Life Insurance Premium Finance

Life Insurance Premium Financing

For clients who are financially successful, estate planning that includes life insurance is a critical step in preserving wealth. Though a life insurance policy is typically owned by an Irrevocable Life Insurance Trust (ILIT) or other entity so that the proceeds are not subject to estate tax, the gifts of potentially large life insurance premiums your client makes to the trust may be taxed as gifts. Moreover, your clients may not prefer to liquidate high-performing assets, and incur additional taxes in doing so, in order to pay large premiums. In some cases, your clients may not have the funds available currently to pay the premiums required to do proper planning. Premium financing can be helpful in overcoming these types of planning obstacles.

What is Premium Financing?

Premium financing is a method of borrowing the cash to fund a large life insurance need. Since the premiums are borrowed, they are not taxed as gifts. That is, a trust or other entity may borrow the premiums from a third-party lender annually. The client can then make gifts of only the loan interest to the trust or business, which in many cases will be covered by the available annual gift tax exclusions. And, by financing life insurance premiums, the client does not need to liquidate assets and is more likely to accomplish transfer planning goals.

How Does Premium Financing Work?

The client, as borrower, applies for a permanent life insurance policy. Once an underwriting offer has been made, the client then submits a premium financing application with the lender. The lender will establish the terms of the note, including the loan interest rate and payment schedule. Although the life insurance policy, in most cases, will be used as collateral for the loan, the lender may also require additional collateral to cover the time period before the policy’s cash values are sufficient to cover the loan liability.

Candidates for Premium Financing

The candidates for premium financing is typically individuals age 60 or more with a net worth of at least $5 million, but usually higher. Individuals who are business owners, or who have the majority of their assets invested, and need life insurance with a premium requirement of more than $100,000 are the best candidates for premium financing. Moreover, clients earning an investment return above that of the loan interest rate may benefit the most from a premium financing plan.

Components of Premium Financing

Premium financing works very much like a personal loan. Although an ILIT or business borrows the premiums from the lender, the client may be required to personally guarantee the loan. The borrower will then pay loan interest to the lender using annual gifts from the client. Ultimately the heirs will receive the life insurance proceeds from the trust net of the loan repayment. However, it is important to consider alternative ways of repaying the loan before death should loan repayment become necessary during lifetime.

Types of Premium Loans – Typically, a new life insurance policy is purchased or an existing policy is exchanged for a newer, more cost-effective one. The amount of the annual loan will be equal to the annual premiums required for the new policy.

If a policy exchange is being considered, any outstanding loan balance on the existing policy is usually repaid by the lender in full and carried forward in the new premium loan balance. Although in many cases, a policy loan can be carried over into the new policy in the exchange, the policy loan cost must be compared to the premium loan cost. Care must be taken, however, to assure that the exchange that carries over a policy loan does not cause adverse income tax results.

Also, it may make sense to finance the collateral assignment repayment, often referred to as a roll-out, of an existing split dollar policy through a new financed policy. That is, if the economic benefit costs associated with a policy under a split dollar plan are becoming costly, or if the arrangement may cause taxation on equity under the new split dollar rules, considering the exchange of an existing policy for a new one may make sense. In this case, the lender would pay the roll-out and include the roll-out amount in the cumulative loan balance going forward.

Loan Interest Rate. Typically, the lender will establish a loan rate formula at the inception of the loan, based on LIBOR (London Interbank Offered Rate) plus a spread that averages in the range of 175 to 350 basis points. Although the spread is usually fixed for the duration of the loan, LIBOR will change annually. The loan interest can be paid at the beginning or at the end of the year. Alternatively, the loan interest can be deferred in some cases for a short period of time, though this is usually not recommended.

Loan Collateral. Typically, premium loans are collateralized by the insurance policy. However, the lender may require additional collateral for the period of time that the policy’s cash surrender values are not sufficient to cover cumulative premiums loaned by the lender. It is important to note that for as long as there is a collateral assignment of the policy’s cash values, the owner of the policy is usually restricted from using the cash values for personal needs. Since the lender has a security in the life insurance policy’s cash values, a cash value rider may be added to the policy. This rider spreads the policy’s costs over a longer period of time leaving more of the cash value intact for collateral purposes. This may result in a lower collateral requirement.

Typically the client will provide the additional collateral since the ILIT or business may not have the funds. Assets that are typically used as collateral are cash, cash equivalents, a letter of credit, and marketable securities. Marketable securities are usually discounted for fluctuations in the market value of the assets. Although real estate and privately held stock are generally not used as collateral, some lenders do allow these assets to secure a letter of credit. Also, some lenders require that they manage or hold the collateral during the term of the loan.

A policy that is classified as a Modified Endowment Contract (MEC) under IRC §7702 will trigger income taxation on the gain when the policy is pledged as collateral for the loan. Therefore, MEC policies are rarely used in a premium financing arrangement. If a MEC policy is used, the carrier will oftentimes require a hold-harmless agreement to be signed by the borrower.2

Personal Guarantee. It is common for the lender to request that the client agrees to personally guarantee the loan. Although there is some thought that this personal guarantee may be considered a taxable gift, there is supporting authority to the contrary. The authority is based on the fact that there is no economic outlay and no transfer of property ownership.

Loan Repayment. A Return of Premium rider (ROP) is often used if the lender is assumed to be repaid its cumulative premiums at death. This rider allows the initial death benefit required for the family to remain intact, net of the loan repayment, by increasing the death benefit annually by the amount of the annual premium loan. There is a cost to the rider and a cost/benefit analysis should be done to determine the benefits of using it.

A loan exit strategy is also critical to the success of the financed plan. Although many financed plans contemplate loan repayment at death from policy proceeds, it is possible to design the plan so that the loan is repaid before death using funds projected to be available in the future from the trust side fund, a credit shelter trust, a family limited partnership or another family trust, or even from the policy’s cash values. A side fund in an Irrevocable Life Insurance Trust (ILIT) made up of annual gifts made by the client may be used in the future to make loan interest payments as well.

Next Steps

Affluent families and individuals can choose from numerous financial products and strategies. They use life insurance when its potential advantages and financial performance increase their ability to pass on more of their net worth and accomplish their other estate planning and wealth transfer objectives. It can be a valuable and efficient wealth transfer tool.

To learn more contact an HNW Life Insurance Professional at (877) 579-9574 or submit an online request to schedule a time to discuss your particular situation.