Premium financing presents some risk. It is vital that prospective buyers understand premium financing risk when funding a significant life insurance policy.
Every financial strategy involves a potential downside. Savvy investors do everything they can to mitigate potential losses. While using premium financing to fund your insurance policy can reduce the amount of assets you would need to liquidate to pay for the premiums, you must plan with caution in mind.
The first half of this article focuses on the potential pitfalls of premium financing. This is so you can design your premium financing strategy with known risk factors in mind.
The second half offers proactive methods to safeguard your premium financing strategy and explain ways to avoid the premium financing risks.
Premium financing is a long-term financial strategy and it is essential to approach it from that angle. Consider both your own financial portfolio and the market to project future fluctuations, both positive and negative.
Working with a premium financing lender and an insurance specialist can minimize potential risk. There are lending companies, financial planners, and insurance agents who can work together to bring you through the process seamlessly.
Like any financial strategy, there are risks involved. Interest rates fluctuate. Setting up the trust improperly can trigger tax obligations. The market returns can affect how fast you build up your cash value accumulation. Having contingency plans for all of these scenarios can help you manage and avoid these inherent risks.
If you landed in this section, you might want to start with a complete look at premium financing in our article Using Premium Financing for Life Insurance.
The Risks of Premium Financing
High net worth individuals often need life insurance policies in the millions of dollars. The ideal type of life insurance for premium financing is a permanent life insurance policy. Permanent life insurance policies are much more expensive because of the cash value accumulation potion and the fact that they will pay out at some point.
The cash value accumulation portion plays a crucial role in both the premium financing funding and the third-party loan to finance the cost of the premiums.
Building up the cash value accumulation in the first ten years is crucial to your success. You can then use that cash value to repay the balance on the loan.
For premium financing, experts favor the indexed universal life policy over other permanent policies such as whole life, universal life and variable life.
Before taking out the loan to financing the premiums, you and your estate planner need to set up an irrevocable life insurance trust (ILIT) and structure it in such a way that it can use the cash value accumulation to repay the loan. Correct structuring of the ILIT is one of the reasons that having professionals on hand with premium financing experience can make a huge difference.
In the interim between taking out the policy and paying off the loan, you have a couple of options. You can fund the trust to pay for the cost of the loan interest, pay down the loan principal, or do both. Your funding approach will depend on your asset liquidity, and the collateral the premium financing lender requires.
When the loan is paid off, the trust becomes the owner of the policy.
Four major things can impact your approach to a premium financing funding model:
- Market fluctuations
- Lending arrangement
- Personal liquid assets
- Lending collateral requirements
Difference scenarios can cause different potential problems. Familiarizing yourself with these problems can help you, and your financial planners, determine safeguards to avoid premium financing risks.
Risk 1: Interest Rates
Currently, interest rates are still low. Right now is the best time to consider setting up premium financing for a life insurance policy.
However, we all know market conditions fluctuate. Most financial experts project that interest rates will rise as the American economy continues to grow. As rates rise, the cost of borrowing money will increase.
Even a small increase in interest rates may result in the decrease of anticipated benefits.
Most premium financing loans are renewable. As the cost of borrowing increases because of higher interest rates, the lender may require your irrevocable life insurance trust (you) to provide the bank with more liquid collateral in order to secure the loan.
In short, have a plan for what to do if interest rates increase.
Risk 2: Life Insurance Policy Cash Value Accumulation Fluctuations
The scenario presenting the most problems is when the cash value portion of the policy does not increase as fast as interest rates. This could cause the loan balance to exceed the value of the life insurance policy.
Generally, as interest rates rise, the performance of the policy should also increase. This offsets the rise in interest rates and keeps everything balanced. However, if interest rates remain low, the policy performance might also stay low in a corresponding manner.
The lender naturally wants to ensure their loan is fully secure. They continuously monitor the cash value of the policy, policy death benefits and the required collateral to cover any shortfalls.
If a shortfall does occur, you may need to provide additional collateral to avoid a loan default.
Finally, the death benefits on the life insurance policy must not be less than the loan balance. If the death benefits of your policy are insufficient to cover the loan, your estate will incur a shortfall should you pass away before repaying the loan.
The takeaway is to structure the policy to ensure that the death benefits will be higher than the balance on the premium financing loan.
Risk 3: Loan Structure Risk
For premium financing, the longer the loan is in place, the higher the risk.
Although your tailored strategy may involve partial withdrawals or policy loans from the cash accumulation portion, you will also be diminishing the overall death benefits in the process. This approach could defeat the objective of providing liquidity to your beneficiaries separate from your estate.
Most lenders will not allow you to take partial withdrawals to pay down the loan in any event. The policy is intended to act as collateral for the loan.
Your lender will also require collateral to secure the loan. Using the investment portion of the policy as collateral increases the potential for the losses for the policyholder. If for some reason, the policy were to lapse and the policy portfolio did not perform as expected, this could increase your overall costs.
Most premium financing loan periods range from three to five years. There is no guarantee the lender will renew the loan. You may need to show that you continue to be creditworthy at each renewal. The lender may also increase rates at their discretion. They may also decline to renew the loan if your income or overall wealth falls.
If the lender declines to renew the loan, this puts the policy at risk of lapsing without means to pay the premiums.
Lenders also occasionally request additional collateral to renew the loan. This can present problems for people whose wealth is not in liquid assets.
Even though the terms on the loan tend to be between three and five years, the loan interest rates can be variable or fixed for a 1-year period. The bank then adjusts them for each subsequent year. Loan interest rate increases can easily affect the overall outlook of the premium financing structure.
Risk 4: Taxation Risks
When planning your premium financing strategy, take into account any potential exposure to taxation since it affects the overall policy success. The most important factor is to ensure that the total death benefits at the end of the loan exceed the loan itself.
If you must surrender the policy, taxes may apply. At the time of surrender, you will need to pay taxes if the overall cash accumulation portion is greater than the total amount of premiums paid.
Finally, there is also tax liability on any amount required to pay off the balance of the outstanding loan because the interest is not tax deductible.
How to Mitigate Premium Financing Risks
Premium financing for life insurance presents risks on several fonts, just like any wealth management strategy.
Each situation is different. But there are some things that anyone can do to prepare for and avoid these risks.
Step 1: Use an Independent Life Insurance Agent When Buying the Policy
An experienced independent life insurance agent can show you which companies will offer you the best underwriting and which companies have policies designed with premium financing in mind.
Of the few dozen life insurance companies with products for premium financing, you need the ability to choose the one that looks at your health in the best light. Life insurance underwriters assign premiums based on age, gender, and health. There is nothing you can do about the first two. Luckily, each company looks at a person’s health a little differently.
A change in health class can mean a difference of 25% in your premiums. Some companies are extremely conservative when it comes to health conditions. Others pick and choose which health conditions they don’t worry about as much.
Buying a policy in the millions of dollars makes it doubly important to look at all the options available to ensure your loan is as low as possible.
Step 2: Use Qualified Planners
Premium financing works best when you involve a team of experts. This means it would be wise to enlist the help of an independent life insurance agent, estate planner, financial advisor, legal advisor, and taxation specialist.
Premium financing is not a situation where you set it up and leave it on its own. The performance of the policy needs to be examined at a minimum of once a year.
Your team needs to keep a close eye on market interest rates, loan rates, and your funding model on an annual basis. Most people who take advantage of premium financing will need to adjust your strategy to counter market fluctuations and loan renewal requirements.
Using lenders who have a lengthy track record of offering premium financing loans also helps. We have the Premium Financing Experts and qualified lenders to help mitigate risk.
Step 3: Buy an Indexed Universal Life Insurance Policy
Indexed universal life policies generally link to a market index such as the S&P 500. This is the best option for growing the cash value accumulation as quickly as possible in the first ten years you hold the policy.
There are several indices you can choose. You can customize the investment portion of the cash value accumulation. Some life insurance companies even design products specifically for premium financing.
The indexed universal life policy you choose should also come with a guaranteed minimum return. This protects you against loss if the market performance declines dramatically. The majority of indexed universal life policies also offer guaranteed death benefit protection.
Step 4: Use Irrevocable Trusts to Fund the Interest and Loan Balance
An irrevocable life insurance trust should both own and manage your life insurance policy. This allows the death benefit on the policy to remain separate from your estate. That separation means it is not subject to estate taxes.
It is best if the trust purchases the policy and makes payments on your behalf. If you move an existing policy to the trust, then you have to wait three years before the IRS considers the policy separate from your estate.
You can employ other irrevocable trusts in your payment model and for premium financing planning. Two common options are a Grantor Retained Annuity Trust (GRAT) and an Intentionally Defective Irrevocable Trust (IDIT). There are other types of trusts which may also suit your needs.
Step 5: Use Gift Tax Exemptions
A popular way to provide funding to your trust is to use your gift tax exemptions. These can go toward paying the interest on the loan balance. As of 2018, gift tax exemptions are $15,000 per person.
You can use the gift tax exemptions per individual beneficiary of the policy to provide all or a portion of the premium financing funding. For more information, see Estate and Gift Tax Benefits of Premium Financing.
Step 6: Plan an Exit Strategy
Both the life insurance policy and the loan will be in place for a relatively long time. Without the ability to predict interest rates and market fluctuations, it is critical to have an exit strategy.
Most experts recommend a 10-year plan to repay the premium financing loan in full. The longer the loan, the more expensive it will become.
Also, if you pass away before repaying the loan, the outstanding balance will come from either the available cash accumulation portion, the death benefits, or a combination of the two. This reduces the amount of life insurance proceeds available to your beneficiaries.
If you instead build up the cash value as quickly as possible, you will ensure the loan remains fully collateralized. It also grows on a tax-deferred basis.
Conclusions on Avoiding Premium Financing Risks
The above strategies are few that you can use to ensure that your premium financing loan has sufficient collateral to satisfy the lender.
Other strategies may be more suited to different circumstances, but those are outside the scope of this article. It’s just one of the reason that enlisting a team of specialists can help design the best plan for your situation.
How Abrams Insurance Solutions Can Help
Abrams Insurance Solutions specializes in providing life insurance premium financing for high net worth individuals. We work with the top-rated life insurance companies in the nation to find the best specialized IUL policy for each premium financing scenario.
To find out if you qualify for premium financing for life insurance, and what type of IUL policy is best for you, give us a call today at 858-703-6178.