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    Estate Planning and Insurance: Does Premium Financing Make Sense?

    by Peter Katt

    Financing permanent life insurance premiums through third-party lenders is a marketing idea that promises to relieve individuals of having to pay their life insurance premiums.

    Typically, this idea is targeted toward those individuals who are buying life insurance that is associated with their estate planning: They have substantial assets and are probably in their 60s or older. The life insurance policies are almost always owned by irrevocable trusts or similar entities, and the financing arrangements are negotiated with lending institutions by either the insurance marketers or the individuals purchasing the policy.

    According to some of the major marketers, there are two primary reasons to consider premium financing:

    • First, financing can allow assets to remain invested that might otherwise need to be liquidated in order to pay premiums, or allow funds that would otherwise go to premium payments to be used for other investments with greater potential.

    • Second, financing can avoid making gifts to trusts.
    Financing both the premiums and interest charges isn’t a realistic option because the compounding costs of carrying the loan interest will likely cause the program to go into deficit before life expectancy. The only realistic option is to finance the premium payments while paying the interest charges annually.

    In researching this issue, I spoke with a person who handles premium financing for a national sales network that works with many different life insurance companies. He informed me that, although premium financing is frequently discussed, it is hardly ever actually used. I don’t know if his perspective is unique or typical. If it is typical, there may be a lot more marketing effort behind premium financing than actual business. As my analysis points out, premium financing may have some merit for individuals with limited cash flow and significant value tied up in assets that either are difficult to market or would incur a high tax cost with liquidation. For others, premium financing is probably not a good solution.

    How It Works

    Generally, these factors are relevant to premium financing:

    • The life insurance policy’s cash values and death benefits are collateral for the loans. If there isn’t sufficient collateral within the trust, the grantor (the person creating the trust) must guarantee the loan with collateral outside the trust. (Whether this would cause the life insurance policy to be included in the grantor’s estate is an interesting question.)

    • The grantor makes gifts to the trust of the annual interest. The trust pays interest to the lender. No income tax deduction is allowed.

    • Typically, the interest rate charged is roughly 200 basis points above the London Interbank Offered Rate (LIBOR). [LIBOR is a widely used benchmark for short-term interest rates; it is the rate at which banks borrow funds from other banks in the London interbank market.] The average LIBOR rate plus 200 basis points for the period September 1989 to March 2003 is 7.44%.

    • If the policy is surrendered, the loan principal is repaid from the cash surrender value. If this isn’t enough, the grantor will have to gift that amount to the trust. Upon death, the loan principal is repaid from the death proceeds.
    To see if premium financing offers any benefits, I ran simulations using two different kinds of policies. Both are second-to-die policies insuring 62-year-old spouses with preferred underwriting.

    Using a Participating Whole Life Policy

    One simulation is for a full-load participating whole life policy with an initial $5 million death benefit that goes up as dividends are earned. The annual premium is $136,350, which is paid every year. The policy illustration’s dividend interest rate is 7.0%.

    A historically accurate spread between the loan interest rate and the policy’s dividend interest rate is needed for my simulations. During the period from 1989 to 2003, LIBOR plus 200 basis points averaged 83% of the insurance company’s dividend-interest-rate average. Therefore, with a dividend interest rate of 7.0% for my simulation, I used a LIBOR rate plus 200 basis points of 5.83% (83% of 7.0%)—not a perfect methodology, but a reasonable relationship between the insurance policy’s investment component and the loan rate.

    Table 1: Premium Financing vs. Premium Payments for Participating Whole Life Policy
    Ages Premium Financing Premium Payments Probability
    Both
    Died
    (%)
    Loan
    Cost
    ($)
    Loan
    Principal
    ($)
    Net Death
    Benefit
    ($)
    Yield
    (%)
    Premium
    ($)
    Death
    Benefit
    ($)
    Yield
    (%)
    66 39,746 681,750 4,349,251 210 136,350 5,031,001 76 0.0
    71 79,492 1,363,500 3,837,562 50 136,350 5,201,062 24 0.1
    76 119,238 2,045,250 3,644,304 21 136,350 5,689,554 12 1.0
    81 158,984 2,727,000 4,228,195 11 136,350 6,955,195 8.3 5.0
    86 198,730 3,408,750 5,381,315 7.3 136,350 8,790,065 6.7 14.0
    91 238,476 4,090,500 6,943,543 5.4 136,350 11,034,043 5.8 33.0
    93 254,375 4,363,200 7,672,371 4.8 136,350 12,035,571 5.6 42.0
    96 278,222 4,772,250 8,954,977 4.3 136,350 13,727,227 5.3 57.0
    99 302,070 5,181,300 10,589,720 3.9 136,350 15,771,020 5.1 70.0

    Table 1 compares the use of premium financing against the grantor simply making gifts to the trust for the full premiums. I compare the yield achieved for each option measured at the second death when the proceeds are received by the trust. The premium financing option has as its cost the loan interest paid with the death benefits reduced by the amount of the loan principal. The premium-paying option has the premiums as the cost with the full death benefits.

    Although the proponents of premium financing assert that they attain better investment results when premiums are avoided or a better gift tax result, I am treating these as neutral. Sometimes investment results aren’t positive and minimizing the amount of gifts to a trust doesn’t always produce a better estate planning result, but this isn’t the column to discuss these issues.

    Table 1 provides information in five-year increments, plus ages 93, which is joint life expectancy. It also shows the probabilities that both insureds will have passed and the proceeds paid out.

    Both the participating whole life policy’s dividend interest rates and LIBOR interest rates are market-priced and will be affected by overall interest rates. However, the relative average spread between them should remain relatively stable, and therefore the yield difference between premium financing and paying premiums should also remain about the same. For that reason, Table 1 has a high predictive value.

    You can see from the table that premium financing starts out as a better value, but it falls behind paying premiums when there is about a 70% probability that at least one insured will be alive and the policy in force. By around joint life expectancy (ages 93), paying premiums instead of premium financing is a better value by some 20%. Although premium financing starts out with less out-of-pocket costs, within about 15 years the costs exceed paying premiums, and in the late years become much higher than the premium.

    Using a No-Lapse Premium-Guarantee Policy

    Table 2: Premium Financing vs. Premium Payments for No-Lapse Premium-Guarantee Policy
    Ages Premium Financing Premium Payments Probability
    Both
    Died
    (%)
    Loan
    Cost
    ($)
    Loan
    Principal
    ($)
    Net Death
    Benefit
    ($)
    Yield
    (%)
    Premium
    ($)
    Death
    Benefit
    ($)
    Yield
    (%)
    66 39,746 681,750 12,633,911 288 136,350 13,315,661 123 0.0
    71 79,492 1,363,500 11,952,161 76 136,350 13,315,661 40 0.1
    76 119,238 2,045,250 11,270,411 36 136,350 13,315,661 21 1.0
    81 158,984 2,727,000 10,588,661 21 136,350 13,315,661 14 5.0
    86 198,730 3,408,750 9,906,911 13 136,350 13,315,661 9.4 14.0
    91 238,476 4,090,500 9,225,161 7.5 136,350 13,315,661 6.8 33.0
    93 254,375 4,363,200 8,952,491 5.9 136,350 13,315,661 6.1 42.0
    96 278,222 4,772,250 8,543,411 3.9 136,350 13,315,661 5.1 57.0
    99 302,070 5,181,300 8,134,361 2.3 136,350 13,315,661 4.4 70.0

    The other simulation I ran is shown in Table 2. It illustrates a no-lapse premium-guarantee (NLPG) policy using the same $136,350 annual premiums as the first simulation, but with level death benefits of $13,315,661. [I discussed this policy type in my July 2003 AAII Journal column, “The Potential Problems With No-Lapse Premium Guarantees.”] I used the same 5.83% interest rate for premium financing as I did for the first simulation. Note, however, that this doesn’t produce as accurate a comparison as it did for participating whole life because the NLPG policy has static-pricing—the premiums and death benefits are guaranteed and aren’t affected by changing interest rates. However, the loan rates will change with interest rates and, therefore, the yield results for premium financing will either be better or worse than shown in Table 2. Consequently, the yield difference between premium financing and paying premiums is not very predictable.

    In this example, the loan interest rate premium financing is a slightly weaker choice around joint life expectancy of ages 93, but better before then. However, if the loan interest rate average is, for example, 100 basis points higher (6.83%), the premium financing yield falls to 4.8% at ages 93, compared with 6.1% for paying premiums.

    In short, whether using premium financing or paying premiums is the better choice will depend on loan interest rates that will change. This makes the decision when using an NLPG policy uncertain. As noted for the participating whole life simulation, the loan costs exceed the premium payments in about 15 years and are much higher when the insureds are in their 90s.

    Other Issues

    Non-NLPG universal life should probably be avoided because many policy series have a dismal history of providing excellent current pricing after being in force for a while compared to the best participating whole life policies. This is true whether premium financing is used or not, but is especially true for premium financing because of the risk the loan interest rate will soar while the policy’s interest crediting rate lags behind the market.

    Variable life should not be used because the extreme volatility of equity funds could put the policy in substantial deficit with respect to cash value collateral and very large unexpected premiums due.

    NLPG policies may have very low to zero cash values that will cause lenders to require significant grantor collateral. Such long-term asset encumbrance should be considered when making premium payment decisions.

    After subtracting the loan principal, premium financing will have net death benefits that are much lower than if premiums are just paid. This can be a difference of 30% to 40% around life expectancy, meaning initial death benefits may be excessive for the actual need or the coverage may fall short of what is desired. And because estate asset values and the need for life insurance usually go up, premium financing is going in the wrong direction.

    Premium financing is an active marketing concept, but it is unclear to me if actual sales are matching this marketing enthusiasm.

    My analysis suggests it will appeal mostly to those who leap before they look carefully and assess their situations.


    Peter Katt, CFP, LIC, is sole proprietor of Katt & Co., a fee-only life insurance advising firm located in Kalamazoo, Michigan (269/372-3497); www.peterkatt.com.

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