Premium financing is often appealing for many high-net-worth clients who are comfortable with leverage or complexity. It comes down to one thing — education is key.
Premium finance is one of the hottest topics in advanced planning circles of the life insurance industry. The strategy looks sophisticated, boasts attractive internal rates of return and attracts clients and advisors alike. Premium financing is often appealing for many high-net-worth clients who are comfortable with leverage or complexity. But, as the old maxim goes, “All that glitters is not gold.” This blog is not to persuade or dissuade clients from this strategy but rather to share a better understanding of the design, elements of risk and the appropriate target markets.
The basic mechanics of premium finance are relatively simple — a client works with a commercial bank to borrow funds to pay life insurance premiums. Your client posts both the insurance policy and outside assets as collateral for the loans and will typically pay loan interest out of pocket for a defined period, at which point your client repays the loan. There can be many reasons for financing, but typically the general premise is that the investment return in the policy will exceed the interest rate charged on the loan. But we’ll discuss that in more detail later.
Premium finance is most attractive to those that have a more compelling growth opportunity with their out-of-pocket funds and don’t want to lose that growth by tying their assets up in insurance premiums. When it comes to the ideal client profile for a premium finance plan, included should be:
Today, most proposal reviews are based on the premise that the long-term cost of borrowing is less than the expected net return on the cash value of a life insurance policy, thus creating arbitrage. When properly structured, cash value life insurance policies can illustrate net returns on cash values of 4%-5%. And with assumed borrowing costs of less than 4%, this can make financing look quite compelling. The most extreme versions of such designs would appear to offer “free insurance” — proposing an arrangement by which a high-net-worth client is able to secure large amounts of life insurance coverage with no out-of-pocket costs, merely posting collateral for the loan.
Understanding the main components of premium financing is crucial to evaluating the strategy and advising your clients.
The loan rate generally spreads over a current benchmark interest rate, often the Secured Overnight Financing Rate (SOFR) or the Constant Maturity Treasury Rate (CMT). For example, the lender may offer a spread of 150 basis points over SOFR. If the current SOFR is 2.5%, then the first-year loan interest rate will be 4.0%.
Most loan rates will reset each year to reflect the current SOFR rate. In some cases, however, a lender may be willing to “lock in” a loan rate for up to five years, though those arrangements may require more restrictive debt covenants and possible repayment penalties.
Often, proposals show loan interest handled in one of three ways:
Lenders require loans to be fully collateralized each year. The primary source of collateral is the policy’s cash surrender value and, to the extent surrender value falls short, the borrower must post additional collateral. The lender has the right to call the collateral — both the policy cash values, and other collateral posted — in the event of a loan default.
Many premium finance proposals are reliant on the future growth of cash values to be sufficient to repay the bank loan and “exit” the financing arrangement. Having a clearly defined strategy to repay the bank loan in the future is a key to successful implementation of this strategy, though it is often overlooked or only loosely developed.
In the context of wealth transfer or business succession planning, a premium financing arrangement may also include a strategy for repayment of the loan using other assets. Some examples of this include:
The financed insurance is almost always a high cash value policy from a highly rated insurance company. High cash values reduce the need to post outside collateral and provide the client with the potential to use policy values to repay the bank loan. In turn, this type of policy is typically a participating whole life or indexed universal life.
Clients implementing a premium financing arrangement are subject to both great risks and great rewards and must manage the transaction carefully. Your clients should be prepared for the possibility that borrowing costs are far higher than anticipated or that policy performance is far lower than anticipated, either of which can have significant economic implications. For example, an unexpected spike in interest rates could require the client to post substantially more collateral or pay more in loan interest than anticipated. Because of this, each client should see stress-tested scenarios for a financing arrangement prior to making a commitment.
It comes down to one thing — education is key. Advisors and clients alike should not take for granted a full and complete understanding of premium finance before deciding to implement. Palladium Group and the Ash Brokerage Advanced Markets teams can help you analyze a competitor’s proposal, design a suitable premium finance arrangement and communicate to your client the potential benefits and the potential risks of borrowing money to purchase life insurance — creating a smooth ride. Contact your team of experts today to learn more.
*This material is for financial professional and educational use only. Not to be reproduced or shown to clients.