Premium Financing: Common Financing Traps and Dilemmas

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1 Premium Financing: Common Financing Traps and Dilemmas Premium financing is often used as a way for a client to leverage his or her current liquid assets. Instead of writing the check for the premium due, the client borrows the premium from a third-party lending institution. The structure is fairly straightforward. The client creates an irrevocable life insurance trust (ILIT). The ILIT borrows the premiums to purchase the life insurance policy on the client. The client pledges collateral for the loan. Interest is due. At the end of the loan term, or death, the outstanding loan is repaid to the lender. Premium Financing Diagram Client(s) (Grantor) Lender lends funds to ILIT to purchase policy. Third-party Lender Additional Collateral Client creates trust for purposes of life insurance. ILIT (Policy Owner) Policy collaterally assigned to lender. Life Insurance ILIT purchases policy and pays premiums. White Paper continues >

2 Page 2 of 6 White Paper Common Financing Traps As with any loan transaction, there are risks and considerations, and there are some common financing traps. Three of the most common traps are outlined below. Trap #1: Pledging a modified endowment contract (MEC) as collateral Common Scenario: A client s ILIT decides to put in premium or premiums in excess of the seven-pay premium to create a lot of cash surrender value in excess of the total premiums paid. When the ILIT finances the policy, the policy is pledged as collateral for the loan, assuming with the excess cash value, it will fully or over-collateralize the outstanding loan. Trap: Internal Revenue Code (IRC) 72(e)(10) and IRC 72(e)(4)(A) state that pledging a MEC as collateral for a loan will be as if a distribution had been made from a policy (even if no actual distributions have been made from the policy). At this point, any cash value in excess of basis is taxable as ordinary income. Additional Trap: But what if the client is older than 59 ½? Then the 10 percent MEC penalty does not apply in this situation, right? Wrong. The ILIT is the owner of the policy, and the ILIT has no age. Therefore the 10 percent MEC penalty applies, to the extent that there is gain in the policy. There are some who believe that as long as there is no gain at the time of the assignment, then there should not be any tax consequences. However, others believe that as long as the assignment exists at the time that gains begin to accrue, such gains become taxable at that time. Unfortunately, the Internal Revenue Service has not yet addressed this issue. Trap #2: Financing a variable universal life (VUL) policy Common Scenario: A client s ILIT decides to finance a VUL policy for greater cash value potential. The higher cash value inside the policy means additional collateral for the loan, and less outside collateral that the ILIT or the grantor has to pledge. Trap: Section 11(d)(1) of the Securities and Exchange Act of 1934 states that broker/dealers may not directly or indirectly arrange for a loan/extension of credit to a client for the purpose of purchasing a security. There are some exceptions to this rule, but they are beyond the scope of this paper. It should be noted that SI does not currently permit using variable products in conjunction with financing arrangements. Assuming that a broker/dealer will allow the transaction to take place, pledging a VUL policy s cash surrender value as collateral for the loan would be considered pledging a marketable security. Lenders typically discount different asset types based on their potential liquidity. Marketable securities are usually discounted a minimum of 50 percent. This may defeat the original purpose of purchasing the VUL for the potentially higher cash value. Trap #3: Gratuitous use of credit Common Scenario: The client creates an ILIT to purchase a life insurance policy. The ILIT is the owner of the policy, and the borrower of the premiums. If the ILIT has no additional assets outside of the policy, and additional collateral is required for the loan, the grantor may have to pledge a letter of credit on behalf of the ILIT to collateralize the loan. Trap: Is this considered a gratuitous use of credit? Would the grantor be subject to gift tax since the grantor has received nothing in exchange for the transfer? How could this be mitigated? The grantor could charge the ILIT a nominal letter of credit fee in exchange for posting the letter of credit as collateral for the financing of the loan.

3 Page 3 of 6 White Paper Common Financing Dilemmas How many times does a client or referral source ask about the following common financing dilemmas? Dilemma #1: I was shown a strategy where if I use premium financing, I can borrow the premiums, accrue interest and never post collateral for the loan, and the policy will pay off the loan later on. Basically I am getting free insurance, right? There is no free insurance. The increasing popularity and subsequent growth of the indexed universal life (IUL) marketplace perpetuated the free insurance via premium financing marketing strategy. How does it work? The ILIT buys a policy and borrows the premiums. The IUL contract is overfunded early on (typically over a period of 10 years or less, depending on the age of the client) at the maximum seven-pay premium, with the death benefit option shown as face amount plus cash surrender value. During this time, the borrowed premiums accumulate interest, and the contract cash value is pledged as collateral for the outstanding loan. At some point, the outstanding loan is paid off via a large loan from the policy s cash surrender value. The policy is projected to continue to grow well past age 100. Sounds great, right? But there are two key elements that will make or break this strategy: loan interest rate and policy crediting rate. The beauty of illustrating an IUL contract in this type of financing is that the policy can be projected at a much higher crediting rate than a typical current assumption UL (CAUL) product. Often the policy is illustrated well north of 8 percent, eclipsing current crediting rates by as much as 400 basis points. The loan rate is typically variable, tied to an underlying borrowing benchmark and subject to market fluctuations; it is often shown at 3 percent or below, projected out years. So the outstanding loan balance is growing at a low rate, and the cash surrender value is earning at a very high rate. Consider the following questions next time you see free insurance via premium financing : Is the crediting rate assumption sustainable? For the strategy to work, the policy has to earn a consistently high interest rate every year. What happens in the down years when the policy only gets the guaranteed rate, often zero percent? Can the policy catch up? It is important to look at the guaranteed cap and participation rates on the IUL product. The non-guaranteed participation rate may be 140 percent and the non-guaranteed cap 15 percent, but the guarantees may only be 60 percent and 3 percent respectively. Is the loan rate assumption sustainable? We are in a historically low interest rate environment, but, at some point, borrowing rates will increase again. Lenders will not forecast much beyond five years, so many loan terms do not extend past five years before renewal. How is the money being pulled from the policy to pay off the outstanding loan? Most of the time, the outstanding loan is paid off via a policy loan, not a withdrawal. Usually the policy loan uses a variable loan rate, so the policy continues to accumulate cash value. For example, the variable loan rate may be 5.5 percent; if the policy is illustrated at 8 percent, the policy loan is actually earning 3.5 percent! However, if the policy earns zero percent, the loan rate stays at 5.5 percent. If the inversion continues, the policy will not be able to sustain the loan and will implode. Will the lender give collateral value for an IUL policy illustrated north of 8 percent? Most lenders will significantly discount the cash surrender value and only consider the guaranteed cash surrender value or request a low-point letter from the carrier. In a low-point letter, the carrier projects the low point of the cash surrender value for the upcoming year. If the policy cash values are insufficient to pay off the loan, what is the client s exit strategy? If the policy does not perform as expected, the client may have to tap into existing assets to pay off the loan and maintain the life insurance coverage. Theoretically, the strategy could work if all the assumptions came true. But the entire financing strategy accrued loan interest, collateral requirements and exit strategy relies entirely on the projected policy performance. It is critical that the client be aware of all the risks of the transaction before making a final decision.

4 Page 4 of 6 White Paper Dilemma #2: My client has a net worth of X, but 90 percent of that net worth is tied up in non-liquid assets (e.g., real estate, private stock, closely held business). This is a fairly common dilemma in which premium financing is thought of as a solution, since the client is illiquid. Traditional premium financing should be considered for the client who can write the check for the premium, but chooses to leverage his or her own liquidity rather than pay the premium. Balance sheet composition is key. In evaluating a potential client s suitability, the lender may want the client to be at least 20 percent liquid. In a traditional premium financing arrangement, collateral and interest are major components. The policy s cash surrender value is the primary source of collateral for the loan. If the cash surrender value is not sufficient to cover 100 percent of the outstanding loan balance, the client/borrower will need to post additional collateral. The lender is looking for collateral that it can easily liquidate should default occur. This means cash, marketable securities and letters of credit. Additionally, interest is due annually on the outstanding loan. If the lender requires interest to be paid, can the borrower afford the annual expense? And if the lender does allow the accrual of the interest, how will the borrower post the additional collateral needed to secure the increased loan amount (premiums plus accrued interest)? It is currently extremely difficult to directly assign real estate as collateral. However, there may be some alternative ways to access liquidity to pay premiums. If the client/borrower has unencumbered real estate, they may be able to take out a home equity line of credit (HELOC) against the property to pay premiums. Additionally, if the client has income-producing commercial real estate, it may be possible to take a line of credit, also called a credit facility, against that property as well. While outside of a traditional premium financing arrangement, it may offer the client additional opportunities to access funds for life insurance. Private stock is a difficult form of collateral because determining the value can be subjective. Depending on the company and the ability to access information about the company, the lender may consider private stock. But it is important to note that if the lender does allow the private stock to be used as collateral, they will discount it heavily, anywhere from percent. When closely held businesses comprise the majority of the client/borrower s net worth, the client/borrower may want to consider options outside of traditional premium financing, such as private financing with sale to a grantor trust with life insurance or simply a sale to a grantor trust with life insurance. Dilemma #3: The client has an existing financing arrangement but can no longer post collateral or pay interest on the loan. In this dilemma, two questions arise: 1. Does the client want to keep the life insurance coverage? 2. Did the client implement an exit strategy at the inception of the loan? It is imperative to determine what the client s objectives are going forward. If the client wants to keep the insurance, and is insurable, it may be beneficial to consider moving into a new product via a Section 1035 exchange with higher cash value to help offset the additional collateral. However, depending on age and health status, there may be new premium costs; not every client can 1035 their way out of the outstanding loan. It is a very real possibility that new coverage may reduce the additional collateral burden on the client, but it will not eliminate it. If the client is uninsurable, it may be challenging to find a solution that works for all parties. If the issue is ongoing interest costs, the lender may be willing to let part or all of the interest accrue going forward. If the client can no longer post collateral, it may be worth taking a look at the type of collateral the client is posting. Perhaps the client has posted a portfolio of marketable securities that is not performing; it may be possible, if the client can obtain a letter of credit and the lender is amenable, to swap collateral. Did the client implement an exit strategy at inception? Did the client create a side fund, earmark an asset to be liquidated at a certain time, or fund a grantor retained annuity trust (GRAT) for purposes of exiting the loan? Was the exit strategy a large withdrawal/loan from the policy? Many times an exit strategy is shown or illustrated to the client, but never implemented.

5 Page 5 of 6 White Paper If no exit strategy exists, i.e., no source of funds to potentially help defray ongoing loan costs, there may be some harsh realities to face. If the client cannot move into a new product with more cash surrender value to offset collateral requirements, or tap into other assets to pay interest or other loan costs, then the client may have to default on the loan. What happens then? The lender is always whole remember, a traditional premium financing arrangement is 100 percent secured. The lender will surrender the policy for the cash surrender value. They will then tap into the assets pledged as collateral for the loan for the remaining loan balance. For the client, this may be a significant hit to their liquid assets pledged for collateral, and they will lose their existing insurance coverage. Summary Premium financing can be a very useful tool for clients who do not want to liquidate existing assets to pay premiums for life insurance. It gives clients the ability to obtain the life insurance coverage they need or desire and can free up existing cash flow. Premium financing comes with risks that should be clearly outlined from the beginning so that the client can make the best decision based on his or her own risk profile. Careful and prudent design based on the client s risk tolerance and planning objectives may ultimately help the client avoid some of the common financing traps and dilemmas. Premium Financing is complex and involves many risks, such as the possibility of policy lapse, loss of collateral, interest rate and market uncertainty, and failure to re-qualify with the lender to keep the financing in place and maintain the desired level of insurance protection. In certain situations, additional out-of-pocket contributions may be required to retire the debt and/or maintain the desired level of insurance protection. A well planned exit strategy should be in place prior to accepting any financing arrangements. Financing is subject to the lender s collateral and financial underwriting requirements. Financing lenders typically require additional collateral during the early years of a policy in the form of cash, cash equivalents, marketable securities, a personal guaranty or a letter of credit from a bank approved by the lender. Interests in closely held businesses and real estate are not generally acceptable collateral.

6 Page 6 of 6 White Paper About s benefits, insurance and wealth management businesses provide a broad range of advisory and brokerage services to companies and individuals, helping them preserve their assets and prosper over the long term. Our advisors partner with clients to help provide clientfocused, and comprehensive solutions, backed by s national scale and resources. is a leader in the delivery of benefits solutions for companies of all sizes and in the delivery of life insurance and wealth management solutions for high net worth individuals. Our leading, independent broker/dealer offers a broad range of options from some of the nation s top investment companies. This document describes fixed insurance. Any guarantees offered by life insurance products are subject to the claims-paying ability of the issuing insurance company. Riders may be available for an additional cost. There are considerable issues that need to be considered before replacing life insurance such as, but not limited to; commissions, fees, expenses, surrender charges, premiums, and new contestability period. There may also be unfavorable tax consequences caused by surrendering an existing policy, such as a potential tax on outstanding policy loans. Please discuss your situation with your financial advisor. This material was created by (National Financial Partners Corp.), its subsidiaries, or affiliates for distribution by their representatives and/or agents. This material was created to provide accurate and reliable information on the subjects covered but should not be regarded as a complete analysis of these subjects. It is not intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be sought regarding your individual situation. Neither nor its subsidiaries or affiliates offer tax or legal advice /12 (INS ) Copyright All rights reserved.