Premium Financing: What Works and What Doesn’t
by Allan D. Gersten, CLU, CFP, ChFC

The stars are aligned for advisors to consider premium financing for certain life insurance clients. This includes lower interest rates over the past seven to 10 years and, most importantly, a growing population with a rapidly expanding group of affluent clients. These conditions have created tremendous amount fuel for a substantial market, which has its place in other parts of the credit market.

Financial leverage can allow the shrewd life insurance buyer to get much larger amounts of coverage than they may have considered otherwise. This investor recognizes the enormous benefits of using other people’s money. These buyers can and will purchase large amounts of life insurance if they understand the risk, can quantify the risk, and have an exit strategy that compares favorably to the expected returns for themselves and their families.

Premium financing is a funding vehicle in which a third party lends money to a client to purchase a life insurance policy. It can take place through a formal life insurance lending program or through a client’s personal or business banking institution.
In many cases, the interest on the loan is paid annually. The insured typically makes a gift to the trust that owns the policy in an amount that is sufficient to cover the interest payment. This amount is considerably less than the insurance premium and the annual gift tax exclusion amount, particularly in the early years of the financing arrangement. It allows the client to avoid gift taxes during this period of the transaction.

A number of premium finance programs do not require payment of principal or interest on the loan until death. As with any loan agreement, there are risks with premium financing including default risk, interest rate risk, collateral risk, and loan call risk.
Here are examples of premium financing concepts that take advantage of leverage:
• Funding for long-term estate needs to minimize gift and estate taxes for the high net worth estate -- Large single life and survivorship purchases are funded using financed premiums.
• Funding with a goal of accumulation for highly compensated employees who are discriminated against in a 401k plan or pension plan. The product of choice is an indexed UL policy in which expected returns and accumulation rates are greater than the interest costs.

There are two main approaches to premium financing. Seniors who do not intend to use their full life insurance capacity are using a hybrid premium financing strategy. These plans defer the insured’s premium and interest for two to five years or longer. The client has a personal guarantee of 25% of the deferred amount. If the client decides that they do not want or need the coverage, they can sell the coverage on the secondary market to pay the outstanding loans and receive a profit, if available.
With another senior plan, the loan and interest deferrals are for life. The exit strategy is death and an insurance benefit for the family. Prospects abound for the many premium-financing plans that are available. While these plans can create opportunity to satisfy a client’s needs, they must be matched carefully to suitable clients for the plan that is being recommended. As a rule of thumb, the appropriate premium-financing client has borrowed previously and understands the risk-reward relationship in this kind of transaction.

It is helpful for the producer to have a strong relationship with the client. It can go a long way toward making the premium financing solution a winning decision for everyone involved. The best candidates for premium financing are affluent and high net worth people who have a clear need for life insurance and are able to pay the premiums. These people recognize the need for life insurance, but would rather not to liquidate assets to fund premium payments.

Premium financing can be an excellent opportunity for the right clients to execute a significant life insurance strategy while making it possible for their assets to continue to be invested elsewhere for a greater return. The optimum threshold is $5 million to $10 million net worth or higher. However, offerings are available with little or no risk for senior clients with a net worth of $1 million.

What doesn’t work in premium financing? You only have to mention, “premium financing for life insurance” to get an array of positive and negative expectations. At the same time, life insurance sales using premium-financing concepts are exploding. The market is interesting and appealing since it includes people from 35 to 85. However, the plans work much better when a client is healthy. In fact, there may be situations in which premium financing does not work at all if the client is not a standard risk.
It’s worth noting that company executives and stockholder employees can participate in plans that can create value for the corporate entity. Having said this, it’s critical for the broker and the client to understand the leverage that’s inherent in using other people’s money and the risks and rewards. It is important to remember that the life insurance sales community has limited experience in this burgeoning marketplace. A thorough understanding of life insurance underwriting, carrier products, flexibility, and design possibilities is the foundation for concepts that work for everyone involved, including clients, lenders, and insurance companies.

As you might guess, lenders and funders have their own criteria for what represents an appropriate loan and what is the appropriate collateral for their target market. There are dozens of funders in the premium financing business with numerous programs that are available through particular lenders from time to time. Lending underwriting criteria can include the following:
• A minimum and a maximum age.
• A minimum net worth.
• Restrictions to use only the approved insurance companies.
• Restrictions to use only approved products,
• What is to be considered valid collateral.
Without question, valid collateral is where the rubber meets the road for the lenders. For example, some conventional high net worth people may be asked for a letter of credit for the entire loan. Other lenders may allow the letter of credit to be as little as 25% of the loan. Hybrid premium finance programs permit the intrinsic value of the policy to serve as collateral for 75% of the premium and interest deferred. A personal guarantee from the policyholders completes the remaining 25% collateral requirement.
Here are some issues to consider when developing a successful premium finance sales strategy:

Guidelines For Selecting The Right Product

1. Use of current assumption UL over a guaranteed UL product.
2. Introduction and evaluation of indexed UL.
3. Use of return-of-premium riders, as appropriate.
4. Strategies for carrier riders to develop high early cash value.
5. Limited premium paying periods, such as seven or 10 payments.

Understanding and Securing a Premium Funding Lender and Plan Design Considerations

1. Evaluate the client’s net worth along with the lender’s collateral requirements.
2. Compare lender’s requirement for personal guarantee, letter-of-credit, or intrinsic value derived from life expectancy reports.
3. Use longer notes whenever possible, such as five years, 10 years, or even lifetime.
4. It might be recommended for the client to contribute a portion of the transaction, such as the interest expense.
5. Going into the transaction, it is important to know the exit strategy. These exit strategies might include the following: repayment of the debt using a GRAT strategy, sale of a business, retirement of an employee, death of the insured, or a sale into the secondary market, if appropriate.

Sales and Marketing Tactics That Don’t Work For The Life Insurance Industry, The Consumer, or The Lender

1. Clients with marginal net worth and minimal understanding of the transaction.
2. Sales providing more coverage than the client can afford, which is not based on appropriate collateral requirements.
3. Stealth or stranger owned life insurance plans in which the true purpose of the transaction is not transparent and there is no insurable interest. This is referred to as a “non-recoverable transaction.” Simply put, it’s toxic for all concerned.
4. Unhealthy risks, such as senior adults without a short exit strategy.
5. Variable universal or variable whole life will not work because of banking and collateral issues.
6. Seniors who are entering hybrid premium financing transactions with expectations of getting specific cash returns from a sale of their life insurance policy.
Life sales professionals have become aware of the opportunities in selling large life policies. This is the result of three key factors: a lower interest rate environment, Wall Street’s recognition and imagination when it comes to valuing a life policy, and a huge reservoir of clients with very large estates. This type of client is discovering the value in the insurance contract and how it can provide a return that is uncorrelated with other financial assets. The premium financing revolution began with seniors who recognized the benefit of maximizing their insurance buying capacity. The revolution continues with younger clients who understand sophisticated concepts for maximizing their estates presented by trusted advisors who know and understand premium financing.
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Allan D. Gersten, CLU, CFP, ChFC, is Chairman of First American Insurance Underwriters, Inc., a brokerage firm based in Needham, MA. He has been in life insurance sales since 1969. He can be reached at 800-444-8715 or agersten@faiu.com.