Successful investors and business people understand the wealth-creating power of leverage. For those with an established need for life insurance, premium financing can take advantage of leverage to potentially reduce out-of-pocket costs and preserve capital for more lucrative investments. Premium financing arrangements also may offer significant gift and estate tax benefits.
It can also be a valuable, cost-effective employee benefit. You may have heard that premium financing was a critical component of the compensation package that made Jim Harbaugh college football’s highest-paid coach. (Note that Schechter Wealth didn’t handle the compensation arrangement for Coach Harbaugh.) In lieu of deferred compensation, the University of Michigan agreed to loan Harbaugh $2 million a year interest-free for seven years to pay life insurance premiums. As we understand it, so long as the policy remains in force and performs as expected, Harbaugh will have access to millions of dollars in tax-free cash during retirement and the loan won’t have to be repaid until he dies. At that time, the University should recoup its $14 million investment, and Harbaugh’s beneficiaries will receive the remaining death benefit.
Is It Right for Your Client?
Premium financing can be an attractive option for anyone who: 1) needs a substantial amount of life insurance coverage for business or estate-planning purposes, 2) is unwilling or unable to use current cash flow or liquidate other investments to fund the premiums, 3) is insurable at standard rates or better, and 4) meets a lender’s underwriting guidelines. Generally, an ideal candidate for premium financing has a net worth of $10 million or more.
A Lower-Cost Funding Strategy
Premium financing simply means borrowing money from a bank or other lender to pay life insurance premiums. Currently, favorable interest rates on these loans allow policyholders to fund premium payments at fairly modest cost. Typically, a premium financing arrangement involves a long-term loan with a variable interest rate tied to the London Interbank Offered Rate (LIBOR) or some other index. The insured must furnish collateral for the loan—in most cases, the policy’s cash surrender value—with any shortfall covered by additional collateral, such as a letter of credit or marketable securities.
For many people, the policy of choice for premium financing may be indexed universal life (IUL). These policies earn interest at a rate tied to a market index, such as the S&P 500, but they also provide a guaranteed minimum return, which protects the principal against loss. The tradeoff is a cap on the returns a policyholder can receive, which limits the policy’s upside potential. Most IUL policies offer guaranteed death benefit protection.
It can be advantageous to fund the policy at the maximum level over the initial seven to 10 years to build up cash value (which grows on a tax-deferred basis) as quickly as possible. This helps ensure that the loan remains fully collateralized by the policy and makes cash value available for tax-free loans and partial withdrawals. It’s important, however, to avoid funding the policy too rapidly: Cumulative premiums that exceed certain levels during the policy’s first seven years can trigger modified endowment contract status, rendering policy loans and withdrawals taxable at ordinary income rates.
In a typical premium financing arrangement, the client establishes an irrevocable life insurance trust (ILIT), which borrows the funds and acquires the life insurance policy. Holding the policy in a properly structured ILIT helps ensure that, under current law, the death benefit and cash value pass to the client’s family free of estate taxes. It’s also possible to transfer an existing policy to an ILIT, keeping in mind that policies transferred within three years of death are subject to estate taxes.
The primary benefit of premium financing is the ability to acquire needed life insurance at a minimal current out-of-pocket cost. This may allow the policyholder to invest the money that would have been used to pay premiums in vehicles that offer higher rates of return.
Example: Jay, a successful business owner, wants to acquire $10 million in permanent life insurance, for which the annual premium is $100,000. If Jay writes a check to cover the premium, his out-of-pocket cost in year one is $100,000. Assuming the policy earns interest at a rate of 5 percent, its cash value grows to $105,000 at the end of year one. Note that Jay’s cost could be even greater if he’s forced to liquidate other investments to pay the premium. Not only might it trigger a substantial capital gain, but also, Jay would lose the future earnings those investments would have generated.
Suppose, instead, Jay finances the premium payments with a loan that charges 3 percent interest, so his out-of-pocket cost in the first year is only $3,000. He invests the remaining $97,000 in a vehicle that, in this hypothetical, does very well and earns a 12 percent return. At the end of year one, he still has life insurance with a cash value of $105,000, but his $97,000 investment has grown to $108,640. The same $100,000 investment has produced nearly three times the return that would have been earned by the life insurance alone. For purposes of this example, insurance charges and investment fees have been disregarded, but should be considered when executing a premium financing contract.
Premium financing can offer significant estate and gift tax benefits. As noted above, holding the policy in a properly structured ILIT avoids estate taxes on the death benefit. Plus, by minimizing the policyholder’s required contributions to the ILIT, these arrangements reduce or eliminate gift taxes. In a traditional arrangement, the policyholder makes annual contributions to cover the premium payments. Often, these gifts exceed the $14,000-per-beneficiary annual gift tax exclusion, so they use a portion of the policyholder’s lifetime exclusion (currently, $5.49 million) or, if the exclusion has already been exhausted, trigger gift taxes. With premium financing, annual contributions are generally limited to interest payments on the loan, which are more likely to fall within the annual exclusion.
No Free Insurance
While the potential benefits of premium financing can be compelling, it’s not “free insurance,” any more than a mortgage loan provides a free house. It’s important for those considering premium financing to do their due diligence and weigh the potential benefits against the risks.
The most significant risks are interest rate risk and earnings risk. If the interest rate on the loan increases more quickly than projected or the policy’s earnings fail to meet expectations, the policy holder may be required to put more money into the policy, provide additional collateral or both. Failure to do so could cause the lender to call the entire loan. If the death benefit fails to grow as quickly as the loan, there’s a risk that the insurance proceeds will be insufficient to pay the outstanding loan balance and/or provide the funds needed to pay estate taxes and meet other planning objectives.
Premium financing arrangements offer a great deal of flexibility when it comes to making interest payments and paying the principal. Some loans allow interest to accrue, but doing so creates a risk that the loan amount will grow more quickly than the policy’s cash value, so it’s advisable to pay the interest currently with annual contributions to the trust. Options for paying off the loan include paying it down over time as liquid funds become available, having the trust or estate pay the outstanding balance out of the insurance proceeds, using tax-free policy withdrawals or loans to pay the principal, or some combination of the above.
Keep in mind that the longer the loan is outstanding the greater the risk. Also, using policy loans or partial withdrawals to pay down the loan may jeopardize the policy’s guaranteed death benefit.