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what is premium financing?

Life insurance can provide very attractive financial protection and accumulation benefits, such as:

1. An income tax-free death benefit

2. Tax-deferred cash value growth

3. Tax-free access to cash value, if done properly; along with

4. Creditor protection, depending on ownership and state of issue.

However, it may require that lucrative assets be liquidated or cash flow be redirected to fund the premiums which many affluent clients may find unattractive. Premium financing can be an alternative method of funding life insurance premiums that involves borrowing the amounts needed to pay the premiums from a commercial lender as opposed to paying them out of pocket. The initial cost, then, becomes only the loan interest which can be paid in cash or accrued, in some instances. The loan is collateralized primarily by the policy’s cash value with any shortfall covered by pledging personal assets.

What are the benefits of Premium Financing?

increased rate of return

Paying loan interest and pledging collateral instead of paying
premiums can help to reduce the cost of the strategy or leverage it for
more efficient results, such as an increased rate of return on cash
value accumulation and/or net death benefit.

reduce gift tax exposure

If the policy is owned by an Irrevocable Life Insurance Trust (an
"ILIT") where gifting is needed, the gift is measured by the annual
loan interest paid by the grantor as opposed to the actual premium,
thus helping to reduce or eliminate gift tax exposure associated with
large premium requirements.

mitigate transaction costs

Additionally, the need to liquidate, or redirect cash flow from, lucrative
investments to fund premiums can be reduced or eliminated which
could mitigate transaction costs such as capital gain taxes.

preserve and grow wealth

Securing life insurance while keeping capital deployed towards
existing investments (i.e. maximizing "retained assets") can help
preserve and grow wealth with reduced opportunity cost assuming
the rate of return on such investments or retained assets exceeds the cost of borrowing.

What are the considerations?

Interest Rate Risk

If borrowing costs rise to a greater extent than originally projected, it could result in more out-of-pocket cost than originally projected. .....

Performance Risk

The policy’s cash value can fluctuate and may be less than originally projected, which may result in more outside collateral required, less net death benefit, or a shortfall in cash value to repay the loan.

Exit Strategy Risk

A plan should be in place to repay the loan which can be done via a loan or withdrawal from the policy's cash value, using cash flow from retained assets, the proceeds of a liquidity event from the sale of an asset, or some combination. If the goal is to design the strategy so that the policy's cash value could be a potential source of repayment, there should be another plan in place to create an additional side fund as a "safety net" due to interest rate and performance risk. The most fundamental way to do so is by retaining and investing the
difference between the annual premium that would otherwise be required to acquire the policy and the annual loan interest cost. If the policy is ILIT owned, the primary or backup source of repayment can be created by making additional gifts to the ILIT, or a Grantor Retained Annuity Trust with the ILIT as the remainder beneficiary, as well as selling an asset to the ILIT in exchange for a promissory note. With ILIT-owned policies, gift taxes may result if the loan is repaid with personal assets; the above strategies can help mitigate this risk as well.

Collateral Risk

If the loan defaults, perhaps from a planned exit strategy failure or a material change in the borrower's/guarantor's financial position affecting the ability to renew the loan, the lender may foreclose on collateral, including the policy, unless the loan can be adequately refinanced with another lender.

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How does it work?

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