount,
- retained assets,
- expected liquidity event like an inheritance,
- gift or sale to another family trust,
- pour overs from a Grantor Retained Annuity Trust (GRAT) or Charitable Lead Annuity Trust (CLAT) for which the ILIT that owns the life insurance is the beneficiary.
The life insurance must be a high cash value non-MEC policy from a highly rated insurance company and illustrated to have sufficient cash value to repay a portion of the loan during lifetime.
Collateral must be posted in the form of the policy, as well as cash equivalents or marketable securities. The lender has the right to call the collateral — both the policy cash values available, as well as other collateral posted — in the event of a loan default.
Advantages of Using Premium Financing
- Offers coverage for a large life insurance need with little cash outlay
- Interest rate arbitrage may be achieved when the investments and policy performance exceed the loan interest charges
- Client-insured(s) may keep their portfolio invested
- Gift amount is limited to loan interest only if the arrangement performs as illustrated
Disadvantages of Using Premium Financing
- Policy under-performs
- Interest rate risk
- Gift tax risk if the loan interest accumulates beyond the gift tax exemption amounts
- When the bank executes a collateral call and consequently requires that the policy be surrendered for repayment substantial income taxes may be triggered. The collateral call of the other assets would also trigger a taxable gift to the Irrevocable Life Insurance Trust (ILIT).
- Loan becomes prohibitive and lowers net death benefit to heirs
1 As long as the bank or other third-party lender offers loan terms for the premium financing arrangement that reflect what the lender offers for other loans it makes, the Final Split Dollar regulations that refer to the IRC§7872 loan regime rules should not apply to premium financing. Clients should consult with their tax and legal advisors regarding their personal circumstances.