Life insurance premium financing is designed for high net worth individuals with assets (excluding their residence) in excess of $5,000,000. Many people in this category understand the need for life insurance in their estate, but frequently are unwilling to divert cash from illiquid assets or incur transaction costs such as taxes.
Premium financing for life insurance is not a means of obtaining an insurance policy for free. This strategy is not a no or low cost method which lacks the necessary insurable interest to support policy coverage and which is often entered into with the intent to ultimately settle the policy in the secondary market.
So, how does life insurance premium financing actually work?
Funds are borrowed from a third-party lender. Loan interest is paid out of pocket. Typically, you would establish an Irrevocable Life Insurance Trust (referred to as an ILIT). This Trust acts as the owner of the policy and is also identified as the borrower on the premium financing documentation.
In all cases, the life insurance policy (technically a unilateral contract) is used as collateral for the loan. A personal guarantee is usually required along with additional collateral as needed. The criteria to determine eligibility for loans is at the sole discretion of the third party Lender and is separate and distinct from the criteria to determine eligibility for life insurance coverage.
Some lenders make premium loans for the life of the policy. Loan conditions can be very flexible. However, lenders usually require that future premium loans be subject to verification of the client’s financial stability and the loan being fully collateralized.
Lenders only allow premium dollars to be borrowed. Interest on the lender’s loan is payable in cash but in some cases can be deferred for a period of up to 5 y4ears with prior lender and life insurance company approval. The deferred interest is capitalized into the aggregate loan balance.
Recently, several new life insurance premium financing companies have entered the market. They offer term loans with varying durations, often with the option to renew the loan. They may offer lower than market loan rates but typically make up for the difference with fees and asset charges.
Collateral Requirements For Life Insurance Premium Financing
Collateral requirements are crucial in premium financing. Policy cash values serve as a source of collateral for the loan. Collateral shortfalls are covered by additional collateral pledged by the policy owner or a Grantor.
Interest on premium loans is usually based on the one-year London Interbank Offered Rates (LIBOR) or the Prime Rate, plus a spread determined by the lender. Barring any future re-negotiation, the spread will not change for the life of the loan.
Loan interest spreads are determined on a case-by-case basis based on the loan amount and the associated risk exposure. Typical loan spreads vary from 175 to 300 basis points. Loan rates are fixed on an annual basis, but may vary from year to year, based on annual fluctuations in LIBOR or Prime rates.
There are three ways to repay the loan:
- At death: Most policies are structured to have the death proceeds pay off the third party loan balance; the remainder death proceeds going to the beneficiary. Increasing premium cost for older insureds make it more difficult to achieve this goal.
- Set up an exit strategy: High net worth individual age to and younger may wish to fund the policy so that the third party premium loan can be repaid from policy cash values at a pre-determined date.
- The high net worth individual repays the loan out of pocket: An infrequent method, unless you are expecting a large inheritance or a contractual payment in the future.
The Benefits and Downsides of Life Insurance Premium Financing
- Borrowing may offer lower opportunity costs than liquidating assets to pay for needed coverage.
- Minimal impact on current investment portfolio.
- Reduces current net out of pocket outlays for life insurances.
- Deterioration in your credit-worthiness may require the posting of additional collateral.
- In the long run, the overall costs of premium financing will be higher than paying premiums out of pocket.
Life insurance premium financing is an excellent way to pay for valuable protection, but only for those who not only qualify, but also thoroughly understand the consequences of the strategy.
