The old adage “neither a borrower nor a lender be” has a contemporary ring to it these days. Faced with a credit crisis that resulted in a near meltdown of the financial sector and the worst economic contraction since the Great Depression, more financial institutions and high net worth clients are questioning a much-touted life insurance funding technique: premium financing.
“Premium finance facilities depend on access to credit,” says Bill Hager, founder and president of Insurance Metrics Corporation, Boca Raton, Fla. “As that access tightens, premium finance facilities are boosting lending requirements for borrowers. Institutions are imposing more rigorous credit underwriting and showing more prudence when extending credit.”
James Sorebo, president and CEO of Four Seasons Financial Group, Mt. Laurel, N.J., agrees. “Most brokers understand there isn’t as much money to be made in this space now. At this time last year, we were reviewing more 400 applications for premium financing. Now, we’re looking at fewer than 100.”
Until the current recession, sources say, many affluent clients were turning to this technique–taking out a loan from a bank or other lending institution to pay premiums on a large life insurance policy–to meet short-term cash flow or investment objectives. This strategy frees up money for clients with large estates, typically those valued at $10 million-plus and comprising mostly illiquid holdings, such as real estate or business assets. Funds that otherwise would be used to pay policy premiums can instead be conserved or invested in vehicles to produce a higher rate of return than what the client would pay on the cost of the loan.
Premium financing is additionally compelling, experts say, because the technique lets clients minimize gift taxes on wealth transfers facilitated through an irrevocable life insurance trust or ILIT. Absent financing, premium payments on ILIT-owned policies are subject to gift tax. With premium financing, policy holders reduce their gift tax liability because only interest on the policy loan is gifted to the ILIT annually.
All well and good. But with many banks now focused on boosting their reserves and riding out the credit crunch, they’re raising the bar for premium financing applicants.
That’s evident, for example, in the cost of financing. Christopher Layeux, director of premium financing at ING-U.S. Financial Services, Windsor, Conn., says the fees bank charge on letters of credit, which may be required of borrowers before a loan is issued, have risen to 3% or more from 1% only a year ago.
Premium financing is also taking more time to secure because lending institutions, which have grown increasingly protective of their balance sheets amid the downturn, are exercising greater due diligence when weighing applications. What was an already lengthy and complex process–establishing the need for life insurance, underwriting the policy, applying for a loan and posting collateral–has slowed, taking upwards of several months to complete.
In many instances, sources say, prospective borrowers are unable to provide the requisite collateral or letter of credit because their portfolios, having taken a beating during the recession, are much diminished. Or they are opting out of financing because the opportunities for arbitrage are fewer than in years past. With fewer buyers in the life settlement market, policy owners are having difficulty selling premium-financed contracts at a profit.
Observers say the recession has hit so-called hybrid loans the hardest. In these transactions, the lender uses part of the value of the insurance policy (often 25% or greater) as collateral for the loan. Today, in most cases, banks are insisting that clients furnish all collateral from other assets, such as cash, brokerage accounts and real estate.
In some instances, institutions are pulling the plug on financing programs–or calling in the loans–because of their own financial troubles.
“Most of these premium-financed loans are callable,” says David Howell, a life insurance consultant and broker to advisors based in Harbor Bluffs, Fla. “And right now, loans are being called in faster than they’re being made. The people that owe money are scrambling to placate the lenders, sometimes by refinancing with another institution.”
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.”