Premium financing is a process of borrowing money to pay life insurance premiums. I know this sounds strange, but there is a perfectly good reason behind the idea. I'll forewarn you, however, that this good idea only takes flight among those with substantial assets.
Financing life insurance premiums works to minimize the net out-of-pocket cost to a potential policy owner by using ‘leverage.” I understand that leverage is one of the buzz words of the day right now, so this statement needs a bit more elaboration.
A Basic Example of Premium Financing
Suppose Bill determines that he needs $30 million in death benefit for estate liquidation planning. He could simply go out and buy a permanent life insurance policy for $30 million. His hang-up? The nearly $920,000 per year premium the insurance company wants for a policy with a $30 million death benefit.
That's a lot of money no matter how rich you are and Bill is rightfully apprehensive to sign up.
Because Bill has substantial assets (that's the primary reason why he needs the death benefit in the first place), he could potentially use some of his assets and strong financial position to acquire a loan from a bank to pay the premium for him.
The procedure looks something like this:
Bill applies for a loan and for life insurance (the timing isn't necessarily important, but traditionally both are done around the same time). The loan he seeks will pay his life insurance premium, and Bill will agree to pay the interest due on that loan. This could potentially drive Bill's annual out-of-pocket cost for the life insurance down to under $30,000 in the first policy year.
Now each year Bill will increase his loan by another $920,000 so his out-of-pocket cost will go up, but it will take many years before he reaches an annual cost of $920,000 in loan interest. In fact, Bill wouldn't likely do this unless he planned to pay off the loan entirely prior to a point where the interest payment was anywhere close to the actual life insurance annual premium amount.
And how exactly will Bill pay off the bank loan? While he's free to do it using whatever cash he wishes, most people use the cash value accumulated inside their life insurance policy to accomplish pay off.
There is one more important element to Bill's agreement with the bank. When the bank makes Bill's first premium payment, the cash value in the life insurance policy will be some figure less than the annual premium payment. The bank doesn't like having a negative equity position, so it requires Bill to pledge assets for the difference between the loan amount and the cash surrender value of the life insurance policy. These assets can, more or less, be whatever Bill chooses, but he'll need to work with the bank to determine the value of any assets he pledges as collateral and he'll need to understand that the bank may not permit the full market value of his asset to count. For example, if Bill chooses to pledge several hundred thousand dollars of stocks he owns as collateral, the bank will likely only recognize 50% of the market value of those stocks to shield itself against volatility in the market.
Each year the difference between the outstanding loan and cash surrender value in the life insurance policy grows, the bank will require additional collateral. Eventually, the cash surrender value in the policy will equal and exceed the value of the outstanding loan. At this point, the Bank will release the assets Bill pledged as collateral for the loan.
What Happens if Bill Dies?
If Bill dies while the bank loan is still outstanding, the bank will recover its loan with a portion of the death benefit payable. The bank will release Bill's pledged collateral (assuming he still has pledged collateral) and the remaining death benefit (what's left over after repaying the loan) goes to Bill Beneficiary.
If the loan is already gone (because Bill repaid it) then the bank is entirely out of the picture and Bill's death benefit goes entirely to his beneficiary.
What Happens if Bill Cancels his Life Insurance Policy?
Canceling his life insurance policy has a wide range of consequences depending on where in the premium financing life cycle Bill happens to be.
If Bill cancels the policy while the loan is still outstanding and his cash value does not yet equal the total amount of the loan, the bank will take Bill's cash value to pay off a portion of the loan, and Bill will need to repay the difference. In some situations, Bill may get to choose whatever option he wishes to repay the difference. This may come from funds not at all related to the collateral he pledged. For example, let's assume Bill pledged some commercial real estate to satisfy the bank's requirements. But he'd rather not lose this asset, so he chooses instead to liquidate some stocks and pay off the remaining bank loan. Most banks would be agreeable to this arrangement.
If Bill cancels his life insurance policy after his cash value is greater than the outstanding loan, but before he repays the loan, then the bank will receive cash released from Bill's decision to cancel his policy up to the pay off amount of the loan. Bill will then receive whatever cash value remains.
If Bill cancels the policies after he repays the bank loan, then he will receive 100% of the cash value accumulated in the policy upon canceling it.
The Benefits of Premium Financing
Premium financing is a way for people with significant assets to leverage their finances to buy large death benefits a discount versus the traditional method of simply paying the premium out-of-pocket.
Sometimes premium financing is the only approach someone with a substantial death benefit need has to establish such a death benefit. While the individual may have substantial assets, cash flow may not support the large premium payment.
The cash accumulation nature of some forms of life insurance allows the applicant(s) to use their other assets in the short term to acquire the loan, and then use this cash value to repay the loan. This leaves the policy owner in a position where the only out-of-pocket expense of the interest due on the bank loan.
Drawbacks to Premium Financing
While premium financing serves a truly great service to the right situation, there are several potential pitfalls. For this reason, it's not generally recommended that newer agents attempt to handle such a case on their own. In fact, it's rare for any insurance agent to handle a premium financing case entirely on his/her own and it's common for several other professionals (i.e. attorneys, accountants, etc.) to be part of the transaction.
The biggest risk premiums financing poses to the potential life insurance applicant is a net loss if the applicant moves forward with a poorly executed plan that results in policy cancelation while the loan is still larger than the cash value in the policy. This can happen when the applicant chooses the wrong plan for premium financing and/or the wrong financing option.
The applicant must factor in the repayment of the loan and this often requires the applicant to apply for a larger life insurance policy than he/she would have when just buying a regular policy and paying the premium out-of-pocket.
Additionally, loan rates on premium financing loans are never fixed indefinitely. This means the interest rate could increase at a rate faster than assumed forcing the applicant to post additional collateral or paying interest premiums for a longer period than expected. There are several stress test scenarios an applicant should review prior to finalizing a premium financing plan.
Premium Financing IS NOT a Cash Accumulation Play
Premium financing is indicated for those seeking permanent death benefit. It is not intended as a way to accumulate cash value in a life insurance plan. There are some marketing groups that claim to have a specialized formula for leveraging assets and multiplying growth potential using primarily indexed universal life insurance and premium financing.
The presentations use a lot of sophisticated-sounding finance terms and are extraordinarily complicated in actual execution. We've taken time in the past to address this sales tactic and remain extremely dubious about its viability. Simply put, assets best purchased through financing are those with extremely high growth potential that can quickly eliminate the debt you take on to acquire the asset. Life insurance cash values simply don't meet this definition and are best accumulated through either periodic payments from cashflow or transferring other hard assets you already own.