Advance Rates and Life Insurance Premium Financing

For those of you unfamiliar with life insurance premium financing we recommend reviewing our prior post explaining the basics of this technique in the estate planning process.

Life insurance premium financing is a process by which the owner of a life insurance policy secures a loan from a bank to make premium payments on a life insurance policy. The bank loan must be fully secured by assets of the policy owner.

What does this mean?

Assume Mr. Worth is interested in purchasing a $10 million life insurance policy with an annual premium of $500,000 per year for 5 years. The cash surrender value of the policy in the first year is $200,000. Because Mr. Worth borrowed $500,000 of premiums payments in year 1, and the cash surrender value of the policy is $200,000, there is a difference of $300,000. However, the $300,000 difference is not necessarily the collateral requirement.

In order to determine the required collateral to secure the loan for life insurance premium financing we need to assign an advance rate to the underlying collateral. First we will review the life insurance policy and its cash surrender value of $200,000.

For this example, we will make the assumption the policy is either a universal life or whole life policy. Based on this particular policy type, it is likely a bank will assign an advance rate of 90% – 100%. Assuming an advance rate of ninety percent, the $200,000 of cash surrender value is worth $180,000 of pledged collateral ($200,000 times 90%).

In order to determine what additional collateral is required to secure the loan we need to identify the asset class of the collateral and assign an advance rate. Here are some common advance rates used for various asset classes (again the advance rate will vary by lending institution):

Cash, U.S. Treasuries, Money Market:                                                   95%

U.S. Government Securities, Government Mutual Funds:            90%

Investment Grade Corporate Bonds, Municipal Bonds:                 80%

Diversified Publicly Traded Securities:                                                 70%

If the client decides to pledge a portfolio of municipal bonds the advance rate would be eighty percent. The current shortfall is $320,000 ($500,000 premium finance loan less $180,000 cash surrender collateral value). In this example, the client would be required to pledge a $400,000 ($320,000 shortfall divided by eighty percent advance rate) portfolio made up entirely of municipal bonds.

Based on the outstanding life insurance premium finance loan and the cash surrender value, the premium finance lender will adjust the collateral requirement on an annual basis. Dependent upon the source of the loan the client will either be required to put the assets on deposit or pledge assets to the lender.

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