Helping up and coming clients meet their life insurance needs
by Christopher J. MonroeMr. Monroe is affiliated with Lakeshore Financial Group in Chicago and Peoria, IL. Connect with him by email: [email protected]
Premium financing has historically been a strategy that high-net worth individuals use to help pay their life insurance premiums when they had a large premium need, but preferred not to access capital or reduce cash flow for the premiums. High-net worth individuals often need to secure life insurance coverage with death benefits exceeding tens of millions of dollars to address their business succession, family inheritance or estate tax planning needs. These larger policies often have annual premiums in the range of hundreds of thousands of dollars, requiring the client to use their cash or investment assets to pay for the premiums. Depending on the assets used to pay the premiums, liquidating those assets could trigger other taxable events such as capital gains taxes. Premium financing can allow clients who require a significant amount of life insurance to use financing strategies to pay the premiums – rather than using their cash or liquid investment assets. The funds needed to pay the premiums are secured by borrowing from a third-party lender such as a bank.
Using this strategy, the client’s attorney drafts an Irrevocable Life Insurance Trust (ILIT), a type of trust that is specifically set up to own a life insurance policy. The ILIT purchases a life insurance policy on the client’s behalf. Since the policy is owned by the trust and not the client, the proceeds will generally not be included in the client’s estate for estate tax purposes. A third-party lender loans funds to the trust each year to pay the annual premiums on the policy. You may choose to finance a portion of the premium, all of the premium, or the premiums plus accrued interest and other costs. The arrangement should be designed so that the loan will be fully repaid during the client’s lifetime, at which time, the ILIT will own the policy outright without the policy being subject to the premium finance loan. If not, any unpaid loan or loan interest is paid back to the lender from the policy proceeds at the client’s death. Any remaining death benefit is paid to the ILIT for the benefit of the trust’s beneficiaries. Note: Any outstanding loan principal and/or interest is paid from the policy proceeds at the time of death.
The triple play premium financing strategy
The Triple Play Premium Financing Strategy addresses the same two reasons many clients traditionally finance large insurance premiums: help provide income to your loved ones in the event of an untimely death or help protect the continuation of a business in the event an owner passes away and funds are needed. In essence, life insurance helps with estate planning for your family or business and helps pay for any estate taxes or final expenses which may be owed upon death. However, the Triple Play Strategy addresses a third need for many emerging wealthy clients – the potential for future supplemental income or retirement income through the use of tax-free policy loans and withdrawals1. This strategy can be a viable option for up and coming high-net worth clients, particularly clients in the age 30 to 45 range with household incomes of $200,000 or more. These are clients who have a need for life insurance, but also have a desire to save additional money for retirement. These clients are often disqualified from contributing to other retirement savings vehicles, such as Roth IRAs, which have income restrictions.
The Triple Play Premium Financing Strategy allows individuals or couples the ability to leverage life insurance benefits for additional income purposes in addition to traditional estate planning needs. The three (triple) benefits this concept may be used for include:
- Estate tax or inheritance planning purposes,
- Insurance protection for survivors or business needs if the client is under age 55, and
- The potential for supplemental retirement income through tax-free loans and policy withdrawals, or through income riders1
With the Triple Play concept, the premium financing strategy is typically used to purchase an Indexed Universal Life Policy (IUL). An Indexed Universal Life insurance policy is usually a fixed Universal Life (UL) policy whose interest is determined, at least in part, by the performance of a specified index of the market. Unlike traditional UL policies, the policy owner may receive zero interest for a single crediting period if the index performs poorly.
However, with most designs, the premiums are protected and guaranteed to credit a minimum interest rate in the event the policy is surrendered. The owner of an IUL policy may experience better interest crediting that a traditional UL policy during periods when the market performs well. IUL policies do not directly participate in any stock or equity investments. The policies should be structured by the agent so that the loan is paid off from policy cash values, typically around years 11 to 15 of the policy, but may vary depending on the performance of the policy.
Some policies offer income riders2, which are additional riders that can be purchased at the time of the application, and if the policy is sufficiently funded the rider may used to provide a guaranteed3 income stream in retirement instead of putting the burden on the client to self-distribute funds through policy loans and withdrawals. The client can secure the life insurance coverage they need from day one with the income rider giving them the option to exercise the rider down the road if the policy accumulation values permit. These riders use tax-free policy loans which allow for a tax-free income stream when exercised.4
It is imperative to work with a team that is highly-skilled in working with clients on these concepts. Care should be taken to properly analyze and project not only a client’s current funding needs, but the impact these strategies could have on their future financial situation, including their future capital needs, performance of their investments and projected expenses.
The risks with triple play and other premium financing strategies
Premium financing may not be right for every client. First and foremost, the client should be able to answer yes to the following questions – Do I want and need more life insurance? Do I want to fund the policy sufficiently to provide the potential for a lifetime, tax-free steady stream of income? Do I have disposable income that could fund this strategy through the 11 to 15 years of the anticipated premium funding? Am I willing to enter into an agreement with a bank for them to fund a significant portion of this strategy up front, to be paid back ideally by policy values if the performance of the policy is sufficient?
Premium finance loans are collateralized by the policy values. The policy’s cash surrender value serves as the primary source of collateral. However, additional collateral will most likely need to be pledged – especially in the early years of the contract, when the amount of the loan and accumulated interest exceed the cash surrender value. Acceptable forms of additional collateral may include5:
- Marketable securities
- Cash surrender value of other life insurance policies6
- Letter of credit (from a bank with AA- or better rating)
Assets that cannot be easily converted to cash, such as real estate, artwork or collectibles, may not be viewed as acceptable forms of collateral. However, these assets may be considered by the bank when obtaining a letter of credit.
Depending on your personal financial situation, the loan may be repaid in a variety of ways: from the policy’s cash value (in the form of a policy loan); from outside funds (such as an inheritance or proceeds from the sale of a business or other asset) gifted to the trust to repay the loan; or from a combination of policy loans and outside assets. Again, any outstanding loan principal and/or interest is paid from the policy proceeds at the time of death.
In addition to the premium financing risks listed above, careful consideration should be made to other risks, including:
- Interest Rate Risk
The interest rate charged on the premium finance loan is generally tied to the one-year London Interbank Offering Rate (LIBOR). Increases in this rate can increase the client’s loan rate and costs
- Crediting Rate Risk
The amounts credited to the life insurance policy cash value each year may be less than projected
- Collateral Call Risk
In the event of a loan default, any supplemental collateral pledged to secure the loan (in addition to the policy’s cash value) may be called and possibly lost. This may also result in a taxable gift with potential gift tax implications
- Trust Risk
to qualify as an asset outside of the estate, gifts to an ILIT to pay the life insurance premium have to be made available to trust beneficiaries who must sign a letter each year stating that they forego taking money from the trust. Beneficiaries have been known to deviate from the plan.
Potential consequences should be discussed and determined to be within the client’s risk tolerance before proceeding with any premium financing strategy.
Potential benefits of premium financing
For clients who are able to navigate these risks, and have the means to purchase insurance, premium financing can provide several important benefits. First, your current cash flow may already be committed to other expenses, so the financing helps balance competing cash flow needs. Financing helps reduce your liquidity needs, which is especially helpful if your assets are not readily convertible to cash. You may not want to move assets that would incur capital gains to liquidate, or if the client anticipates that the assets could experience a higher rate of return than the cost of the borrowing. Finally, financing can provide gift-tax leverage, as loans made to your Irrevocable Life Insurance Trust (ILIT) to pay premiums are not subject to gift tax. Capitalizing (or accruing) interest as part of the loan will increase the gifting leverage – in that case, there is no need to gift premium or loan interest.
Premium financing transactions can be beneficial for the right client, but can also be complex. These strategies should always involve the right team of financial professionals including the agent or financial advisor providing the life insurance, an estate planning lawyer and a tax professional to determine if this strategy, and its associated risks, are appropriate for you. ◊
1The use of cash value life insurance to provide a resource for retirement assumes that there is first a need for the death benefit protection. The ability of a life insurance contract to accumulate sufficient cash value to help meet accumulation goals will be dependent upon the amount of extra premium paid into the policy, and the performance of the policy, and is not guaranteed. Policy loans and withdrawals reduce the policy’s cash value and death benefit and may result in ta taxable event. Withdrawals up to the basis paid into the contract and loans thereafter will not create an immediate taxable event, but substantial tax ramifications could result upon contract lapse or surrender. Surrender charges may reduce the policy’s cash value in early years. Premium financing and administration is provided by a third party administrator independent of the life insurance carrier. The life insurance carrier is bound only by the terms of the life insurance contracts it issues.
2Life insurance income riders typically have limitations and restrictions to exercising them, including but not limited to, minimum and maximum age requirements, years policy has been in force and minimum policy values. Receipt of other policy benefits that reduce policy values may also reduce the ability to exercise the income rider. Receipt of income benefits will reduce the policy’s cash value and death benefit, may reduce or eliminate the availability of other policy and rider benefits, and may be taxable. Riders are supplemental benefits that can be added to a life insurance policy and are not suitable unless you also have a need for life insurance. Riders are option, may require additional premium and may not be available in all states or on all products.
3Guarantees are dependent upon the claims-paying ability of the issuing company.
4Except in the case of a Modified Endowment Contract (MEC), withdrawals up to the basis paid into the contract and loans thereafter will not create an immediate taxable event, but substantial tax ramifications could result upon contract lapse or surrender.
5Securities and advice regarding securities can be offered solely by representatives registered to offer such products or services through a broker/dealer or registered investment adviser.
6Securities and insurance policy value may be accepted subject to a discount.
This information is not intended as tax or legal advice. For advice concerning your own situation. Please consult with your appropriate professional advisor.