Understanding Life Insurance Premium Financing

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Key Takeaways

  • Life insurance premium financing is designed for high-net-worth individuals and business owners who have liquid assets of more than $1 million to pay for very expensive premiums without using their own money.
  • Premium financing is available for different kinds of life insurance policies – term life, whole life, and universal life – by securing a loan through a private bank or premium financing life insurance lender.
  • Insurance premium financing involves interest rate risk, policy earnings risk, qualification risk, collateral shortfall risk, and underlying policy charges risk.
  • Benefits of life insurance premium financing include preservation of your own investing capital to potentially grow the value of your liquid assets and maximize wealth inheritance to the next generation.
  • Premium financing of life insurance is a complex strategy requiring professional input and guidance from your financial advisor and/or legal counsel.

What Is Life Insurance Premium Financing?

Life insurance premium financing is a way to protect your own personal assets by allowing you to take out a loan to cover the cost of high life insurance premiums rather than using your own monetary resources. One motivation for choosing life insurance premium financing is to invest the liquid assets you are protecting in alternative investments in an attempt to earn a higher rate of return than the interest rate for the premium financing loan - thereby “coming out ahead financially.”

The cost of life insurance depends on a variety of factors, including your age and health, the type of life insurance you want — whether it’s whole life insurance, term life insurance or universal life insurance - and the amount of coverage you need. Premium financing is available for different types of policies, including whole, term and universal life. By purchasing a permanent life insurance policy like whole or universal life, your policy will build tax-deferred cash value. However, whole and universal life premiums will most likely be more expensive than term life premiums for the same amount of coverage.

How Does Life Insurance Premium Financing Work?

The basics of life insurance premium financing are pretty straightforward to understand but perhaps more challenging to manage over time. How it works is that you borrow money in order to pay the policy’s premium costs. Qualifying high-net-worth individuals can obtain these kinds of loans from many of the world’s largest private banks or premium financing life insurance lenders. Most premium finance lenders provide interest-only loans with capital repayment when the loan term ends. In addition, the rates from these third-party lenders are often higher than those offered by private banks.

What Happens If the Insured Passes Away Before the Loan Is Repaid?

With this type of policy, if the insured dies, then the death benefit proceeds first go toward paying off the outstanding balance of the loan. If extra money remains after the loan is completely paid, then the beneficiaries of the policy will receive whatever is left. In some cases, the death benefit may not be enough to repay the premium finance loan, which means the policyholder’s other estate assets would have to be used to pay whatever remainder is due on the loan.

What Is the Difference Between Policy Financing and Premium Financing?

Policy financing involves a life insurance policy loan and refers to a policyholder (who is not necessarily a high-net-worth individual) borrowing money from the cash value that has previously accumulated in their life insurance policy. Premium financing is a loan taken out by a policyholder who is a high-net-worth individual from a private bank or premium financing life insurance lender to pay the life insurance premiums on the policy.

Who Uses Premium Financing to Buy Life Insurance?

High-net-worth individuals — defined as people with at least $1 million in liquid assets — are likely candidates to use premium financing to buy life insurance. High-net-worth individuals may want to protect their liquid assets in the hopes of making a higher rate of return on them than the interest rate they will be paying on the loan to pay their premiums.

Business owners also have an incentive to consider life insurance premium financing because they could have tens or hundreds of millions of dollars or more invested in their company assets and key employees. Without certain highly valuable employees at the company, the monetary success and legacy of the business could be put into serious jeopardy. This is why business owners purchase key person insurance. Premium financing allows a business to obtain protection for its most valuable people while maintaining an efficient cash flow for its operating costs and growth initiatives.

Premium Financing Risks and Risk Management

Even though you may be a wealthy individual with enough assets to qualify for life insurance premium financing, taking on the debt of this kind of loan still involves risks. Managing both your life insurance policy and the loan that finances its premiums can present serious challenges and increase the urgency for effective risk management.

Think about these premium financing risks:

  • Interest Rate Risk — Interest rates can fluctuate significantly over time. Just recently, the prime rate has doubled from 4.25% (March 4, 2020) to 8.50% (July 27, 2023) within a span of less than three and half years.1 The majority of premium finance loans have a variable interest rate, so imagine that rate doubling in a short amount of time. The financial consequences of such an interest rate hike could be dramatic.
  • Policy Earnings Risk — Because of market volatility, a life insurance policy’s cash surrender value (the money you as a policyholder receive from an insurer if you terminate the policy before it matures) can run the risk of underperforming, potentially leading to the balance of the loan exceeding the value of the borrower’s collateral. In this case, to avoid defaulting on the loan, additional collateral would be required. Similarly, if the policy’s death benefit fails to grow, it may not be enough to pay off the loan when the time comes, which means the insured’s estate ultimately would be responsible for the loan repayment.
  • Qualification & Collateral Shortfall Risks — Lenders generally require premium finance borrowers to requalify every time the loan is renewed. Consequently, these borrowers also run the risk of collateral shortfall, meaning that they could be forced to provide additional collateral for the loan if the value or quality of their existing collateral goes down. For example, if the borrower’s holdings of stocks or corporate or municipal bonds are downgraded, the bank could potentially deny them as loan collateral. Then, the insured borrower will need to post more collateral to cover the loan.
  • Underlying Policy Charges Risk — Whole life policies have fixed underlying mortality charges (fees an insurer charges a policyholder to provide life protection) that never increase. However, an indexed universal life (IUL) policy has dynamic policy charges that can increase over time, which may cause the policyowner to either pay more in premiums or decrease the death benefit amount.

Benefits and Drawbacks of Premium Financing

Life insurance premium financing has its pros and cons. Below is a quick summary of premium financing’s benefits and drawbacks.

Benefits

  • Preserves investing capital to potentially earn better rates of return.
  • Avoids liquidating assets (to pay for the premium upfront) that could trigger capital gains taxes.
  • Helps maximize wealth to your heirs and keeps your legacy intact by paying estate taxes from death benefit proceeds.
  • Allows investments (cash value) within the policy to grow tax-deferred.

Drawbacks

  • Increases the overall cost of insurance because of the interest and fees associated with the loan.
  • Incurs the additional risk of loan default, which could terminate the policy and its benefits.
  • Involves several major areas of risk, including qualification and collateral shortfall risks, interest rate risks and policy earnings risks.
  • Runs the risk of possible reduction in policy benefits if the insured fails to keep up with interest payments for the loan.

How Do I Qualify for Premium Financing?

Potential candidates for premium financing for life insurance typically have to meet a series of standards that insurers have established. These include:

  • Identified as someone with high net worth — High-net-worth individuals are people who have accumulated a total wealth of $1 million or more in investable or liquid assets, which may include cash, stocks, and bonds.
  • Under age 70 — Another requirement for life insurance premium financing is being less than 70 years old and in overall good health.
  • Demonstrated financial need — You have to have a clear insurable interest — meaning a financial stake in an object of insurance, such as a $15 million resort property — such that the loss, damage or destruction of which would cause a major negative financial impact or monetary loss for you.
  • Necessary collateral and ability to repay — You will need to provide additional collateral (e.g., real estate investments) for your loan besides your life insurance policy. Insurers want a guarantee from you that you are able to repay the loan by separate means other than the policy’s death benefit.
  • Involvement of professional consultants — You have demonstrated that you have consulted with an outside financial advisor or legal professional about the viability of premium financing for your specific life situation.

Can Premium Financing Be Used for Other Insurance Types?

Although life insurance premium financing may be more common, premium financing also can be used to pay premiums on property and casualty insurance as well as commercial insurance policies, including property, general liability, and workers’ compensation insurance.

Just like premium financing for life insurance, property, and casualty insurance; premium financing and commercial premium financing can provide more financial choices and flexibility to both individual policyholders and businesses by freeing up monetary funds that would have been used for premiums for alternative investments and other purposes. By avoiding big upfront premium payments, individuals and businesses can manage their cash flow more effectively. However, premium financing for these other types of insurance carries similar risks and downsides as life insurance premium financing, including higher costs in interest and fees and the risks of interest rate fluctuations, market volatility and loan default.

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Sources

  1. HSH: Prime Rate — current values and history covering 2020-present. https://www.hsh.com/indices/prime-rate.html.

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IMPORTANT DISCLOSURES

Information provided is general and educational in nature, and all products or services discussed may not be provided by Western & Southern Financial Group or its member companies (“the Company”). The information is not intended to be, and should not be construed as, legal or tax advice. The Company does not provide legal or tax advice. Laws of a specific state or laws relevant to a particular situation may affect the applicability, accuracy, or completeness of this information. Federal and state laws and regulations are complex and are subject to change. The Company makes no warranties with regard to the information or results obtained by its use. The Company disclaims any liability arising out of your use of, or reliance on, the information. Consult an attorney or tax advisor regarding your specific legal or tax situation.