For our clients with an established need for life insurance, premium financing is an option that allows an individual or business to minimize out-of-pocket costs while preserving capital for more profitable investments. With interest rates at an all-time low, premium financing for life insurance has become a popular strategy for growth potential and specific tax and estate planning benefits. But what is it exactly and for whom is it best suited? Put simply, premium financing for life insurance is a strategy whereby a prospective policyowner obtains third-party financing to pay for life insurance premiums.
For whom is it designed?
- High-net-worth individuals, corporations or trusts that; have illiquid assets, have assets that are generating a higher return, want to reduce their gift tax exposure or expect to have a future liquidity event.
What are the advantages of a well-designed premium financed plan?
- It can provide a way to build, protect and transfer wealth in a cost-effective way.
It allows policyowners to acquire considerably more life insurance with minimal cash flow outlay.
- It can provide the policyowner more flexibility with their cash flow and the opportunity to direct capital to higher-yielding assets such as real estate or a business.
How does it work?
- An individual (or business) applies for a substantial amount of life insurance and submits a premium-financing application to a third-party lender such as a bank.
- The lender establishes the terms of the note including the interest rate, and payment schedule.
- The life insurance policy cash value and the policyowner’s external funds are used as collateral for the loan.
- The third-party lender pays the premium on the policy and the policyowner borrower makes principal and interest payments on the premium finance loan.
- Upon the insured’s death, proceeds are paid to the beneficiary or the lender if the loan has not been repaid.
It is common for the life insurance policy to be held in an Irrevocable Life Insurance Trust (ILIT) If that is the case:
- The lender may pay the insurance premiums to the ILIT.
- The ILIT would then pay the premiums to the insurance company.
- The policyowner can make a gift of the loan interest to the ILIT.
- The ILIT pays the loan interest and principal (at death or earlier).
- The ILIT receives the death proceeds, which is then paid to the beneficiaries, according to the terms of the trust, after the balance of the loan has been paid to the lender.
While premium financing can be a valuable strategy for certain individuals, there are risks that should be taken into consideration including:
- The loan interest rate may fluctuate over the term of the loan and the interest paid is not deductible for income tax purposes.
- The lender may require the borrower to post additional collateral, other than the cash surrender value of the policy.
- A premium finance loan will usually come due every 3-5 years – if the policy does not perform as well as originally illustrated, a lender can choose not to refinance if the borrower’s collateral diminishes, or credit score is lowered.
It is important to discuss with your financial advisor how to protect yourself against the risk of poor policy performance.
The world of premium financing is more accessible, however understanding all the pros and cons and having a clear exit strategy for premium financed life insurance are paramount. Including your accountant and attorney in the planning phase is a key step in the process. To explore whether a premium financed plan is right for you, call the Knox Grove team at 609-216-7440.