Recession Casualty

To be sure, there are bright spots in the marketplace. Though banks are raising collateral requirements, they’re also lowering the cost of financing for high net worth clients who allow the institutions to manage their portfolios. Typically, says Conroy, banks will fund premiums for between 2% and 3% in interest charges. The lender compensates for foregone interest by charging a fee (such as 1%) on assets held under management

Experts say that interest in private or intra-family financing of policies also continues apace. That is, in part, because of currently low interest rates. The mid-term applicable federal rate, or AFR governing repayment of loans that come due between 3 and 9 years, is at a historically low 2.05%, observes Howell.

A second reason: The bank is not a party to the transaction. Collateral and letters of credit are not at issue in private financing cases, only the lender’s desire to secure gift tax leverage. In a typical scenario, high net worth grandparents will fund premium payments of a trust-owned policy from their own resources, the trust being responsible for repayment of the loan.

“This technique is used by wealthy folks who can well afford to pay the full premium of the policy, but they don’t want to pay gift taxes to do it,” says Howell. “It’s a very attractive way to fund a substantial amount of life insurance while incurring zero or low gift.”

Also a favored technique for reducing gift taxes are private split-dollar plans, which the IRS legitimized when it issued its finalized 409A regulations governing non-qualified deferred comp arrangements in 2008. Typical of such plans is side-fund split-dollar, which calls for (among other steps) the creation of an intentionally defective grantor trust, funded with assets (such as appreciated stock or partnership interests) in addition to a life insurance policy; implementation of a non-equity collateral assignment split-dollar plan between the grantor (insured) and the trust; and repaying the grantor for their split-dollar advances from the trust side fund.

For clients motivated as much by the opportunity to gain leverage–investing funds in assets yielding a higher rate of return than the interest they would pay on a loan–then traditional bank financing might still be attractive, collateral issues notwithstanding, because of today’s low interest rates.

“Such leverage is still possible, but realizing gains will depend on how assets are being deployed,” says Sorebo. “If clients are reinvesting in their businesses, then hopefully they can get a better return. If they’re buying up real estate at depressed prices on the expectation that home values will rise, then they might be better off deploying assets there, rather than tying up moneys to fund a life policy.”

Leverage aside, bank financing might also be elected by clients who don’t want to liquidate assets to fund premiums until markets recover. Because of depressed asset prices and due to the growing likelihood the estate tax will be reformed rather than repealed, ING is witnessing a rise in wealth transfer activity, of which premium financing is a component.

“A lot of clients would rather not sell assets in this down market,” says Layeux. “Premium financing can provide an alternative source of funding until the markets bounce back, when they’re able to liquidate at higher prices. So we’re experiencing an increase in number and size of premium-financed cases.”

Layeux is, however, in the minority among those interviewed by National Underwriter in taking a bullish view of the market. Overall, sources say, premium financing is on a downward path, buffeted by a recession that has not yet hit bottom; by continuing troubles in the banking sector; and by increasingly squeamish clients who are unable or unwilling to buy into a technique that, without a well developed exit strategy, could cost them more to finance than what they bargained for.

“Given all the economic uncertainty, I’m not going to recommend premium financing to a client who has a liquidity problem,” says Peter Katt, a fee-only life insurance advisor and principal of Katt & Co., Mattawan, Mich. “I’ll let him buy term insurance for a couple of years to get the liquidity he needs. Let’s let the dust settle and revisit the issue in 2 or 3 years.”

“If a client absolutely must finance premiums, then I strongly recommend paying interest,” he adds. “To finance the interest charge is to invite disaster, as it can make the cost of the loan so exorbitant as to make continuing payments unsustainable.”