In many ways, financial planning is the art of balancing competing interests.
When investing, you balance the need to control risk against the potential for greater upside.
In retirement planning, you harmonize the promise of a comfortable, worry-free retirement with the hope of handing down a substantial legacy to the next generation.
And, when making life insurance decisions, particularly in regards to business succession or estate planning, you weigh the benefits of being fully insured against the cost of the premiums necessary for sufficient coverage.
Because affluent individuals require greater levels of life insurance coverage, the premiums necessary for an appropriate policy can be sizeable.
If a significant portion of your assets are illiquid, though, the cost might seem to present a choice between not having life insurance and liquidating other assets to pay premiums.
When presented with this choice, some individuals decide that the opportunity cost is too high, and so they end up under-insured or even forego life insurance altogether.
However, premium finance life insurance (PFLI) offers a means of balancing both current liquidity needs and the long-term necessity of a high-dollar, permanent life insurance policy.
What is Premium Finance Life Insurance (PFLI)?
PFLI respects a financially sophisticated client’s need for liquidity during life while softening the financial impact that death will have upon family members and business partners.
There are many benefits of premium financing life insurance, but probably the essential concept is that, instead of using cash to pay life insurance premiums, you finance the premium payments through a third-party lender.
The goals of PFLI are to avoid or reduce any decrease in present liquidity, lessen estate and gift tax liability, and provide the optimum benefit to policy beneficiaries by incorporating permanent life insurance into a comprehensive estate-planning strategy.
PFLI is best thought of not as a single financial product but as a customizable approach to life insurance with several moving parts. A premium finance strategy for life insurance can be complex, but the complexity allows an approach to be tailored to the specific needs of the individual insured.
Financing policy premiums allows the insured to allocate resources to the most productive use now while still securing a high-coverage permanent life insurance policy guarantying sufficient liquidity upon death.
The target when formulating a PFLI strategy is for the policy’s death benefit to pay off any outstanding premium financing, with enough left over to meet the estate’s cash needs. PFLI is useful as part of an estate plan, business continuity plan, or both.
For example
Suppose a significant percentage of the wealth of a high-net-worth prospective insured (we’ll call him ‘Randy’) comes in the form of ownership interests in one or more business entities that Randy helped to build. Due to Randy’s wealth level and his professional position, his death would have a substantial financial impact on both his family and his business partners.
But, to pay the premiums necessary to secure sufficient life insurance coverage, Randy would need to liquidate a portion of his equity, which would cost him some control over his business’s management.
So, instead, Randy works with a professional to develop a PFLI strategy that avoids any reduction to his equity interests but makes sure he is adequately covered to protect his family and business partners.
Alternatively, Randy’s business might use PFLI to obtain keyman life insurance on Randy that guarantees the business will have sufficient cash to purchase Randy’s interest from his estate upon his passing.
Who Might Benefit from Premium Financing Life Insurance?
Generally speaking, PFLI is appropriate for wealthy, financially secure clients as part of a multi-faceted estate plan.
Prominent life insurance companies offering premium-financed policies typically suggest that customers have assets totaling at least $5 million.
More specifically, PFLI is particularly advantageous if you have a substantial portion of your wealth in non-liquid assets that are performing well and which you wish to retain, but your estate needs a guaranteed source of liquidity.
Proceeds from PFLI are useful for estate taxes and administration costs, as a source of cash to repay any outstanding loans at death, and also for traditional life-insurance goals such as income-replacement for beneficiaries or as a source of funding for a trust for the benefit of family members.
When considering the usefulness of a PFLI strategy for you, it will depend in part on the your age, health status, and similar factors affecting insurability and premium amounts.
As with any life insurance, younger and healthier insureds will have comparatively lower premiums, which, in turn, reduces the amount of financing necessary for premiums. The longer a policy remains in place, the more opportunity it has to grow. Thus, all things being equal, a 45-year-old applicant can expect to receive a larger policy pay-out than a 55-year-old applicant, even if their premiums are similar.
It’s important to remember that a PFLI strategy should be designed to fit within a larger estate plan. An approach should be tailored to ensure the right level of liquidity at death and employ a funding structure that complements other gift and estate-tax strategies being used.
Structuring Life Insurance Premium Financing
In most cases, a PFLI structure will rely upon three distinct financial instruments: a permanent cash value life insurance policy, a loan to fund the policy premiums, and an irrevocable life insurance trust (“ILIT”) to legally own the policy.
An ILIT is a specialized irrevocable trust formed for the single purpose of owning a life insurance policy and thereby removing the policy proceeds from the insured’s taxable estate.
A declaration of trust creating an ILIT designates a third-party trustee and provides instructions to the trustee as to how insurance proceeds will be distributed once paid into the trust.
An ILIT is not an absolute prerequisite to a PFLI strategy, though using a trust will usually result in the best outcome, as it preserves the estate-tax exemption to protect other assets within the estate.
Because life insurance premiums are financed, premium payments are not counted as a “gift” for gift and estate tax purposes, as is sometimes the case when a policy is held by an ILIT.
Collateral
The underlying life insurance policy should be a permanent policy with a cash surrender value (i.e., not a term policy) and an appreciating death benefit. The policy’s cash value and death benefit serve as security for the loan, and, early in the life of the policy, the insured will need to post additional collateral – often securities, real estate, and/or a letter of credit.
After the policy has been in place long enough, the cash value will be the only necessary collateral. Until that point is reached, most lenders will review collateral on an annual basis, requiring either more or less security based on policy growth, changes to the value of existing collateral, and the outstanding loan amount.
- Because the policy is owned by an ILIT, the ILIT is also the designated borrower for the loan, which avoids any negative impact on the insured’s access to credit.
- PFLI loans are mostly or fully collateralized and personally guaranteed by the insured, so they generally come with favorable interest rates, typically linked to the prime rate.
- Repayment terms are flexible and can be negotiated with the lender, though most lenders require that at least some of the interest be paid each year.
Depending on the situation, it sometimes makes strategic sense to pay back some or all loan principal early, either from the policy’s cash value or from other assets. Although payments of interest or partial premium payments can potentially trigger the gift tax, the payments can be arranged to take maximum advantage of the $15,000 (as of 2019) annual gift exclusion.
If an insured outlives the loan’s maturity, the loan can be paid from cash value or other assets or, in many cases, the lender will refinance as long as sufficient security is provided.
Lenders usually review PFLI loans annually whenever premiums are due. With most loans, borrowers have some flexibility from year to year in deciding the form of collateral and the amount of premium and interest contributions, subject to the loan agreement’s minimum requirements.
Loan agreements may give the lender the right to forego disbursement of additional premium payments or require increased contributions under certain circumstances, such as a substantial drop in the value of collateral or downgrade in the insurer’s rating.
Developing a Successful PFLI Strategy
A successful PFLI strategy relies on positive symbiosis between the policy and the loan. The objective is for the policy’s performance to outpace the insurance and borrowing expenses.
Underwriting costs, fees for the specific insurance product, market performance, and prevailing interest rates can all increase or decrease the amount of policy growth necessary for successful implementation.
The fundamental equation is straight-forward:
policy performance – (borrowing costs + insurance costs) = net benefit.
But there are several variables that can be fine-tuned in order to achieve the desired outcome.
For instance,
- Borrowing costs can be reduced – and net benefit therefore increased – through partial premium payments or greater interest payments.
- Or, a lender might charge a lower interest rate if additional collateral is posted.
- An insured who can demonstrate excellent medical condition during the underwriting process will be charged lower premiums, thereby requiring a smaller spread to achieve the desired net benefit.
Policy Considerations
The extent to which policy performance is a shifting variable depends in large part on the type of permanent life insurance policy selected.
Whole life insurance policies grow at a guaranteed rate of return and come with fixed premiums, allowing for the greatest predictability.
A variable life policy’s growth is linked to investment or market performance – creating potential for superior growth but also the risk that underperformance in bad markets will lead to a reduced death benefit or necessitate supplemental premiums.
Whichever type of policy is selected, the ultimate objective is to earn enough growth that, after repaying the loan, sufficient cash is left over to meet the estate’s liquidity needs.
Tax Considerations of Premium Finance
If a PFLI policy is held in an ILIT, the eventual death benefit will not be included within the insured’s taxable estate, preserving the estate tax exemption for other assets. Disbursement of the policy’s pay-out will also not be taxable income to the estate or beneficiaries. Because premiums are financed, premium payments will not trigger gift-tax liability.
If partial premium payments are made directly (i.e., without financing), the partial payments could qualify as a “gift” and result in current gift-tax liability or a corresponding decrease in the insured’s estate tax exemption, but only to the extent partial premium payments are greater than the annual gift tax exclusion in effect for the year of the payment ($15,000 as of 2019).
The Bottom Line.
By facilitating high-coverage life insurance and favorable tax treatment without compromising current liquidity, premium financing life insurance offers considerable advantages for estate and business-succession planning.
As a sophisticated financial strategy, PFLI should be deliberately designed to integrate within and complement a comprehensive estate plan.
If you are interested in implementing a PFLI strategy within your estate or business-succession plan, an adviser with I&E experienced with PFLI can assist you in selecting the appropriate policy, securing favorable financing approved by the insurer, and navigating the application, underwriting, and renewal processes.
