What is Premium Financing?
Simply put, premium financing is a strategy for paying for life insurance. It allows high net-worth individuals who need a large amount of life insurance to use an alternative method for paying premiums – rather than using your current cash flow or liquidating assets to pay premiums, you obtain the funds needed by borrowing from a third party lender.
Potential Benefits of Financing
If you have the means to purchase the insurance, why would you want to finance the premiums?
• Your current cash flow may already be committed to other expenses.
• Financing reduces your liquidity needs, which is especially helpful if your assets are not readily convertible to cash.
• You may not want to move assets that are working for you in the market to another use, especially if the return on assets in your current portfolio exceeds the cost of borrowing.
• Financing can provide gift-tax leverage, as loans made to your Irrevocable Life Insurance Trust (ILIT) to pay premiums are not subject to gift tax.
How it Works
Your attorney drafts an Irrevocable Life Insurance Trust (ILIT) and the ILIT purchases a policy on your life. Because you don’t own the policy, the proceeds will not be included in your estate for estate tax purposes. A third party lender loans funds to the trust each year to pay the annual premiums on the policy. You may choose to finance a portion of the premium, all of the premium, or the premiums plus accrued interest and other costs. Ideally, the loan will be fully repaid during your lifetime, at which time, your ILIT will own the policy outright. If not, any unpaid loan or loan interest is paid back to the lender from the policy proceeds at your death. Any remaining death benefit is paid to your ILIT for the benefit of your beneficiaries.
Premium finance loans are 100% collateralized at all times. The policy’s cash surrender value typically serves as the primary source of collateral. However, additional collateral will most likely need to be pledged –especially in the early years of the contract, when the amount of the loan and accumulated interest exceed the cash surrender value.
Acceptable forms of additional collateral can include:
• Marketable securities
• Cash surrender value of other life insurance policies
• Letter of credit (from a bank with AA- or better rating)
Assets that cannot be easily converted to cash, such as real estate, artwork or collectibles, may not be viewed as acceptable forms of collateral. However, these assets may be considered by the bank when obtaining a letter of credit.
As there are various risks associated with premium financing, careful consideration should be made to determine if this concept is suitable for you.
Interest Rate Risk – The interest rate charged on the premium finance loan is usually tied to the one year London Interbank Offering Rate (LIBOR). Increases in this rate can increase your loan rate.
Crediting Rate Risk – The amounts credited to the life insurance policy cash value each year may be less than projected.
Collateral Call Risk – In the event of a loan default, any supplemental collateral you pledge to secure the loan (in addition to the policy’s cash value) may be called and possibly lost. Potential consequences should be discussed and determined to be within your risk tolerance before proceeding with any financing strategy.
Income, Gift and Estate Tax Considerations
• Interest on a loan to acquire a life insurance policy is generally considered personal interest and is not deductible for income tax purposes.
• Since loans to a trust for premium payments are not taxable gifts, gift taxes can be minimized.
• Providing a personal guarantee or collateral on a loan doesn’t cause incidents of ownership in the policy.
• Life insurance proceeds are included in the insured’s estate only if the insured owns the policy or has any incidents of ownership. Since the financed policy is owned by an ILIT, the proceeds will not be included in your estate.
Creation of the premium finance arrangement is completed by an independent third party specialist. Premium financing relies on internal policy funding to pay back the loan. This is not guaranteed and results may be more or less favorable than illustrated. The ability to internally fund a life insurance contract will be dependent upon the performance of the contract and is not guaranteed. If remaining policy values and scheduled premiums are insufficient, additional out-of-pocket payments may be needed to keep the policy in force or to repay the loan. Kai-zen is responsible for the premium financing arrangement. The life insurance companies with which they work are bound only by the terms of the life insurance policies that they issue.
Associates of Vital Financial Group do not offer tax or legal advice. For advice concerning your own situation, please consult with your appropriate professional advisor.