Because of its tax-favored treatment, permanent life insurance has long been touted as an ideal vehicle with which to retire estate tax liabilities. But purchasing a large enough policy to cover those liabilities can come at a steep cost: Upwards of hundreds of thousands of dollars in annual premiums to fund a death benefit running into the millions of dollars.
For affluent individuals who don’t have sufficient liquid assets to cover those premiums–or, more typically, for clients who have the assets but are better off keeping the assets invested in a high-yield portfolio to meet long-term retirement planning objectives–paying for such expensive premiums out of pocket might seem like a less than appealing option.
Enter premium financing. A growing number of affluent clients are turning to this technique–taking out a loan from a bank or other financial institution to cover the premiums for a period of years–to meet short-term cash flow or investment objectives. But for the strategy to be employed successfully, sources tell National Underwriter, a sound exit strategy for retiring the loan is essential. Without one, the client might ultimately be forced to sell the policy to pay off the rising interest costs on the loan leaving his or her estate planning in tatters.
“Like any good financial strategy, the exit strategy must be thoroughly thought out before getting into premium financing,” said Michael Babikian, vice president of strategic marketing services at Transamerica Insurance and Investment Group, Los Angeles. “Every year that premiums are paid, the loan gets bigger. If you’re paying premiums for the next 25 years, it might be difficult to pay off the loan with just the death benefit. There are ways around this logjam, but deciding on an appropriate course of action requires a lot of upfront planning.”
It’s difficult to say how much premium financing is taking place because the evidence so far is largely anecdotal. In a June 2006 report, Windsor, Conn.-based LIMRA International attributed 15% rise in first quarter life insurance sales to several factors including “a stronger equities market, as well as premium financing and investor- and corporate-owned life insurance.” Insurers interviewed for this article also noted a surge in recent years of premium-financed sales, but did not provide supporting data.
However large in dollar terms, the market is attracting a broader spectrum of the affluent than was the case in recent years. Matt DeSantos, vice president of marketing and business development, life and annuities companies at National Life Group, Montpelier, Vt., said the premium amounts being financed have dropped “from hundreds of thousands of dollars per year to tens of thousands of dollars. He attributes the evolution to a rise in the number of lenders vying for market share–and sweetening deals to capture more business. Transamerica’s Babikian also observes a rise in the number of producers marketing the packages.
The heightened activity has seen a rise in abuses. Frequently cited are unscrupulous premium financing companies that, acting as middlemen between the insured and the lenders financing the premiums, market packages with hidden fees or high interest rates that ultimately prove too expensive for policy holders. The result: A call-in of the loan and the sale of the collateralized insurance policy on the secondary market.
Producers also share some blame. Too often, observers say, advisors promote financing as a way to ease the sale of an expensive policy to prospects who otherwise would be disinclined to pay out of pocket for costly premiums. The fact that a premium-financed contract may not be suitable in light of the client’s insurance need, cash flow or estate planning objectives is given marginal consideration, if not altogether ignored.
“Some life insurance agents like the idea of premium financing because it lets them distract the client from the real cost of the insurance,” says Peter Katt, a certified financial planner based in Kalamazoo, Mich. “The technique may smooth the way to a sale and boost the agent’s commission, but ultimately can be detrimental to the client.”
Adds DeSantos, “A common mistake of advisors is to believe that premium financing fits every case involving a large life insurance sale. But it’s just a tool–an arrow in the quiver.”
Directing that arrow to its appropriate target–fulfillment of the client’s estate planning objectives–requires a thorough fact-finding. Sources say premium financing generally is only appropriate for clients holding assets exceeding $4 million, an amount equaling the federal estate tax exemption for couples in-force between now and 2009. The ideal client, Katt asserts, also is one who has a low income relative to his or her assets. Example: An individual whose wealth consists of chiefly of illiquid real estate properties valued in the tens of millions of dollars, but that contribute little to cash flow.
Also underpinning the appeal of premium financing is the ability to keep assets–illiquid or otherwise–invested in high-yield portfolios. Though premium financing can add significant cost to a life insurance policy compared to out-of-pocket funding, clients leveraging the technique will come out ahead financially if the rate of return secured on invested assets (assets that would otherwise be tapped to pay for insurance premiums) is higher than the interest rate on the policy loan.
“For clients to draw on their personal wealth to the tune of the hundreds of thousands of dollars each year may not best way to fund a policy,” says Babikian. “A better option may be to let the money earn 15% or 20% annually, then borrow at 8% or 10% to cover the insurance premium. This is where we’re seeing appropriate use of premium financing.”
The technique is also compelling, he adds, because it affords the high net worth client gift tax leverage. A life insurance policy is typically placed inside an irrevocable life insurance trust or ILIT; this insulates the insured from estate tax at death, but still engenders a gift tax while the policy is being funded premium payments to the ILIT treated as gifts. Premium financing lets policy holders reduce their gift tax liability because only interest on the policy loan is gifted to the ILIT annually.
That takes care of Uncle Sam, but clients still need an exit strategy for retiring the loan if the policy is to fulfill its role in the client’s estate plan. Because loan interest costs grow each year, the longer the client finances premiums, the more expensive–and difficult–it becomes to maintain the policy. That is why, experts say, premium financing generally is more advantageous for retirees than it is for their affluent individuals in their 40s or 50s.
How is the younger client to surmount this challenge? One option, says Babikian, is to purchase a return of premium (ROP) rider with the policy, which can guarantee a fixed net death benefit for the client. To illustrate, Babikian invokes a hypothetical policy that requires $150,000 per year in premium payments to fund a $10 million death benefit. If the client dies 10 years after initiating the policy, the policy face amount will have grown to $11.5 million, leaving a net of $10 million after using the $1.5 million additional death benefit to retire the policy loan.
Alternatively, says Babikian, clients can establish a grantor retained annuity trust alongside an ILIT. If, as above, the policy is funded over a 10-year period, premiums paid to the GRAT can be rolled into the ILIT at the end of the term. And these assets may be used to repay the third-party lender.
Still other exit strategies are available to advisors. Getting the choice right, says Babikian, will depend not only on a close reading of the client’s assets, goals and objectives, but also a detailed understanding of the financial implications of premium financing.
“Advisors really need a holistic view of financial planning to get involved in something like this,” he says. “They don’t necessarily need an advanced credential, but they definitely should gain a knowledge of the appropriate uses of premium financing and ramifications of loan structures. They also need to leverage the resources and expertise available to them through their carriers and partnering advisors.”