Premium Financing: How HNW Clients Buy Life Insurance
Recently, a friend of mine who has been a private banker for over ten years, Anita, called to both vent her frustration and to ask for advice. “I’ve got a bone to pick with you,” she said. “I’ve been listening to you espouse the benefits of using life insurance in a financial plan and you had me convinced until today!”
It seems one of Anita’s clients was in the midst of re-doing his estate plan with his attorney and there was a need for a sizeable life insurance policy. The premium for the proposed whole life insurance policy was a single payment of $5 million.
Anita was upset for two reasons. Personally, she did not like losing the assets under management (AUM) she had worked so hard to generate for her client. More importantly, she had been earning the client between 10% and 11% on that $5 million and it was uncomfortable seeing that capital put into a life insurance policy where it would earn closer to 3%.
“I’m glad you called, Anita, because there is a way to make this transaction better for everyone,” I said. “Have you heard about life insurance premium financing?”
Financing the single premium on a permanent and fixed life insurance policy – such as a whole life or universal life contract – can significantly lower the cost of the insurance transaction for a client while maintaining a client’s current investment strategy.
Here’s how it works:
A client receives a loan from either a bank or lending institution with which they have a relationship or a third-party bank or lending institution which specializes in life insurance premium financing. The loan may be cheaper with a relationship bank - especially if the client has significant assets with the institution - and obtaining LIBOR plus 75 basis points is not uncommon. Third-party lenders will charge a bit more but may also make a favorable adjustment if a relationship is formed with additional deposits.
The lender will collateralize the cash surrender value of the life insurance policy, so it is important that the policy is purchased from a high rated life insurance carrier. The lending value tends to range at between 80% and 95% of the policy’s cash surrender value and this means for a $5 million premium, for example, the lender will be willing to lend in the neighborhood of $4.5 million.
The client can either pay the difference between the loan and the premium in cash or leverage other assets. Many clients choose the additional leverage option so that their only commitment to keeping the policy in-force is to pay quarterly interest cost to the bank.
The loan can be paid back from the policy’s cash values at a point in the future – usually in after ten years or more – or paid back at death from the policy’s proceeds.
In the meantime, the client’s capital remains deployed with the private bank earning a rate far higher than that of the life insurance policy. The client is happy to have reduced the cost of the insurance transaction while continuing to keep his money invested and the banker is thrilled to not have lost any AUM and to have gained fees from the loan.
Does this sound too good to be true? It could be if the client has not been shown models in advance showing what could go wrong and what that would mean. For instance, if loan rates soar above that of what the policy earns, the client could become ‘upside down’ in the loan and need to pay more premium into the policy or potentially unwind the loan if the loan costs are not saving money in the transaction.
A professional life insurance advisor will illustrate for the client numerous models which show various policy rates and loan rates. What happens if loan rates shoot up in year 5? What if the policy’s credited rate falls to its guaranteed minimum? What if your investment returns in your private bank account fall to where re-paying the loan and paying cash for the premium makes sense?
Premium financing is not the magic solution to every single premium purchase of a life insurance policy. If the client understands leverage and interest rate arbitrage, has professional money management, chooses the appropriate policy from a well-rated insurer and asks to see a variety of scenarios illustrated, premium financing could be a fit.