Premium financing is often introduced to affluent clients as the ultimate planning strategy -- the hero coming to the rescue -- for low or no cash flow and big death benefits.
If only it were that simple. Let's first look at the question that should be answered immediately -- are you truly trying to design a solution for the client's estate liquidity needs, or are you manipulating their greed, vulnerability, ignorance, and insurability to create wealth for someone else? The end of the second story is always the same -- someone else will receive the majority of the death benefits while the client receives a stipend for the convenience.
History has proven that individuals who attempt to receive disproportionate gains are some of the most creative people around. While the industry and carriers are attempting to close the door on such unscrupulous practices, these noncompliant agents are creating new and more elaborate ways to continue to successfully place significant cases. This success is dangerous and is a threat to the industry and an advisor's ability to bring premium financing to a client who really needs an agent who maintains fiduciary standards in premium financing cases.
The client advocacy approach can be a winning strategy for the client who needs estate liquidity. However, even those with the best motives can, intentionally or unintentionally, mislead clients in a premium financing transaction. Most miscommunication comes from a lack of understanding or a reliance on policy uncertain assumptions. Let's look at a few areas that will allow advisors to make sound decisions and be able to communicate fully to a client who is interested in premium financing.
Cash flow
One of the most compelling reasons for a client to consider premium financing is the reduced cash flow versus purchasing a policy directly. This is especially true in a low-interest-rate environment, such as exists today. As most premium financing strategies are based on a loan utilizing the London InterBank Offer Rate (LIBOR) plus a spread of 150 bps to 300 bps, the interest requirements are very low. Herein lies the danger -- many advisors and clients get caught up in the low interest requirements in the early years of a policy and ignore the fact that cash flow for interest in the later years can be significantly greater than the premiums.
Additionally, the current interest rate market is just that -- current. Future interest rates may not be as favorable.
Interest deferral
Responding to the cash flow risk component, many advisors will attempt to design the premium financing strategy with a deferred interest component -- a very powerful strategy in the short run, a very dangerous strategy in the long run.
While this approach can significantly decrease or, potentially, eliminate cash flow requirements in the early years, it can create enormous cash flow requirements in the later years and create a need for sizeable collateral requirements.
Collateral requirements
The deal killer of most premium financing is the collateral component of the
loan -- hence, most deceptive programs are based around no or minimal collateral requirements. The importance of the collateral component cannot be overstated.
The easiest form of collateral is to utilize the cash surrender value, which often prompts advisors to design the policy with large premiums in the early years, thus creating the build-up of cash values. An equally (arguably more) important result of this design is the creation of a larger loan balance early in the policy, thus creating greater interest requirements.
Alternatively, a client may utilize many other types of collateral, including a letter of credit, stocks, bonds, certificates of deposit, cash, collectibles, and real estate.
An advisor must be knowledgeable of a particular lender's approach to the alternative collateral assets. More importantly, the advisor must be aware of the danger represented by the reliance on collateral. Collateral values can change based on a number of factors, and the collateral requirement as a percentage of estate assets can become unacceptable to the lender.
Loan structure
No matter what anyone says, there are no loans for life. Every lender's loan is a renewable term loan. Many lenders will commit to a multi-year term -- say five, seven, or even 10 years -- but they are renewable at the end of that term, thus subjecting the client to finance risks at that time. This is not to say that the lender will walk away at this point --- quite the contrary, most lenders want this to continue through fruition. However, it is a risk of which advisors must be aware.
By being knowledgeable of the different design components and their respective risk characteristics, an advisor can work with a client to create a successful premium financing design. In doing so, an advisor must be mindful of the ideal client profile. Premium financing from a true estate planning focus can work very well for individuals or couples 65 years of age or greater with estate values in excess of $5 million. Premium financing can be successfully implemented for younger individuals, but a sound exit strategy must be incorporated into the plan (actually advisable for all premium financing cases). One such exit strategy would be the use of a GRAT to transfer an asset to the trust owning the life insurance policy, with the asset ultimately being sold to eliminate the loan.
So when it comes to premium financing, knowing the mistakes before you make them can go a long way in building trust and serving your client as they should be served.
Mark P. McLaren, CPA, MBA is a cofounder of M2 LLC, an advanced planning firm in St. Louis, MO. He can be reached at mark@m2llc.com.
