Around since the 1980s, Premium Financing is a strategy used by High-Net-Worth Individuals (HNWIs) to cover the expense of large life insurance premiums by taking out a third-party bank loan to pay for the policy’s premiums.
Many HNWIs are not always willing to use their liquidity to fund their life insurance premiums out of pocket, so premium financing provides them with a different and more efficient option to maintain their liquid assets. Plus, they can avoid triggering a capital gains tax on any assets they would have liquidated to fund the premiums. Premium Financing offers clients significant opportunity, allowing them to invest their money in investments that may yield a higher return on investment (ROI).
People with a high-net-worth should think about premium financing when purchasing life insurance. Many parties are involved in the process which could make it a little lengthier than buying a life insurance policy in the traditional way.
With all financial endeavors, there is always risk. There are three areas of risk to consider:
Since these loans are always 100% collateralized, lenders typically require borrowers to re-qualify every year the loan is renewed. The life insurance policy itself will act as the first line of defense for collateral but, there is additional external collateral the borrower will need to post in the earlier years. This means that the external loan collateral, such as stocks, cash, life insurance cash value and other investments, will be re-evaluated.
If the collateral is found to fall below a certain threshold, borrowers may be required to provide additional collateral. If the borrower fails to provide the necessary collateral, it may cause the loan to default and/or not renew.
Policy Earnings Risk
This is another situation where the borrower may be forced to provide more collateral to avoid defaulting on the loan. If either the policy’s cash surrender value or the external assets that were posted as collateral underperforms, the loan balance will exceed the value of the collateral thus handing the borrower with the same decision as with a qualification risk. More collateral or default.
Interest Rate Risk
Perhaps the most prevalent of the three risks. Many premium finance loans are offered with variable interest rates. Thus, if interest rates rise, then the loan rate would increase instantly, and the policy’s dividend rate would most likely lag for a few years.
There are ways to control the loan interest rate for a longer period of time but will typically come with a cost. One option is to purchase a cap on the loan rate which at times can go up to 10 or 15 years. The longer the cap duration, the higher the cost is for the borrower. Banks do also offer fixed rate loans but will be at an increased interest rate comparatively to the variable rate.
It’s important for clients to understand the concept of leverage and arbitrage when it comes to their finances. The goal of being a HNWI is remaining a HNWI and taking advantage of strategies, like premium financing, that most of the general investment population can’t use.
If you want to discuss the potential of premium financing for your portfolio, we can help. Contact us today.