For affluent people who don't want to liquidate other assets to pay for life insurance, borrowing funds from a third party to cover the cost of a policy and paying it back in installments -- a practice called premium financing -- can seem a practical solution.
How it works
A good prospect for premium financing might be someone who is still working and needs life insurance but is not ready to liquidate his assets. For example, let's say Sam, age 67, wants to leave a legacy of $5 million to his wife and children. His business is worth a couple of million dollars, but he's not ready to sell it.
The premiums for a $5 million universal life insurance policy for a healthy 67-year-old would run about $100,000 per year. Rather than pay that in a lump sum, Sam might take out a premium finance loan, either from a premium financing company or, more rarely, from an insurance brokerage.
It's no different from any other type of borrowing. Premium financing allows very wealthy people whose assets are illiquid to borrow at a rate close to the Libor (London Interbank Offered Rate).
However, though Libor rates are currently low and may stay low for awhile, they are subject to interest rate changes. From this level, they would invariably rise.
One advantage is that an indexed universal life (IUL) insurance policy accumulates a cash value and will, therefore, become an income-producing asset (loans can be taken tax-free). If the cash value linked to an index grows at a rate higher than the interest rate being charged on the premium that was financed then you have an arbitrage.
For example, the policy can be used as collateral for a bank loan. When you have a premium financing structure, if you die before that loan is repaid, the bank can attach the cash value or receive a portion of the death benefit, up to the loan balance.
Premium financing is a legitimate way for someone who needs a large amount of life insurance with a big premium to find ways to buy it.
It's often a business deal, where a key person has to be insured for borrowing purposes, but it has risks.
Potential problems
For example, there's renewal risk. Because most premium financing contracts have terms less than the life of the policy, they have to be renewed periodically, requiring refinancing.
For someone like Sam, that opens up the potential for the loss of other assets. It used to be the loans were non-recourse, meaning they couldn't attach any of your other assets. That has pretty much gone away. If at the end of five years the loan lapses, the lender can come after personal assets. It can get nasty.
Those who don’t understand the true benefits of life insurance premium financing worry this is a tool dependent on interest rates or policy performance. But even when interest rates have been high and markets have been shaky, financially savvy advisers have been able to use the premium financing to fund life insurance premiums.
Why? Because in order for high-net-worth individuals to continue to grow and protect their wealth, they need to take advantage of leverage and actively look for investment opportunities that yield returns greater than the cost of capital. In other words, many need life insurance to address inheritance, business and tax issues, but they’d prefer to keep the funds they would spend on life insurance premiums in investments that yield more profitable returns.
The economy, although sluggish, is moving again, and with rates hovering at all-time lows, premium financing life insurance makes more sense than ever.
The reason? Retained capital.
In this instance, retained capital is the amount of money a client can hold on to — and ultimately invest elsewhere — by paying interest on a loan that covers the cost of a premium versus paying the premium itself. Many high-net-worth clients report that they earn 10 percent to 15 percent or more on their money. If that’s the case, why take funds out of profitable investments in order to pay a premium?
But let’s be clear. Premium finance is not a gimmick. It is not free insurance. It never was and never will be. It is not a play on the potential arbitrage between policy crediting rates and interest rates. The policy owner will have to pay interest to a lender and will have to post collateral equal to the difference between the cash surrender value of the policy and the loan balance. It is simply a tool to help an affluent client reduce the initial out-of-pocket expenses relating to the purchase of a life insurance policy and a way to keep their money working for them in their investments of choice since they only pay the interest on the loan.
To finance or not to finance?
To better understand what an asset premium financing can be, we have to look at the potential profit an affluent client would lose out on if they don’t use it. In other words, the lost opportunity cost. So, let’s take a look at the numbers and consider the lost opportunity cost of paying a $100,000 premium out of pocket.
If an individual truly earns 10 percent on the funds he would use for a premium payment, then he would lose the opportunity to grow his net worth by $10,000 if he were to pay the premium himself. Utilizing the benefits of premium financing, if the client finances the $100,000 premium at 5 percent interest, his out-of-pocket cost in year one is $5,000, and his retained capital is $95,000. That policy owner could re-invest the $95,000 in a vehicle that returns 10 percent and ends the year with $104,500 and a life insurance policy to protect those assets. Over time, this growth compounds. This is the power of premium finance!