How Premium Financing Works

The Traditional Way

Typically, when you want to buy life insurance, you go to an insurance carrier.

The Traditional Way

If healthy enough, the carrier would issue the coverage. If wealthy enough, that coverage would be owned by a trust.

The Traditional Way

These policies come with two major components:
Cash Value + Death Benefit.

The Traditional Way

Death benefit is for the benefit of the beneficiaries of the trust, to pay for estate taxes, provide income for a surviving spouse, pay for your kid’s college, etc. In a business planning case, it could be used to fund a buy-sell agreement or protect against the loss of a key employee.

The Traditional Way

The Cash Value is also available to the trustee, for the benefit of the trust beneficiaries. In the case of individual ownership it is available for the owner’s benefit. It may be accessed to use as needed, keeping in mind that accessing this policy equity will reduce the death benefit.³

The Traditional Way

In traditional situations the client will give money to the trust for the policy premiums or will pay premiums directly to the insurance carrier.

When there is a need for very large death benefits, the premiums can be proportionally as large. It is not uncommon to see clients paying $50,000, $100,000, or even as high $400,000 out of cash flows…

The Traditional Way

…While premiums this large may be reasonable to some people that have significant assets or income, the premium payments may begin to take away from the client’s opportunity to accumulate wealth in other asset classes that have higher returns.

This is where financing comes in. Financing is for the clients who are able to return more on invested assets than they would be repurposing those dollars to pay for life insurance.

Premium Financing: At Inception

The trust and lender enter an agreement where the lender provides the financing each year in order to pay for policy premiums on behalf of the trust. In exchange, the trust agrees to pay interest to the lender every year.

You, the client, will give the trust enough cash to pay interest on the loan and post collateral to cover the shortfall between policy cash values and the principal of the loan.

Premium Financing: At Inception

Each party to the transaction is looking for certain criteria to be met in order to approve the transaction. For carriers, properly designed financed policies should have longevity, leading to an increase in profitability.

For lenders, the primary concern is interest payments and loan repayment. To meet the institutional needs, we typically use heavily guaranteed high-cash value policies that ensure principal growth within the cash value of the policy.

Premium Financing: At Inception

In premium financing, the two parties from the Traditional arrangement (Insurance Carrier + Trust) add a third party, the Lender.

Trust and lender enter an agreement where the lender provides loan each year to enable the trust to pay the policy premiums. Trust agrees to pay interest to bank every year. You, the Client, will give the Trust enough cash to pay interest on the loan. The lender will require collateral as part of the agreement, which at inception will include not only the policy but also additional assets.

Premium Financing: At Inception

Your trust-owned policy—along with your personal funds—become collateral for the loan until repayment.

Since the policy is pledged, the lender has the first right to policy cash values and death benefit while the loan is in place, meaning that the funds available to the trust will be net of the loan.

In addition to gifts of interest, you should maximize your annual gifting to the trust. You may also make gifts using lifetime gift exemption.

Premium Financing: At Inception

Collateral can be posted as either cash or securities. While cash is susceptible to inflation, securities come with market risk and volatility.

Premium Financing: At Inception

While many advisors suggest making annual interest payments and posting cash collateral, we believe there are more effective strategies. Calculating and devising a “sinking fund” strategy can account for both interest payments and collateral needs.

By structuring your coverage this way, you’re optimizing the growth of your own funds by keeping your money invested.

Premium Financing: At Inception

The three largest variables to premium financing are interest rate risk, policy performance risk, and collateral risk. Typically interest rates are floating and costs can go up in a rising rate environment. Policy performance is based on dividends, which are not guaranteed. Collateral risk or market volatility must also be managed when securities are posted.

Premium Financing: Exit Strategy

An exit strategy is a necessary piece of your overall case design, but because it will be implemented in the future, we cannot predict all of the factors that may influence how you ultimately choose to approach it.

Therefore, while a provisional strategy should be discussed, we may find that a different strategy or combination of strategies may be more suitable at the time of exit.

Premium Financing: Exit Strategy

Trust repays loan using policy values. Policy values may be accessed via policy surrenders and/or policy loans.

Premium Financing: Exit Strategy

Trust repays loan using non-policy assets.

Premium Financing: Exit Strategy

Grantor repays loan using personal assets. Personal assets include any that are still within one’s estate. Often the repayment can be timed to the sale of a business or buyout of partnership. The Grantor’s payment to the lender will be treated as a gift to the trust in most cases.

Premium Financing: Exit Strategy

Some combination of option 1, 2 and 3, is also acceptable.