Is life insurance premium financing right for you?
The most important challenge I face when meeting a new person considering premium financing is to help them determine if financing makes sense for them. I’ve met many people who are perfect candidates but never get involved and I’ve met many more people who are not good candidates for life insurance premium financing but they are drawn to its advantages.
Life insurance premium financing is not free life insurance. This alone eliminates 90% of the prospects.
Since financing doesn’t mean “free”, what is the cost of financing a life insurance policy? The annual interest expense is the true “cost” and it is the main reason most people do not pull the trigger. As the loan increases, so too does the annual interest expense. In the early years, the annual out-of-pocket cost exceeds the cost of term insurance. In the later years, the annual out-of-pocket cost will exceed the cost of permanent coverage.
A properly structured premium finance loan is best suited for wealthy people who need and want life insurance for life. They can borrow money at lower rates than than the ROI from their assets, creating an arbitrage that must be present for this to make sense. The need for permanent life insurance should be non-negotiable for all serious considerations and it is crucial to have this meaningful conversation before creating a premium financing arrangement. After all this time in the premium finance space, I am still surprised by the fact that most people are really not interested in long term death benefit. They are only considering it because financing has been improperly presented as “free” or close to a free as possible.
Premium Financing Considerations:
A low cost loan supports the financing arrangement because the collateral (cash surrender value) is strong and that dictates low rates. Banks like cash surrender value as collateral for loans. The borrowing rate should be significantly less than the borrowers ROI. For example, a corporation with a 12% ROI should consider PF (Premium Financing) at a rate of 6% or less. Floating interest rates are most common which can create additional stress when interest rates rise. When interest rates are unusually low, consider locking in rates.
There must be a clearly defined exit strategy to pay off the loan. The debt can be retired with cash value from the policy, if the policy performs in such a way that it creates sufficient cash value to pay off the debt and keep the policy inforce for life.
Can Real estate be used as collateral for premium finance loans? In theory, yes.
Lenders typically don’t like using real estate for this type of lending because the collateral is not easily available. There are some lenders that work with good clients to effectively use real estate to support these loans. This complicates something that is already complex but if you are a great customer of a bank and that bank will do exceptional things for you, it is worth a discussion.
Premium Financing and Estate Planning.
If you currently own large amounts of life insurance or may be looking for additional permanent coverage, premium financing may be beneficial in your overall estate plan. The life insurance policy is often owned in a trust without gift tax or estate tax consequence. It is not uncommon for life insurance policies in excess of $20,000,000 to be owned in properly structured trusts designed to avoid income, gift or estate taxation.
Life Insurance Premium Financing Is Suited For:
- Clients who NEED significant amounts of permanent death benefit and can afford to pay premiums without loans.
2. Clients who understand leverage, or
3. Clients who wish to use life insurance to offset estate taxes.
Business owners who want large amounts of death benefit for succession planning and key-person protection are also good candidates:
- Fund executive benefit arrangements with meaningful amounts of insurance…
- Wish to use their business balance sheet for other purposes.
A low-interest rate environment creates interest in premium financing. Each loan is unique and it should be analyzed using conservative stress testing assumptions. For some, higher interest rates means no change to their ROI. For others, it can negatively impact their ROI. You are well advised to engage only with experienced insurance professionals and experienced lenders.
Top 7 Premium Finance Considerations:
- The lenders and the insurance companies require that 100% of loan value is provided as collateral.
- The relationship between borrowing costs and the carriers crediting rates has been correlated for decades. Insurance company crediting rates and dividend scales are typically higher than market interest rates.
- If you fear this correlation could change – you may not be a good candidate for premium financing. If you believe the strong correlation will continue, life insurance premium financing may be right for you.
- The positive arbitrage creates an excess cash cushion that acts as a hedge against interest rate volatility.
- When interest rates rise quickly, there may be rate compression or even rate inversion. Either scenario could increase the interest expense until rates stabilize.
- The cash value of the life insurance policy should provide the majority of the required collateral.
- A properly structured premium finance loan should not require personal guarantees.
The Premium Finance Risks.
– Policy interest rate and performance risk.
– Increasing borrowing cost risk or inability to refinance risk.
– Policy lapse risk.
– Collateral call risk.
– Income tax risk.
Too many premium finance structures are complicated schemes to take advantage of consumers and insurance companies by purchasing policies for the sole purpose of re-selling them for a profit. We urge everyone to avoid using life insurance for anything other than its approved uses. Stranger Owned Life Insurance (STOLI) is not legitimate premium financing and should never be done. Avoid premium finance without fully understanding the financing arrangement, the exit strategies, the risks and without having a lifetime need for the coverage.