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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

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

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
• 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 premium
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. Beneficiaries 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, or
call 516-938-5007.

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