Premium finance life insurance necessitates the policyholder obtain a loan from a bank to pay the premiums on his or her policy. The strategy works to lower the net cost of purchasing a large life insurance policy, and wealthy Americans use premium financing for this purpose. However, there are times when unscrupulous insurance agents and/or marketing firms attempt to use the core concepts of premium financing to sell life insurance in an extremely risky manner.
What Is the Process of Financing Life Insurance Premiums?
Borrowing money to pay all or part of the premium due on a life insurance policy is how life insurance premium financing works. Borrowing money to pay a life insurance premium may seem unusual, and it’s certainly not for any old life insurance policy. When someone has a significant need for life insurance, and the cost of that life insurance is always significant, premium financing becomes available.
Consider the following scenario: a wealthy individual discovers that he requires $30 million in life insurance coverage and that the annual premium for such a policy is $900,000. He could pay the $900,000 (remember this because it’s important), but he chooses to approach the problem through his banking relationships. He seeks out a bank willing to lend him $900,000 per year to cover the premium. He will pay the loan’s interest and pledge the cash value of the life insurance policy as collateral for the loan. Because the cash value of the life insurance policy will not equal the total loan amount from policy inception, he will need to pledge other assets he owns as collateral to satisfy the bank’s requirements for issuing the loan.
The good news is that he’ll be able to get a loan with low-interest rates. A loan that is linked to either LIBOR or Prime plus a small spread. This means that the out-of-pocket insurance costs will be a fraction of the $900,000 annual premium. If, for example, the loan has a 2.25 percent annual percentage rate, the first year’s out-of-pocket insurance costs will be $20,250. However, as the loan balance grows each year, the policy owner/insured will need to plan ahead of time and develop an “exit strategy.” This exit strategy simply means that he will repay the entire loan balance to the bank at some point.
If everything goes according to plan, the wealthy individual will pay off the loan, reach a point with the life insurance policy where he no longer needs to pay premiums, and now own a permanent life insurance death benefit that he obtained much more cheaply than if he had purchased the policy the traditional way. You may notice an underlying implication that things may not go as planned. This can and does happen, so let’s take a look at some of the possibilities.
Changes in Policy or Loan Provisions
The loan rate can fluctuate when financing the premiums of a life insurance policy. Typically, the bank will lock the rate on the loan for the first few years of the arrangement before switching to a floating rate. Some lending agreements also require the borrower to reapply for the loan after a certain period (e.g. 10 years). A falling interest rate is unlikely to be a major issue. It means that the borrower will pay less interest to service the debt than was previously assumed.
A rising interest rate, on the other hand, poses a risk. It is almost certain that the borrower is paying more interest than was originally assumed. This could significantly alter the expected benefit of financing the premiums versus simply purchasing the policy without financing the premiums.
Furthermore, the accumulation feature of the life insurance policy may produce less cash value than originally assumed, which may change the collateral requirements the borrower must meet and/or the timing of the exit strategy. A declining dividend (in the case of whole life insurance) or a change in the index cap, participation, and/or spread rate (in the case of indexed universal life insurance) can all raise the cost of financing the premiums.
What Happens If You Are Unable to Pay Your Life Insurance Premium?
Remember how I said earlier that the individual in my example could simply pay the entire premium? This was something I took note of. When a prospective policy owner can pay the premiums out of pocket but chooses not to, premium financing should be discussed. Premium financing is not a tool used to enable people to purchase life insurance that they would not be able to afford otherwise.
This raises a fascinating question. Is life insurance really necessary if someone has enough money to pay a $900,000 life insurance premium with a $30 million death benefit? Yes and no are both possible answers. It is determined by the liquidity of the individual’s assets as well as how he earns his income.
There are undoubtedly situations in which people with this level of income and net worth do not require life insurance. However, there are some situations in which people with this kind of income and net worth desperately need life insurance to avoid catastrophic financial consequences upon death. The critical point to grasp here is the small number of people for whom premium financing will ever make sense.
Finally, if you borrow money to pay premiums and cannot pay those premiums yourself, you are likely to suffer a painful loss. To be honest, the bank’s underwriting process should have discovered this fact and denied the loan. That used to be more reliable than it is now.
Using Premium Financing to Purchase Cash-Focused Life Insurance
I hope you can see by now that premium financing is not for the faint of heart. Several elements can go wrong and change the overall benefit of the plan. At best, it’s a risky bet for those looking to use leverage to get life insurance at a lower price by using the bank’s money. Understanding this, there’s another marketing aspect to premium financing that has never made sense to me, and we’ve been warning people about it for years. This entails financing premiums under the guise that doing so will multiply your returns on a cash-focused life insurance purchase.
In other words, you borrow money to purchase whole life or indexed universal life insurance policy to use it as a retirement income play. Instead of paying the premiums with your own money, you borrow a much larger amount of money and use it to extract additional gain from dividends or indexing credits provided by the cash accumulation features of the life insurance.
Insurance agents frequently use examples of borrowing money to make investments to frame their pitch for this type of life insurance sale. A common example is a real estate investor who borrows money to buy a house that she then flips and sells for, say, $300,000. Her investment was the $40,000 down payment she made on the loan she used to buy the house in the first place. This gives her rate of return the appearance of being astronomical, and in fact, this does work to some extent with real estate.
However, life insurance is not the same as real estate. For at least a few decades, no one will borrow any amount of money to pay life insurance premiums and generate cash surrender value close to the borrowed amount. I’ve frequently argued that we should consider the option of simply paying the premium out of pocket, and I’ll use the following example to demonstrate my point.
Assume a bank is willing to lend you $100,000 at 6% interest per year while also extending the loan on a zero-coupon basis with a 20-year balloon payment. Yes, I understand that such a loan is unusual today, but stick with me because this example highlights the key point behind premium-financed life insurance in the context of cash accumulation.
At the same time, you are confident that you can take this $100,000 and earn an 8 percent annual return on investment. So you borrow the money and everything goes exactly as planned. Your loan balance at the end of 20 years is $320,713.55. Your investment, on the other hand, is worth $466,095.71. As a result, you can repay the loan and pocket $145,382.17. This move necessitates no out-of-pocket expenses on your part. To accomplish this, you simply need to sign the loan application and accept the risk as a borrower. You’d be foolish not to take advantage of such an opportunity if it presented itself. This is an example of how to use leverage to increase your net worth.
These figures appear impressive, but when using this example to sell the concept of financial premiums for a life insurance policy, we need to use more realistic figures to determine whether the juice is worth the squeeze. Assume the loan now has a 2% annual interest rate and your “investment” will grow at 4% per year for the next 20 years. You will have $70,517.57 after repaying the loan. This isn’t bad, but it’s less than half of what you’d have if you followed the previous example.
Furthermore, consider your alternatives, such as how much money you’d need to save out of pocket in the same “investment” to arrive at this $70,517,57 balance in 20 years. The annual cost is $2,277.02. Remember that borrowing and investing money entails risk. There’s a chance you won’t get the investment return you expected over the next 20 years. In a real premium finance context, there’s also a chance that the loan interest accumulated over 20 years will be higher than you expected. As a result, when deciding whether it’s worthwhile to take the risk, the net return is extremely important. I understand that everyone is different, but if the path to the same result of $70,517.57 cost me only $2,277.02, I’d skip the loan application. I realize this is just one example with one set of numbers, and yes, the gain grows as the numbers grow larger (i.e. you borrow more money), but the relative numbers remain the same.
Life insurance simply cannot generate enough return in a short enough period to make borrowing money to extract a slightly higher return worth the risk of financing the premiums. Some disagree, but after many conversations with them, I’m convinced that they don’t fully understand the risks associated with such an arrangement.
Finally, life insurance is intended to be a secure means of accumulating wealth. It’s supposed to be a reliable asset allocation strategy. One that does not expose you to the risk of losing your principal. In this context, introducing premium financing takes an otherwise safe asset with a reasonable return and dramatically skews the risk/reward ratio heavily against the policy owner.