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Premium Financing: It's The Retained Capital, Stupid!

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In the estate planning and wealth transfer markets, much attention has been given to life insurance premium financing. Some commentators have highlighted the strategy?s perceived risks and pitfalls. Others have focused on financed life insurance as a stand-alone transaction.

I believe these discussions ignore the most important attribute of the transaction: the cash flow savings component, or what we call retained capital.

Much of the misunderstanding can be attributed to gimmicky marketing that portrays premium financing as a “cheaper” way to buy life insurance. That naturally leads to improper evaluation of the strategy where the economics can seemingly break down when applying adverse variables, such as rising loan rates.

Simply stated, when clients finance a life insurance policy, the capital they would have allocated to the premium will instead be retained in their own capital base. This retained capital should continue to accumulate and compound, providing an additional but separate capital base.

If the life insurance policy is designed with an increasing death benefit to offset the premiums loaned, the economic results can be significant compared to traditional insurance funding – even when the performance of other strategic variables is less than expected.

Before we illustrate, let’s review the mechanics of financing a life insurance policy. The true cost of a policy is not the premiums paid but the amounts the insurance company deducts periodically to cover policy costs.

Insurance premiums for permanent policies typically represent significant overpayments in the early years to accumulate a cushion within the policy to help offset the much higher costs that will be deducted later as the insured approaches or exceeds life expectancy.

Paradoxically, the initially overfunded premiums, while necessary for long-term viability of the policy, can be inefficient for the client, considering the opportunity costs and the fact that the client’s beneficiaries don’t get any remaining cushion back when the client dies.

Financing the insurance premium, then retaining and investing the capital the client would have otherwise paid out of pocket, uses the same capital more efficient.

Consequently, the appropriate premium financing scenario exists when the client has already made the insurance decision. Financing is simply a more efficient alternative for employing the capital they will commit to the insurance decision.

To illustrate, consider a typical 70-year-old female widow who has 14 Crummy beneficiaries and who needs $5 million of insurance coverage in an irrevocable life insurance trust (ILIT) to help pay estate taxes. The following 6 examples the first using traditional funding, and the subsequent 5 using premium financing (summarized in the table)?will explore the differences between the two approaches.

Assuming the policy requires annual premiums of $150,000, the client could, in our first example, fund the premiums out of pocket by making annual exclusion gifts to the trust. The trust would then transfer the gifted amounts to the insurance company to pay the premiums, and the proceeds would provide the liquidity to pay estate taxes.

If, however, the trustee chooses to finance the same $5 million policy with the $150,000 premium, the trust will instead borrow the annual premium from a lender at an assumed 4% annual loan interest rate (scenario 1 in table). In the first year, the client transfers in the same $150,000 in annual gifts; however, the trustee only pays $6,000 in interest due to the lender, leaving $144,000 to retain and invest.

Let’s also assume that the trust investment advisors can deliver a 4% net of tax annual return on the retained capital (the same as the loan rate).

If the client died in the first year, the first $150,000 of the policy’s $5 million death benefit would go to the lender, leaving $4,850,000 of the policy’s proceeds for the trust. Also, the $144,000 saved by financing the premium would have grown back to roughly $150,000; when combined with the insurance net death benefit, the savings would yield roughly $5 million in capital for the trust.

Premium financing in this case offers no economic benefit over traditional insurance funding, no matter when the client dies. The retained capital saved by financing must therefore (absent a change in the strategy design) be invested at a net return greater than the loan rate (a.k.a., arbitrage) to realize an economic benefit.

Assuming the retained capital generates a 6% net return versus the 4% loan rate (hence, an arbitrage opportunity of 2%), and assuming the client died in year one, the $144,000 retained by the trust after paying loan interest would grow to $153,000. This, combined with the $4,850,000 net insurance benefit after loan payoff, provides an additional net benefit to the trust beneficiaries over the $5 million level benefit provided via traditional funding.

If we project the numbers to the client’s life expectancy in year 16, the retained capital would grow to $3 million. Now the financed transaction would provide approximately $5.5 million to the trust versus the $5 million provided in the nonfinanced and no arbitrage examples (scenario 2 in table).

So we have now dispelled the smoke and mirrors reputation of premium financing by demonstrating that unless the opportunity for arbitrage exists, there is no economic benefit, agreed? Wrong! The single greatest misconception is that the client must have an arbitrage opportunity for the financed transaction to provide a benefit over traditional funding.

The power of premium financing is based on the leveraging effect created by combining the financing piece with a properly designed life insurance policy. Let’s take another look.

In the last two examples, the net death benefit of the $5 million policy was reduced each year as the cumulative loan grew with each premium borrowed. However the retained capital saved each year offset the net decrease so long as it earned a net rate of return equal to (scenario 1) or greater than (scenario 2) the loan rate.

Now let’s redesign our insurance policy to provide additional leverage using a more efficient means to pay off the financed loan. To accomplish this, we add a rider that automatically increases the policy death benefit by the amount of premium deposited into the policy (scenario 3).

The policy thereby has enough additional death benefit to pay off the loan while maintaining a level net death benefit to the trust of $5 million in our example. The Return of Premium rider in our example increases the premium by $100,000 to roughly $250,000.

Bear in mind, however, that the trust borrows the increased amount via premium financing. This is where the leveraging efficiency can become significant.

Let’s review the transaction in the first year where the client again makes the same gift of $150,000 to the trust. However, the trust borrows the higher $250,000 premium in exchange for the increasing Return of Premium death benefit option and now owes $10,000 in interest.

This leaves $140,000 left to invest as retained capital, for which we will again assume a 4% investment rate (i.e. no arbitrage advantage). If the client dies in the first year, the policy death benefit would automatically increase to $5,250,000. The first $250,000 is paid to the lender and the remaining $5 million is paid to the trust.

Factor in the retained capital which would have grown back to just under $150,000 and the trust would have $5,150,000 in combined benefit. And as with any time value of money concept, the cumulative effect over time is significant.

At our benchmark 16th year, and assuming there was no arbitrage opportunity with the trust assets growing at 4%, the retained capital component would still grow to a staggering $1.7 million. That’s $6.7 million of capital in the trust and a 30% improvement over traditional insurance funding using the same capital base gifted to the trust by the client!

Lastly, it is plausible that the variables used in our example may not turn out as favorable as illustrated. However, with a 30% improvement as a starting point, there should be some room for cushion.

So let’s now assume the loan rate experiences a 50% increase to 6% by year 5 (scenario 4). Furthermore, let’s assume that the client’s net return on the cash flow savings in the retained capital account remains at 4%.

In year 16, the retained capital account, while adversely impacted by the higher loan rate and stagnant growth rate, would still be worth nearly $1 million and the strategy would still deliver nearly $6 million in capital for an improvement of over 20% versus traditional funding.

What happens if the loan rate again increases to 6% by year 5, but the client earns 0% on the retained capital? Interestingly, the strategy would still deliver nearly $500,000 in additional capital in year 16 (scenario 5).

Does this $500k figure ring any bells? The strategy provides roughly the same benefit delivered in Scenario 2, where we had the benefit of a level loan rate and 2% arbitrage effect in all years!

In summary, the power of premium lies within the same simple concepts related to the leveraging of permanent life insurance for estate liquidity and wealth transfer planning. The key is to evaluate premium financing not as a stand-alone transaction, but as an alternative to the traditional funding of life insurance using the same capital base.

For as we have demonstrated, the economic benefit of combining an effectively designed insurance strategy with the leverage gained via premium financing can be significant even when variables turn out to be less than their most favorable.

, CPA, CFP, is a Denver, Colo.-based estate and business planning advisor for Capital Management Strategies Inc. He can be reached at [email protected].

Reproduced from National Underwriter Edition, October 28, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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