Structuring life insurance premium finance when interest rates are high

When it comes to estate planning, wealth transfer planning and business transition planning, life insurance plays a crucial role in providing financial security and ensuring a smooth transfer of wealth. When borrowing interest rates were low, annually paying the premiums on policies with significant death benefit was not always the most cost-effective way to buy life insurance.  By financing premiums, some policyholders were able to leverage low interest costs to use borrowed funds rather than to tap into money deployed elsewhere where it was earning a higher yield.

It seemed as though the entire life insurance industry was abuzz about premium finance, and the strategy flourished. Now that borrowing costs have nearly tripled, does this mean that premium finance should not be a part of the conversation when deciding to buy life insurance?  Not necessarily.

When interest rates were low

Premium finance is a financial strategy that allows qualified individuals and businesses to acquire large life insurance policies without tying up significant capital. Instead of paying the premiums directly, the insured borrows the funds from a lender, often at competitive interest rates, to cover the policy premiums.

When money cost less to borrow, premium finance was positioned as a cost-saving tool, not only for death benefit-driven planning but also for standalone income strategies. At one end of the spectrum, very wealthy clients were able to obtain preferred lending rates from their banks to finance sizable policies intended for estate and wealth transfer planning. Policies often were financed for the dual purpose of furnishing needed death benefit and as a way to provide income.

This market still exists and contrasts with the way premium finance was positioned at the other end of the spectrum – to high earning professionals solely to supercharge a life policy to provide future income. In a traditional income strategy, a life insurance policy is funded so that the death benefit is always at the minimum amount permitted by the Internal Revenue Code for the sum of the premiums paid. This typically allows for the cash value to grow more quickly and, at a time in the future when cash is needed, the policyholder can take tax-free withdrawals and loans from the policy.

Even back when borrowing interest rates were low, there was a level of complexity and risk added to the premium-financed purchase of a policy focused only on future income when the policyholder, who may not be qualified from a net worth perspective, borrowed the premiums.  At today’s interest rates, the borrowing math rarely works for this segment of prospective policyholders and the potential financial consequences of the transaction collapsing are exponentially higher.

Today’s market for premium finance

The market is essentially back to addressing those for whom premium finance was originally intended – those needing to buy large amounts of life insurance where the death benefit can provide liquidity for an estate, wealth preservation or business transition plan. This includes those buyers who leave their planning options open by focusing on both the death benefit and future income potential.

By being qualified, these buyers should meet several conditions:

• Possess a significant balance sheet so that the premiums loans and the corresponding policy asset do not make up a majority of a client’s liabilities or assets.
• Have a familiarity with using leverage that may stem from applying leverage in an investment portfolio or in real estate dealings.
• The ability to pay, without material financial injury, all planned premiums without having to finance those premiums.
• The desire to preserve liquidity is because either money is invested and earning attractive yields elsewhere or much of the client’s net worth is comprised of illiquid assets.

Examples of where premium finance may prove advantageous in today’s interest rate environment include someone with a considerable real estate portfolio who needs a large sum of life insurance to pay estate taxes and does not want to have to sell any properties. Similarly, a large law firm or medical practice with unfunded shareholder repurchase liabilities that needs to purchase a number of policies might have cash-flow obligations making out-of-pocket premiums challenging.

Be aware of the risks

While premium finance presents compelling benefits, it is essential to consider potential risks and implement risk management strategies.

1. Interest costs: Borrowing at high-interest rates could lead to increased overall expenses, potentially outweighing the benefits of the insurance policy.
2. Default risk: If the insured fails to repay the loan, the policy may lapse, resulting in loss of coverage and potential financial losses.
3. Market fluctuations: Depending on the investment strategy used to repay the loan, market downturns could reduce returns, making it challenging to cover premiums.
4. Collateral needs: The requirement for collateral to be held by the lender can increase or decrease based upon several factors, including the borrower’s financial condition, interest rates and the policy’s cash value.

Keep premium finance in the conversation

In a high-interest rate environment, using premium finance to purchase life insurance for death benefit purposes can be a strategic solution for estate planning, wealth transfer and business transition needs. This approach allows individuals and businesses to leverage low interest rates, diversify their assets, and access larger life insurance policies without significant upfront costs.

As with any financial strategy, it is crucial to work with experienced professionals to tailor the approach to individual circumstances and risk tolerance.  By doing so, clients can optimize the benefits of premium finance while securing the financial future of their loved ones and ensuring a smooth transition of wealth.

Michael Seltzer is a founder member and principal of Vérité Group. He may be contacted at [email protected].

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