Daniel P. Wachs - CFP®,CLU®,ChFC® Dan is the creator of The Wealth Confidence Builder Process. He is a premium finance specialist and owner of Perpetual Wealth Management located in Chicago and NW Indiana.
Premium Finance Solutions and Applications for the Affluent Individual Capitalizing on the opportunities at the correct time has advantages for the privileged few. The concept of premium financing of life insurance policies has been around for quite some time. The main application of this strategy is used by High Net Worth clients to purchase the appropriate amount of Life Insurance to pay for their estate taxes due upon demise. This concept, based on the current interest rate environment, can substantially lower the out of pocket cost of the plan. It also can minimize the gift tax obligation for the client. The gift is based on the interest payments rather than the planned premium amount. The interest can also be accrued to keep the gifts below the annual gift exclusions in certain planning scenarios.
Figure 1: % of Household that Qualify for Premium Financing in the US
Many new insurance product innovations created over the past few years have led to more solutions for the qualified consumer to utilize. When done properly through specialized planning, we can and have helped clients provide protection for their family while keeping the death benefit out of their estates. The other major planning benefits through certain policy features are: providing for long term care if needed and providing supplemental tax favored income in retirement. If the policy is designed properly it has a tremendous impact on the clients overall financial plan. The strategy can provide flexibility in covering many unknown life risks. The desired outcome is the ability for the client to maintain choice and control throughout his or her lifetime, rather than trying to make irrevocable decisions now. These unchangeable decisions could take 30 years to materialize in the future and may not accomplish the original intention of the client in a changing world. Let’s take a look at the current economic environment to evaluate the potential of this concept. The strategy consists of borrowing the
money from a commercial lender to pay the insurance policy premiums. The current interest rates are based on the one year LIBOR rate plus an additional spread, which will determine the annual rate. These current interest rates are very favorable due to the historically low interest rate environment.
Note: retirement accounts cannot be pledged as collateral. This is deemed a prohibited transaction by the IRS. Some individuals may also obtain a letter of credit from their existing bank relationships. The bank usually charges a fee based on the amount of the LOC needed to cover the collateral shortfall. The outside collateral is reduced while the cash value of the policy increases over time. The CV eventually will serve as the only collateral needed until the loan is paid back. The CV is usually able to collateralize the loan at the end of the year when the last premium is deposited into the policy by the lender.
Figure 2: Strategy Concept
The objective of the strategy is to service the loan and pay interest for 10 to 12 years. The policy will then make a lump sum distribution from the cash surrender value and pay back the commercial lender in it’s entirety. At this point, the client owns the policy outright. Up until this point in time, the policy is assigned to the bank as collateral while any collateral shortfall is covered by the individual with a form of a liquid asset. These assets pledged for collateral can be cash - valued at 100%. A brokerage account is valued at a discount ranging from 50% - 80% depending on the securities held in the account.
Figure 3: One Year LIBOR Rates
The Premium Finance lenders which we select do not charge origination fees on this type of loan. Additionally, these lenders will not charge penalties for prepayment of the loan. This allows maximum flexibility for our clients. The interest rates choice can be adjustable or fixed depending on the preference of the borrower. The loans can be underwritten in the name of the individual, a business or a trust. The interest due is usually paid annually in advance to the
lender. The interest rate is declared in advance annually and will not adjust during the given period. The qualification for the loan is a fairly quick and painless process. Firstly, the lender will verify the client’s credit worthiness. Secondly, the assets for the additional collateral shortfall will be determined and verified by the lender. The loan is a full recourse loan which is 100% secured through this process. The loan amount will not be reported to the credit bureau and/or added to any existing debt obligations. (This is a vitally important point, especially to our clients that are real estate developers. Their livelihood is determined by their ability to borrow as much capital to fund their projects. As stated earlier, this transaction will not deter from their ability to borrow after implementing the premium finance transaction.)
The selection of the appropriate life insurance policy when implementing this strategy is critical for all parties, the consumer and the lender. The lender does not allow any variable life policies to be used in this strategy because the cash value is invested in the stock market which can produce gains or losses and is too
unpredictable. The lender requires the principal to be secure and will not be comfortable with massive fluctuations in the policy value. A guaranteed fixed universal life policy provides a death benefit guarantee but these policies provide limited growth and access to the cash value to repay the loan. Whole life policies could work for estate planning strategies but developing tax favored retirement income due to the policy flexibility restrictions make them less attractive. We have found that fixed index universal life products have performed well in accomplishing all the areas of the planning that are involved with this transaction. For example, estate taxes gifting amounts, retirement income, LTC riders the policy crediting performance has provided the growth needed. This is critical for paying the loan obligation back in a reasonable time frame. Ideally, we project holding the loan for a ten to twelve year period of time. The client will pay interest to the lender simultaneously allowing the cash value to grow to a reasonable level to support the policy, while still paying off the lender obligation. This time frame based on our experience tends to be the most suitable. The client needs to work with a specialist that has experience with these products and can help them maximize the interest credited in the IUL designed policy. The advisor should also understand the policy crediting method options. Not all the policies or carriers are the same. I can’t stress this enough- this is where experience is needed. The strategy and goals of the individual will help in determining the right product and carrier to choose to obtain the desired results. The lenders will only work with highly rated carriers that have a history in the premium finance market. This gives the lender comfort that the strategy will work, number one, for the client and second, that they will be repaid on the loan. I have been utilizing these
concepts with clients for nearly 15 years and have helped protect and grow their assets with these strategies successfully. The distributions inside a life policy can be taxfavored when done correctly. This can provide an alternative income source in retirement. The distributions of the proceeds will not be subject to income taxation or subject to estate taxation when properly designed. This part of the strategy needs the expertise of a qualified estate planning attorney and CPA. Furthering the conversation on tax – tax free distributions for high net worth individuals should not be discounted or ignored. Let’s explore this a little further … The question that usually arises from clients on the tax advantages of the properly designed max funded insurance contracts is whether to pay the premiums out of pocket or to finance the premiums. Here are some points to consider: When funding a policy for estate tax reasons, the premium amount is considered the annual gift. Depending on the number of beneficiaries of the ILIT (Irrevocable Life Insurance Trust) it may work. The client also may only buy enough coverage to utilize their annual gifting amount. In 2017, the limit is $14,000, per beneficiary- per person. Contrarily, the gift in a premium finance transaction is deemed to be the interest paid to the lender, not the premium deposited by the lender into the insurance policy. We will try to control the impact of the gift, by the loan design, and also in the type of loan we implement for the client’s particular situation. (Such as, fixed or adjustable rate loans, paying all interest or deferring and/or accruing part of the interest payments.) Each scenario is different and the solution is custom designed to meet the client’s goals and objectives. These designs help clients to
understand the exit strategy, which is based on paying interest for a 10-12 year period of time to the lender. The lender can be paid back through the policy cash values or other assets to keep the policy growing if desired. High Net Worth clients are also limited in the amounts and vehicles offered to provide tax free income in retirement. The premium deposited in the maximum funded insurance contracts has no contribution limits or income restrictions. By using leverage, the premium finance strategy can substantially increase the amount of capital implored in this tax- free asset class. This allows for their current investments to stay invested. The investments will not need to be liquidated to fund the necessary insurance premiums. This approach enhances the overall net worth of the client. The client also pays only the interest payment rather than committing substantial amounts of their after tax income to fund the larger insurance premium requirements. Rather, they can choose to use these funds for other opportunities or investments. This approach improves diversification of their total portfolios and asset holdings. In conclusion, this concept is not for everyone. Remember, less than 2% of the U.S. population is able to qualify financially for this strategy. The qualification requirement is based on an individual accumulating a net worth of over $5,000,000. This limits many consumers, but if an individual does qualify, the concept is compelling enough to explore for utilization and implementation in his or her overall planning needs. The individual also has to qualify for the insurance policies based on their current health status. This is the actual starting place for the strategy. A favorable offer received from an insurance company is needed, and numerically
has to make sense, in order for this strategy to be a viable potential solution.
3. Retained Capital – Many high net worth clients earn double-digit returns on their investments, be it in their business, real estate or investments. Premium Finance allows those clients to keep their money working for them in those high returning asset classes. 4. Increased IRR – Utilizing premium finance reduces client outlay in the early year’s thereby increasing long term IRR.
“There are risks and costs to a program of action. But they are far less than the longrange risks and costs of comfortable inaction.” — John F. Kennedy Here are the top reasons… Why people use the premium finance solution to fund their insurance needs: 1. Leverage – Most self-made millionaires are comfortable leveraging their assets and have used that to create wealth. Premium Finance permits clients to leverage their current assets and the policy’s cash surrender value to obtain the coverage they need. 2. Tax Savings – By paying interest instead of premiums and structuring ownership of the life insurance properly, clients can minimize gifts and estate tax. Premium Finance can help clients use more of their annual gifting exclusions rather than tapping prematurely into their lifetime exemptions. The policies can also provide tax favored supplemental retirement income if structured properly.
Contact Information: Daniel P Wachs CFP, ChFC, CLU 1431 Opus Place #630 Downers Grove, IL 60515 630-445-1399