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The Advisor’s Guide to Premium Financing

California Broker Magazine
Oct. 2008

by Lance Wallach, CLU, CHFC

Premium financing allows your clients to purchase life insurance
without liquidating their investments or changing their cash flow.
Clients who are most likely to use premium financing are high net-
worth seniors who are over 70.However, younger people can
benefit with alternative forms of financing, other than through a
bank.

It began in 1973 with the financing o property and casualty
insurance policies. In 1995, lending companies started financing
life insurance policies. Ever since then, the life insurance industry
and lending institutions have been developing innovative designs
and products.
Premium financing can answer some of the objections people
have to life insurance. Most have an aversion to paying premiums
and to dealing with matters relating to death, especially when
someone else is profiting. It allows clients to do the following:

• Retain capital for lifestyle and investment needs.
• Have additional liquidity for a family or business or additional
liquidity to pay taxes on the value of a business.
• Eliminate unnecessary gifting or use of their unified credit.
(Premium financing does not impede unified credit or annual
gifting.)
• Avoid or reduce estate, inheritance, and generation-skipping
taxes.

Why Premium Financing is Getting Popular
Many consumers are finding that it is not cost efficient to purchase
life insurance by paying term or permanent premiums. Premium
financing may provide more favorable financial terms for clients
who are seeking to purchase life insurance.

Many people don’t have adequate protection for their financial
legacies. People are living longer and our economy is producing
many multi-millionaires, which creates larger estates. At the same
time, estate tax laws are subject to change. Premium financing
does not interfere with estate planning strategies including
generation skipping.

The grantor/insured can loan annual life insurance premiums to
the ILIT rather than gifting them when the ILIT owns the policy. IRS
Letter Ruling 9809032 declares that a loan to an ILIT is not an
incident of ownership. The grantor/insured is not responsible for
the premium finance loan. The ILIT repays the loan when it
receives the death proceeds.

Premium financing eliminates annual gifting issues that can come
up with an ILIT. It provides substantial leverage for the gift tax.
Under IRC Code 7872, if paid by the grantor, only the loan interest
is considered an annual gift rather than the entire premium. There
could be a gifting problem if the contract has been classified as a
modified endowment contract. However, this issue should never
arise unless the client tries to make a single premium deposit into
the contract. When the insurance policy is issued, it is designed so
that it is not classified as a modified endowment contract.

ILIT deposits are transferred irrevocably, which means that the
money cannot be used for alternative investments or used to
improve a person’s lifestyle.

Premium financing enables the trust to receive death proceeds
income-tax-free without including them in the insured’s estate.
Total death proceeds are not included in the insured’s estate if the
ILIT trust has been arranged properly.

Premium Finance Loans

The four major steps of premium financing are to get a policy,
create an irrevocable life insurance trust (ILIT), obtain a loan, and
collateralize the loan. A third-party lending institution finances the
life insurance premiums. A trust owns the policy, keeping the death
benefit out of the estate. Through the trust, the insurance policy is
assigned to the third-party lender as collateral.

The two general types of premium finance loans are “interest paid”
and “inter-est accrued.”
When your client pays interest out of pocket, they avoid additional
deferred risk by tying up collateral for a longer period .Also, your
client does not need additional collateral. The disadvantage is that
the money your client pays out-of-pocket could be used for
investments or for maintenance of their lifestyle.

The following are the usual terms of an interest-accrued loan:

• Interest is accrued for the length of loan, which is generally five to
10 years.
• The borrower must show financial ability to pay the premiums and
interest even though the premiums are being financed.
• The borrower must be able to post additional collateral for as long
as necessary if the policy surrender values are insufficient in any
given year. The lender per-forms a collateral analysis each year to
determine if there is a shortage. This is normally is done 45 days
before the anniversary date to give the client enough time to post
additional collateral.
• The borrower must give the lender a cover letter explaining why
interest is being accrued. They must also provide their estate
planning strategy.
• The amount of life insurance the borrower purchases cannot
exceed their networth. Also, the borrower’s projected net worth
cannot be less then the projected accrued loan. If the lender’s risk
analysis indicates that the borrower’s projected net worth is less,
the borrower has to apply for less life insurance coverage.
The accrued interest loan creates future deferred risk. The London
Interbank Offered Rate (LIBOR) is used as a base index for setting
rates of some adjustable rate mortgages and other loans.
Suppose LIBOR loan rates continued to increase instead of
leveling off and eventually decreasing to their long-term average
rates. Every year, the corresponding life insurance product would
be under extreme pressure to produce crediting rates that
exceeded the LIBOR rate.
Collateral could be put at risk if the loan balance increased while
the policy’s cash value did not. It could create the need for
additional collateral, which the client may not have. When bank
loans have com-pounding non-fixed interest, the annual interest
payment could end of being higher than the annual premium
payment. This is particularly true with younger clients.
There are ways to avoid the pitfalls of the interest-accrued loan.
Creative financing can offer interest accrued loans with the
following advantages:

• Non-recourse
• Unlimited term
• Fixed interest rates as low as 3%
• Non-compounding of interest
• No additional collateral requirement Why Universal Life Is Not a
Good Choice
Traditional universal life is the most com-mon life insurance
product to be used for premium financing and is most commonly
accepted by lending institutions. However, it should not be used for
premium financing in today’s interest rate environment for the
following reasons:
• The current crediting rate for most UL policies is too low.
• The guaranteed rate for most UL policies is 4%. This is also the
current rate for some companies.
• Long-term surrender charges cause additional collateral
shortages.
• Death benefits are falling short of what was targeted.
• An insurance company generally invests in medium-term maturity
fixed-income instruments, primarily notes. Bond fund yields tend to
fluctuate more slowly than do money market interest rates. Short-
term interest rates fluctuate rapidly while the portfolio yields are
slower to react.
• The interest rates charged on premium finance loans are greater
than current portfolio yields. This may continue for several years
before portfolio rates catch up. Annual shortages will increase if
this continues for many years while interest is accruing. There
would be a concern about whether the premium finance
arrangement could continue.

Equity-Indexed UL –an Acceptable Alternative
Equity-indexed universal life insurance is an acceptable alternative
for premium financing. A critical difference sets it apart from other
flexible premium UL products. The carrier can credit interest that is
based partly on the potential growth of an out-side index (excluding
dividends). At the same time, none of the policyholder’s cash value
participates directly in an equity market. This probably provides
better long-term values than a fixed universal life product can
provide. It also creates less risk to principal than a variable
universal life product brings.
There is a way to avoid losing the death benefit as interest accrues.
Special insurance riders increase the death benefit each year by
the amount of interest on the pre-mium finance loan. This is called
a“return-of interest/cost of money rider.”The death benefit will not
get eaten away by accrued interest when combined with a standard
return-of-premium rider. Ben-eficiaries always receive the original
death benefit.
In short, premium financing can allow your client to protect their net
worth and pass along their financial legacy to future generations
without altering other financial strategies. ❑
––––––––––
Lance Wallach, CLU, ChFC, the National Society of Accountants
Speaker of the Year, speaks at more than 70 national conventions
annually and writes for more than 50 national publications about
financial planning, retirement plans, and tax reduction. For more
information, visitwww.vebaplan.com or call 516-938-5007.