Premium Finance Life Insurance Problems
To pay the premiums on a premium financing life insurance policy, the policy owner must obtain a loan from a bank. The method seeks to minimize the net cost of purchasing a large life insurance policy, and wealthy Americans use premium financing to do this. However, there are situations when unscrupulous insurance agents and/or marketing firms attempt to use the underlying concepts of premium financing to sell life insurance in a highly risky manner.
How Does Life Insurance Premium Financing Work?
Life insurance premium financing works by borrowing money to pay all or some of the premium due on a life insurance policy. Borrowing money to pay a life insurance premium may sound strange, and it’s certainly not for just any life insurance purchase. Premium financing comes up when someone has a substantial need for life insurance, and the cost of that life insurance is always considerable.
Consider a situation where a wealthy individual discovers that he needs $30 million in life insurance coverage and the per year premium cost of such a policy is $900,000. He could pay the $900,000 (remember I said this because it’s important), but he decides instead to approach this problem with the help of his banking relationships.
He goes in search of a bank willing to lend him $900,000 per year to pay the premium. He’ll pay the interest that accumulates on the loan, and he’ll 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 whole loan amount from policy initiation, he must also pledge other assets he has as collateral to meet the bank’s conditions for issuing the loan.
The good news is that he’ll obtain a loan with relatively low borrowing costs. Generally, a loan pegged to either LIBOR or Prime, plus a small spread. This means the out-of-pocket cost of the insurance will be a fraction of the $900,000 annual premium.
If for example, the loan comes with a 2.25% annual percentage rate, the first year out-of-pocket cost of the insurance will be $20,250. But this amount will increase each year as the loan balance increases, so the policy owner/insured will need to look into the future and develop an “exit strategy.” This exit strategy simply means a point where he’ll repay the entire loan balance to the bank.
If everything goes as planned, 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 for a lot less money than if he had purchased the policy the old-fashioned way. You could notice an underlying implication that things might not go as planned. This can and does happen, so let’s look at some of the possibilities.
Policy Or Loan Provision Changes
When financing the premiums of a life insurance policy, the loan rate can change. Normally the bank locks the rate on the loan for the first few years of the arrangement but then uses a floating rate thereafter. There are also some lending agreements that require the borrower to effectively reapply for the loan after a certain period (e.g. 10 years). A falling interest rate is likely no big deal. It means the borrower will pay less interest to service the debt than originally assumed.
A rising interest rate, on the other hand, poses a risk. It is almost clear that the borrower is paying more interest than was originally thought. This could significantly impact the expected benefit of financing the premiums versus simply purchasing the policy without financing the payments.
Additionally, the accumulation feature of the life insurance policy might produce less cash value than originally assumed, which potentially alters the collateral requirements the borrower must satisfy and/or the timing of the exit strategy. A declining dividend (if whole life insurance) or a change in the index cap, participation, and/or spread rate (if indexed universal life insurance) all potentially increase the cost of financing the premiums.
If the loan interest rate increases and the accumulation feature of the life insurance policy decreases, there’s a multiplying effect on how much more expensive premium financing becomes. While it’s unlikely for these two aspects to move in opposite directions, it’s not impossible.
What Happens If You Can’t Pay The Life Insurance Premium?
Remember earlier when I mentioned that the individual in my example could choose to simply pay the entire premium? I noted this was important. Premium financing should only be a discussion when the prospective policy owner has the capacity to pay the premiums out-of-pocket but chooses not to. Premium financing is not a tool used to allow people to buy life insurance they cannot otherwise afford to own.
This raises an interesting question. If someone had the money to pay a $900,000 life insurance premium providing a $30 million death benefit, does he really need life insurance? The answer can be both yes and no. It depends on the liquidity circumstances of the individual’s assets and how exactly he goes about earning his income.
There are no doubt situations where people with this sort of income and net worth do not absolutely need to own life insurance. But there are also circumstances where people with this sort of income and net worth desperately need life insurance in order to avoid disastrous financial consequences at death. The really important thing to understand here is the limited number of people for whom premium financing will ever make sense.
Ultimately, if you borrow money to pay premiums and you do not have the ability to pay those premiums yourself, you are likely headed down a road of painful loss. Truth be told, the bank’s underwriting process should uncover this fact and deny the loan. That used to be more foolproof than it is today.
Using Premium Financing For Cash-Focused Life Insurance Purchase
I hope by now you can see that premium financing is not for the faint-of-heart. There are several components that can go sideways on you and alter the overall benefit of the plan. At its best, it’s a risky bet for those looking to use leverage to buy life insurance at a discount by using the banks money to do it.
Understanding this, there’s another marketing aspect to premium finance 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 can multiply your returns on a cash-focused life insurance purchase.
In other words, you borrow money to purchase a whole life or indexed universal life insurance policy that is designed to provide retirement income. Instead of paying the premiums with your own money, you borrow a much greater sum and utilize it to extract more benefit from dividends or indexing credits provided by the cash accumulation features of the life insurance.
Insurance agents like to use examples of borrowing money to make investments as the starting point to frame the pitch for this sort of life insurance sale. Common examples look something like the real estate investor who borrows money to buy a house that she flips selling for let’s say $300,000. Her invested amount was the $40,000 down payment she made for the loan she got to purchase the house originally. This makes her rate of return look astronomical and in truth, this does work to some degree with real estate.
But life insurance is not real estate. No one will borrower any sum of money to pay life insurance premiums and create cash surrender value anywhere close to the borrowed amount for at least a few decades. I’ve commonly argued that we need to consider the alternative of simply paying the premium out-of-pocket and I’ll use the following example to make my point.
Assume that a bank is willing to lend you $100,000 for 6% interest annually, but also extend the loan on a zero-coupon basis with a 20-year balloon payment. Yes I understand such a loan is highly unusual today, but follow with me, because this example highlights the key point behind premium financed life insurance in the cash accumulation context.
At the same time, you are certain you could take this $100,000 and achieve an 8% per year investment return on the money. So you borrow the money and so exactly as you planned. At the end of the 20 years, your loan pay off amount is $320,713.55. But your investment is worth $466,095.71. So you can pay back the loan and pocket $145,382.17.
This move requires no money out-of-pocket on your end. You simply have to sign the loan application and take on the risk as a borrower to accomplish this. If such an opportunity presented itself to you, you’d be foolish not to take it. This is an example of using leverage to bolster your net worth.
These numbers look great, but when using this example to sell the idea of financial premiums for a life insurance policy, we need to use more realistic figures to evaluate whether or not the proverbial juice is worth the squeeze. So let’s assume the loan now has a 2% annual interest rate and your “investment” will grow at 4% per year over the next 20 years. After repaying the loan, you’ll have $70,517.57. This isn’t bad, but it’s less than half of the money you’d have under the previous example.
In addition, let’s entertain your alternative options such as simply 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 answer is $2,277.02 per year.
Keep in mind that borrowing and investing the money involves risk. There’s a risk that you may not achieve the investment result you assumed over the 20 year period. In a real premium finance context, there’s also a risk that the loan interest accumulated over 20 years will be more than you originally anticipated.
So the net return matters a lot when deciding if it’s worth taking on the risk. I realize everyone is different, but if the path to the same end result of $70,517.57 was a mere $2,277.02 out of my pocket, I’d skip the loan application. I do realize that this is one example using one set of numbers and yes the gain does increase as the numbers get bigger (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 greater return worth the risk of financing the premiums. There are many who disagree, but after several interactions with them, I’m confident that they don’t completely understand the risks connected with such an agreement.
Finally, life insurance is designed to be a secure means of accumulating wealth. It’s believed to be a reliable asset allocation strategy. One that does not put the principal at jeopardy. In this situation, introducing premium financing takes an otherwise safe asset with an acceptable return and substantially skews the risk/reward ratio heavily against the policy owner.