- What is the risk associated with premium financing?
- August 9, 2013
Premium financing is when a policyholder contracts with a – third party – lender to pay the life insurance premium for their policy. The policyholder agrees to repay the lender for the cost of the premium, plus interest.
This arrangement is especially popular among wealthier, older clients who have significant need for life insurance.
However, like any other financial product, there are risks associated with this arrangement.
The following risk factors, both alone or in combination, would result in a significant burden and could cause the entire program to fail:
Interest Rate Risk
If the loan interest rate increases more than projected, more money may needed to fund the program, and/or more collateral may need to be provided than originally anticipated.
If there is not sufficient funds and/or collateral to make up this shortfall, the entire loan could be called – forcing the loan be repaid prior to the original planned-on date.
If the value of the collateral falls below the level required by the lender to satisfy the loan, additional collateral could be required. If there is not sufficient collateral to make up this shortfall, the entire loan could be called – forcing the repayment before originally planned.
This also could occur at an inopportune time and put collateral at risk.
While alive, should the loan be called and the collateral posted not be sufficient to repay the loan, other assets, whether cash or otherwise, may be at risk of being forfeited to satisfy the outstanding loan balance.
At death – should the total death benefit be less than expected:
· The net death benefit available after replaying the loan could be less than needed to satisfy estate liquidity needs, thus, putting other assets at risk of having to be sold to satisfy this need.
· If the total death benefit is less than the outstanding loan balance, but the family owes the remaining loan balance – without neither the funds to satisfy this loan obligation nor those to satisfy the estate liquidity need.
If the policy’s cash surrender value does not perform as projected, there may be a requirement of more collateral than originally anticipated.
If the policy’s death benefit does not, or can not, grow sufficiently to keep pace with the outstanding loan, then there is risk of either not getting as much coverage as expected, after the loan is paid off, or, worse yet, getting no insurance coverage at all and having to come up with additional funds to repay the balance of the loan.
There is no guarantee that the insurance policy will be able to repay the entire loan and provide the needed insurance protection.
If a side fund is used to accumulate assets to later offset the loan, the growth of this side fund could be lower than projected. This could require that additional funds be paid off the loan as scheduled and/or require a longer time than expected to repay the loan from the side fund.
Policy Design Risk – Policy Pricing
The cost of increasing death benefits, especially in the later years, can have an enormous effect on the policy’s premium requirements. With premium-financing programs, higher premiums means a larger loan is required to pay the policy’s higher premium.
However, a larger loan means even higher death benefits are needed, which in turn means higher premium. This circular dependency can require significantly more insurance just to satisfy the ultimate loan.
While this may be nice for commission purposes, it poses a particular problem if the cost to maintain the entire program becomes either more expensive than just purchasing the insurance outright or becomes cost prohibitive.
Policy Design Risk – Lack of Guarantee
There is no guarantee the policy will keep pace with the outstanding loan balance. Since the loan is repaid from the insurance proceeds first, if the loan is larger than projected, the additional amount would be paid from the death benefit originally intended to be available for the beneficiary.
Therefore, there would be insufficient coverage, or possibly no coverage.
Loan Underwriting Risk
Loan can be made for a fixed term of years, but cannot be made in perpetuity. Premium-financing programs assume the loan continuously gets renewed at the end of each term until the insured’s death when the insurance proceeds are intended to repay the loan.
Since each loan renewal is subject to the lenders underwriting guidelines, the lender’s desire to continue to fund insurance premiums and the individual’s financial situation, there is no guarantee the lender will renew the loan or that any lender will offer a new loan to continue the program.
In this program, the loan could be required to be repaid at a time other than death and from funds other than death and from funds other than the insurance policy.
Depending on the design of the insurer’s policy, if an increasing death benefit is used to keep pace with the outstanding loan balance, the ultimate death benefit may have to be underwritten up-front.
The following could be issues in these situations:
· The insured doesn’t qualify, due to medical or other reasons, for the required amount of reinsurance, thereby limiting the amount of coverage to repay the loan.
· Even if the insured can qualify, there may not be sufficient reinsurance available in the marketplace to satisfy the ultimate need – thereby limiting the amount of insurance that can be purchased up-front.
Since the worldwide reinsurance capacity is limited, if the insured is able to secure all the reinsurance they need, these committed amount would not be available to satisfy any of their other insurance needs, such as key person, increased estate liquidity needs, etc.
Anyone of these risks could affect the performance of the entire arrangement, which is why it is advised to consult with your adviser before making this decision.
About Tony Steuer
Noted insurance author Tony Steuer has spent over 25 years in the life insurance industry. Steuer’s leadership roles include serving on the California Department of Insurance Curriculum board and the National Financial Educator's Council Curriculum Advisory Panel as well as having served as President of the San Francisco Chapter of the American Society of CLU & ChFC, President of the leading Life Insurance Producers of Northern California, and as a board member of the San Francisco Life Underwriters Association. Mr. Steuer is the author of Questions and Answers on Life Insurance: The Life Insurance Toolbook, The Questions and Answers on Life Insurance Workbook and The Questions and Answers on Disability Insurance Workbook - the first two were awarded the “Excellence in Financial Literacy (EIFLE) Award from the Institute of Financial Literacy. Steuer holds a Chartered Life Underwriter (CLU) designation and also holds the Life and Disability Insurance Analyst License, a designation that is held by less than thirty people in California.
Questions & Answers on Life Insurance by Tony Steuer, CLU, LA, CPFFE is licensed under a Creative Commons Attribution 3.0 Unported License.