Life insurance often is the best way to pay estate taxes, offering better timing and leverage. And one of the best ways to obtain life insurance for wealthy clients is through premium financing.
Premium financing refers to a group of strategies that use borrowed money to pay life insurance premiums, either in total or in part. The structure of premium financing can be very complex and intricate. When done correctly, it can prove very advantageous for the ultra-high-net-worth client. When done poorly, it can be a complete disaster.
The first step typically involves the creation of a life insurance trust, which buys the client's life insurance and borrows money to pay the premiums.
The loan interest is usually slightly higher than a published rate, such as LIBOR. Periodically, the loan renews and sometimes the interest rate is reset. The loan interest is paid yearly or sometimes more frequently. In some scenarios, the interest can be accrued.
Loans beyond a certain number of years, commonly five years, are not guaranteed. When that time limit is reached, an assessment is made of the life insurance policy's performance, the creditworthiness of the client and the potential forms of collateral.
Collateral for the loan comes in a number of forms. It includes the cash value as well as the death benefit of the life insurance. Other assets such as securities and real property can also be used as collateral. But no matter what, the client is responsible for the loan.
The types of life insurance policies that are usually used include whole life, universal life and equity-indexed universal life. Both whole life and universal life are predicated on long-term interest rates. In contrast, premium financing uses short-term interest rates.
Why is premium financing suitable for high-net-worth clients? One reason is that the use of borrowed money allows clients to capitalize on leverage in a way that doesn't put pressure on cash flow. Furthermore, it reduces the need for gifting.
Some things, however, can sabotage a client and his or her life insurance policy. The following scenarios are the ones we see most often:
1. Interest rate mismatches. This is when the interest rate on the loan becomes too big to keep the life insurance policy in force. This usually leads to a need for more collateral.
2. Poor life insurance policy designs. Very often, when premium-financing transactions go bad, it's because the policy was poorly designed. Sometimes this is because the policy was minimally funded; other times it is because the projected returns were unrealistic. This also leads to the need for more collateral.
3. A client's inability to renew the loan. It's not always possible for the client to continue to borrow money to pay the premiums. This could be for a number of reasons, ranging from the ones we mentioned above to the lender getting out of the business. If maintaining the policy is dependent on renewing the loan and that proves impossible, then the transaction collapses.