Premium Financing
Using Life Insurance
Premium financing is the borrowing from a third-party lender, such as a bank, of funds to pay premiums of a life insurance policy. Premium financing allows an individual who has a life insurance need to defer using a larger portion of his or her income or assets to fund a life insurance policy. Because the premiums are borrowed, current out-of-pocket costs as well as gift tax costs1 may be reduced. Please note that premium financing is not the only method of paying premiums. For example, premiums may be paid from savings, sale of assets or investments, after-tax income received from an employer or business, or from gifts from family members. Additionally, premium financing is not a tool that may be utilized to purchase a life insurance policy that the individual could not otherwise afford. The individual must have the ability to pay the life insurance premiums without using premium financing in order for premium financing to be considered.
PREMIUM FINANCING ARRANGEMENT
Once a premium financing application with a lender has been approved and an underwriting offer from Asofsp has been made, the policy may be issued. Once the policy is in-force, the borrower will pay the loan interest each year on the outstanding loan at the rate and schedule set by the lender. During the life of the loan, the life insurance policy’s cash value, death benefit and other personal assets may be used as collateral for the loan. At the insured’s death, the life insurance proceeds may be paid to the beneficiary, net of the loan repayment (assuming the loan has not been repaid prior to death). Please note that Asofsp is not a party to the loan arrangement.
CANDIDATES FOR PREMIUM FINANCING
Candidates may be wealthy individuals or business owners, or both, who have a large life insurance need. The most common use of premium financing is to finance the purchase of a life insurance policy to provide an estate with liquidity to offset the loss to the estate by estate and generation-skipping taxes³.
Although each lending institution has its own requirements, the better-suited prospects for premium financing are clients who have:
✅ A net worth of $5 million or more
✅ The majority of their premium-paying assets tied up in other illiquid assets
✅ A need for life insurance with an annual premium requirement of more than $100,000
Premium financing should be used as a method of financing a life insurance need; it is not intended to be used to generate tax benefits. In almost all cases, interest paid on borrowed funds will not be deductible for income tax purposes.
By assigning the policy as collateral, the lender will gain certain rights over the policy’s death benefit and cash values. Specifically, the assignment will grant the lender the right to surrender the policy, or make policy loans or withdrawals, in certain circumstances.
¹ As of January 1, 2013, the annual gift tax exclusion is $14,000 per donee (indexed for inflation). According to the American Taxpayer Relief Act of 2012, the federal estate, gift, and generation-skipping transfer (GST) tax exemption amounts are all $5,000,000 (indexed for inflation effective for tax years after 2011); the maximum estate, gift, and GST tax rates are 40%.
² Please note that Asofsp does not allow the interest payment to be capitalized into the loan. The interest payment must be paid out of pocket and in advance.
³ According to the American Taxpayer Relief Act of 2012, the federal estate, gift, and generation-skipping transfer (GST) tax exemption amounts are all $5,000,000 (indexed for inflation effective for tax years after 2011); the maximum estate, gift, and GST tax rates are 40%.
⁴ Please note that the financial qualification requirements for the premium financing arrangement and the life insurance policy may be substantially different.
Premium Financing Process for an ILIT
1. Loan
- The Irrevocable Life Insurance Trust (ILIT) purchases a life insurance policy, generally on the life of the trust’s grantor.
- At the same time, the ILIT applies for a premium financing loan from a third-party lender.⁴
2. Premiums
- If the ILIT qualifies for the premium financing loan, it will use the loan proceeds to pay the premiums for the life insurance policy.
3. Collateral & Interest
- The ILIT provides collateral interest in the cash value and death benefit of the life insurance policy equal to the loan balance.
- The lender may require additional collateral, including a personal guarantee by the ILIT’s grantor, in addition to the life insurance policy.
- The ILIT must pay interest to the lender at the rate stated in the premium financing loan documents.
4. Death Benefit
- At the insured’s death, the ILIT will receive the death benefit from the life insurance policy.
- A portion of the death benefit will be used to repay the lender for the premium financing loan.
- In some cases, a rollout strategy may be implemented by the trust’s grantor to repay the loan before their death.
5. Distributions
- The ILIT can distribute the life insurance death benefit proceeds to its beneficiaries.
- Alternatively, the ILIT can use the death benefit proceeds to provide the insured’s estate with liquidity to pay estate taxes.
Advantages & Disadvantages of Premium Financing
Advantages Include:
✅ Preserves Asset Use: Allows a wealthy client to acquire life insurance coverage without giving up the current use of assets.
✅ Potential Gift Tax Reduction: May reduce the size of a current gift a client makes to fund a life insurance policy owned outside of their estate.
✅ Improved Cash Flow Management: The annual loan interest for premium financing may have a smaller impact on the client’s current cash flow compared to paying life insurance premiums outright.
✅ Attractive Borrowing Option: Provides an opportunity to borrow cash from a third-party lender at a potentially lower interest rate instead of liquidating taxable investments that may be earning a higher return than the loan interest cost.
✅ Estate & Wealth Transfer Benefits: Assists in estate planning and wealth transfer to heirs.
Disadvantages Include:
❌ Risk of Default: Borrowing more than the client can comfortably repay may lead to defaulting on the loan, surrendering the policy, transferring it to the lender, or selling it to a life settlement company to cover the debt.
❌ Policy Performance Uncertainty: The policy crediting rate may be lower than the loan interest rate. The credited interest rate of the policy has no direct relationship to the financed premium loan interest rate charged by the lender.
❌ Interest Rate Fluctuations: The premium loan interest rate may increase over time, affecting repayment costs.
❌ Exit Strategy Required: Repaying the third-party lender may require a planned exit strategy to ensure financial stability.
❌ Ongoing Financial Qualification: The client may be required to requalify financially each time a premium is borrowed, rather than being pre-qualified for all premiums upfront.
