Premium finance life insurance requires the policy owner to get a loan from a bank to pay the premiums on his/her policy. The strategy works to reduce the net cost of buying an extremely large life insurance policy, and wealthy Americans use premium financing for this very purpose. There are, however, times when unscrupulous insurance agents and/or marketing agencies try to apply the core concepts of premium financing to sell life insurance in a fashion that is extremely precarious.
How Does Life Insurance Premium Financing Work?
Life insurance premium financing works by borrowing money to pay all or some of the premium due on a life insurance policy. Borrowing money to pay a life insurance premium may sound strange, and it's certainly not for just any life insurance purchase. Premium financing comes up when someone has a substantial need for life insurance, and the cost of that life insurance is always considerable.
Consider a situation where a wealthy individual discovers that he needs $30 million in life insurance coverage and the per year premium cost of such a policy is $900,000. He could pay the $900,000 (remember I said this because it's important), but he decides instead to approach this problem with the help of his banking relationships. He goes in search of a bank willing to lend him $900,000 per year to pay the premium. He'll pay the interest that accumulates on the loan, and he'll pledge the cash value of the life insurance policy as collateral for the loan.
The cash value of the life insurance policy will not equal the total loan amount from policy inception, so he'll also need to pledge other assets he owns as collateral to satisfy the bank's requirements to issue the loan.
The good news is that he'll obtain a loan with relatively low borrowing costs. Generally, a loan pegged to either LIBOR or Prime, plus a small spread. This means the out-of-pocket cost of the insurance will be a fraction of the $900,000 annual premium. If for example, the loan comes with a 2.25% annual percentage rate, the first year out-of-pocket cost of the insurance will be $20,250. But this amount will increase each year as the loan balance increases, so the policy owner/insured will need to look into the future and develop an “exit strategy.” This exit strategy simply means a point where he'll repay the entire loan balance to the bank.
If everything works out perfectly, the wealthy individual will pay off the loan, achieve a point with the life insurance policy where he no longer needs to pay premiums, and now own a permanent life insurance death benefit that he acquired much more cheaply than if he had bought the policy the old fashion way.
You might detect an underlying insinuation that things might not work out perfectly. This can and does happen, so let's dive into what those scenarios look like.
Policy or Loan Provision Changes
When financing the premiums of a life insurance policy, the loan rate can change. Normally the bank locks the rate on the loan for the first few years of the arrangement but then uses a floating rate thereafter. There are also some lending agreements that require the borrower to effectively reapply for the loan after a certain period (e.g. 10 years). A falling interest rate is likely no big deal. It means the borrower will pay less interest to service the debt than originally assumed.
A rising interest rate, on the other hand, is a potential problem. It certainly means the borrower is paying more interest than originally assumed. This could dramatically alter the benefit anticipated from financing the premiums versus just buying the policy without financing the premiums.
Additionally, the accumulation feature of the life insurance policy might produce less cash value than originally assumed, which potentially alters the collateral requirements the borrower must satisfy and/or the timing of the exit strategy. A declining dividend (if whole life insurance) or a change in the index cap, participation, and/or spread rate (if indexed universal life insurance) all potentially increase the cost of financing the premiums.
If the loan interest rate increases and the accumulation feature of the life insurance policy decreases, there's a multiplying effect on how much more expensive premium financing becomes. While it's unlikely for these two aspects to move in opposite directions, it's not impossible.
What Happens if you Can't Pay the Life Insurance Premium?
Remember earlier when I mentioned that the individual in my example could choose to simply pay the entire premium? I noted this was important. Premium financing should only be a discussion when the prospective policy owner has the capacity to pay the premiums out-of-pocket but chooses not to. Premium financing is not a tool used to allow people to buy life insurance they cannot otherwise afford to own.
This raises an interesting question. If someone had the money to pay a $900,000 life insurance premium providing a $30 million death benefit, does he really need life insurance? The answer can be both yes and no. It depends on the liquidity circumstances of the individual's assets and how exactly he goes about earning his income.
There are no doubt situations where people with this sort of income and net worth do not absolutely need to own life insurance. But there are also circumstances where people with this sort of income and net worth desperately need life insurance in order to avoid disastrous financial consequences at death. The really important thing to understand here is the limited number of people for whom premium financing will ever make sense.
Ultimately, if you borrow money to pay premiums and you do not have the ability to pay those premiums yourself, you are likely headed down a road of painful loss. Truth be told, the bank's underwriting process should uncover this fact and deny the loan. That used to be more foolproof than it is today.
Using Premium Financing for Cash-Focused Life Insurance Purchase
I hope by now you can see that premium financing is not for the faint-of-heart. There are several components that can go sideways on you and alter the overall benefit of the plan. At its best, it's a risky bet for those looking to use leverage to buy life insurance at a discount by using the banks money to do it.
Understanding this, there's another marketing facet to premium financing that never made any sense to me, and we've warned people against it for years. This involves financing premiums under the pretense that using leverage will multiply your returns on a cash-focused life insurance purchase.
In other words, you borrow money to buy a whole life or indexed universal life insurance policy intended to by a retirement income play. But instead of paying the premiums with your own money, you borrower a much larger amount of money and use that to squeeze additional gain produced by the dividends or indexing credits afforded by the life insurance's cash accumulation features.
Insurance agents like to use examples of borrowing money to make investments as the starting point to frame the pitch for this sort of life insurance sale. Common examples look something like the real estate investor who borrows money to buy a house that she flips selling for let's say $300,000. Her invested amount was the $40,000 downpayment she made for the loan she got to purchase the house originally. This makes her rate of return look astronomical and in truth, this does work to some degree with real estate.
But life insurance is not real estate. No one will borrower any sum of money to pay life insurance premiums and create cash surrender value anywhere close to the borrowed amount for at least a few decades. I've commonly argued that we need to consider the alternative of simply paying the premium out-of-pocket and I'll use the following example to make my point.
Assume that a bank is willing to lend you $100,000 for 6% interest annually, but also extend the loan on a zero-coupon basis with a 20-year balloon payment. Yes I understand such a loan is highly unusual today, but follow with me, because this example highlights the key point behind premium financed life insurance in the cash accumulation context.
At the same time, you are certain you could take this $100,000 and achieve an 8% per year investment return on the money. So you borrow the money and so exactly as you planned. At the end of the 20 years, your loan pay off amount is $320,713.55. But your investment is worth $466,095.71. So you can pay back the loan and pocket $145,382.17. This move requires no money out-of-pocket on your end. You simply have to sign the loan application and take on the risk as a borrower to accomplish this. If such an opportunity presented itself to you, you'd be foolish not to take it. This is an example of using leverage to bolster your net worth.
These numbers look great, but when using this example to sell the idea of financial premiums for a life insurance policy, we need to use more realistic figures to evaluate whether or not the proverbial juice is worth the squeeze. So let's assume the loan now has a 2% annual interest rate and your “investment” will grow at 4% per year over the next 20 years. After repaying the loan, you'll have $70,517.57. This isn't bad, but it's less than half of the money you'd have under the previous example.
In addition, let's entertain your alternative options such as simply how much money you'd need to save out-of-pocket in the same “investment” to arrive at this $70,517,57 balance in 20 years. The answer is $2,277.02 per year. Keep in mind that borrowing and investing the money involves risk. There's a risk that you may not achieve the investment result you assumed over the 20 year period. In a real premium finance context, there's also a risk that the loan interest accumulated over 20 years will be more than you originally anticipated. So the net return matters a lot when deciding if it's worth taking on the risk. I realize everyone is different, but if the path to the same end result of $70,517.57 was a mere $2,277.02 out of my pocket, I'd skip the loan application. I do realize that this is one example using one set of numbers and yes the gain does increase as the numbers get bigger (i.e. you borrow more money), but the relative numbers remain the same.
Life insurance simply cannot produce enough return over a short enough period to make borrowing money to squeeze out slightly higher gain worth the risk associated with financing the premiums. There are people who disagree, but I'm quite convinced having had many conversations with them that they don't fully appreciate the risk associated with such an arrangement.
Ultimately, life insurance is intended as a safe option for wealth accumulation. It's supposed to be the asset allocation you can depend on. One that doesn't risk the loss of principal. Introducing premium financing in this context takes an otherwise safe asset with a reasonable return and dramatically skews the risk/reward ratio heavily out of favor for the policy owner.