The Risks of Premium Financed Life Insurance

There are multiple moving parts involved with premium financed life insurance, and therefore multiple types of risks associated with any premium finance arrangement.

Lender Risk with Premium Finance

Premium financed life insurance is most often illustrated with funds being borrowed continuously from a 3rd-party lender for at least 11-20 years before any sort of exit strategy is illustrated. This is in stark contrast to the fact that most premium financing arrangements start with an initial loan term of only 3-5 years.

Therefore, there is a genuine risk of having the loan come due in the early years when the cash surrender value is not sufficient to have the built-in policy loan feature cover this steep capital call.

Lenders can call the loan or choose not to refinance for any number of reasons such as:

• The borrower’s credit score worsens
• The borrower’s amount of collateral diminishes
• The life insurance company’s ratings worsen significantly
• The lender arbitrarily decides not to renew your loan at the end of the term

Keep in mind that many banks offer attractive premium finance rates as sort of a teaser program to develop a deeper relationship with affluent borrowers. Some even require the borrower to transfer their collateral accounts to the lending bank rather than the accepting borrowers existing accounts and relationships. Therefore, when shopping for your premium finance loan it is good to either:

• Utilize a lender whose core business is premium financed life insurance and won’t require transferring collateral directly into their possession
• Or to use a lender with whom you already have a strong relationship, so you are not forced to upset your personal apple cart by transferring accounts away from your existing financial institutions

Doing either of the above may increase your chances of your premium finance loan being renewed at the end of the loan term.

It is also worth noting that premium financed life insurance has become more mainstream over the last 25 years. More and more lending institutions have become familiar with these programs and as a result, are comfortable offering these loan programs. As it has become challenging for banks to earn competitive yield in this low interest and now volatile economy, more lenders are becoming interested in the proposition of collateralized premium financed life insurance.

Therefore, if one premium finance lender does not renew your loan with favorable rates/terms, then perhaps another will.

Loan Interest Risk with Premium Finance (adjustable & based on what?)

How high can your interest rate go with premium finance?

Premium finance loans are most often an adjustable-rate loan even though the loan spread may be fixed for the entire term of the loan. Most often premium financing rates are expressed as a fixed spread over some underlying loan benchmark such as LIBOR, WSJ Prime, or certain Treasury Rates, all of which will cause the premium financing rate to fluctuate.

Nonetheless, while the threat of future higher interest rates has always loomed over premium finance borrowers, it obviously hasn’t come to fruition in any meaningful way since the inception of premium financing around 25 years ago. That said, many borrowers are concerned that hyperinflation and spiking interest rates still remain an impending threat that will occur at some point in the future.

For an additional fee or higher interest rate, many lenders will offer a true fixed premium finance interest rate for the term of the loan (usually 3-5 years but sometimes as much as 10-years). The additional fee or higher interest rate is used by the lender to purchase derivatives to hedge their risk of interest rates floating higher while your loan maintains the lower fixed rate.

However, just as what occurred with fixed vs. adjustable-rate mortgage products over the last 25 years, premium finance borrowers would have been much better off choosing the lower and unhedged adjustable-rate option. Remember, the hope of most premium finance borrowers is that their cash surrender value will grow to a point where they can relinquish all collateral and even absorb the outstanding debt using the policy loan feature (especially if you have an IUL policy with a locked or capped policy loan).

Loan Benchmark Risk? – What will your premium financing rate be based on?

Another unique loan interest rate risk worth mentioning is how your loan rate will be calculated in the future. At the time of this article being written (Q4-2020), most premium finance loans are based on LIBOR (London Interbank Offered Rate) plus some fixed spread usually with a minimum floor regardless of how low the underlying benchmark goes. Although LIBOR remains extremely low even with a modest spread added to it, this benchmark is scheduled to go away at the end of 2021.

It is not known if COVID-19 will slow down the process of its removal, nor exactly how this will affect existing financial contracts using LIBOR (like the myriad of premium financed life insurance loans).

It is predicted that loans previously tracking LIBOR will someday track a benchmark called SOFR (Secured Overnight Financing Rate). However, the exact transition and conversion process has yet to be laid out for existing or prospective borrowers still being quoted premium financing rates involving LIBOR.

Collateral Risk with Premium Financed Life Insurance

There is always the potential risk that a premium finance borrower will have to produce more collateral if the value or quality of their collateral declines. Banks have denied certain types of corporate and municipal bonds after being downgraded.

When stock and even municipal bond portfolios decline drastically (like they did during the onset of COVID-19) lenders may ask borrowers to produce recent statements and post more collateral if there is a shortfall.

Collateral is obviously posted during the early years of every premium financed life insurance policy when the cash surrender value has yet to eclipse the amount of the loan balance. If the policy underperforms the original assumptions (such as we have seen as IUL caps or Whole Life dividends have declined) then collateral requirements may increase and probably need to be posted with the lender for a longer period of time than originally intended.

There are certain providers that offer non-recourse premium financing loan arrangements. In a true non-recourse situation, the policyowner would pay all or a portion of the initial premium so the policy cash value is sufficient to collateralize the entire loan arrangement. In such a case, no outside collateral nor personal guarantee would be needed from the lender, and their sole recourse for any default would simply be the policies themselves. It is worth mentioning, that the loan interest charged for this type of arrangement is typically a little higher than what you can get from a premium financing arrangement where the lender has some recourse.

Policy Performance Risk with premium financing

There is also a risk that your IUL or Whole Life policy will not perform as well as it was originally illustrated. Regardless of how well the policy performs, the borrower is still on the hook for the total loan amount, interest payments, and any unforeseen collateral gaps resulting from poor policy performance.

Recently IUL companies have faced the challenge of increased market volatility, which raises the options pricing thereby lowering IUL caps. Throughout most of 2020, the average amount of market volatility has been more than double that of previous years.

Also, for the last couple of decades interest rates, in general, have been declining. And life insurance companies rely largely on yield to provide ongoing policy growth parameters like Whole Life dividend rates as well as IUL caps and participation rates. We, therefore, have seen the projected growth declining on all life insurance products since carriers must adjust policy growth parameters as the yield on their general accounts morphs with outside economic forces.

Thankfully though, premium finance loan rates and life insurance company portfolio rates for the most part move in tandem. That is why for the 25 years or so premium finance has been in existence, there has been a favorable spread between what you can borrow at and what your life insurance cash value and death benefit can potentially grow to.

To protect against the risk of poor policy performance, it’s paramount that you do these 3 things:

1. Make sure you fund the policy to the maximum allowable IRS limit to reduce early collateral gaps and provide robust long-term performance
2. Have an expert choose, design, and build you a diversified premium financed life insurance portfolio with multiple policies for unique and ideally
   uncorrelated growth triggers as well as hedging against company-specific risks
3. Stress test against poor assumption sets to plan for unforeseen collateral gaps and plot out potential exit strategies

Most premium finance clients and agents alike simply pick the winner of the illustration beauty contest when choosing the underlying premium financed life insurance product. Implementing a premium finance strategy after this kind of one-dimensional analysis has led many premium finance life insurance clients to disappointing results and perhaps additional collateral necessary to support the premium financing.

Diversifying amongst different insurance companies and products that perform well during poor assumption sets can help you not only build a more sustainable premium finance strategy but also plot out when a potential exit strategy makes sense if things don’t work out favorably.

Policy Charges Risk with Premium Financed Life Insurance

The other risk specifically with a premium financed life insurance policy is the underlying charges.

With a Whole Life policy, the underlying mortality charges are fixed at the onset of the policy and can never go up. However, an IUL policy’s charges are dynamic. This amplifies the risk of achieving worse policy performance than was originally illustrated since the underlying charges will increase unless the adjustments are made to offset the poor performance. The policyowner will either need to pay more premiums or reduce the death benefit to offset the poor performance.

Also, any IUL company can actually increase the charge structure of a policy that’s already been sold, whereas a Whole Life company cannot. Now it’s worth noting that this horrific move is rarely used by life insurance companies that offer Indexed Universal Life, but it is possible.

Again, diversifying with multiple products from different life insurance companies in your premium financed life insurance portfolio to hedge against the potential of higher than illustrated IUL charges is key to developing a sustainable premium financing strategy.

More and more we are seeing premium financiers adding slices of Whole Life insurance into their premium finance designs to hedge against this risk. Similar to lowering standard deviation with non-correlated asset classes in an investment portfolio, adding Whole Life to a mix with IUL can support the entire premium financing strategy during rocky times. With a properly structured Whole Life policy, this can be done without sacrificing much in the way of projected returns during even the most optimistic of projections.

Taxation Risk of Premium Financing

Serious tax traps exist if a premium finance transaction goes wrong even though the embedded tax benefits are some of the main draws of premium financed life insurance.

First of all, the loan interest payments on premium finance loans are not deductible. Though certain promoters and exotic structures may offer the prospect of deducting your interest on premium finance loans, you should know that the IRS severely frowns upon tax-deductible life insurance of any sort since the back-end benefits are essentially tax-free.

Second, there is also the risk of overfunding your premium financed life insurance policy to the point where it changes its tax classification from a life insurance policy to a modified endowment contract (MEC). When doing so, any cash value distributions during your lifetime become taxable at that time according to your highest marginal income tax rate.

It is safe to say that both of these first two taxation risks of premium finance are easily avoided since either would essentially be an “unforced error” of sorts.

However, this final potential tax trap can result if a policyowner were to take substantial retirement distributions from the premium financed life insurance policy to the point where it could no longer survive without more premiums. If so, the policyowner may be inclined to simply fold up the tent and cancel the life insurance policy.

But should the premium finance policy be canceled and the total distributions exceeded what was paid into the policy, then the amount in excess would all be taxable in the year of cancellation. This would obviously include any loans/withdrawals to pay back the premium finance lender.

Therefore, any cancellation situation in retirement would cause concentrated taxation since all prior distributions over and above basis will be added together and taxed in that single year. This would probably push anyone into the highest and most penal of tax brackets assuming they weren’t there already.

It is worth mentioning, however, that most premium finance life insurance companies have something called an “overloan protection rider” built into their policies now to avoid this exact taxation risk. Quite simply, an overloan protection rider is like a parachute that deploys when the policy loan has grown so big it is about to lapse the policy and cause this horrible tax trap.

When the overloan protection parachute kicks in (often when the total loan amount is greater than 95% of total cash value), it simply cuts off the policyowner from taking any further lifetime distributions and freezes a nominal amount of death benefit for the heirs.

This move by the insurance company preserves the tax-exempt tax status of all prior lifetime distributions until the death of the insured consummates everything as tax-free.

Although different life insurance companies have different rules that trigger this helpful rider, an overloan protection rider incurs no cost to install into your premium financed life insurance policy. Thankfully, many insurance companies had seen enough of this tax trap occurring in the past to create this helpful rider for those seeking to use whole life and indexed universal life insurance for retirement.

7 Steps to take with your Premium Financed Life Insurance Agent  (Proper Sequencing)

Premium financing is an extensive process with multiple moving parts where the sequence and timing should be orchestrated by a specialized premium finance life insurance agent.

1) Informal modeling of your premium financed life insurance strategy

This first step is essential for you to see if the potential benefit is worth going through the other more intensive steps below needed to implement any premium financed life insurance policy. This is also where you can learn about the different product features and visualize the pros and cons of premium financing through different assumption sets.

2) Confidential (but informal) field underwriting by your agent to be shopped anonymously amongst desired premium finance companies

This second step is so incredibly important to optimize your premium financing strategy. Since the underlying cost of insurance charges will be based on your health rating, it is important to shop the insured’s health situation to multiple carriers since certain insurance companies are more forgiving with certain issues than others.

It is imperative that your premium finance agent shops the underwriting situation on an “informal basis.” This is because all life insurance companies share their official findings with the Medical Information Bureau (MIB). Therefore, if negative data goes through official underwriting channels, the well will be poisoned so to speak, and your insured’s health status will be common knowledge amongst other insurance companies.

3) Compare informal health ratings that have been received by desired companies and have your agent rerun the numbers to find the most favorable financial outcomes that can be achieved by premium financing.

This third step is similar to the first one, but only with more precise underlying data plugged into the assumptions. This is where the really intensive stress-testing of various companies and policy designs take place so the policyowners can narrow down which company/product(s) they will include in their premium financed life insurance portfolio.

Since this step is somewhat similar to step one only more intensive, the complex learning curve often gets easier here. Context that was once foreign now becomes familiar. Although the potential clients begin building upon what they learned previously, this is still not where the final design is modeled and finalized.

This step is simply to choose the best set of ingredients for their premium financed life insurance portfolio.

4) Formally apply with your premium finance life insurance agent to the top company or companies (diversification is recommended here)

Once the premium financed companies have been narrowed down to 2-3 companies, and their informal health ratings appear to be favorable, we start officially applying to these companies.

Potential clients often get nervous during this step because they mistakenly assume that an official application is a contract or some sort of commitment to do business with that company. It is not. A formal application is simply a policyowner petitioning the insurance company for an official health rating. Once the life insurance company declares what the insured’s health rating will be, policyowners can still decide if and how much business they choose to do with said company.

5) Concurrently apply to third-party lenders for the premium finance loan

As the premium financed life insurance is being officially applied for, so too should be the premium finance loan if the first premium will be financed. Sometimes the policyowners choose to pay the first premium themselves to quickly lock in their current health or younger age while more complicated estate planning is being finalized.

Doing so may also avoid future collateral issues if the policy is designed in such a way that most of that first premium is available in cash surrender value before the 2^nd policy is due.

However, when premium financing is desired at the onset, the loan underwriting has a similar timeframe to policy underwriting and should be done concurrently.

6) Where applicable, concurrently engage in complimentary estate planning

When premium financing will be done in conjunction with certain irrevocable trusts designed to enhanced asset protection strategies and/or dynasty estate planning, the legal work should commence, once the policyowner is committed to the premium finance transaction.

When premium finance is more of a retirement planning strategy than an estate planning strategy, then it may not be imperative to have the legal planning completed before the life insurance policies are initiated. Since the legal work can take considerably longer, and the policies can be immediately transferred to an ILIT via sale at any point in the future, then it may be optimal to initiate the policies earlier rather than waiting and having them become less efficient at a later age.

It is worth noting that keeping such large life insurance inside one’s estate may cause estate tax if two married spouses both die before the policies are sold to the newly completed trusts. That said, if both spouses were to pass away early to where the death benefit caused estate tax, then one tiny premium payment yielding such a massive death benefit (even net of estate tax) would result in considerably more wealth to heirs than if the insured died without placing the insurance.

7) Service and monitor the policies

Although finally putting the premium financed life insurance policies in their proper place represents a huge milestone in this transaction, the work has just begun. This is why it is so important that you have a team behind your premium financed life insurance transaction to help you throughout the different phases.

Remember, the prior illustrations used to model the future are imperfect because they usually show linear growth and ongoing market arbitrage when in fact, the policy values will certainly fluctuate.

Whether it is an IUL or Whole Life policy, IUL caps and participation rates will vary over time as will Whole Life dividend rates. Even if you modeled rising loan interest rates in the premium financing scenario, they certainly won’t evolve exactly as modeled.

This is why it is so important to review the design on a regular basis with an expert to manicure the premium financed life insurance policies along the way so your desired retirement and estate planning objectives are met.

Schedule a call with our team of life insurance specialists to discuss your options with or without using premium financing.