With interest rates at all-time lows, premium financing, which entered the mainstream over two decades ago, has become both a viable and potentially profitable option for well-to-do Americans. However, at the same time, premium financing has begun to see widespread marketing, even to individuals who shouldn’t necessarily be attempting to capitalize on such an opportunity. Much of this stems from a lack of understanding of premium financing.
In this article, we will cover the basics of what exactly premium financing is and then dive into some of the risks and rewards associated with it. We will end with a unique way to look at premium financing that is different from how many financial and life insurance advisors view premium financing.
At its most basic level, Premium financing is the process of borrowing funds to cover the cost of the premium on a life insurance policy. Qualified individuals utilize a third-party loan to finance these premiums. A plan is then constructed to maximize returns and minimize outside collateral.
Americans make use of life insurance policies for many reasons; however, one of the most significant advantages of life insurance policies is their tax advantages. For example, death benefits are typically tax-free, and the total cash value on life insurance accumulates on a tax-deferred basis.
However, to maintain and build a comprehensive life insurance policy, individuals have to make significant premium payments that can take a large bite out of their cash flow. Of course, premiums vary significantly based on factors and variables like age, health, policy size, and policy type.
Premium financing is primarily designed for high-net-worth individuals (HNWIs) looking at a life insurance policy in the millions. For example, a whole life insurance policy of $25 million could run in the range of $16,000 or more a month. Further, liquidating assets to cover such an expensive policy (i.e. $192,000/year) will inevitably result in individuals incurring substantial capital gains taxes.
Overall, the lens we like to view premium financing through, one that we’ll expand upon later on, stems from the following question: Can the money spent on the policy premiums potentially be better spent, or instead invested, elsewhere, earning returns higher than the borrowing rate. Essentially, premium financing comes down to one fundamental idea: can you make a higher return on the money you would be pouring into life insurance premiums than the interest rate on a premium financing loan?
Then, once the policy generates enough cash value as it continues to mature, the loan value can be paid back from the policy value or money outside of the policy - depending on what makes more sense at the time (large withdrawals from the cash value can jeopardize the guaranteed coverage of the policy, which must be considered carefully).
Premium financing may sound simple, but there are actually quite a few risks involved, and to utilize the method effectively, financial advisors must really understand how premium financing works. The fundamental risks involved are as follows:
Premium financing loans typically come with variable interest rates, which can put your ability to outperform your interest rate in jeopardy if interest rates rise. While interest rates are expected to remain low for the foreseeable future, this could change, especially if the United States experiences a sharp recovery from the COVID-19 downturn in the near future.
With markets at all-time highs despite being in a pandemic, there is always the inevitable risk of a market crash and further economic downturn, which could further jeopardize one's ability to outperform the interest rate on a policy loan.
Additionally, this could lead to the cash surrender value of your policy (also known as the policyholder’s equity, this is the sum that insurance companies pay to the policyholder if their policy is terminated before its maturity or, in the case of life insurance, the death of the policyholder) underperforming. Since a policy’s cash value is used as the collateral for policy loans, the loan balance could exceed the value of the cash value (i.e. collateral). This would require the borrower, or insured in this case, to provide additional collateral. Failure to do so would result in a default.
In the long-run, if the death benefit fails to grow at a rate that outpaces that of the loan, the insured’s estate could end up having to repay the loan if the death benefit cannot.
The traditional view of premium financing is that the insured can outperform the loan borrowing rate with their returns on the policy credits (the portion of premiums credited to the account’s cash value). Via this line of thinking, advisors believe that clients can partially or fully pay for their policies without using their own money extensively, or in the best-case scenario, at all.
Thus, premium financing, under the traditional view, is a money-making opportunity. Unfortunately, this view rarely works out, and those who utilize this view typically end up making far less than they expected or taking on unexpected losses.
You might ask, why is this the case? On a basic level, we must first understand the cash value of an insurance policy.
An insurance policy’s cash value is simply the value of the money that builds within your life insurance policy. When you pay a premium to a life insurance company, three things happen:
The second part of this is what builds up the cash value of your insurance. This cash value is built by credits the insurance company makes to your policy based on the money that your premiums generate through investments.
We could dive into the IRR on premium to cash value and crunch a multitude of numbers. However, for simplicity and brevity, it is easiest to imagine the flaws in this following approach.
After you take out the first and second portions of the premiums, you can imagine the part of the premium actually going to your cash value is significantly less than your premium. However, your premium financing loan is paying for the entirety of your premiums; hence, if your loan rate is 4% annually, it is not good enough to make 4% on your cash value year-over-year. In fact, it is probably not good enough to make 5%, 6%, or even 7%. As you can imagine, the returns required begin to get very high, and the higher the returns required, the greater the risk and easier it is for financial loss.
That said, this does NOT mean that premium financing is not a viable option. It depends on how you look at the opportunity that premium financing presents. We will discuss how we view the real opportunity in premium financing below.
Premium financing can get complex quickly, and, as noted, the approach that is typically pitched by advisors to their clients revolves around making a higher rate of return on the policy credits (the amount of the monthly premium credited to the cash value) than the borrowing rate on the loan. This is typically a messy approach and usually does not yield the returns projected by advisors.
This does not mean there is not an opportunity for financial gain in premium financing. So, where is the real opportunity in premium financing?
First, we have to put this whole idea about the difference between policy crediting and borrowing rates to the side. The real opportunity can be found in the spread between your borrowing rate and your opportunity cost. Finance revolves around the opportunity cost of investments, and we can look at premium financing the same way.
Let’s say you will start a $25 million whole life insurance policy, with annual premiums of $15,000 a month, or $180,000 a year. Now, you could pay for this policy outright, in which case you would have to liquidate $180,000 of assets a year to meet the premiums - however, what sort of return are you making a year on this $180,000? If you are earning 8% interest on this money, then the opportunity cost of paying it into a life insurance policy could be very high.
Suppose you can finance your policy at 4% interest, and you are earning 8% interest on your investments on average (as a little reference, the annualized return of the S&P 500 is 9.8% over the last 90 years). In that case, the opportunity cost of using that money to pay for your life insurance policy is relatively high.
With this approach, you don’t have to worry as much about outpacing the loan with your insurance policy’s cash value, since if you are outperforming the loan rate with the invested money you would have otherwise had to liquidate, then you are ahead of where you would be had you been paying for the premiums directly.
It is important to emphasize that this view only applies if you need to buy life insurance, regardless of whether you use premium financing or not. It does not work if you are looking to make money off of premium financing, in which case the spread between the borrowing rate and the policy crediting is the only way to look at it.
This approach is most comparable to buying a car with a loan. HNWIs can afford to buy a car without financing, but if you can get a 5-year car loan at 3.5% APR on a, for example, $85,000 car, and you are making 7% annually in the market, paying off the car would cause you to lose out on money that could be made by taking out the loan.
Cars are paid off monthly, but we’ll look at it through an annual lens for the sake of easy to understand calculations. In the first year alone, you will accrue interest of $2975 on your loan; however, by taking out the loan and leaving the $85,000 in the market (or wherever it is invested, if you earn 7%, you have made $5950 - more than enough to pay off the interest and cut into the car’s premium. You can think about viewing whole life insurance policies in a similar light.
We’ve mentioned that premium financing is typically for HNWIs, but to drill down a little further, those using premium financing should meet some basic qualifications:
Premium financing is a viable option for a wide range of individuals. However, in summary, the value of the opportunity stems not from the difference between borrowing rates and policy credits but borrowing rates and the opportunity cost of the money being used to pay the premium.
This approach significantly cuts the risks involved with premium financing since it relies on the fundamental idea that the insured needs or desires the policy, to begin with and is not buying it simply to make money. There are many ways to make money - premium financing is usually not one of the best ways.
If you have any questions and are interested in how our approach to premium financing could benefit your financial situation in the long-run, please don’t hesitate to reach out. We are always happy to discuss how our innovative and unique approach to life-insurance advising can help each unique and individual financial situation.
StarFort Financial is a leading life insurance advisory firm representing high net worth clients across the United States. We tailor insurance solutions that fortify wealth within estates and businesses. We pride ourselves on our unwavering commitment to being loyal financial advocates for our clients.
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