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Using a lender to finance your insurance premiums? Here’s what you need to know

November 29, 2022 Article 3 min read
Steven J. Gibson Wealth Management Christina Slongo
Over the past decade, low interest rates supported a consideration of a premium financing strategy, offering high-net-worth individuals a low-cost way to get life insurance. But as financial conditions change, so does the risk. Is this strategy right for you?
Business professional looking at a report in an office.Life insurance premium financing is a strategy that allows policy owners to borrow funds from a third-party lender to pay life insurance premiums. It can be a helpful strategy for high-net-worth individuals who need large amounts of life insurance but don’t have the cash on hand to pay the premiums or would rather keep their money invested in other areas, relying on a cheaper borrowing rate instead. It has evolved into a segment of the industry that tries to capitalize on low borrowing rates to get life insurance for little to no out-of-pocket cost.

How does premium financing work?

A lender makes the premium payments on a life insurance policy with the promise that the policy owner will repay that amount plus interest at some future point. Additionally, the policy owner is required to post collateral if the policy cash value isn’t high enough to cover the full repayment to the lender. If the insured passes away before the loan is repaid, a portion of the death benefit is used to repay the lender and the remaining amount is paid to the beneficiaries.

Who’s it for?

Premium financing is often best suited to high-net-worth individuals (typically $20 million and more of assets) who have a need for permanent insurance but are low on cash or liquid assets because their capital is used in places that earn more than the current borrowing rate.

Why use premium financing?

  • Tax savings: Premium financing can help minimize estate and gift taxes and provide necessary liquidity for heirs.
  • Leverage: With premium financing, policy owners can use the life insurance policy’s cash surrender value and current assets to get the coverage they need today while paying the cost back in the future.

What are the risks?

Depending on plan design, there could be many risks, the severity of which are lessened or amplified based on the assumptions used at time of purchase.

  • Interest rate risk: A significant risk, that’s increased in the second half of 2022, is the impact of rising interest rates in premium financing. Typical loan terms for a premium financing arrangement use a rate — usually based either on LIBOR or SOFR plus a spread — that resets every 12 months. When entering a premium financing strategy, the expectation is most loan repayments occur after 15 years. Therefore, the impact of compound interest over that time can be significant if the loan rate rises higher than anticipated. How many borrowers expected the one-month LIBOR rate to rise from .09 to 3.35% in the last 12 months?
  • Policy performance: Most premium financing arrangements used to get life insurance at little to no cost use an index universal life policy. The illustration provided at time of purchase would show a hypothetical expectation of cash value at a rate of return — based on historical data — that exceeds the expected borrowing rates from the bank. But that return can be as little as 0% in any given contract year based on market performance. In fact, many policies would’ve seen 0% credit in 2022 thereby potentially requiring the borrower to put up additional collateral against the bank debt.
  • Collateral risk: As the premium financing loan is renewed at the end of each term, the policy owner may have to provide additional collateral to satisfy the loan based on policy performance. For example, if the collateral is in marketable securities, as those securities fluctuate in value, the banks may want more collateral pledged or even require that the collateral be in less volatile assets. Furthermore, the lender typically reserves the right to call the note if it gets concerned about defaults against the debt, so it’s important to be prepared for this eventuality as well.

Premium financing can still be a viable planning option for the right reasons and in the right situation. But with the low cost borrowing rates of the last decade coming to an end, and uncertain financial conditions ahead, careful planning is necessary to ensure the strategy is right for you.

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