Premium-Financed Life Insurance
The Premium-Financing Structure
- Premium financing structures provide a means for individuals and businesses to obtain large amounts of whole life insurance with reduced annual outlays. These structures are viable for situations where constraints due to cash flow availability or gift tax concerns may complicate traditional planning methods. Premium financing can provide a sophisticated solution as an alternative to paying large premiums out-of-pocket for estate and business insurance needs.
- Premium financing structures combine a permanent life insurance policy and a loan facility, both tuned to reach a desired outcome. Generally, the insurance policies are structured using Ten Pay premium payment options and the loan facility is drawn to fund large portions of the annual premiums and, as an option in certain structures, a portion of accrued interest. The remainder Partial Payment of annual premiums (and in certain cases accrued interest) is made by the policy owner in an amount targeted as a multiple of the annual gift tax exclusion. The facility is generally secured by a combination of the cash value of the insurance policy and posted collateral such as cash, stock and bond portfolios or, at times, a letter of credit for shortfalls that occur in the earlier years.
- The insurance policy and financing facility are set up and optimized to provide the desired death benefit on a net basis (after paying off the facility amount) for the beneficiaries, while providing increasing cash value to secure the financing over the policy duration. While premium-financed insurance structures can provide viable solutions for many cases, parties must understand the underlying risks as well as the structural tools available for mitigation.
What are the Benefits from Premium Financing?
- Premium financing is designed for high net worth individuals with assets (excluding principal residences) in excess of $5,000,000 with needs for large amounts of permanent insurance. Small corporate entities also employ the structure for buy-sell situations and key person insurance.
- Premium financing provides a cost-effective alternative to usage of post-tax dollars for premiums, rather than liquidation of existing investments which can change portfolio composition and trigger taxable income. This can benefit wealthy individuals with illiquid investments, such as real estate or a closely held businesses, who may be not be willing to incur liquidation costs (such as taxes), or sell into adverse markets.
- Premium financing potentially reduces annual outlays for life insurance (sometimes, 30% or less of the annual premium required for conventional permanent insurance); however, it is important to remember that premium financing is not a means to obtaining free or reduced cost life insurance.
- Typically, the Trust assets (the policy and other assets) are structured to be excludible from the insured's taxable estate.
- Premium financing provides a means to reduce gift tax liabilities and to conform with annual and lifetime exemptions.
- While these benefits can be attractive, potential insureds should work closely with estate planners and accountants to ensure the structure meets their specific needs
The Loan Facility
The Interest Rate - Interest rates for premium financing loan facilities are usually based on PRIME or a LIBOR rate, plus a spread determined by the lender.
Maturity – Maturities for loan facilities vary from one year to ten years, depending on the lender and other terms
Additional Collateral Requirements - Policy cash values serve as the primary source of collateral for the loan. Collateral shortfalls, in the early years, are typically covered by additional collateral pledged by the policy owner or a Grantor.
Premium-Financed Life Insurance - Understanding the Risks
Exit Strategies - The insurance company and the lender will require a well-defined exit strategy for repaying the loan facility, which is an important component of the planning process, given facility is secured with a first lien on the (surrender value) and the death benefit. A full examination of possible exit strategies allows for a better understanding of the risks inherent with premium financing. These may include:
- Refinancing with the current lender, or with a different lender
- loans or withdrawals against the policy cash value may be used; these may be done in one transaction or over time
- Proceeds from sales of other assets
- Death benefit proceeds upon death of the insured which are first allocated to loan payoff
Interest Rates - Given interest rates for the loan facility are generally floating and PRIME or LIBOR based, these rates are correlated to future Federal Reserve policies for Fed Funds rates, which may put short-term rates on an upward trajectory and increase the interest costs for the loan facility. Rising interest rate risks may be mitigated through use of capital markets tools to convert floating interest rates to fixed rate.
Given insurance carrier investment portfolios (which back their permanent insurance obligations) are correlated to longer-term interest rates, a prolonged downward trajectory of these rates will lead to lower dividends and crediting rates and negatively affect the performance of permanent insurance policies.
Credit Deterioration – Credit deterioration by parties to a premium-financed transaction may negatively affect performance, including:
- Client credit-worthiness which, if declining, may lead to additional collateral requirements
- Declining financial strength and stability of the issuing insurance company may cause the lender to require additional collateral requirements or a default on the loan
- Declining financial strength and stability of the lender may lead the client to seek an alternative lending source which may be more costly
Partial Payment Amounts – Reduced levels of annual Partial Payment amounts will increase the annual borrowings and increase the amount of the loan facility which may lead to long-term underperformance of the premium-financed transaction
Collateral Value – Declining valuations of posted collateral likely will lead to requirements for additional to meet lender margin calls. Required levels of posted collateral are dependent on the excess of policy cash value to the outstanding loan facility amount.
Completing a Premium-Financed Insurance Transaction
Individual or Trust borrower
- Cover Letter and signed credit application
- Personal financial information, including personal financial statements, bank and brokerage statements, previous two years of full tax returns, and other items
- Insurance carrier and premium-financed illustrations
- Premium finance illustration
- Complete copy of executed trust agreement
Corporate Entities for Buy-Sell and Key Person
- Individual information as outlined above
- Consolidated corporate financial statements for the previous two years, plus interim income statements and balance sheets,
- Corporate tax returns – for the previous two years
- Corporate formation documents
- Buy-Sell agreement