California Broker Magazine
by Lance Wallach, CLU, CHFC
Premium financing allows your clients to purchase life insurance without liquidating their investments or changing their cash flow. Clients who are most likely to use premium financing are high net-worth seniors who are over 70. However, younger people can benefit with alternative forms of financing, other than through a bank.
It began in 1973 with the financing, property and casualty insurance policies. In 1995, lending companies started financing life insurance policies. Ever since then, the life insurance industry and lending institutions have been developing innovative designs and products.
Premium financing can answer some of the objections people have to life insurance. Most have an aversion to paying premiums and to dealing with matters relating to death, especially when someone else is profiting.
Premium financing allows clients to do the following:
- Retain capital for lifestyle and investment needs.
- Have additional liquidity for a family or business or additional liquidity to pay taxes on the value of a business.
- Eliminate unnecessary gifting or use of their unified credit. (Premium financing does not impede unified credit or annual gifting.)
- Avoid or reduce estate, inheritance, and generation-skipping taxes.
Why Premium Financing is Getting Popular?
Many consumers are finding that it is not cost efficient to purchase life insurance by paying term or permanent premiums. Premium financing may provide more favorable financial terms for clients who are seeking to purchase life insurance.
Many people don’t have adequate protection for their financial legacies. People are living longer and our economy is producing many multi-millionaires, which creates larger estates. At the same time, estate tax laws are subject to change. Premium financing does not interfere with estate planning strategies including generation skipping. The grantor/insured can loan annual life insurance premiums to the ILIT rather than gifting them when the ILIT owns the policy.
IRS Letter Ruling 9809032 declares that a loan to an ILIT is not an incident of ownership. The grantor/insured is not responsible for the premium finance loan. The ILIT repays the loan when it receives the death proceeds. Premium financing eliminates annual gifting issues that can come up with an ILIT. It provides substantial leverage for the gift tax.
Under IRC Code 7872, if paid by the grantor, only the loan interest is considered an annual gift rather than the entire premium. There could be a gifting problem if the contract has been classified as a modified endowment contract. However, this issue should never arise unless the client tries to make a single premium deposit into the contract.
When the insurance policy is issued, it is designed so that it is not classified as a modified endowment contract. ILIT deposits are transferred irrevocably, which means that the money cannot be used for alternative investments or used to improve a person’s lifestyle.Premium financing enables the trust to receive death proceeds income-tax-free without including them in the insured’s estate. Total death proceeds are not included in the insured’s estate if the ILIT trust has been arranged properly.
Premium Finance Loans
The four major steps of premium financing are to get a policy, create an irrevocable life insurance trust (ILIT), obtain a loan, and collateralize the loan. A third-party lending institution finances the life insurance premiums. A trust owns the policy, keeping the death benefit out of the estate. Through the trust, the insurance policy is assigned to the third-party lender as collateral.
The two general types of premium finance loans are “interest paid” and “inter-est accrued.”
When your client pays interest out of pocket, they avoid additional deferred risk by tying up collateral for a longer period. Also, your client does not need additional collateral. The disadvantage is that the money your client pays out-of-pocket could be used for investments or for maintenance of their lifestyle.
The following are the usual terms of an interest-accrued loan:
- Interest is accrued for the length of loan, which is generally five to 10 years.
- The borrower must show financial ability to pay the premiums and interest even though the premiums are being financed.
- The borrower must be able to post additional collateral for as long as necessary if the policy surrender values are insufficient in any given year. The lender per-forms a collateral analysis each year to determine if there is a shortage. This is normally is done 45 days before the anniversary date to give the client enough time to post additional collateral.
- The borrower must give the lender a cover letter explaining why interest is being accrued. They must also provide their estate planning strategy.
- The amount of life insurance the borrower purchases cannot exceed their net-worth. Also, the borrower’s projected net worth cannot be less then the projected accrued loan.
If the lender’s risk analysis indicates that the borrower’s projected net worth is less, the borrower has to apply for less life insurance coverage.The accrued interest loan creates future deferred risk. The London Interbank Offered Rate (LIBOR) is used as a base index for setting rates of some adjustable rate mortgages and other loans. Suppose LIBOR loan rates continued to increase instead of leveling off and eventually decreasing to their long-term average rates. Every year, the corresponding life insurance product would be under extreme pressure to produce crediting rates that exceeded the LIBOR rate. Collateral could be put at risk if the loan balance increased while the policy’s cash value did not. It could create the need for additional collateral, which the client may not have. When bank loans have com-pounding non-fixed interest, the annual interest payment could end of being higher than the annual premium payment. This is particularly true with younger clients.There are ways to avoid the pitfalls of the interest-accrued loan.
Creative financing can offer interest accrued loans with the following advantages:
- Unlimited term
- Fixed interest rates as low as 3%
- Non-compounding of interest
- No additional collateral requirement
Why Universal Life Is Not a Good Choice
Traditional universal life is the most common life insurance product to be used for premium financing and is most commonly accepted by lending institutions. However, it should not be used for premium financing in today’s interest rate environment for the following reasons:
- The current crediting rate for most UL policies is too low.
- The guaranteed rate for most UL policies is 4%. This is also the current rate for some companies.
- Long-term surrender charges cause additional collateral shortages.
- Death benefits are falling short of what was targeted.
An insurance company generally invests in medium-term maturity fixed-income instruments, primarily notes. Bond fund yields tend to fluctuate more slowly than do money market interest rates. Short-term interest rates fluctuate rapidly while the portfolio yields are slower to react.
The interest rates charged on premium finance loans are greater than current portfolio yields.
This may continue for several years before portfolio rates catch up. Annual shortages will increase if this continues for many years while interest is accruing. There would be a concern about whether the premium finance arrangement could continue.
Equity-Indexed UL –an Acceptable Alternative Equity-indexed universal life insurance is an acceptable alternative for premium financing. A critical difference sets it apart from other flexible premium UL products. The carrier can credit interest that is based partly on the potential growth of an out-side index (excluding dividends). At the same time, none of the policyholder’s cash value participates directly in an equity market. This probably provides better long-term values than a fixed universal life product can provide. It also creates less risk to principal than a variable universal life product brings.
There is a way to avoid losing the death benefit as interest accrues. Special insurance riders increase the death benefit each year by the amount of interest on the premium finance loan. This is called a“return-of interest/cost of money rider.”The death benefit will not get eaten away by accrued interest when combined with a standard return-of-premium rider. Beneficiaries always receive the original death benefit.In short, premium financing can allow your client to protect their net worth and pass along their financial legacy to future generations without altering other financial strategies.
Lance Wallach, the National Society of Accountants Speaker of the Year, speaks and writes extensively about retirement plans, Circular 230 problems and tax reduction strategies. He speaks at more than 40 conventions annually, writes for over 50 publications, is quoted regularly in the press, and has written numerous best-selling AICPA books, including Avoiding Circular 230 Malpractice Traps and Common Abusive Business Hot Spots. He does extensive expert witness work and has never lost a case. Contact him at 516.938.5007 or visit www.vebaplan.com.