Today’s economic uncertainty challenges producers in all areas of the life insurance business. Low prevailing interest rates can make life policies with fixed-interest features a tough sell, while a slumping stock market can make variable products unattractive to tentative clients. Underneath these factors are the continuing subprime mortgage crisis, spiraling energy prices and other financial pressures that can put life insurance purchases lower on the priority lists of most consumers.
Of course, “most consumers” do not encompass high-net-worth clients whose significant financial means and sophisticated requirements transcend today’s economic turbulence. These clients always require life insurance policies, both for the unique ability to provide near-term death benefit coverage and longer-term, tax-preferred cash value accumulation.
These individuals also focus on their estate plans to ensure that the effects of any federal estate tax law developments in 2009 and beyond do not adversely affect their legacies. A wait-and-see approach cannot suffice when issues as important as wealth transfer to loved ones, dispositions of businesses, and endowments of favorite charities are at stake.
For clients with a net worth exceeding $5 million, the demand for solid estate planning steps today may run head-on into liquidity and investment considerations. These considerations may make it less advantageous to lay out the large premium payments that accompany life policies with multi-million dollar face amounts.
Potential solution: premium financing
For such clients, producers may wish to discuss a premium financing arrangement. Premium financing lets clients buy life insurance without immediately liquidating other investments or otherwise changing their normal cash flow. When properly structured, it may also help them transfer assets to family members and charities with potentially reduced gift and estate-tax costs.
In a nutshell, premium financing allows the client to borrow money to pay life insurance premiums. Depending on interest rates, policy crediting rates and charges, and mortality and other factors, premium financing arrangements may even be less expensive than paying life insurance premiums outright. Even if that’s not the case, premium financing may be attractive to clients with non-liquid assets and those who wish to fund an irrevocable life insurance trust without paying gift taxes.
Typically, premium financing is used as part of an estate plan. To keep the death benefits outside of the insured’s taxable estate, the client may use an irrevocable life insurance trust to purchase and own the life insurance policy. Premium financing is an arrangement between a bank and the client’s ILIT where the trust is the borrower.
In a typical arrangement, an ILIT borrows money from a lender and uses the funds to buy a policy insuring the life of the client (and spouse, if applicable). To the extent the policy does not have sufficient cash surrender value to collateralize the loan, the client is also asked to pledge a standby letter of credit or other assets acceptable to the lender to make up the collateral shortfall. (The extent to which such guarantees may in themselves trigger gift tax issues is beyond the scope of this article.)
The ILIT will either make annual interest payments on the loan or the interest will be accrued and added to the principal of the loan. When the insured dies, part of the death benefit will pay off the loan and the rest will go to the ILIT to benefit the client’s heirs.
The underlying trade-off involves the rate of interest the bank lender charges. The interest rates charged on a premium financing loan vary by lender, loan amount, and loan terms, such as if interest will be paid in advance or arrears, but the rates are often stated as a margin rate over the London Interbank Offered Rate (LIBOR). Typically, the larger the loan and non-accrued interest, the lower the margin.
Indeed, these clients should be comfortable with the risks often associated with premium financing: interest rate risk and collateral risk. In both cases–either a rise in interest rates charged on the loan and/or a drop in the value of collateral (including the policy) that support the loan–the client could be forced to pay more interest and/or post additional collateral or risk loan default. In the event of default, the lender could foreclose on the collateral, including the policy.
Three attractive prospects
Beyond tax implication and interest-rate arbitrage, there are reasons why high net worth individuals may prefer premium financing to paying premiums with cash in hand or by liquidating assets. In the current economy, 3 types of clients may experience the greatest benefit.
1. The professional
Any practicing doctor, dentist or lawyer will tell you that many clients today do not settle their bills promptly. Especially with regard to medical care, people will use credit or insurance, in which case payment for services rendered today may not come for months. As a result, many professionals have accounts-receivable balances that are the single largest asset of the business–yet this asset earns no interest and is non-performing.
Producers with access to such clients may be able to offer an attractive premium financing approach: use those accounts receivable as collateral for the bank loan. By doing so, these professionals gain protection immediately, while making regular payments over time, a pattern that aligns with their typical revenue stream. Since the accounts receivable are viewed as an “asset,” the bank can offer a more attractive interest rate on the loan as well.
2. The real estate owner
When foreclosures and insolvent lenders hit the headlines, clients with significant real estate holdings–apartment buildings, malls, second homes, etc.–often must look for creative solutions to their life insurance needs. These owners are particularly disinclined to liquidate when property values are depressed, even if they might have pressing life insurance needs. Yet, despite short-term devaluation, many of their properties still have tremendous value in a premium-financing scenario.
Producers can help these clients to leverage their real estate valuations appropriately to achieve attractive interest rates with the financing bank. By using equity in one or more of their properties as collateral, the client also protects against potential creditors in the event of death. This is because the bank’s lien on the real estate’s value will take priority, putting other creditors behind them in line and making settlements with these creditors more easily attained.
3. The investor/business owner
Regardless of their situation, clients want their return on current investments or other assets to outplace the interest paid on a premium-financing loan. Many successful investors pride themselves on achieving double-digit gains in spite of daunting odds, so their ability to purchase life insurance using borrowed dollars may enable them to continue to earn those returns on capital they would have otherwise spent for premiums. These clients see significant value in using leverage to achieve wealth transfer goals and obtain a higher return on their capital.
Still, when working with clients like these, producers must be prepared to make the case for premium financing in clear, direct terms. Investors may be reticent to withdraw assets from the market to fund even something as necessary as life insurance. So it is important that the producer show concrete scenarios, charts and graphs detailing how the process works and what the potential financial outcomes might be.
Bringing it all together
When you present premium-financing concepts to a client, be sure to demonstrate variations in interest rates. Rates will fluctuate over time and affect the premium financing concept’s ability to perform as illustrated, so it is important to manage your client’s expectations. Of particular importance, you must illustrate the client’s exit strategy–their ability to close out the financing–to ease concerns. Look to your life insurance carrier for the tools to create effective illustrations that help your client grasp this complex topic.
As we have noted, collateral is critical in premium financing, and meeting the lender’s collateral requirements can be challenging. There are many variations on collateral approaches, but essentially the client can adopt a traditional arrangement in which the loan is fully collateralized, or opt for a hybrid arrangement, in which the lender generally accepts less collateral but often demands a higher interest rate.
You can provide your client with any suitable general account life insurance product in a premium-financing concept. This includes both single-life and second-to-die policies. You should look for the most flexible life insurance products available so you can help your client adapt the policy–from payment schedules to investment options–over time.
With $5 million or more in net worth, clients who are eligible for premium financing are likely to have a financial planner, lawyer and accountant as trusted advisors. Producers should include these players in the planning and financing design discussions when possible to assure that they, too, understand the value of this financing concept and can integrate it into the client’s financial strategies. If you include them early, these advisors can become great allies and even sources of future business.
Your ability to guide clients through the intricacies of premium financing will strengthen your relationship with them and open avenues for future opportunities. More important, your attention to these clients–in particular to the professionals, real estate owners and investor/business owners–will help them overcome short-term challenges in order to potentially protect their net worth and pass their financial legacy on to future generations.