Almost everyone who enjoys a measure of financial success has at some point borrowed to facilitate their plans. Debt provides financial leverage to control or acquire more assets, and the opportunity to multiply productivity. Very few people “pay cash” on their way to creating a fortune.
Which is why some high-net-worth households or businesses may opt to borrow to implement their life insurance plans.
Premium financing is exactly what the term implies: An individual or business borrows from a bank or other lender to pay life insurance premiums. Because financing can reduce immediate out-of-pocket costs while preserving capital and cash flow, it may be an attractive option for wealthy individuals or growing businesses to immediately address pressing life insurance issues.
When businesses and high-net-worth households have large life insurance needs, the premiums can be substantial, particularly if the individuals to be insured are older. Yet while the business or estate may have the assets to pay large premiums, cash may not be readily available. Assets may be illiquid, like real estate or equipment. Or the assets may be liquid, but highly profitable (such as an appreciating stock), making the owners reluctant to cash out. In a similar way, a business may have plenty of assets and cash flow, but wants to allocate these profits to further expansion, not premiums. In all these circumstances, premium financing can be a prudent approach to establishing the life insurance today without requiring other assets to be sold or reallocated.
An application for life insurance is submitted. When the coverage is approved, the prospective owners of the policy solicit funding offers, either from a bank, or other lenders that specialize in premium financing.
Terms will vary, but premium loans are typically of short duration, like three to five years, at a variable rate, with options for renewal. The typical payment terms are often interest-only, with the principal balance due at the end of the term.
Depending on the person or entity that owns the policy and secures the loan, the premium financing arrangement may require integration with a legal document, such as an irrevocable life insurance trust, a grantor-retained annuity trust or a charitable lead trust.
In a February 2017, wealthmanagement.com blogpost, CFP Aaron Hodari provided the following hypothetical premium-financing scenario:
Jay is a successful business owner who wants $10 million in permanent life insurance, for which the annual premium is $100,000. If he writes a check to cover the premium, his out-of-pocket cost in Year 1 is $100,000. But his true out-of-pocket costs could be even greater if he has to liquidate other assets to pay the premiums; a sale could result in a substantial capital gain, triggering additional taxes. Jay also incurs an opportunity cost because he loses the additional earnings the liquidated assets might have generated.
Instead, Jay finances the premiums with a three-year loan that charges 4% interest. With interest-only payments, his out-of-pocket cost in the first year is just $4,000, which allows $96,000 of personal assets to remain invested. In Hodari’s hypothetical, the investment does very well, spinning off a 12% return, growing to $107,520. At the end of Year 1, Jay has increased his assets and secured $10 million in life insurance. (This simple accounting does not consider any cash value that may have accrued in the policy.)
But Remember…Loans Must Be Repaid
Leverage in the above example is significant: A $100,000 premium is paid with an out-of-pocket cost of just $4,000. But another premium will be due in Year 2, and the interest-only payment will now be $8,000, or perhaps more if interest rates have changed. The interest payments increase again the following year, at which time the lender may call the loan and demand full repayment of the principal ($300,000 at the end of Year 3).
This simple example shows why every premium-financing scenario should include a clear idea of how the loan will be repaid. Ultimately, the success or failure of a premium-financing arrangement hinges on repayment of the loan.
Repayment plans typically include pledging a portion of the death benefit, should the insured die while the policy is in force. Other options might use loans or withdrawals from the policy’s cash values*, a side account funded by gifts to a trust or the sale of specified assets from the business or estate.
Big Numbers? It’s Just Business
Life insurance is a financial instrument based on leverage; a small premium secures the right to a much larger benefit. Premium financing magnifies that leverage, making the initial outlay even smaller. Used judiciously, premium financing can be a great option for maximizing protection with minimum disruption to existing estate and business plans.
For the average consumer, $100,000 annual premiums, and a decision to borrow to pay those premiums, may be hard to comprehend. But in large estate and business applications, life insurance is just another asset that needs to be acquired and properly positioned in a portfolio or business plan. And sometimes, the expedient way to acquire assets is to take advantage of the financial leverage in borrowing.
* Policy benefits are reduced by any outstanding loan or loan interest and/or withdrawals. Dividends, if any, are affected by policy loans and loan interest. Withdrawals above the cost basis may result in taxable ordinary income. If the policy lapses, or is surrendered, any outstanding loans considered gain in the policy may be subject to ordinary income taxes. If the policy is a Modified Endowment Contract (MEC), loans are treated like withdrawals, but as gain first, subject to ordinary income taxes. If the policy owner is under 59 ½, any taxable withdrawal may also be subject to a 10% federal tax penalty.
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This article was prepared by an independent third party. Material discussed is meant for general informational purposes only and is not to be construed as tax, legal, or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon only when coordinated with individual professional advice.
Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS), 355 Lexington Avenue, 9 Fl., New York, NY 10017, 212-541-8800. Securities products and advisory services offered through PAS, member FINRA, SIPC. This firm is an agency of The Guardian Life Insurance Company of America® (Guardian), New York, NY. PAS is an indirect, wholly owned subsidiary of Guardian. Wealth Advisory Group LLC
Submitted by Elozor M. Preil