For educational and informational purposes only, This is not a recommendation to buy, sell or invest. Please consult your advisor and tax consultant.
Premium Financing is an alternate method of paying for life insurance premiums for high net-worth purchasers through third-party lenders.
The potential benefits of premium financing vs. insurance can give you more direction in choosing one of these methods over the other. Financing, for example, reduces any of your liquidity needs and can provide loans in the form of gift-tax leverage – proving to provide a serious advantage to your asset portfolio.
How Does Premium Financing Work?
After determining if Premium Financing is the right path for you, an attorney then begins the process of drafting an Irrevocable Life Insurance Trust (ILIT). The ILIT then purchases a policy on your behalf. This third-party method means that because you do not own this policy, ILIT assets will not be included in your estate. This third-party continuously funds the trust each year ensuring that the annual premiums on the policy are handled appropriately.
A key point to understand is that if the loan is not fully repaid in your lifetime (and the ILIT owns your policy in full), the remainder of the loan is paid back to the original lender from your policy’s death benefits while any remaining balance is paid to your beneficiaries.
Collateral of Premium Financing
Any Premium Finance Loans are collateralized in full. Most of the main sources of this collateral will be cash surrender; however, additional collateral may need to be committed during the early stages of the loan – the reason for this is that the full amount of the loan and the sum of the interest will exceed the cash surrender value.
This additional collateral can include cash surrender sum of other life insurance policies, a letter of credit from a bank, and any marketable securities It is important to note that there are methods of collateral that are not accepted such as any assets that cannot be easily converted in cash. If any of these assets are necessary, they may be included by a bank for collateral consideration by obtaining a letter of credit.
The Risks of Premium Financing
Naturally, while there are advantages to Premium Financing, there are three specific risks to keep in mind. The interest rate risk is tied directly to a one year London Interbank Offering Rate (LIBOR) – which can increase your loan rate.
Crediting Rate Risk could mean that each year your life insurance policy’s cash value may be less than projected.
Collateral Call Risk, which in the event of a loan default, means any additional collateral you provide could be lost.
Premium Financing comes with additional key points to consider as you weigh the risks, collateral, and process. One of the main details to note is the interest.
Interest on these loans is considered personal interest and is not deductible for income tax purposes. Additionally, gift taxes can be reduced since loans to a trust for premium payments are not taxable.
The benefits of the life insurance proceeds are only included in the insured’s estate if they own the policy in full. As mentioned above, the Irrevocable Life Insurance Trust (ILIT) will own the policy in full and therefore cannot be included in your estate.