Is life insurance premium financing right for you? What you need to know.
Successful premium financing relies on two very important arbitrages that present when premium financing is done right.
Financing life insurance policies is about managing expectations, managing risks and playing it straight with insurance companies and lenders. The primary reason people borrow from banks to pay for life insurance is because they can borrow the annual premiums at a lesser interest rate than they earn on the money they would otherwise pay for permanent life insurance coverage. This historically reliable arbitrage between loan interest rates and the borrower’s ROI must be present for this to make sense. We will explore this important arbitrage in more detail.
With short term interest rates near zero percent, life insurance premium financing gets strong consideration among high net worth life insurance buyers. Proceeds from life insurance payouts provide the much needed liquidity that complements succession planning and wealth transfer planning strategies. Financing jumbo life insurance policies is often appealing to HNW people and their advisors because this arbitrage DOES EXIST between their actual borrowing cost and their overall ROI. If we look back 50 years, we will see that interest rates are always lower than insurance company crediting rates, with almost no exceptions.
I have arranged financing for more than 500 families over the course of my career. As a result, I bring expertise and experience to each new transaction to benefit consumers, their advisors, lenders and life insurance companies. For example, low interest rates are beneficial, if nothing more than lower out of pocket cost. But, financing a life insurance policy should make sense when interest rates are 3%, 6% or 9%. Without fully understanding this reality, a premium finance loan may not be right for you. The borrowing rate is only one part of the premium finance story. Historically, insurance companies pay higher interest on policy cash values than borrowers pay for interest on loans. This is the second arbitrage that exists in properly structured premium finance arrangements.
Premium Financing Done Right. Not free life insurance.
If premium financing is not “free life insurance”, then what is the true cost of financing a life insurance policy? It is the annual interest expense; that is the true out of pocket “cost” of a premium finance loan. When the loan is paid off, either during lifetime or upon death, that too is part of the cost.
With rates near 0%, premium financing is a strategy that deserves strong consideration for high net worth individuals, families and business owners who need permanent life insurance coverage. Compared to paying the annual premiums out of pocket, there are advantages to using a competitively priced loan to pay the premiums.
A properly structured premium finance arrangement is best suited for people who need and want lifetime coverage. The cost to borrow the annual premiums should be at least 3% lower than the ROI on other assets. This creates the necessary arbitrage that justifies premium financing. For example, if the loan interest rate is 4%, then the borrower’s ROI on other assets should be 7% or greater. If it is not, then it may not make sense to finance life insurance.
Premium Financing Considerations:
Each premium finance loan is unique and should be stress tested using conservative assumptions. We recommend working with experienced insurance professionals, advisors and experienced lenders who are familiar with this asset class.
The majority of the collateral for premium finance loans is typically the cash value within the policy. The reason lenders are willing to make premium finance loans at low interest rates is because cash value is considered to be as creditworthy as cash. Currently, premium finance loans are less than 3%. While interest rates are at historic lows, it can be wise to consider locking in a fixed rate.
The Loan Payoff.
There must be a sensible exit strategy to pay off the loan. One option is to use cash value from the policy. Another is to use assets that may already be in the trust, such as inheritance monies, liquidity events from sales, etc. When the cash value of the policy is used to pay off the debt, make sure the policy is designed to remain inforce for life, after the cash value has been withdrawn or borrowed from the policy.
Can Real estate be used as collateral for premium finance loans?
Lenders typically do not like lending against real estate for these loans because the collateral is not easily available. However, there are some lenders that do work with existing clients to use real estate to support these loans. This tends to complicate something that is already complex. Customers with strong relationships have been known to receive loans from their existing bank.
Premium Financing and Estate Planning.
A premium financing arrangement can be beneficial to your overall estate plan. The life insurance policy is typically owned in a trust without gift tax or estate tax consequence. It is not uncommon for $20,000,000+ life insurance policies to be financed and owned in trusts that may be exempt from gift or estate taxation.
Premium Financing Is Best Suited For:
- Clients who need jumbo amounts of permanent death benefit.
2. Clients who understand leverage & complex financial transactions, or
3. Clients using life insurance to offset estate taxes.
Business owners interested in succession planning and key-person protection may also be good candidates for premium finance arrangements:
Top 7 Premium Finance Considerations:
- Lenders and insurance companies require that 100% of loan value is provided as collateral. The policy’s cash value is typically the majority of the collateral.
- The borrowing cost and policy crediting rates have long been favorably correlated for these types of structures. They historically move in the same direction with the insurance policy crediting rates and dividend scales being higher than the borrowing costs.
- If you feel this strong correlation will be the rule going forward, financing may be right for you.
- This positive rate arbitrage is created when policy crediting rates are greater than loan costs and it creates a cushion that can be used when interest rates turn volatile.
- When interest rates rise quickly, there may be rate compression or even rate inversion. Either scenario could increase the annual interest expense until rates stabilize.
- The cash value of the life insurance policy should quickly grow to 100% of the required collateral for the loan.
- Properly structured, no personal guarantees should be necessary.
The Premium Finance Risks:
– Decreasing policy interest rates and policy performance risk.
– Increasing borrowing costs or inability to refinance.
– Policy lapse risk.
– Collateral call risk.
– Income tax risk.
STOLI RISK: Many premium finance structures have been created or used to take advantage of consumers and insurance companies by purchasing policies for the sole purpose of re-selling or using them for an illegal profit. We urge people to avoid using life insurance for anything but long term death benefit. Stranger Owned Life Insurance (STOLI) is not legitimate premium financing and should not be considered. Before proceeding with a premium financing arrangement, you should fully understand the risks, the exit strategies and the interest rate arbitrage.
In addition to securing coverage and arranging for the appropriate lenders to consider, Ted is often hired as an impartial consultant to help life insurance buyers determine which is the best financing solution. You can Email Ted or contact him directly at 561-869-4500.