As financial planners know, an important part of any high-net-worth client’s financial picture is the effective use of life insurance. And while these affluent clients can certainly afford their life insurance premiums, there’s a growing trend in the industry to use financing to pay those premiums.
Whether used to offset estate taxes or to allow for a tax-free exchange, premium financing of life insurance offers a range of advantages. The attraction for clients is the ability to borrow at today’s short-term rates while keeping their money working in their investment portfolio. Of course, for you, premium financing also provides a benefit–rather than liquidating assets to pay premiums, advisors can keep more of clients’ assets under management.
Premium Financing Basics
First, let’s look at the basics of a life insurance premium financing strategy. We’ll use Ima Blueblood as an example. Ima is in her 70s, has three children, five grandchildren, and an estate worth approximately $10 million. The assets are split equally between real estate and her stock portfolio. Like most high-net-worth clients, Ima wants to pass as much wealth as possible to her family at her death.
As part of her estate planning strategy, Ima needs $5 million in trust-owned life insurance. But she doesn’t want to liquidate her investments to pay the annual $150,000 life insurance premium (plus any applicable capital gains taxes). Instead, Ima’s irrevocable trust borrows the money from a third-party lender unrelated to the life insurance carrier issuing the trust-owned policy.
Ima only pays annual interest on the loan, allowing her other assets to remain invested. As a trust grantor, Ima personally guarantees the loan. As with most loan arrangements, collateral is required to the extent the loan exceeds the policy cash values. As the cash values build in Ima’s life insurance policy, they can ultimately be used as the sole source of the loan collateral. Even though some of Ima’s investment portfolio is used as collateral, in most financing arrangements, trades can continue to be made and investment allocation changes made as needed.
It’s important to note, however, that not all third-party lenders are alike. While most lenders are not interested in managing a client’s assets, others may want to manage your client’s investment portfolio if the client pledges it as collateral. This, of course, negates the benefits to you of keeping the client’s investment portfolio intact and under your management.
With an appropriate financing arrangement, Ima’s loan can be repaid at any time without penalty, or it could be repaid at her death.
As our example illustrates, the premium financing strategy can be a valuable tool for financial planners. Instead of the old insurance adage, “buy term and invest the difference,” planners and clients can now consider “borrow for life insurance and invest the difference.” This approach offers clients the key life insurance protection for their estate and business planning needs while ensuring assets are kept under your management.
Naturally, financing insurance policy premiums makes the most sense when the loan’s interest rate is lower than the rate the client would expect to earn on the assets that he or she did not need to liquidate to pay the premiums. Programs will differ in the interest arrangement but most have a variable rate using a spread on top of some short-term rate, such as the London Interbank Offered Rate (LIBOR).
Also, since the interest paid on the amounts borrowed to pay life insurance premiums is considered personal interest, clients generally cannot deduct this interest on their individual tax returns.