Premium Financing: 5 Things to Know About Using “Other People’s Money” to Fund Life Insurance
Premium financing for life insurance can be a powerful tool for high net worth clients’ estate planning and wealth transfer goals. But like any tool, it needs to be used properly to create value. Capturing the benefits of premium financing requires a firm understanding of the risks and potential rewards.
Premium Financing: Harnessing the Power of Leverage
High net worth clients understand using “other people’s money” can significantly enhance a family’s ability to create enduring, long-term wealth. The principle of leverage can also be applied to purchasing life insurance.
When structured and executed properly and under the right circumstances, using a third-party loan to pay the premiums of a life insurance policy can provide a host of benefits for affluent individuals and families, particularly those with illiquid or highly appreciated assets. Premium financing allows clients to purchase a sizeable death benefit without needing to liquidate other potentially higher returning assets, which often have large built-in capital gains or generate significant current income.
By paying just the interest on the loan rather than the life insurance policy’s premium, clients can maintain their current cash flow situation and keep their wealth invested in opportunities where the potential rate of return on the assets exceeds the interest rate of the loan. A properly performing premium financing transaction can also reduce the amount of gift tax owed when transferring wealth to younger generations.
Five Things to Know About Premium Financing
Capturing the benefits of premium financing requires more than just a cursory understanding of the mechanics; it requires a full assessment of the risks and the unique characteristics of this transaction.
Here are five important elements clients need to understand about premium financing:
- This is not “free insurance:” Economists like to remind people that there is no such thing as a free lunch. This principle definitely applies to premium financing. Clients should not view this as “free insurance.”
There is always an element of risk when using leverage, and the client will have to “pay for” that by assuming interest rate risk and collateral risk. A premium financing transaction might initially show little or no out-of-pocket costs for the client, but that might not always be the case over the life of the transaction. The client needs to understand—and prepare for—this.
If interest rates change significantly and the cash value of the insurance policy stops outperforming the loan’s interest rate, the client may have to start making interest payments out-of-pocket. Furthermore, to get the most favorable terms, the loan needs to be fully secured by the client’s personal assets. The policy’s cash surrender value serves as the primary collateral, but if the policy underperforms the loan for an extended period, the client will likely have to provide additional collateral. It is also important to note that the value of the securities or other marketable assets the client puts up as collateral will fluctuate with market conditions. Any significant market downturns may create a shortfall in the outside collateral, regardless of the performance of the policy or the loan’s interest rate.
Given these risks, it is absolutely vital to “stress test” the pending transaction so clients understand what their financial commitments would look like under different market conditions. Most importantly, clients need to know what their maximum collateral exposure might be in a worst-case scenario. Clients need to have not only the tolerance for the risks involved with premium financing, but also the financial capacity to absorb it.
- The devil is in the assumptions: Many premium financing transactions fail because they are built on unrealistic assumptions about the loan’s interest rate and the insurance policy’s performance. Remember, these transactions succeed when there is a positive arbitrage between the loan’s interest rate and the policy’s crediting rate. With many loans the interest rate is not fixed, so a positive arbitrage situation can easily turn into a negative arbitrage and a failed transaction as market conditions change.
It is absolutely essential to closely evaluate the assumptions a premium financing transaction uses and make sure those assumptions are realistic and sustainable. There should also be a reasonable margin of error built into the transaction; a transaction that only performs under today’s favorable market conditions is not a transaction worth executing. In particular, be wary of premium financing arrangements using flat-line forecasts for interest rates. No one can claim to know exactly when and by how much interest rates will rise. But assuming that today’s record-low interest rate environment can last forever is dangerously unrealistic.
- Must have an exit strategy: Before entering a premium financing transaction, the client must have a plan for getting out. Given the variables and risks described above, you don’t want to find yourself trapped in an underperforming transaction. It is important to have a tax-efficient strategy for paying off the loan and exiting the transaction.
Beyond using the policy’s cash surrender value, one of the most common exit strategies is using annual gift exclusions to help fund the Irrevocable Life Insurance Trust(ILIT). Other strategies include creating a Grantor Retained Annuity Trust (GRAT), creating a Charitable Lead Trust (CLT), or selling the policy to an Intentionally Defective Irrevocable Trust (IDIT). These strategies aren’t necessarily mutually exclusive; it often makes sense to use a combination of multiple strategies.
- Premium financing is not an all-or-nothing proposition: There’s no rule that says premiums have to be paid 100% out-of-pocket or 100% financed. As with a car loan, a premium financing transaction can be designed where part of the premium is paid out-of-pocket and the rest is financed. Or the client can finance the premiums for the first few years and then begin paying the premiums out-of-pocket if the client’s financial situation or economic conditions change. Alternatively, premium financing can be used for policies already in-force.
- Both parts—the policy and the loan—need to be reviewed annually: Like all aspects of life insurance, it is dangerous to have a “set it and forget it” attitude with premium financing. The strategy needs ongoing oversight and coordination of both the loan and the insurance policy.
The performance of the transaction needs to be rigorously evaluated every year by trusted advisors who can assess how the two components of the transaction are working and make recommendations for improving performance. The earlier you identify elements of the transaction that may be veering off track, the easier—and cheaper—it is to correct it.
Putting a Powerful Tool to Work
At Goldstein Financial Group, we believe premium financing for life insurance can be a powerful tool to help high net worth families continue growing, while simultaneously protecting, their wealth. We also believe using this tool correctly requires a full understanding of the risks and potential rewards—the strengths as well as the limitations—of these strategies.
We help affluent families mitigate the risks of premium financing by using realistic, sustainable assumptions; developing effective exit strategies; and providing ongoing reviews of both the loan and the insurance policy. If you would like to learn more about our approach to premium financing or have us review an existing transaction, we are happy to help.