The competition to attract business from the desirable high-net-worth niche is fierce, and wealth managers must continually find ways to differentiate themselves to capture their share. One opportunity that may allow wealth managers to stand out from the crowd lies in the premium financing of life insurance. Often misunderstood and improperly utilized, the concept of premium financing can be a very attractive strategy for both the client and the advisor.

But first, it’s important to understand for whom and when premium financing may be most appropriate.

Illiquidity issues in the estate
Think of some of your current clients. Do any of them have a considerable net worth consisting primarily of illiquid assets? If so, how do they envision the transfer of their assets via their estate plan?

Under current law, an estate worth more than $3.5 million ($7 million if the clients are married and have a properly structured plan) is subject to federal, and possibly state, estate and inheritance taxes. A client with an illiquid estate above this threshold risks the possibility that illiquid assets such as real estate and business interests will have to be sold by heirs in order to pay the estate tax liability associated with those same assets. And in a situation where the seller’s hand is forced, sales proceeds are often diminished–therefore exacerbating the issues surrounding the tax liability.

Is there a simple solution to such a situation? Yes: life insurance. This should come as no surprise, as life insurance has long been a staple of effective and efficient estate plans. The trouble, however, lies in the ability of a client with an illiquid estate to obtain the appropriate coverage while being able to support the premium payments.

Financing an irrevocable life insurance trust
Life insurance is useful in estate planning because it offers the ability to instantly create liquidity, enhance or create a legacy, and replace wealth that would otherwise be depleted by transfer taxes. For most clients, an estate plan that includes a marital and credit shelter trust, along with an irrevocable life insurance trust (ILIT), is more than adequate. But the high-net-worth client is not like most clients.

If you have experience in implementing an ILIT, you are most likely familiar with the practice of using a client’s annual gift tax exclusions (currently $13,000) to provide for gift tax-free transfers of cash to the ILIT trustee on behalf of the trust beneficiaries. The trustee then applies the gift toward the payment of life insurance premiums. This method of funding an ILIT is simple and tax-efficient. The gifts to the ILIT are gift tax-free, and the death benefit received by the ILIT is estate and income tax-free. It doesn’t get much easier.

So why wouldn’t every client establish an ILIT if it is so simple and effective? One reason could be that the client is uninsurable, in which case he or she must seek an alternative strategy that doesn’t include life insurance. Another reason–and the one I would like to focus on here–is the client’s inability to effectively fund the trust due to potential gift tax costs or cash flow constraints, rather than affordability of the insurance.

Take, for example, a client who is worth $16 million and whose wealth is primarily composed of investment real estate. Understanding that the gross estate will be subject to estate taxes upon death, the client has formed a family limited partnership funded with investment properties. Using his applicable credit for lifetime gifts (currently $1 million per individual), he has transferred $1 million of limited partnership interests to his children. When applying the discounts available to the partnership interests, the gift has reduced the gross estate to just under $15 million.

The client wants to do more to mitigate the damage of estate taxes upon his death, but he is concerned about paying out-of-pocket gift taxes for any additional lifetime transfers. The client’s advisor recommends an ILIT to provide a pool of liquidity to pay estate taxes and therefore avoid a fire sale of any of the investment properties.

Even with very modest appreciation, it is possible that the client’s estate could be worth well over $20 million at death, so how much insurance should he obtain? After meeting with the client’s attorney and CPA, the advisor recommends that the client apply for a death benefit of $10 million. The client agrees but asks how he will pay the six-figure premiums when a majority of his cash flow is dedicated to current living expenses and the maintenance of his investment properties. He is also adamant that he not pay gift taxes. The client has exhausted his credit for lifetime gifts through previous planning, and his four children, as beneficiaries of the ILIT, would only afford him the ability to transfer $52,000 annually to the trust free of gift taxes under the annual exclusion.

How can we align the client’s needs with a workable solution? The answer may be through premium financing.

Incorporating premium financing
Typically, there are two parties concerned with the payment of premiums on a life insurance contract: the owner of the contract and the insurance company. Under a premium financing arrangement, a third party–the lender–is inserted into the equation. In this type of situation, the borrower applies for the life insurance policy while indicating to the insurer that the premiums will be financed. Once the insurer approves the arrangement, the borrower can then apply for a loan to finance the payment of the life insurance premiums.

The terms of the loan may vary, but a common arrangement is to borrow enough to produce a death benefit sufficient to repay the loan at the insured’s death and also to leave enough to meet the needs for which the insurance was purchased in the first place–such as payment of estate tax. When applied to the example above, a $10 million death benefit from a premium finance agreement may be apportioned between the balance of the note ($2 million) and the ILIT beneficiaries ($8 million). The actual amount to be apportioned will depend upon the terms of the note.

Most high-net-worth clients are familiar with the concept of leverage–or using someone else’s money to create wealth. And one factor that makes premium financing attractive to this group of clients is its use of leverage to attain a desired result. Not only can premium financing provide for an impressive rate of return on the life insurance policy, but the client can also leverage the amount that can pass to the trust gift tax-free under the annual gift tax exclusion.

Again using the example above, an annual gift of $52,000 could be made to the trust without incurring any gift tax. The cash could then be applied to the ongoing service of the note, which can be structured with flexible terms, such as interest only with a balloon payment at the insured’s death.

Words of caution
As with any strategy, there are inherent risks. Some loan arrangements require a pledge of capital in addition to the policy cash value and death benefit. A personal guarantee by the borrower and the posting of other collateral is common as well. Advisors must understand exactly what the client may have at risk in any premium finance agreement. Policy underperformance, an adjustment in the loan’s interest rate, or a decrease in the value of posted collateral can put a client in a precarious financial position. Too often clients are surprised to learn that they have more at risk than they previously thought.

Doing it right
I believe that premium financing can be an excellent strategy for providing a workable solution for the right high-net-worth client. Be sure to include expert tax and legal counsel when designing any plan that includes premium financing. I have also found the Advanced Markets/Sales departments of many insurers to be an excellent resource for advisors exploring the world of premium finance. It is also most important to perform thorough due diligence on the lender in any potential premium finance arrangement. There are many high-quality lenders that specialize in this type of transaction, and, in times like these, advisors cannot leave any detail to chance.

Gavin Morrissey, JD, is the director of advanced planning at Commonwealth Financial Network, in San Diego, Calif. He can be reached at gmorrissey@commonwealth.com.