Journal of Financial Planning - July 2004

Third-party premium financing for life insurance may be getting marketing attention these days, but it shouldn't get the attention of most clients.

An Analysis of Premium Financing

by Peter Katt, CFP, LIC

Financing permanent life insurance premiums via third-party lenders is a marketing idea that promises relieving clients of having to pay their life insurance premiums. But whether premium financing makes sense for some of your clients will require some careful analysis.

Typically, targeted clients are buying life insurance associated with their estate planning, and therefore have substantial assets and are probably in their sixties or older. The life insurance policies are almost always owned by irrevocable trusts or similar entities. The marketers of life insurance or clients negotiate financing arrangements with lending institutions.

According to some of the major marketers, there are two primary reasons to consider premium financing. First, financing can allow assets to remain invested that might otherwise need to be liquidated to pay premiums, or allow funds that would otherwise go to premium payments to be used for other investments with greater potential. Second, financing can avoid making gifts to trusts. Financing both the premiums and interest charges isn't a realistic option because the compounding costs of carrying the loan interest will likely cause the program to go into deficit before life expectancy. The only realistic option is to finance the premium payments while paying the interest charges annually.

In researching this issue, I spoke with a person who handles premium financing for a national sales network that works with many different life insurance companies. He informed me that although premium financing is frequently discussed, it hardly ever is actually used. I don't know if his perspective is unique or typical. If it is typical, there may be a lot more marketing effort about premium financing than actual business. As my following analysis points out, premium financing may have some merit for clients with limited cash flow and significant value tied up in assets that are either difficult to market or where liquidation would come at a high tax cost. For others, premium financing is probably not a good solution.

Generally, these factors are relevant to premium financing.

• The life insurance policy's cash values and death benefits are collateral for the loans. If there isn't sufficient collateral within the trust, the grantor must guarantee the loan with collateral outside the trust. (It is an interesting question whether this has Section 2042 issues that would cause the life insurance policy to be included in the grantor's estate.)
• The grantor makes gifts to the trust of the annual interest. The trust pays interest to the lender. No income tax deduction is allowed.
• LIBOR (London Interbank Offered Rate) plus 200 basis points is the common marker for the interest rate charged. The average LIBOR rate plus 200 basis points from September 1989 March to 2003 was 7.44 percent.
• If the policy is surrendered, the loan principal is repaid from the cash surrender value. If this isn't enough, the grantor will have to gift that amount to the trust. Upon death, the loan principal is repaid from the death proceeds.

Participating Whole Life Simulation

I ran two premium financing simulations. Both are second-to-die policies insuring 62-year-old spouses with preferred underwriting. One simulation is for a full-load participating whole life policy with an initial $5 million death benefit, which goes up as dividends are earned. The annual premium is $136,350. The policy illustration's dividend interest rate is seven percent. A historically accurate spread between the loan interest rate and the policy's dividend interest rate is needed for my simulations. During the period from 1989 to 2003, the insurance company's dividend interest rate averaged 8.92 percent, while the LIBOR plus 200 basis points averaged 7.44 percent-that is, the LIBOR rate plus 200 basis points averaged 83 percent of the dividend interest rate average. Therefore, using a dividend-interest-rate of 7 percent for my simulation I used a LIBOR rate plus 200 basis points of 5.83 percent. While this isn't a perfect methodology, it does produce a reasonable relationship between the insurance policy's investment component and the loan rate.

Table 1 compares using premium financing versus the grantor simply making gifts to the trust for the full premiums. I am comparing the yield achieved for each option, measured at the second death when the proceeds are received by the trust. The premium financing option has as its cost the loan interest paid, with the death benefits reduced by the amount of the loan principal. The premium paying option has the premiums as the cost with the full death benefits.

Although the proponents of premium financing assert better investment results when premiums are avoided, or a better gift tax result, I am treating these as neutral. Sometimes investment results aren't positive, and minimizing the amount of gifts to a trust doesn't always produce a better estate planning result, but this isn't the column to discuss these issues. Table 1 shows information in five-year increments, plus ages 93, which is joint life expectancy. I am also showing the probabilities that both insureds will have passed and the proceeds paid out.

Both the participating whole life policy's dividend interest rates and LIBOR interest rates are market priced in that they will be affected by overall interest rates. The relative average spread between them should remain relatively stable; hence the yield difference between premium financing and paying premiums should also remain about the same. Therefore, Table 1 has high predictive value.

While premium financing starts out as a better value, it falls behind the paying premium option when there is about a 70 percent probability that at least one insured will be alive and the policy in force. By around joint life expectancy, paying premiums instead of premium financing is a better value by some 20 percent. Although premium financing starts out with lower out-of-pocket costs within about 15 years, they exceed paying the premiums and in the late years become much higher than the premium.

NLPG Simulation

The other simulation I ran uses a no lapse premium guarantee (NLPG) policy using the same $136,350 annual premiums as the first simulation (Table 1), but with level death benefits of $13,315,661. (See my July 2003 Journal of Financial Planning column for a discussion about NLPGs.) I used the same LIBOR plus 200-basis-points interest rate for premium financing of 5.83 percent as I did for the first simulation. This doesn't produce as accurate a comparison as it did for participating whole life because the NLPG policy has static pricing due to the fact that the premiums and death benefits are guaranteed and thus aren't affected by changing interest rates. But the LIBOR plus 200 basis points loan interest rates are. Therefore, the yield results for premium financing will either be better or worse than shown in Table 2. Consequently, the yield difference between premium financing and paying premiums is not very predictable.

Based on a LIBOR plus 200 basis points of 5.83 percent for the loan interest rate, premium financing is a slightly weaker choice around joint life expectancy of ages 93, but better before then. But should the loan interest rate averages 100 basis points higher (6.83 percent), for example, the premium financing yield falls to 4.8 percent at ages 93 compared with 6.1 percent for paying premiums. Whether using premium financing or paying premiums is the better choice will depend on loan interest rates that will change. This makes the decision when using an NLPG policy uncertain. As noted for the participating whole life simulation, the loan costs exceed the premium payments in about 15 years and are much higher when the insureds are in their nineties.

Miscellaneous Issues

• Non-NLPG universal life should probably be avoided. Many policy series have a dismal history of providing excellent current pricing after being in force for a while, compared with the best participating whole life policies. This is true whether premium financing is used or not, but is especially true for premium financing because of the risk the loan interest rate will soar while the policy's interest crediting rate lags behind the market.
• Variable life should not be used because the extreme volatility of equity funds could put the policy in substantial deficit with respect to cash value collateral and very large unexpected premiums due.
• NLPG policies may have very low to zero cash values that will cause lenders to require significant grantor collateral. Such long-term asset encumbrance should be considered when making premium payment decisions.
• Premium financing will have net death benefits, after subtracting the loan principal, that is much lower than if premiums are just paid. This can be a difference of 30 percent to 40 percent around life expectancy, meaning initial death benefits may be excessive for the actual need or the coverage may fall short of what is desired. And because estate asset values and the need for life insurance usually go up, premium financing is going in the wrong direction.
  

Premium financing is an active marketing concept, but it's unclear to me if actual sales are matching this marketing enthusiasm. My analysis suggests its appeal will mostly be for those who leap before carefully assessing situations.

Reprinted with permission by the Financial Planning Association, Journal of Financial Planning, Volume 17, Issue 7, July 2004.

Peter Katt, CFP, LIC, sole proprietor of Katt & Co., is a fee-only life insurance adviser located in Kalamazoo, Michigan (269.372.3497).