Is life insurance premium financing right for you?
The most important challenge I face when meeting a new financing prospect is to determine if financing is right 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 financing but they are intensely drawn to its advantages.
Life insurance premium financing is not free life insurance. This alone eliminates 90% of the prospects. If it’s not “free”, what is the cost to finance a life insurance policy? The annual interest expense is the “cost” of premium financing a life insurance policy. It is the main reason most people ultimately 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 could exceed the cost of permanent coverage. The reality of this annual cost drives away 90% of the remaining prospects, leaving a legitimate population of 2-3% who qualify for financing a life insurance policy. Who are these 3% and what do they have in common?
A properly structured premium finance loan is best suited for wealthy people who need and want life insurance and who can borrow money at lower rates than than the ROI on their assets. This arbitrage is one of the signs I look for in a PF candidate. The need for permanent life insurance should be ground zero for all serious considerations and it is crucial to have this meaningful conversation with anyone considering this type of long term financing arrangement. After all this time in the premium finance space, I am still surprised by how many people are really not interested in the policy they are considering for financing. They are only considering the coverage because financing the policy has been presented as “free” or very low cost way to buy life insurance.
Premium Financing Considerations:
A low cost loan is supported for financing arrangements because the collateral (cash surrender value) is strong and it 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.
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 will create sufficient cash value to retire the debt and continue the policy. If the policy needs additional premiums to keep it inforce after paying off the loan, that will increase the cost of borrowing at the onset.
Can Real estate be used as collateral for premium finance loans? In theory, yes.
In practicality, but not likely. Lenders typically don’t like using real estate for this type of lending because the equity is not readily or 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.
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 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. 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:
- Wish to borrow instead of using corporate assets otherwise earmarked for superior ROI opportunities.
- Fund executive benefit arrangements (capital split dollar) with meaningful amounts of insurance…
- Wish to use their business balance sheet for other purposes.
The low-interest rate environment creates interest in PF. Each loan is unique and it should be analyzed assuming higher rates. For some, higher 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 borrowing rate is only one consideration in the structure. Client ROI and the policy projections are some others.
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.
- This correlation will produce a positive arbitrage, or an excess cash cushion that will create 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 often provides the majority of the required collateral.
- A properly structured premium finance loan should not require personal guarantees.
Premium Finance Risks?
– Policy 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 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 be avoided. Try to avoid getting involved in a premium finance structure without fully understanding the financing arrangement, the exit strategies and the need for the coverage. Proper origination is the key to successful premium financing.