By: Randall A. Denha, J.D., LL.M.
Life insurance can play a major part of any financial plan. It can protect your family, business and your estate. Life insurance premium financing is a financial tool that some high net worth individuals take advantage of to secure the coverage and protection they desire. Allowing individuals to obtain an appropriate life insurance policy without the need to deplete cash reserves or liquidate high performing investments, premium financing can be used as a beneficial tool to provide the desired financial security.
WHAT IS LIFE INSURANCE PREMIUM FINANCING?
Most life insurance policies used as part of an estate plan for a substantial estate will be owned by an irrevocable life insurance trust (“ILIT”) to ensure the proceeds are excluded from the value of the taxable estate of the decedent. In some instances, the trust that owns the policy has sufficient other assets to fund the payment of the annual premiums. That is the rare exception, however, and usually a planner will need to consider the source of funds for premium payment and the method that will be employed to transfer the funds to the trust when needed. The simplest way to fund premium payments is for the individual, or grantor, to transfer funds directly to the trustee to use to pay the insurance premiums when due. If the annual premiums are small enough then using premium financing to pay for the insurance premium is not warranted. This type of funding arrangement will be of particular use if the insured is young and the policy in question is a term policy. But if the premiums are considerably greater than the annual gift tax exclusion amounts available, other options must be explored to determine what funding method is best suited to the scenario at hand.
When an individual wishes to take out a new life insurance policy and the premiums for the policy are considerably greater in dollar amount then the individual may have the option to borrow cash in order to pay the life insurance premiums. This is commonly known as premium financing. The premium finance company (also known as the ‘provider’) will lend the premiums to the policy owner in exchange for interest on the loan. The policy owner then uses the cash to pay the insurance company to keep the policy in-force. When the loan period ends or the insured passes away, the principal amount plus interest is paid back to the premium finance company and the owner retains the life insurance policy or collects the death benefit to be paid to the policy beneficiary less the outstanding loan value.
HOW DOES PREMIUM FINANCING WORK?
With a premium financed program, the potential insured applies for premium financing after being underwritten for a life insurance policy. Once the loan is approved, the lender pays the annual premiums on the life insurance policy and the policyowner (or a trust) will only have to pay annual interest on the financed premium. The life insurance policy and other assets are used for collateral against the loan. The loan may be repaid in a lump sum, in installments over time, or at the death of the insured.
The borrower (client) will name the trust beneficiaries which may include a spouse, children, other heirs, business partners or a charity. Typically the borrower will have to post additional collateral (in addition to the life insurance policy’s death benefit and cash values) to qualify for the loan. Acceptable forms of collateral include a personal guarantee (some programs only require a personal guarantee for 25% of the loan balance), a letter of credit, cash or marketable securities. Upon securing the required collateral the initial loan amount is dispersed to the Trust which in turn pays the first premium on the life insurance policy. The grantor makes gifts to the trust of the annual interest payment. The trust then pays interest to the lender. No income tax deduction is allowed.
Typically, the interest rate charged is roughly 200 basis points above the London Interbank Offered Rate (LIBOR). LIBOR is a widely used benchmark for short-term interest rates; it is the rate at which banks borrow funds from other banks in the London interbank market.
As future premium payments to the insurance company are required, the premium finance company continues to disperse funds according to the premium schedule.
When the loan matures the policy owner may have a number of choices including continuing to finance the premiums, paying off the loan with the life insurance cash values or other estate assets or possibly selling the policy in the secondary market (also known as a Life Settlement). Should the insured pass away during the financing period, the Trust will receive the death benefit proceeds, pay off the lender and disperse the remaining proceeds to the trust beneficiaries.
WHO IS A CANDIDATE FOR PREMIUM FINANCING?
The candidates for premium financing are usually individuals ages 50 and older, with high net worth and who are seeking insurance with large annual premium (usually $75,000 per year and up). These individuals may have their assets largely structured in long-term investments. Premium financing lets the client leverage the cost of a new life insurance policy by paying only interest on the loan, allowing the client to maintain other investments.
WHY PREMIUM FINANCING?
First, financing can allow assets to remain invested that might otherwise need to be liquidated in order to pay premiums, or allow funds that would otherwise go to premium payments to be used for other investments with greater potential. Second, financing can avoid making large gifts to trusts. Additional benefits include: ability to access full insurability based on total net worth including illiquid assets; part of an estate tax plan (transferring wealth to the next generation) to name a few.
Premium financing a life insurance plan is complex and may not be the right fit for all situations, so each proposal and arrangement must be closely analyzed in the context of the specific fact pattern presented by the individual in question. The economics of each arrangement needs to be scrutinized to ensure that the plan achieves the desired goal at an acceptable cost. Not all plans are appropriate in all cases and in some instances should be avoided in almost any context. With that said, third party financing can, in the right circumstances, be powerful tools used to minimize gift taxes and leverage the value of premium payments for large life insurance policies.