Fall 2008
By Douglas P. Hepburn, CPA, PFS, CFP
Premium financing for life insurance has been around for years, but its popularity exploded in 2003 when investors identified life insurance policies purchased in the secondary market as a potential portfolio holding. This has fueled the growth of the life settlement industry and raised important ethical issues surrounding the question of insurable interest. Yet, premium financing continues to be an estate planning tool that requires careful consideration.
Typical premium financing arrangements involve a permanent policy, such as universal life or equity indexed universal life, where the cash value of the policy is used as collateral for a loan financing the premiums.
In many instances, policies can be structured with lower initial expenses and no surrender charges. This process maximizes the policy cash surrender value, thereby minimizing the additional collateral required by the lender.
Premium financing loans have variable interest rates that are fixed from three to 12 months. The rates are based on a widely accepted index, such as the London Inter Bank Offered Rate, plus a spread. The borrowing rate is seldom higher than the crediting rate in the policy, leaving little opportunity for interest rate arbitrage.
Equity indexed universal life provides policy crediting rates based on the returns of one or more equity indexes and usually has a minimum guaranteed rate of return. These products have the potential to exceed the borrowing rates of the premium loan without the downside risk of negative returns associated with traditional variable policies. The fluctuation of the targeted indexes, however, makes it difficult to accurately model these policies or make long- term projections.
During the term of the loan, the policy owner may opt to defer the interest or pay it currently. By deferring the interest until death, the loan value will likely grow faster than the cash value. The result being additional collateral requirements and a reduced net death benefit.
Planners should consider the facts and circumstances of each case to determine whether this course is appropriate. As a planning point, it may be possible to pay the loan interest from annual gifts to the trust, depending on the number of beneficiaries. This effort would minimize the need for additional collateral while maximizing the net death benefit.
Premium financing is most often used with larger, illiquid estates that expect significant estate tax liabilities, such as those with privately held businesses or vast real estate holdings. Younger clients only rarely employ premium financing.
It is more often used for those whose life expectancy is less than 20 years from the date of purchase. Rarely do all assumptions used in a financial strategy remain valid for the life of the client. For that reason, it is critical to test any options against a worst case scenario prior to implementation so an action plan for recovery can be developed in advance. Once implemented, the strategy should be monitored regularly and adjusted to avoid having to make a major course correction at the last minute. The easiest exit strategy is to repay the loan at death. The downside here is that the longer the insured’s life, the greater the opportunity for something to go wrong. If the interest is deferred and paid from the death benefit, the net proceeds may no longer be sufficient to meet the client’s needs.
Repayment of the loan is the safest strategy, but it is often complicated by a limited ability for the grantor to make gifts. To make repayment easier, explore placing an income generator within the trust using a widely accepted discounted gift or sale technique.
Surrendering the policy is an exit strategy that deserves careful consideration since it could trigger gift or income taxes, depending on who is guaranteeing the loan and who ultimately repays it. As a last resort, if the financing arrangement cannot be unwound without significant pain, a life settlement may be the only option.
If an owner of a policy receives a payment in exchange for a life insurance policy, that transfer is considered a life settlement. These payments were once limited to situations where the insured had a terminal condition. In recent years, investors have recognized that they can purchase policies for a fraction of the death benefit with very little risk. This approach has become increasingly popular as an exit strategy for unwanted policies. It is even being pitched as a source of revenue for seniors who purchase insurance, then sell the policy after the two-year contestability period has passed. This development has raised ethical concerns among regulators and the insurance industry because of the high transaction costs and the potential for unintended consequences.
Despite the negatives surrounding these life settlements, premium financing remains a viable strategy for successful clients, provided they are fully informed of all the potential implications and have an exit plan if their situation changes.
Douglas P. Hepburn, CPA, PFS, CFP, is an advisor representative of Multi-Financial Securities Corporation. He can be reached at dhepburn@hepburnadvisors.com.
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