Vol 6 No 4		June 2004

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Financing Life Insurance Premiums

My analysis suggests premium financing's appeal will mostly be for those who leap before carefully assessing situations.

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. 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.

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 plus 200 basis points is the common marker for the interest rate charged. The average LIBOR rate plus 200 basis points for the period 1989 (September) to 2003 (March) is 7.44%.
• If the policy is surrendered, the loan principal is repaid from the cash surrender value and 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.

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 $5,000,000 death benefit that goes up as dividends are earned. The annual premium is $136,350 that is paid every year. The policy illustration's dividend-interest-rate is 7.0%. An 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% and LIBOR plus 200 basis points averaged 7.44% during the same period. That is LIBOR plus 200 basis points averaged 83% of the dividend-interest-rate average. Therefore, using a dividend-interest-rate of 7.0% for my simulation I used a LIBOR rate plus 200 basis points of 5.83%. 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 with 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.

Table 1 - Premium Financing vs. Premium Payments for Participating Whole Life Policy

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 paying premiums at a time there is about a 70% probability 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%. Although premium financing starts out with less out-of-pocket cost within about 15 years they exceed paying the premiums and in the late years become much higher than the premium.

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 May 2003 and April 2004 LIFE INSURANCE PERSPECTIVES about NLPGs). I used the same LIBOR plus 200 basis points interest rate for premium financing of 5.83% 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 since the premiums and death benefits are guaranteed and aren't affected by changing interest rates. But the LIBOR plus 200 basis points loan interest rates will change with interest rates. 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.

Table 2 - Premium Financing vs. Premium Payments for NLPG Policy

Based on a LIBOR plus 200 basis points of 5.83% for the loan interest rate premium financing is a slightly weaker choice around joint life expectancy of ages 93, but better before then. However, if the loan interest rate averages 100 basis points higher (6.83%), for example, the premium financing yield falls to 4.8% at ages 93 compared with 6.1% 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 90s.

Miscellaneous Issues

• Non-NLPG universal life should probably be avoided because many policy series have a dismal history of providing excellent current pricing after being in force for a while compared to 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 are much lower than if premiums are just paid. This can be a difference of 30% to 40% 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 is unclear to me if actual sales are matching this marketing enthusiasm. My analysis suggests that its appeal will mostly be for those who leap before carefully assessing situations.