Premium Financing: It Could Be a Wild Ride

Some people like the thrill of riding roller coasters.  They enjoy get shifted from side to side and may even get turned upside down for a bit.  Others find roller coasters to be too intense and may even make them sick just thinking about them; they may prefer the lazy river.  Everyone has different tastes and ways of thinking.  When it comes to purchasing financial products, some people prefer to use leverage and accept risk for a potential greater reward – the roller coaster riders.  Others prefer to avoid risk and desire something predictable and without surprises – the lazy river drifters.

Premium financing is a method some use to leverage other people’s money to fund the premiums for their life insurance policy.

This is an aggressive strategy that involves several risks.  It is not a strategy that is suitable for everyone and should only be used after a careful analysis of the situation.  Over the years, the insurance industry has seen a variety of programs and designs promoting premium financing.  Some are legitimate and have good intentions while others are abusive and promote Stranger-Owned Life Insurance (STOLI) which ultimately can cause harm to the families that get entangled with these undesirable programs.  STOLI sales are prohibited by National Life.  Luckily, most of the “bad” programs have been exposed and shut down.  However, a good program can turn bad if not properly designed and maintained.

Before one should even think of funding options, they need to understand their need for life insurance coverage.  Whether it is for family protection, estate planning, business continuation, or any other reason, the appropriate amount of insurance needed should be determined and there must be a need for the death benefit protection.  It is unsuitable to sell life insurance solely for the cash value features or for its riders.  Who is the intended beneficiary and how should the policy be owned?  Entering a transaction without thinking about the fundamental design aspects often leads to a design that may not be in anyone’s long term best interest.

Once the owner, beneficiary and amount of insurance are determined, the next step is to determine the source of funds to pay for the policy premiums.

• Does the future policy owner have the full premiums available in the correct accounts?
• If not, is the amount of desired coverage too much?
• Will paying the full premium cause a financial burden to the owner?

Premium financing is not a way to pay the premiums when it would not otherwise be suitable for the owner to purchase the desired policy.  If the future owner does have the source of funds needed to purchase the policy, but it is not positioned where it needs to be, or the owner does not want to disrupt their asset mix, then they may want to consider the use of a financing design.

There are many appropriate uses for premium financing.

Many policies are owned by trusts for estate planning reasons.  The trust as the owner of the life insurance policy must come up with the money to pay for the premiums.  In many situations trusts do not have adequate assets and the donor gifts the money to the trust for it to be able to pay the premiums.  A gifting plan needs to be established to place the correct amount of money in the trust.  Annual gifting limits are typically not enough to cover the full premium costs and a donor may not want to deplete their lifetime gift exclusion amount or incur gift tax liability.  In these situations, it may be appropriate to implement a financing strategy so the trust can purchase the desired amount of life insurance protection.  The donor needs to have adequate assets and be willing to pledge such assets to secure the loan the trust takes out for the premiums, as well as any interest that accrues.

Some business owners have placed most of their assets into their business and are reaping the benefits with impressive profit margins and a growing book value.  They may not want to deplete their profits to purchase the life insurance coverage they need.  Instead, they would rather reinvest the profits or allocate them to business expansion.  They may own the buildings, machinery or other assets that can be leveraged or provide a source of collateral to use in a life insurance premium finance strategy.  If the business profit margin is 20% or more, it may be more advantageous to borrow money as the source of funds for their premiums since the current return from their business is greater than the cost of the loan interest.¹

There are other clients with a large portfolio of stocks, bonds, and other investable assets where they may have a sizeable gain.  Maybe they have Microsoft stock from the 1980s or others that have grown very well.  If they were to liquidate some of these stocks to come up with the money for their life insurance premiums, they will pay income tax on the gains which may be higher than the cost of borrowing.  They may wish to hold on to their stock and hope there is still a step-up in basis at death for their family.  These are assets that can easily be pledged as collateral toward a financed loan for the premiums.

Another potential candidate for a financed arrangement is someone who is expecting a large, deferred payment in the future but wants to protect their insurance needs currently.  An independent contractor may have a long-term contract under which they receive a small salary and large bonuses based on the future deliverables. They may be expecting future bonuses well into 6-digit figures, but currently they do not have the discretionary funds to allocate to the full premiums for the coverage they desire.  However, they can afford the current interest payments and plan to use some of their deferred bonus to pay off the principal balance of the loans they take out for their life insurance premiums.

Any client that is interested in a financed arrangement must have adequate assets and an appropriate risk tolerance.  There are a variety of risks that the client must be willing to accept.

Loan interest rate risk and policy performance risks are the two most prevalent risks, but there are plenty of other risks that are involved.  For instance, the lender may run into capacity issues and be unwilling to fund future premiums, an investment portfolio that is used for collateral may have a negative change in value, or a business may run into operating problems causing a loss in profits.  The recent COVID-related issues and future economic and societal issues may adversely affect business owners in many and potentially unknown ways.  Changes in employment status or personal injuries may impact the financial status of a family.  All of these and more must be fully considered before entering into any leverage funded arrangement.

When designing a leveraged life insurance arrangement, it is more important than ever to stress test the projections and repeatedly have meaningful conversations with the clients.

With the recent rise in interest rates, many clients are seeing higher loan interest payments or larger accrued loan balances than originally anticipated.  This has a direct impact on any collateral shortfall projections. Even though rates are higher than they were a year ago, if the policy was designed with leverage and the returns on other assets are still strong, financing should still be a viable funding option for many clients. Fixed indexed policies will likely earn 0% in down markets and may earn higher than average rates (not guaranteed) in rising markets – this is to be expected.  Bank loan rates will also fluctuate over time unless a fixed rate is used and locked in for a long duration.  Early negative changes can cause a larger collateral shortfall.  This may be corrected in the future if strong policy crediting is achieved, or loan rates go down.  Stressing a design before implementing a plan can make sure the client truly understands the arrangement and is comfortable with any collateral projections.

If the unexpected happens and policies are deviating from the intended plan, there are ways to bring things back in line.  A client can always use their own money to pay the next few premiums and not increase their borrowed amount.  That will increase the policy value while the loan remains steady, and the amount of collateral required to pledge potentially goes down.  Moreover, the death benefit amounts could be adjusted, but care must be taken to ensure the modified endowment and guideline limits are not violated.  Changes to the death benefit could also impact the maximum future allowable premiums.

People have been using leverage to fund life insurance policies for decades.  We saw increasing loan rates in the mid-1990s and both the early and late 2000s before there was nearly a 10-year span of below normal interest rates with only minor fluctuations.  As interest rates rise, company’s general account returns should also start to rise.  There is usually a lag before the portfolio rate benefits from the higher new money rates, but over time the policy features will adjust to the better market conditions.  The reverse will also happen in the future if rates start to fall again.

Leverage remains a viable option for the correct client with the appropriate risk tolerance and adequate net worth and liquidity.  It is important that agents and clients understand all the risks and potential rewards that can come from an arrangement, and clients must be able to tolerate the impact that the economic conditions may throw at them.

If the roller coaster has too many turns, drops and loops it doesn’t have to be ridden.  But it can be a thrilling ride for the right person.

– David Hayward, Advanced Sales Specialist

 

This business strategy is offered and managed by an independent third party who is not affiliated with the companies of National Life Group. No National Life Group company nor anyone acting on its behalf has evaluated the strategy or is authorized to make any representation regarding the suitability, effectiveness or legality of using life insurance in connection with the strategy’s use. This is not a solicitation of any product or service. Please consult your clients’ tax and/or legal advisors regarding whether this strategy is appropriate for their situation.

¹Premium financing relies on internal policy funding to pay back the loan. This is not guaranteed and results may be more or less favorable than illustrated. The ability to internally fund a life insurance contract will be dependent upon the performance of the contract and is not guaranteed. If remaining policy values and scheduled premiums are insufficient, additional out-of-pocket payments may be needed to keep the policy in force or to repay the loan.