Using leverage to purchase life insurance has been a popular and effective strategy for over two decades. By borrowing to pay policy premiums, a policyholder can preserve liquidity, keep capital invested in higher earning investments and lower policy costs. Over the past 10 years, a prolonged, low interest rate environment where the arbitrage between a policy’s growth rate and the loan interest rate contributed to the success of most premium financing arrangements.
Today, economic conditions are changing, and interest rates are quickly rising leaving many prospective life insurance purchasers wondering if premium financing is a viable strategy. Recent media covering abuses involving taking loans to fund policies has added to the skepticism. Should someone buying a life insurance policy consider premium financing? The answer is “yes” if both the client and the life insurance sales organization take care to evaluate and monitor the three legs of a premium financing transactions: client suitability, product design and active service.
Using leverage involves risk and any client financing premiums should be able to afford not to use the strategy. In other words, if the strategy is not as successful as planned, the client should not be financially injured by an increase in costs. Although a goal of premium financing is to reduce costs, premium financing is not free insurance. Howard Insurance relies upon a number of criteria related to client suitability that significantly increase the probability for success, especially as interest rates rise.
· Clients should accept that premium financing is a long-term strategy with fluctuations in performance over at least 20 years.
· Clients need to have at least $20 million in investable net worth so that the financing loan and the resulting policy asset do not make up a majority of a client’s liabilities or assets. This is not a strategy for a high earning professional who is considering borrowing money to pay premiums on a maximum funded life insurance policy purchased to supplement retirement income.
· Clients should have some familiarity with using leverage. This could be from using leverage in their investment portfolio or with real estate dealings. At the very least, there should be a full understanding of the risks and rewards of applying leverage in a financial matter.
· Clients should be able to pay, without financial injury, all planned premiums out-of-pocket instead of borrowing the funds should conditions make financing imprudent, or a loan cannot be obtained.
Premium financing is not for everyone and having criteria for client qualification and adhering to that criterion is critical.
The life insurance policies whose premiums are financed are typically “general account” cash value life contracts. These include traditional whole life, universal life and index universal life policies where premiums paid become a part of a life insurance company’s general investment account. The insurance company invests premiums and shares much of the return from the investment with the policyholder. For the most part, this means if an insurer’s investment performs well, this will be reflected in a policy’s cash value dividend or crediting rate. The opposite is also true with poor investment yields by an insurance company reflected in a policy’s performance.
A client’s profile determines the suitability of the product to be considered for premium financing. Some product designs carry more risk than others and a client’s risk tolerance – in addition to the previous client criteria – should be evaluated. No policy type is necessarily better than another and often address different planning goals such as accumulating cash or providing a needed amount of death benefit. Generally, the better a policy performs, the more effective the premium financing arrangement.
Howard Insurance recommends illustrating a number of policy performance and interest rate variations as a part of stress-testing a premium financing transaction. This should include modeling scenarios where policy is at its guaranteed minimum and there interest rates are low and/or volatile.
Client involvement in the management of both the life insurance policy asset and the premium loan is key to making the strategy work. A life insurance policy must be managed. Specifically, for an IUL policy, indices performance will likely change annually, and the insurance company can make changes to any number of policy features, including yield ceilings, minimum guarantees or insurance costs.
Equal attention should be given to the premium loan. Lenders offer various types of loans that have different terms and rules. Some loans are annually renewable, and some can lock in rates for a period of years. Loans can also be called, and, in some financing arrangements, non-policy collateral will need to be posted.
While a client should actively be involved in understanding policy and lending changes, it is the responsibility of the sales organization to monitor for changes and to communicate them to a client. Ninety days in advance of a policy anniversary, Howard Insurance begins the process of analyzing the premium financing structure. This means ordering in-force illustrations to study policy performance, examining the lending situation and, if needed, applying for the next premium loan and seeing what collateral needs exist.
Premium financing is a not a “set and forget” strategy and problems will almost certainly arise if either the client or the sales organizations fails to actively manage the transaction. By sticking to an annual process that involves both defined servicing activities and an open line of communication, incorporating leverage can be an extremely effective planning tool.
In today’s rising interest environment, premium financing remains a viable strategy for qualified clients to purchase large life insurance policies. Navigating the options available and explaining the risks involved, is where Howard Insurance can help. For over 75 years, Howard Insurance has helped each of our select clients secure their assets, their ambitions, their businesses and, ultimately, their legacies. Leaders in private insurance advisory and risk management, we pair deep expertise with sincere attention to our clients’ needs to create unique solutions that benefit them best.