Like most financial topics, premium financing lends itself to a variety of opinions perhaps resulting from salesmanship or misinformation. After all, huge life insurance deals may depend upon whether folks think this is a good or terrible idea. If you’ve heard anything about this topic by the time you’ve arrived on this page, perhaps you’ve formed an opinion such as:
It’s a way to get free life insurance.
It’s a bad deal to avoid at all costs.
It’s way for agents to get big commissions.
The fact is, premium financing isn’t bad or good, but rather a tool to be used for very specific financial circumstances and goals. With that said, there is a time and place for premium financing, just as there are times when it should be avoided in lieu of other options.
For all of the above reasons, this article will clarify the good, bad and the ugly aspects of premium financing.
Comparing Real Estate and Life Insurance
At Insurance and Estates we use a common comparison between permanent life insurance and real estate are similar ASSETS because they tend to share a number of common characteristics such as:
requiring some up front investment
requiring some annual maintenance costs
accruing equity (or cash value)
growing in a tax advantaged way
allowing for financial leverage
to acquire other assets
. . . and with today’s topic, we can add another item to the above list. Just as you can finance the purchase of real estate, you can also finance life insurance premiums.
Prerequisites When Considering Premium Financing
There are couple of prerequisites for those who are interested in either selling or purchasing life insurance through premium financing.
- This is for high net worth people with a need for a large amount of life insurance; and/or
- This is for people who may require liquidity for businesses and thus don’t want to come out of pocket for substantial premiums; and/or
- This is for those whom it makes financial sense to keep their money working harder in other areas.
Each of the above 3 will be considered in more detail to follow.
Premium Financing Life Insurance
The Good, Not So Good and Downright Ugly of Premium Financing
Part 1. When Premium Financing is Ideal [the Good]
There is a definite time and place for premium financing life insurance and it generally looks like this:
An affluent individual…
- Needs life insurance; and
- Wants to leave a legacy; and
- Is still working; and
- Has substantial liquid assets; and
- Doesn’t want to liquidate assets to pay premiums; and
- Has money working hard in other areas.
If these aspects, or at least a majority, are present, then premium financing may present a viable solution that offers a large amount of life insurance at a minimal cost. To make this strategy more appealing simply securing a death benefit, a cash value life insurance policy can be used to improves the overall performance and strategy.
For example, people often talk about premium financing and suggest that the only test is whether the affluent applicants asset’s (cash reserves or investments) are producing a better ROI elsewhere concentrating on the applicant’s other financial ventures. This would justify the cost of the loan because the money is being used for a positive financial arbitrage elsewhere. A simple math example would be to ask “if the loan is costing 6% annually, how does this compare with the 10% that the applicant’s other investments are returning?”
However, this limited approach doesn’t consider the positive ROI that is occurring due to the accrual of cash value within a permanent life insurance policy. As a quick reminder, in many articles, we’ve reviewed the various benefits of both traditional whole life insurance AND universal life insurance for cash value accumulation. We’ve also discussed the ability to take policy loans from permanent life policies in order to create financial leverage and maintain the velocity of your money. We suggest that all of these factors should be reviewed when considering a premium financing strategy because they can make it more appealing.
The 2 primary types of permanent life insurance offer specific benefits that improve the premium financing picture.
For example, whole life insurance pays policy dividends, and this offers life insurance tax advantages for cash value accrual can generally range around 5-6% per year based upon history with most top dividend paying whole life insurance companies.
Universal life policies such as indexed universal life OR variable universal life offer market based opportunities for cash value accumulation within the life policy that can range up to 12 or 13% in high market years.
So, we contend that not only should the cost of financing and the positive ROI earned elsewhere be considered, but the structure of the policy and the return on investment within the policy should also be included in the math. In this way, premium financing for life insurance is also similar to real estate, because it isn’t just the equity that is being purchased but also the cash flow and tax advantages that can be realized by properly managing a real estate investment.
How Premium Financing Insurance Loans Work
If the right pieces of the puzzle (described in general above) are in place, an individual may be able to qualify for third party financing of the life insurance premiums. This is an alternative to having to spend available business capital or liquidate other assets. A premium financing loan is obtained from a licensed third party lender, which is usually a bank and occasionally an insurance brokerage. This means that premium financing is really no different than any other 3rd party loan.
Loan interest is often variable and based on the Libor (London interbank offered rate) and paid annually. The loan balance of principal may typically be paid at any time until the death of the insured. However, loan terms such as when the loan is repaid, may vary and may affect the overall performance of the premium financing plan.
Another aspect that affects the overall plan is how individual applicant’s non-liquidated assets perform. The idea is to get a better rate of return (ROR) from the non-liquidated assets than what is being paid for the premium financing.
If cash value life insurance is being used, the cash value can be used to repay the loan depending upon the type of policy as can a portion of the death benefit. In this way, the overall estate and the heirs are not being put at risk to repay the policy loan.
The Downside of Premium Financing [the Bad]
There is often a catch when borrowing money from a third party lending institution. Thus, loan terms should always be carefully reviewed and negotiated whenever possible. Because premium financing is primarily for affluent individuals, there is an even better likelihood, in my opinion, to be able to negotiate favorable loan terms in a way similar to negotiating private placement life insurance.
That said, loan rates for premium financing are generally variable (and NOT fixed) and we’ve been operating in an environment of very low interest rates. Thus, it is easy in today’s environment to make the numbers work for premium financing loans. However, were interest rates to rise, those taking advantage of premium financing loans may find themselves in a different financial scenario. To keep this in perspective though, in an environment of rising interest rates, it is also highly likely that dividend rates on whole life insurance premium financing policies would also likely rise, although probably not as quickly.
No Tax Advantages
The other bad aspect of premium financing loans is that there are NO tax advantages on the financing itself. What I mean is, when you take out a home equity loan on a personal residence, the interest on the loan is tax deductible. Premium financing loans DO NOT offer this benefit, in the same way that life insurance premiums are generally NOT tax deductible unless certain life insurance strategies such as split dollar plans to compensate key employees are used.
Because the interest on a premium financing loan is not tax deductible, some suggest that a home equity loan may be a better options, thereby returning us to our analogy to real estate. Still, if a cash value life insurance policy is being used, then tax advantaged cash value accumulation is being realized regardless of the interest on the loans.
Another final downside to premium financing loans is that these loans are typically secured by other assets and are NOT non-recourse. This means that taking premium finance loans may be a negative legal asset protection move for affluent individuals and business owners because it subjects other valuable assets to liability to pay the loan.
When Premium Financing Goes Wrong [the Ugly]
Like any financial transaction, a premium financing loan has the potential to go terribly wrong. Usually, an ugly result would involve a lender pursuing and attaching liens to other assets in order to collect on a policy loan that has gone into default.
As mentioned above, because policy loans are generally secured by other valuable assets and are NOT non-recourse, other assets can be pursued to satisfy the debt. Couple this with variable interest rates and there is a certain amount of risk to be aware of and managed.
We suggest that at a minimum, a cash value whole life policy or indexed universal life policy should be used for this type of strategy in order to offset the other risk that naturally arises from borrowing the funds.
There you have it, an overview of premium financing that also considers the wealth building benefits of permanent life insurance. It you have any questions about this or any other life insurance or estate planning strategy, connect with us today.