In your lengthy list of priorities that grows by the day, which one tops them all? If you’re like most individuals, you’d probably say your family is the runaway leader of the pack. Whether it’s your spouse, your children, parents or siblings, it’s the people you love — and who love you back — that truly matter. To paraphrase Hall of Fame NFL coach Vince Lombardi, your flesh and blood aren’t everything; they’re the only thing. Look no further than the incredible growth of life insurance sales for proof. Perhaps spurred by the COVID-19 pandemic, total annualized life insurance premium levels jumped 20% in 2021 compared to the previous year, according to data from LIMRA. That’s the most substantial surge in life insurance sales since the early 1980s.
But as you can undoubtedly attest, supporting your most important priority requires balancing many other priorities as well, paired with the appropriate funding. From your business to your home to your children’s education and so much more, the sheer volume can drain your revenue stream, even as a high net worth individual or business owner.
In short, if you need more life insurance than what you have currently, it may be financially impossible if managing your priorities has you stretched too thin. And that’s not including the rising costs of living due to inflation.
What is premium financing?
Premium financing is a strategy that high net worth individuals use for their long-term needs – from estate planning to business succession. Through borrowed funds — which come from a premium finance lender — premium financing allows individuals to keep their money in its current role while obtaining additional life insurance (i.e. high cash value life insurance). In essence, premium financing is a loan arrangement between at least two parties: the borrower and the premium financing lender.
How does premium financing work?
Life insurance is a highly customized product. How the death benefit is used — and the amount of coverage that is considered enough — tends to vary depending upon a policyholder’s family situation and their overall needs. The same goes for how life insurance premium financing plans are structured; they’re rarely identical. However, the arrangements do have a few commonalities in terms of the players and what happens once a loan request is made.
1. After an eligible applicant (i.e. the borrower) requests a loan and they’re approved for it, the funds are generally dispensed from the lender to the borrower or (more often) directly to the life insurance carrier. These funds are used to pay the premiums of the high cash value life insurance policy. The funds may also go to the borrower’s irrevocable life insurance trust (ILIT).
2. Next, the borrower pays the lender back over time on a simple interest or negative amortizing basis. Negative amortization is a minimum payment option, which means the balance increases over time so as to pay down the interest. This may be a worthwhile option if you want to leverage the policy’s earnings as they accrue over time. The length of that repayment period is determined upon loan approval.
3. The borrower then pledges collateral for the loan in order to secure it. Forms of collateral that are acceptable may include government-issued securities, cash, or letters of credit by a certified financial institution. The cash value of the policy may also be considered sufficient collateral.
4. Finally, the borrower pays off whatever balance on the loan still exists once (or before) the term period ends. The assets used for payoff can be either their own money or the cash value of the policy if it’s built up enough equity. They also have the option of extending the loan term if the borrower so desires.
What are the biggest advantages of premium financing?
Just as you have many priorities, premium finance has several things going for it as a planning strategy beyond the fact that it pays for life insurance premiums and associated death benefit. Here are a just a few:
Retain more control of your money
Even if cash flow is not a major issue, you never know when it could be. COVID-19 was a classic example of that. In addition to the tragic loss of life, the economy plummeted during the pandemic, forcing many businesses to close. As you may recall, in March 2020, the jobless rate in the U.S. rate was under 5%. One month later, nearly 15% of Americans were out of work, according to Labor Department figures.
The stock market also encountered wild fluctuations during the crisis, with billions of dollars in corporate earnings erased.
While the economy has largely rallied, the coronavirus was testament to how quickly things can take a turn for the worse and why it’s important to maintain an emergency fund. Leveraging premium financing allows you to do that.
Increase purchasing power
While it’s important to have an adequate amount of discretionary income, premium financing can also take your dollar further than it would otherwise. Because borrowed funds service life insurance premiums — or the other potential uses referenced earlier — you can use your own money for other productive purposes that allow your earnings to grow.
Then there’s the inflation to consider. From fuel to food to furniture to flowers, the price of just about everything is more today than last year or even last month. In fact, the Consumer Price Index — which the government uses to gauge inflation — recently rose to its highest level in over 40 years (7.9% on a year-over-year basis in March), based on calculations from the Department of Labor. Economists don’t think prices will cool down until 2023 at the earliest, according to The Wall Street Journal, even with corrective actions taken by the Federal Reserve designed to rein in demand.
Everyone’s dollar buys less in a high inflation environment, but with borrowed funds addressing your life insurance needs, you can more easily make the necessary adjustments with adequate discretionary income available.
Potential tax benefits available
As previously noted, life insurance — as well as premium financed life insurance — is modifiable, so depending on how the arrangement is set up, there may be certain tax advantages that you can obtain. For example, if the premium-servicing loan funds are held in an ILIT, the beneficiary of the policy may be able to avoid estate taxes on the resulting death benefit. Furthermore, the funds may also be utilizable for business or personal retirement tax planning strategies.
Funds can go toward business needs
“Life insurance” and “premium financing” go together for a reason: The solution is primarily utilized for life coverage. But the keyword here is primarily, as the proceeds can also go toward other financial strategies and solutions. They include:
- Business succession
- Key-person financing and retention
- Buy-sell arrangements
- Estate planning
- Paying for employee benefits
In short, even if you already have sufficient life insurance, premium financing may still make sense if you want death benefit and planning flexibility.
What risks are associated with premium financing?
It’s important to be mindful of the fact that all borrowing arrangements carry risk. Such is the case for premium financing. The primary unknown concerns your interest rate, which largely determines your loan balance aside from the principal. Let’s say that you decide you want to pay off the loan balance through the earnings of the policy itself. Cash value makes this option possible. But it’s also possible the policy may not hold enough equity to satisfy the debt. Thus, if interest rates rise more appreciably than the policy’s worth, you may have to tap other resources to break even. This means that while additional time can increase the cash value of the policy, going an extended period of time with a balance means you could wind up owing more than if you’d paid off the loan debt earlier.
Fortunately, there are some strategies that can offset this risk. These include:
- Choose a fixed-rate interest rate
- Select an annual structure crediting method, which can expedite cash value accrual.
- Opt for an indexed universal life insurance policy so the interest rate is tied to a market index (i.e. S&P 500, LIBOR, etc.).
Being aware of the benefits and risks associated with life insurance premium financing is key in making an informed decision for your planning needs. However, premium financing may prove to be the catalyst you need to more effectively protect your most important priority. Global Financial Distributors can set you up with a plan today as an individual or business owner. Contact us to learn more.