One of the most cost-effective ways for high net worth individuals to protect their assets and create estate liquidity is to take advantage of premium financing for life insurance.
The problem is that high net worth individuals require large life insurance policies. These can become extraordinarily costly. While paying the premiums may not be an issue, you may need to liquidate assets to cover the premiums.
Premium financing for life insurance avoids incurring capital gains tax and liquidating investments to cover these life insurance premiums.
Why High Net Worth Individuals Buy Life Insurance to Protect Their Estates
A 2015 CNBC millionaire survey found that 38% of people with investable assets of $1 million or more have not used a financial expert to establish even the most basic estate plan.
A life insurance policy is a hedge against future risk. Its primary purpose (for high net worth people) is to maintain liquidity and security for your estate.
Specifically, high net worth people use it for at least one of the following reasons:
- Protect their business(es)
- Wealth transfer/inheritance issues
- Mitigating state and federal taxes
The proceeds of a life insurance policy provide immediate tax-free liquidity to your beneficiaries. Your beneficiaries can use the cash proceeds from a policy to cover any estate issues or expenses. They won’t have to wait for other assets from the state to become available, preserving the estate’s assets.
Life insurance is a financial tool for high net worth families. It’s not the same type of expense as a middle or working class family would consider it.
Typically, the IRS factors life insurance proceeds into the sum of your estate. This can present a problem with federal and estate taxes. If your estate exceeds $11.2 million for an individual or $22.4 million for a couple, these taxes apply to your estate.
Premium financing of life insurance is a simple financial strategy to separate your life insurance benefits from the total of your estate.
What is Premium Financing?
Premium financing is an exclusive life insurance option for people with a net worth exceeding $5 million. The are few exceptions to any individual or couple with a net worth under that benchmark.
Premium financing for life insurance sets up an irrevocable life insurance trust that removes the life insurance proceeds from the value of your estate. The trust takes out a loan through a 3rd party lender that works with the life insurance company to pay for those premiums.
The life insurance company gets paid from the loan to the trust. The bank gets paid through gifts to the trust, then entirely repaid with a portion of the death benefits. Your beneficiaries get immediate, tax-free cash upon your death.
It is not quite that simple in practice. Working with an estate lawyer to set up the trust, a life insurance agent for the insurance and loan portion, and a trusted financial planner are all key to setting this up correctly.
How Does Premium Financing Work?
Certain life insurance companies created specific products exclusively for premium financing of life insurance policies. These plans are designed to minimize third-party collateral and maximize returns.
The purpose of the premium financing loan is so that you do not need to liquidate any assets to pay the life insurance premiums.
If you were to pay for the premiums, you run the risk of paying capital gains tax or lowering your ROI on your remaining investments. This runs the risk of diminishing your overall net worth.
Keep in mind that individual life insurance premiums are not tax deductible. The IRS considers life insurance premiums to be a personal expense.
Simply put, you use the premium financing loan to pay for life insurance premiums. Like any loan, you pay interest on the loan (and some of the principal if you structure it that way).
When you pass away, the benefits from your life insurance policy first repay any remaining balance on the loan. Some people choose to pay only the interest on the loan and have the death benefit pay off the rest. Other people prefer to pay down both the interest and principal. This is why an estate planner and financial advisor can be of use when setting up the premium financing.
Preliminary Steps Using Premium Financing for Life Insurance
The most important thing to keep in mind is that financial consultation can provide enormous help if you are not yourself a financial professional.
Your financial advisors and life insurance agents collaborate to set up and employ premium financing to your advantage.
Life insurance premiums for high net worth individuals can cost as much as several hundred thousand dollars annually. The cost depends on:
- Amount of coverage
- Type of policy
Because estates and investment can vary between high net worth individuals, each estate needs its own custom-made strategy.
The first steps should be consulting with a financial advisor to see if this makes sense for you. Next, determine the amount of coverage you will need. After you finish those, consult an insurance agency with premium financing specialists.
Best Life Insurance Policy for Premium Financing
There are a variety of life insurance policies available for premium financing. Typically, avoiding term life insurance entirely is wise due to its inherent limitations.
Permanent policies are a better choice because the point is to ensure tax-free benefits to your heirs. However, not all permanent policies are equal. Whole life policies tend to restrict what you can do with them. Variable life insurance tends to come with higher risk.
A universal life insurance policy is better, but an indexed universal life insurance policy is the best choice for premium financing.
An indexed universal life (IUL) policy contains both a death benefit and a cash value accumulation portion. The main reason to choose an IUL policy is because it allows you greater control. The cash value accumulation portion permits you to allocate the funds to a fixed account or an equity index such as the S&P 500 or the Nasdaq 100.
Your ROI is likely to be significantly better than other permanent policies.
You can learn more about the pros and cons of using different life insurance policies by reading our in-depth article Best Life Insurance Policy to Use for Premium Financing.
The Process for Premium Financing with Life Insurance
The first (and most important step) to take is finding an experienced Premium Financing Expert like we have here at Abrams Insurance Solutions. Our team can walk you through the process to make sure it is setup correctly and in the most efficient way possible to accomplish your goals.
Next step is to set up an irrevocable life insurance trust. Most of the time, this will be an estate lawyer. This trust will both own and manage your life insurance policy.
For more details on why this is crucial for setting up premium financing for life insurance, read Using an Irrevocable Life Insurance Trust for Premium Financing.
This step is vital because when you pass away, the life insurance proceeds will be payable to the trust - not the estate. The trust can use the proceeds to pay off any amount on the outstanding premium financing loan. The balance of the remaining proceeds can then be distributed to your heirs, tax-free. The proceeds are separate and thus not part of the estate.
Aside from separating life insurance benefits from your estate value in the eyes of the IRS, there are extra tax and gift advantages to this approach. More info in Estate and Gift Tax Benefits of Premium Financing.
The next steps are as follows:
- Develop a preliminary life insurance and financing strategy with your life insurance agent, financial planners, and financial management group.
- Choose the best custom premium financing plan for your needs.
- Initiate life insurance carrier underwriting.
- Initiate formal bank loan application.
Another trick to minimize premiums long-term is to add a return of premium rider on your policy. It can add to the initial cost, but the life insurance company will return all premiums paid. This is an easy way to pay off the bank loan.
Also, if you are married, considering a second to die policy can save money.
Finding a Premium Financing Company
The loan process for premium financing is different from more traditional loans. It not just a simple matter of contacting the baking institution you use already. Our premium financing team already has relationships in place with banks who will approve loans for this strategy.
Premium financing loans require tailoring to the specific needs of each client. Loan commitments will vary on a case by case basis so that both you and the bank can reach a beneficial arrangement.
Structuring your loan properly allows you to:
- Align your long-term need for permanent life insurance
- Determine a sustainable long-term financing strategy
Ideally, the best scenario is obtaining a premium financing arrangement using a long-term loan that involves a variable or fixed interest rate. This interest rate should be tried to the London Interbank Offered Rate (LIBOR) or some other index.
The best tactic for financing an IUL policy is to fund it over the first seven to ten years at the maximum level. Doing this allows the policy to grow a cash value quickly and on a tax-deferred basis. This financing plan management strategy permits the life insurance policy to be fully collateralized.
You also need to be careful in how you fund the policy in the first ten years. If you fund it too fast, you can impact the endowment contract status.
The overall strategy should be structured to build up enough cash accumulation which you can then borrow against to pay off the loan. Because the money is technically the life insurance proceeds, it is not taxable.
It’s also vital to keep in mind that you must not borrow more against the policy than you have paid in premiums. Any amount you borrow that is greater than the total premiums paid will become taxable.
Finally, have an exit strategy in place. Most experts suggest a 10-15 year exit strategy. Review it annually so you or your financial advisor can make appropriate adjustments.
Premium Financing Repayment Options are Flexible
What many people appreciate about premium financing is that the lending plans are incredibly flexible. You can tailor both how you make interest payments and pay down the principal.
Some loans allow interest to accrue. This can present a problem, depending on the economic environment at the time. The risk is that the amount borrowed will increase faster than the cash value of the policy. This makes it difficult to borrow against the policy to pay the lender.
Most premium financing experts currently recommend paying down the interest with annual contributions to the irrevocable life insurance trust.
There are various repayment options you can employ. The most common are:
- Pay down the loan as liquid funds become available
- Use the trust to pay the outstanding balance from the tax-free proceeds of the cash value portion of the policy.
- A combination of the above
You can also take advantage of a variety of leverage funding models which use bank loans to fund the life insurance premiums utilizing some form of interest deductibility.
Finally, you should consider structuring your loan so that it allows you to repay the loan at any time without repayment penalties. It’s also smart to use a lender which does not have origination fees or commissions on the loan. Because there is competition between lenders to provide premium financing loans, finding a loan meeting both of those criteria is reasonably easy.
Collateral Requirements for Premium Financing
Typically, every lender requires that every borrower be able to secure the premium financing loan with collateral. The life insurance policy secures the loan, but lenders still need collateral protection.
Generally, they accept collateral liquidity such as:
- Cash or cash equivalent
- Letters of Credit
- Other existing life insurance policies
- Marketable securities (50% discount for stocks)
Most lenders will also consider other cash values to use as a source of collateral.
In ideal circumstances, the cash value of the policy will provide all (or a substantial portion) of the necessary collateral for the loan.
The Risks of Premium Financing
All investments incur risk. This is also true of premium financing with life insurance. Understanding the potential risks of premium financing can help you create a more suitable financing plan to mitigate these risks.
The most significant risks of premium financing are the following three.
Although rates are low at present, they could rise. This impacts any loan which utilizes a variable interest rate. Loans are also renewable. Higher interest rates may change the structure requirements of the loan. This runs the risk that the cash value of the policy may not increase as quickly as the rise in interest rates.
Loans are often renewable. This means you will need to re-qualify each time. The lender will review the collateral you are using to secure the loan. This can lead to the need to supply additional collateral.
Policy Earning Risk
Should the cash value portion of the policy underperform, then the lender may ask you to increase the collateral necessary to secure the loan. One approach to mitigating this risk is to add a death benefit rider (different than the life insurance death benefit) when you initially apply for a policy.
Another approach to reducing these risks is to use a lender who caps the interest rates. You could also obtain a loan which has a fixed interest rate. This is another conversation to have with your financial planner when looking into premium financing for life insurance.
For more information on mitigating the risks of premium financing, click the link to our article on How to Avoid the Risks of Premium Financing.
How Our Premium Financing Specialists Can Help
At Abrams Insurance solutions we have premium financing experts standing by to help answer any questions you have about the process. We are an independent life insurance brokerage with access to over 70 of the top rated life insurance companies in the country, including top-rated companies offering premium financing appropriate policies.
Because we specialize in meeting the needs of high net worth individuals, we provide not only individual life insurance policies, but also a variety of business life insurance services such as buy/sell agreements and key man life insurance. We already have relationships with the banks who are best for premium financing cases.
Additionally, because not everyone has the good fortune of perfect health, we focus on helping people with pre-existing medical conditions find life insurance at the lowest prices possible.
Give us a call anytime at 858-703-6178. We are here to answer your questions, and there is never any obligation to buy.