Affluent individuals who can afford life insurance premiums but prefer not to liquidate assets or redirect cash flow to pay them, need to know about premium finance. So do advisors who want to help them make informed life insurance decisions.
Let’s say your client is a successful business owner, family estate owner, and investor, and understands the importance of life insurance. Beyond its asset protection value, life insurance funds buy-sell agreements, provide liquidity for wealth transfer taxes, support asset equality for heirs, and expand charitable opportunities.
However, your client may hesitate to liquidate assets to pay the premiums, but understands how to utilize leverage to create wealth. That same principle can be applied to life insurance with premium finance. Premium finance is a financial tool with which life insurance coverage can be obtained without having to liquidate profitable investments by leveraging third party funds.
Breaking that last sentence down, premium finance consists of borrowing money from a bank or other third-party lender to pay life insurance premiums. These arrangements typically involve a long-term loan with a variable interest rate that is tied to the London Interbank Offered Rate (LIBOR).
Collateral is required for the loan, but in most cases the life insurance policy’s cash surrender value is utilized, with any deficit covered by additional collateral generally in the form of a letter of credit, cash, or marketable securities. Most premium finance arrangements consist of short term financing, usually 10 years or less. The loan interest is typically paid in cash, but alternative options, such as accruing interest, may be available. Additionally, premium finance clients need the willingness to have some “skin in the game,” either through the pledging of collateral and/or the payment of loan interest.
It is extremely important that the arrangement also considers an exit strategy for repaying the loan other than just from the policy values. Should the insured die prior to the repayment of the loan, the outstanding loan is repaid from the policy death benefit proceeds.
Premium finance should not be thought of as a way to get “free insurance” or earn substantial returns. Additionally, it should not be the reason why someone purchases life insurance. It is a financial tool that allows clients to obtain the necessary life insurance coverage to provide for future obligations, such as estate taxes, while allowing them to leave more assets invested in their businesses and other investments.
As interest rates slowly rise, questions about premium finance also arise. Will premium finance become less efficient for paying life insurance premiums? It’s not a yes-no question. Policyholders do not opt to premium finance because of low interest rates. They do it because they understand the power of leverage and redirecting assets for higher earning returns.
In the 1990’s, when premium finance began to be more widely utilized, interest rates were significantly higher. During that time, the arbitrage between the loan interest rate and the policy crediting rate was not as attractive. But this did not stop life insurance clients from financing their premiums.
The banking and life insurance industry have made adjustments to accommodate the changing interest rate environment and continue to make premium finance an attractive option. Some banks that actively participate in premium finance have lowered lending rate spreads to combat the rising short-term interest rates. Other banks are offering longer-term notes.
On the life insurance side, some life insurance companies are releasing new products that are better suited for premium finance, and some are adjusting their premium finance rules to make it available across varied client circumstances.
Premium finance does have some risks you need to consider in order to determine suitability. Among these risks are:
- Interest rate changes
- Policy performance
- Increased collateral requirements
- Loan term adjustments upon renewal
- Change in client’s financial conditions
Risk management is really more about expectation management, and it is important to create realistic expectations. The premium finance design must be stress-tested and modeled based on various possible scenarios and outcomes. Additionally, premium finance clients should be prepared to pledge more collateral or make additional payments if necessary, and implement plans to facilitate back-up repayment sources. Once the plan is in place, ongoing monitoring is necessary to ensure the plan stays on track and to make necessary adjustments if issues arise or needs change.
Conversely, there are also significant risks with not purchasing the necessary amount of life insurance for effective planning. Premium finance can be a very efficient financial tool for the right situation, even in today’s rising interest rate environment, but it must be used appropriately and with detailed and careful preparation.