How to Finance New or Existing Life Insurance Premiums
December 10, 2020
Financing your life insurance premiums can be a powerful, flexible, and tax-efficient option for high-net-worth individuals to meet a myriad of financial objectives. Here’s a closer look at how life insurance premium financing can help grow your wealth and whether this transaction is the right fit for your family.
What is Life Insurance Premium Financing?
Premium financing is an insurance concept that allows a buyer of insurance to allow the bank to pay the premiums for them. Banks will loan up to 95% of the cash value of a policy in a premium financing transaction.
Who is the Best Fit for Life Insurance Premium Financing?
Schechter Wealth sees premium financing used mostly by ultra-high-net-worth individuals, $25 million net worth all the way up into the billion-dollar net worth range. These people generally have access to very favorable borrowing rates, they’re comfortable with leverage and have used it in other parts of their lives, and they understand (and have a team that can help them understand) the concepts involved in how the insurance policy works, how the loan works, and how you play those two together.
What are the Benefits of Life Insurance Premium Financing?
The benefits of a premium-financed transaction are that the out-of-pocket cost for the investor–for the same amount of death benefit–becomes substantially less than if they were to pay for that policy out of their own pocket. By applying leverage at an expected interest rate lower than what the policy will credit, it increases the returns on the dollars that the buyer actually puts in. That’s what creates the leverage in these transactions. You’re capturing a spread every year allowing the return on the money that goes in (in the form of interest in the bank) to earn a higher rate of return than you would otherwise earn if you put the money into the policy.
Another benefit of premium financing is that the cash value, as it grows within these policies, can be used by the owner via tax-free distributions in the form of loans or withdrawing to basis.
A third benefit is the returns. In today’s insurance environment, the expected return on policies at life expectancy is in the 5% to 6% range. By applying leverage and using assumptions about what the interest rates will be over time, premium financing can take the expected return of an insurance contract up to 9% to 11%.
What is the Collateral?
Banks are excited to make these loans. Schechter finds banks all over the country that are asking to finance premiums. The reason is the collateral that they get is a life insurance policy with significant cash value.
When purchasing a premium-financed policy, the bank will generally need additional collateral on top of the insurance policy for the first couple of years. That collateral can be in the form of existing insurance that’s already been paid for, cash, or marketable securities. In very large transactions, the banks will also look at more complex collateral, such as artwork, boats, planes, or homes.
But, for the most part, these transactions are done using liquid assets such as the cash value in other insurance policies as well as cash in stocks and bonds.
The majority of loans used in premium financing transactions are interest-only loans. The borrowers are not expected to pay back the principal on an annual basis, however, at some point in the future, there is an expectation that at some point the principal is repaid.
What Do You Need to Consider Before a Premium Financing Transaction?
Oftentimes people say, “What is the loan repayment plan in a premium financing transaction?” This is one of the biggest considerations for premium financing.
Generally, the loan repayment is actually going to come from the cash value of the policy that has been financed. There isn’t enough cash value in the policy to pay it back in the first five to seven years. Generally, the loan repayment happens sometime between year 10 and year 20. These are long-term transactions and long-term strategies that families need to be planning for.
Another consideration to think about when doing a premium financing transaction is that the policy is the policy and it’s going to do what it’s going to do. You want to make sure you buy the best policy available before you introduce a loan component, which adds risk. As a firm, Schechter constantly looking for the best loan terms, moving clients’ loans from one lender to another as interest rates improve and negotiating power strengthens.
On top of that, these loans are generally floating rate, meaning if interest rates rise, our borrowing cost comes up. Historically, insurance policy crediting rates do have a high correlation to interest rates, but they lag. So if interest rates go up today, based on historical analysis, insurance crediting rates may not rise for two, three, even four years.
What Schechter is always looking to do is ask, “How do we hedge that interest rate risk?” Schechter works with banks today to do fixed-rate loans, swaps, interest rate caps, other financial instruments to control and know what our interest rate exposure is going to be over the next five, seven, ten, or fifteen years.