The estate planning landscape of premium-financed life insurance is both changing and expanding, creating new opportunities. To capitalize on them, insurance professionals must be able to identify potential candidates and then help them work through the key characteristics that will determine the best solution.
Why Premium-Financed Life Insurance?
At its most basic, in premium finance, one borrows money to pay large premiums on a high face amount life insurance policy. For wealthy individuals with large estate liquidity needs, the premiums needed to fund a large life insurance policy can run into the hundreds of thousands of dollars.
While the client may have sufficient assets that could be liquidated to fund the premium, they may be reluctant to sell assets that are appreciating significantly or currently generating income. They may have a significant portion of their wealth tied up in a business interest that they intend to pass on to the next generation, or they may hold assets that cannot easily be liquidated, such as real estate, or assets that, if sold, may trigger capital gains tax.
By borrowing the money needed to pay the premiums, high-net-worth clients can buy insurance without fronting the cash or selling valued assets. By financing the premium instead of liquidating a valued asset, the client can:
o enjoy continued asset growth and income (ideally the return exceeds the loan interest);
o postpone potential capital gain taxes;
o retain control of the valued asset;
o use "someone else's money" rather than pay out-of-pocket; and
o avoid potential gift tax issues.
Regarding the last point, where an irrevocable life insurance trust (ILIT) owns the policy, large premium amounts may exceed the annual exclusions and may incur gift tax. Even the current lifetime credit of $1 million may be insufficient. If the ILIT borrows funds, however, to pay premiums by using annual exclusions (and perhaps some portion of the lifetime credit) to make gifts of loan interest only -- a prevalent strategy in these cases (see chart below) -- the irrevocable life insurance trust (ILIT) that owns, holds, and finances the policy can afford a much larger premium.
Certainly, the recent period of low interest rates has enhanced the appeal of premium finance. One potential reward of using premium financing relates to the spread between the loan interest rate and the rate of return on the asset that was not liquidated to pay premiums. The lower the loan rate, the higher the potential reward of the program.
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Characteristic #1: Loan Repayment Schedule
Generally speaking, premium finance programs have certain key characteristics that define their various advantages. One factor is whether the loan will be set up to be paid off at some designated point in the future, or at death. If it is to be paid off during life, a means of funding the loan payoff separate from the death benefit will be needed. This could be done by liquidating assets at some point. An asset that is expected to experience high growth over the next several years, but whose prospects beyond that are uncertain, might be a good fit for this strategy. An advantage of paying off the loan during life is that there is no risk the death benefit will be reduced by having to pay off the loan at death.
On the other hand, if the loan is to be paid off at death, this concern could be addressed by a universal life policy with a death benefit Option 3, in which the death benefit grows by premiums paid. That return of premium benefit could be used for loan payoff. By waiting until death to pay off the loan, maximum financial leverage applies, but with a commensurate increase in risk -- primarily interest rate and return.
Characteristic #2: Likely Candidates
Premium finance may be most suitable to those who have an understanding of, and are comfortable with, interest rate risk and arbitrage. Older clients are preferable because of the assumption of interest rate risk, which increases with the duration of the loan. The longer the loan is outstanding (more likely for younger individuals), the greater the risk that interest rates could rise significantly. Business owners and individuals with significant investment portfolios may be good candidates because they believe in their ability to grow wealth. These individuals may be particularly averse to paying premiums out-of-pocket and may be more risk inclined.
Characteristic #3: Loan Rate and Type
Most programs use a variable rate, reset annually. The rate is typically determined by using a reference rate plus a spread of around 100-350 basis points. These spreads have generally been decreasing as more programs compete in the premium finance market. The most common reference rate used is the London Interbank Offered Rate (LIBOR), although other reference rates may also be used.
Clients looking to decrease interest rate risk may consider a fixed-rate program. In instances where fixed rates are offered, they may be fixed for a specified period only, such as five years. They may also look into using a cap that may be placed on the interest rate. Loans may also be structured with deferred interest, rolling the interest into the cumulative loan balance, but clients need to be aware that deferring interest may reduce the net death benefit below the needed amount.
Additional factors that affect this rate include:
o creditworthiness of the client or entity guaranteeing the loan;
o type of asset pledged as collateral;
o size of the loan; and
o whether there is an interest rate cap.
Loans can be structured as either recourse or non-recourse. Under recourse loan agreements, the insured or a third party guarantor pledges other assets as collateral for the difference between the loan balance and the policy's cash surrender value. As the policy's cash value increases, the amount of required collateral may decrease. Under non-recourse financing arrangements, only the life insurance policy collateralizes the loan. Non-recourse arrangements of this type have been generally associated with abusive financing practices such as Stranger-Originated Life Insurance (STOLI). Recourse loans also generally obtain lower interest rates.
Characteristic #4: Preferable Insurance Products
While any cash value life insurance policy could be used for premium finance, policies that have guarantees related to investment return and preventing policy lapse appeal most to lenders. It is critical that the policy is funded and kept in force. If the policy is allowed to lapse, the remaining loan value will become immediately due. Because recourse financing requires collateral equal to the shortfall of policy surrender value to cover the loan, products with shorter or smaller surrender charges are preferable, also.
Under current estate tax laws, second-to-die policies may fit very nicely for married couples since estate taxes can be deferred until the second spouse dies, precisely when the survivorship policy will pay a death benefit. The cost of this coverage is, of course, less expensive than single life coverage for two policies.
Case Study
Let's see how premium finance provides a solution in the real world. Wesley Reece, age 65, is worth more than $5 million and realizes he needs more life insurance to provide estate liquidity. A significant portion of his wealth is invested in rental property, and he would prefer not to liquidate any of it to fund the life insurance coverage.
Working with his insurance professional, Wesley decides on a strategy to finance the premiums on a life insurance policy. In this way, he'll continue to receive income from the real estate (see chart).
The premium finance arrangement allows for annual payments of interest only (this will be done using Wesley's annual gift exclusion and possibly some of his lifetime credit), with the loan principal scheduled to be paid off in 10 years. An ILIT will apply for and purchase a permanent policy on Wesley's life that will be paid-up after 10 years. Wesley will also set up a Grantor Retained Annuity Trust (GRAT) with a term period of 10 years.1 The GRAT is a useful estate planning tool for shifting assets to his his children and out of the taxable estate (this GRAT is not reflected in the chart). To be successful, however, the grantor must survive the GRAT term or the trust assets will be included in the grantor's estate. A 10-year term policy will provide additional protection during that period. Steps in the process and results include:
1. Wesley (and his attorney) creates an ILIT that applies for a permanent insurance policy on Wesley and applies for the loan.
2. The ILIT will also apply for a 10-year term policy for as much as the anticipated loan principal.
3. Policy is issued to the ILIT and with premiums paid by ILIT, funded by loans.
4. Wesley now has the insurance protection he needs when he dies.
5. Wesley (and his attorney) creates a GRAT with a period of 10 years and transfers rental property to the trust.
6. Wesley will receive payments from the GRAT.
7. Wesley uses income from GRAT to pay loan interest (via gifts to the ILIT).
At this point one of two things will happen: Wesley will live for 10 years, or he will not.
If he dies: The permanent policy death benefit proceeds may be used to cover estate settlement costs, such as state and federal estate taxes. The 10-year term policy proceeds will be used to pay off the outstanding loan balance. Keep in mind that the GRAT would not have been successful, in the sense that the value of GRAT assets will be included in Wesley's taxable estate.
If he lives: The GRAT terminates and its assets are shifted to the ILIT. Enough assets are liquidated to pay off the loan balance. The permanent policy is now paid-up for Wesley's life, and he was able to fund it without liquidating any real estate for at least 10 years.
While the ILIT could sell the real estate asset to pay off the loan balance, there are other possibilities. Instead of selling the asset, the trust could potentially refinance the loan and use income from the asset to make interest payments, or to pay down the loan (interest and principal). Another possibility is for the ILIT to sell the asset back to the grantor so that the ILIT would have the cash from the sale to pay off the loan and the grantor would regain control of the asset.
The Exit Strategy
Before entering into a premium finance arrangement, clients would be wise to consider the inherent risks, and to have an exit strategy defined.
In almost every premium financing arrangement, loan repayment could take place at any time between a few years' time or at the death of the insured. Interest payments could be made regularly, or deferred for a few years, or deferred entirely until loan repayment. The longer the loan is outstanding, the greater the interest rate risk becomes. Also, if interest payments are not made regularly, the loan balance may accumulate rapidly and may eliminate the death benefit.
Your client needs to know how the plan can be terminated for interest rate reasons, or otherwise, should they desire to preserve the necessary death benefit proceeds.
The Opportunity
At least for the foreseeable future and in a low-interest-rate environment, premium finance is gaining respect and interest as a tool of choice for the affluent needing to acquire large amounts of life insurance protection.
Dan de la Chapelle, CLU, ChFC, is an advanced markets consultant for Western Reserve Life Assurance Co. of Ohio, an AEGON company. He has been in the insurance and financial services industry for 14 years. Mr. de la Chapelle specializes in business and estate planning strategies for high-net-worth clients.
Footnote:
1. The GRAT is an irrevocable trust in which the grantor retains the right to receive fixed payments at least annually for life or for a term of years. These fixed payments must be made. The value of the transferred remainder interest is equal to the value of the entire property reduced by the value of the retained interest.
