Success Or Not, Its All In The Design
Premium financing is a technique that has been used with life insurance for decades. In one form or another, and under various names, financing purports to allow a client to purchase life insurance with little or no out-of-pocket expense. However, in recent years premium financing has truly come into its own as major financial institutions set up units specifically staffed to handle it.
However, whether or not premium financing makes sense for a given situation can be difficult to assess. The decision may turn on many assumptions. In other cases, even where the financial calculations might point in a different direction, a clients specific needs may tip the planning in favor of premium financing.
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This article will look at why premium financing might be attractive and where it makes sense. It will look at different life illustrations and financing designs for a specific case to see how different assumptions might steer a client one direction or another.
Why Premium Financing?
Financing is attractive because, in many cases, it may be a lower-cost option than large gifts into a trust for very high-premium cases. With the future of estate and gift taxes still uncertain, many advisors are reluctant to see their clients enter into large gifting arrangements, particularly if it may trigger potential gift taxes at some point.
Financing can be done in a variety of ways, although a full discussion is outside the scope of this article. The financing can be done privately or through commercial lenders. Both methods are similar, but each carries certain rules relative to interest rates and tax treatment. Private arrangements can be an attractive way to avoid gifting and retain the ability to recover funds that were advanced for the premium payments. These arrangements are well regulated by the Internal Revenue Code through recent changes to split dollar and the below-market interest rate regulations. Commercial lending for life insurance has been around for decades but, recently, has come into its own as a number of commercial lenders have pursued it aggressively.
If you have clients who intend to use a commercial lending arrangement, they can work with their local bank or a life insurance carrier. Most carriers have aligned themselves with one or more premium financing organizations and can direct you to the design most appropriate for your clients. Premium financing arrangements vary widely. The exact arrangement may steer the policy to one or the other lending arrangement, or influence the design of the life insurance policy.
Focus on the Design
The best way to see how premium financing could affect a clients planning might be through the following examples. We look at a hypothetical 59-year-old clienta male, preferred nonsmokerwith an $8 million life insurance need. Why such a large case when most client situations involve much lower amounts? This is because the typical premium financing case involves larger premiums (and a larger death benefit) than traditional gifting techniques might allow.
Before comparing different premium financing designs, a non-financing design should be examined. Chart One details the death benefit that can be purchased under a non-financed arrangement with an annual premium of $121,600. With that premium, the death benefit remains intact in all years, and by year 30, the internal rate of return (IRR) is 4.68%. (For a more thorough discussion of IRR, see the section on Issues to Weigh.)
Against this baseline design, we can compare four premium financing designs. Keep in mind, these are not the only designs that might be appropriate. One of the strengths of life insurance is its flexibility of design. Four approaches are presented here, but any number of others might work better or differently for a client.
The charts that accompany this article show the highlights of some possible premium financing designs. The first two designs, detailed in Chart Two, show no termination of the loan. One design shows a 10-year financing arrangement with annual loans of $332,000 in each year. Assuming an annual loan rate of 5%, the interest payments start at a low $16,000 and increase each year. By the end of year 10, a total of $3,320,000 has been financed and the annual loan interest is $166,000. By year 30 the IRR is 4.43%. The second design shows a 5-year approach. It calls for higher annual premiums and loans during the premium paying years ($569,000), but by overfunding the policy in the early years, less needs to be paid into the policy in later years, so the overall loan is lower. By year 10, the total loan is $2,845,000 and the annual interest payment is a lower $142,000. The IRR in year 30 under this second arrangement is slightly better at 4.46% but still below that of the non-financed arrangement.
Both of these designs assume that there will be no termination of the loan. Assuming the interest has been paid in each year, the heirs will receive $8 million. The trade-off is that the interest payments required in each year bring down the overall return (the IRR) offered by the non-financed “baseline” illustration. Some financing arrangements allow for the interest to be accrued each year, so there is no out-of-pocket cost. Although this will drive up the cost of the premium, that additional cost also could be financed.
In many cases, it may be desirable to pay off the loan prior to death. However, some carriers offer what is known as a return of premium rider. This rider allows a loan to remain in place indefinitely, yet the death benefit paid includes both the desired amount plus additional benefits due to this rider, which should be sufficient to repay the loans and any unpaid and accrued interest.