Premium financing has been around for years in the life insurance industry and has been heavily promoted, especially among wealthier clients. This arrangement involves an outside – third party – lending sources like a bank or hedge fund paying the premiums on a life insurance contract.
The unique characteristics of premium-financing arrangements are:
· The loan is assumed to be renewed until death.
· The insurance proceeds are relied upon to be sufficient to repay the loan at death
· Provides the family with the insurance coverage that they need.
Conceptually, this is a great idea: you use the borrowed funds to pay for the insurance programs, which will ultimately pay off the loan and provide the family with the needed funds at death.
Premium financing is especially attractive in low-interest rate environments when it is likely the death benefit will exceed the loan and accrued interest
It is also an attractive method of buying life insurance if a trust is unable to purchase additional insurance due to taxable gift limitations.
Interest is generally compounded in a premium-financing arrangement with an optimal loan period of less than 10 years. Therefore, the best prospects for premium financing are insureds who are 70 years old or older and with a life expectancy of 10 to 15 years.
Like any other financial investment, there are risks that could derail the entire program from its original purpose. In addition to determining product suitability, purchasers should be wary of loan terms and implied interest rate assumptions.
Purchasers need to have a full understanding of the life insurance contract – future yield assumptions, death benefit structure, cost assumption and the appropriate amount of death benefit – before considering premium financing.
Since the target demographic is a wealthier, older client, prospect clients should have a net income of at least $5 million as well as a significant life insurance need with an annual premium of $100,000 or greater.
Most loans for premium are variable; the interest rate depends on the type of contract and the personal guarantee of either the insured or the purchaser.
Financing for premiums is generally based on LIBOR –the London interbank offered rate – plus an additional percentage cost, assuming sufficient collateral. Banks will usually lend up to 70 percent of the cash value of a universal life contract or below 50 percent when lending against the cash value of a variable universal life contract.
So, how does premium financing work?
The premium-financing loan works similarly to other loans and has three components – interest rate, loan term, and collateral.
The interest rate is usually a variable one-year rate but can sometimes be fixed up to 10 years.
The loan term is usually for one year, but can sometimes be high as 10 years. Each year during the loan term, the lender will review the loan to make sure everything is in order. If the numbers don’t match up, adjustments will have to be made to bring everything in line.
At the end of the loan term, you must either repay the loan or apply for a new loan, which will be subject to new financial underwriting. Due to change in financial situation or a change in the lender’s willingness, there is no guarantee the loan will be renewed.
Like any other loan, collateral has to be posted for the loan. The policy’s cash surrender value is usually acceptable as collateral and, to the extent it is not sufficient to cover the loan, additional collateral will be posted – usually in the form of market securities.
There may be an indefinite number of collateral calls – should the value of the collateral fall at any time.
A premium-financing loan can be tied into a life insurance policy through a rider. Some insurers have recently developed death benefit riders, which are intended to grow the death benefit by the amount of the loan and, in some cases, the interest.
Today’s riders fall into one of three categories:
The death benefit is increased each year by the premiums paid in that year. The death benefit is intended to keep pace with the loan’s principal so the loan principal can be repaid at death while still providing the insurance coverage needed.
This rider is used when the goal is to pay the loan interest each year.
Return-of-Premium with Interest Rider
The death benefit is increased each year by that year’s premiums and interest, which is intended to keep pace with the loan’s principal plus accrued interest so the entire loan can be repaid at death while providing the needed insurance coverage.
This rider would be used to accrue loan interest.
If no rider is chosen, the only option for the death benefit is either the Level Death Benefit Option or the Increasing Death Benefit Option, which neither is designed to work with premium financing.
The best option would most likely be the Increasing Death Benefit Option to have some death benefit growing to at least keep pace with part of the growing loan balance.
While the life insurance purchase and the loan are two separate transactions, attempts have been made to combine them.
In recent years, lenders have become more willing to provide the necessary capital for clients to fund their insurance programs, and insurers have become more receptive to designing their products to work in the premium-financing markets.
Since the insurance policy and the loan operate independently of each other, there are no built-in mechanisms or guarantees that they will work in sync.
In other words, if changes occurred to one without a corresponding change to the other, the entire premium-financing arrangement could fail to perform as projected, resulting in a precarious situation.
Steuer, author of Questions and Answers on Life Insurance: The Life Insurance Toolbook, has more than 25 years of experience and holds the Department of Insurance Analyst License (LA) as well as the Charted Life Underwriter (CLU) designation. Tony holds various leadership positions and has authored three books on the topic of life insurance.
Steuer’s work has been awarded the “Excellence in Financial Literacy (EIFLE) Award from the Institute of Financial Literacy for his The Questions and Answers on Disability Insurance Workbook and The Questions and Answers on Insurance Planner. Forbes named Questions and Answers on Life Insurance: The Life Insurance Toolbook as one of their top nine great investment books.
He’s also the founder of the Insurance Literacy Institute and creator of The Insurance Bill of Rights designed to empower consumers and to identify members of the Insurance Industry dedicated to strong professional standards.