An Overview Of Premium Financed Life Insurance

An Overview Of Premium Financed Life Insurance

Introduction The purpose of this presentation is to assist you in understanding how life insurance can be funded using a bank loan as a means of financing premiums. The purchase of life insurance to meet a long term death protection need generally entails the use of permanent life insurance (universal life or whole life). To the extent that the life insurance premiums are paid through borrowing, you must consider the premium funding alternatives to determine if borrowing is an appropriate funding vehicle based on your objectives. Borrowing life insurance premiums can be a useful instrument for funding premiums under select circumstance. Below are some examples of when premium financing may make sense: Cash Flow Issues and Opportunity Costs Funds are tied up in investments that need time to mature or there are restrictions when the funds may be accessed A significant portion of wealth is currently in stock options or restricted stock that mature in a number of years A significant deferred compensation payment will be available to the client at retirement within a few years Client has a unique opportunity to invest in a desirable offering or is reluctant to expend funds in case such opportunities arise in the future Closely-held Business Issues The client is looking to transition from active management from his/her business in the near future and will be considering a sale of the business at that point Closely-held business has cash invested in capital that will eventually generate significant revenues, but a business continuation plan needs to be funded in case of an unforeseen emergency Income/Gift/Estate Planning Issues Income and capital gains tax issues dictate that the client retain certain assets for an extended period of time

Introduction Leveraged gift tax strategies by having only the annual interest payments be considered transfers to an irrevocable trust rather than the full premium amount Incorporate the financing piece into the client s overall estate plan, i.e., remainder interest of a GRAT or CLAT being used to repay the loan amount in a fixed number of years Premium financing as part of the client s charitable giving plan These materials do not constitute opinion or advice on legal, tax, accounting or investment matters. Please understand that Provada, its agents or employees, may not and do not give legal or tax advice. We recommend everyone seek and rely upon the advice of his or her own professional advisors prior to the application of this general information to specific situations. This presentation is only valid when preceded or accompanies by the complete basic illustration for the life insurance product(s).

Life Insurance Funding Options A policy owner can utilize various strategies for funding life insurance premiums. The following outlines some of the strategies used to fund annual life insurance premiums. Additionally, split-dollar and lowinterest private loans may be used in conjunction with the premium financing technique. For purposes of this report, we have assumed that the life insurance premiums are funded with financing from a bank. AFTER-TAX CASH FLOW Pay life insurance premiums with after-tax cash flow. SPLIT-DOLLAR Split-Dollar provides a funding strategy to use a third party sponsor s pocket book to pay the annual premiums. The policy owner s cost is based on the value of the death protection rather than premiums which provide the insured/policy owner with the ability to make significantly discounted gifts (generally for estate planning purposes). Note that new proposed split-dollar regulations were published in July 2002 which will change the taxation of split-dollar programs. This strategy may be used with the premium financing strategy through having the bank make loans to the premium payer. Note the Sarbanes-Oxley Act of 2002 may disallow this funding strategy for public companies. On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002, which focuses on fighting corporate corruption. Section 402 of the Act applies to any corporation that publicly issues securities and prohibits those corporations from extending credit to any director or executive officer. Some have raised concern that this prohibition on loans to executives might be interpreted to apply to split-dollar life insurance arrangements. We recommend that any corporation considering a split-dollar life insurance arrangement request that their own legal advisors consider whether the prohibitions of Sarbanes-Oxley apply

Life Insurance Funding Options IRC SECTION 7872 BELOW MARKET LOAN This also provides a funding strategy to use assets to make interestfree loans. The insured/policy owner would have imputed income and/or gift based on the excess, if any, of the applicable federal rate over the actual interest charged against the outstanding cumulative loan. Note the Sarbanes-Oxley Act of 2002 disallows this funding strategy for public companies. Once again, this strategy may be employed with premium financing, through having the bank loan made to the lender, who would re-loan the premiums to the policy owner at a minimal interest rate.

Overview PREMIUM FINANCING Clients with significant wealth are familiar with the benefits of using credit at the right times and for the right reasons to enhance their financial situation. In a low interest rate environment, these financial savvy individuals will consider financing certain current liabilities rather than being forced into untimely liquidation of personally owned assets. This is the theory behind life insurance premium financing. The wealthy client has a present need for life insurance protection whether it is estate planning, business succession planning, or part of a wealth accumulation/preservation strategy but the client has sound financial/business reasons not to liquidate assets in order to fund the insurance need. In these situations, financing the life insurance premiums may be an attractive solution for the client. In general, premium financing strategies involve the policy owner obtaining financing from a financial institution to pay the annual life insurance premiums. This strategy allows you to benefit from being protected by the life insurance policy, with the leverage of premium financing, while utilizing the tax features of life insurance. This analysis will illustrate, based on hypothetical assumptions, the potential benefits and risks delivered via a properly structured premium financing strategy. THE PLAN A typical premium financing arrangement will involve the following: Life insurance premiums are paid by a working line of credit or term loan from a bank, with premium advances for up to 10 years Collateral for the loan is provided by the life insurance policy values as well as any outside collateral that may be required should the policy values create a shortfall Borrower pays loan interest when due (monthly, quarterly, or annually) Loan terms typically will not exceed 10 to 15 years Loan repayment from refinance, policy withdrawal, policy maturity or cash payment

Overview Combines both the tax treatment provided to life insurance contracts with the leverage of financing life insurance premiums Life insurance is used to provide death proceeds and in some instances supplemental income PREMIUM FINANCING BENEFITS Aside from any costs related to the loan, no up-front out of pocket cost for the life insurance premium required to place the coverage Borrowed premiums are not subject to gift or income taxes the measure of the gift is based on interest and not the premium payment With certain life insurance products and financing, limited external collateral is required from the policy owner to gain access to financing Policy owner receives all the tax advantages of life insurance o Death benefits are generally income tax free o Cash value accumulation is tax free or tax deferred o Cash value can be withdrawn up to cumulative premiums income tax free 1 o Cash value can be borrowed income tax free 2 Other benefits of premium financing include: o Maintain current liquidity and existing investment strategies o Avoid income taxes from liquidating assets to pay premiums 1 Withdrawals may be subject to income tax, if they exceed premiums paid. In addition surrender charges may apply. 2 Loans against your policy accrue interest at the current rate and decrease the death benefit by the amount of the outstanding loan and interest.

The Premium Finance Solution POTENTIAL LENDER There are many lenders that offer premium financing programs. Premium Funding Group will work with Provada and the client to arrange financing with an institution rated AA or higher. A client may also utilize an existing banking relationship although it is important to make sure that any institution in this niche market is committed for the long-term. TYPICAL FINANCING STRUCTURE The final structure of any premium finance arrangement is dependent upon the client s specific situation and the details of the life insurance strategy. Common terms include: A minimum loan amount of $250,000 per year and $1,000,000 over the life of the loan. Financing is available for up to ten years with an additional fiveyear optional period. The terms of the five-year option period may be different from the original loan. Collateral equal to 100% of the outstanding loan balance. o 95% of the cash value of the life insurance policy is typically counted against the collateral requirement. o Additional collateral of cash, U.S. government obligations, or high grade securities may be used. The client maintains investment control over the collateral. o A letter of credit from a major bank may be used. Letters of credit typically cost the client up to 1% of the letter amount each year. Interest rate One-year LIBOR rate plus 150 to 200 basis points. Interest may be paid in advance or in arrears. Other terms and variables may be discussed with Premium Funding Group LLC and individual lending institutions.

The Premium Finance Solution HOW IS THE LOAN REPAID (EXIT STRATEGIES)? Premium financing may be a viable solution for a client s insurance funding, but the program is not without risk. The interest rate on the loan balance and projected rate of return of the collateral assets are just two variables that may deviate significantly from original estimates. An unanticipated spike in rates or a downturn in the market may affect even the best laid plans. In order to minimize the potential risks with premium financing, the client is encouraged to develop an exit strategy to repay the loan at the end of the original term. Loan repayments may be incorporated into the client s overall estate planning strategy or by creating a side fund to ensure completion of the financial strategy. Provada can work with the client and his/her other advisors to help form an exit strategy that conforms to the client s goals and financial plan. HOW PREMIUM FINANCING WORKS Once a decision is made to finance the premium payments on a life insurance policy, a multi-step process commences. 1. Preliminary inquiry: Client confers with Provada and other advisors to determine the insurance need and the correct policy that fits these particular needs. 2. Ownership: With the assistance of tax advisors and Provada, the client determines the best person or entity to own the policy. 3. Application process: The person/entity that will own the policy applies for life insurance coverage. 4. Meet with financing consultants: Client and advisors meet with Premium Funding Group to discuss financing options, contract terms and collateral requirements. A decision is made as to the most appropriate lender and the policy illustrations are provided to the lending institution. Alternatively, the client and advisors can meet directly with their own lending sources. 5. Loan closing: Once the loan is finalized and sufficient collateral advanced, lender advances funds to the insurance company as premium payment on behalf of the person/entity owning the life

The Premium Finance Solution insurance contract. The policy owner pledges the insurance contract as further collateral to the lender. 6. Annual interest payment: The owner of the policy pays to the lender an annual interest amount on the outstanding loan balance and receives an annual accounting of the transaction. 7. Loan repayment: In many cases, the principal of the loan is repaid to the lender at the end of the loan term and the assignment on the life insurance policy and additional collateral is released. Under certain circumstances, the owner may consider refinancing the loan for an additional term.

The Premium Finance Solution Basic Strategy Diagram During Life Engagement into Loan Agreement Client & Advisors Negotiate Loan Terms Premiums & Loan Interest Financing Institution Collateral as Needed Collateral Source Insured, Parents, Children, Trust(s), Family Partnerships, Family LLC, Corporation Pays Premiums Policy as Collateral Life Insurance Trust (owner of policy) Life Insurance Company Trust Receives Tax Free Death Benefit Proceeds At Death Life Insurance Policy Life Insurance Trust (owner of policy) Loan Repayment Financing Institution Net Proceeds to Heirs Collateral Released After Loan Repayment

Historical Interest Rate Information BANK PRIME LOAN RATE AND LIBOR RATE Two common indices used in bank loans are the Bank Prime rate and the LIBOR rate. LIBOR stands for London Interbank Offered Rate and is the rate at which banks borrow funds from other banks in the London interbank market. Interest Rate Index Mean High Low Sept. 2003 Bank Prime Rate 7.63% 10.50% 4.00% 4.00% 1-Year LIBOR 5.29% 9.38% 1.20% 1.286% M onthly Interest Rates from September 1989 to September 2003 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% Sep-89 Sep-90 Sep-91 Sep-92 Sep-93 Sep-94 Sep-95 Sep-96 Sep-97 Sep-98 Sep-99 Sep-00 Sep-01 Sep-02 Sep-03 12 M onth LIBOR Bank Prime Rate M onthly Interest Rates from September 1989 to September 2003 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% Sep-89 Sep-90 Sep-91 Sep-92 Sep-93 Sep-94 Sep-95 Sep-96 Sep-97 Sep-98 Sep-99 Sep-00 Sep-01 Sep-02 Sep-03 12 M onth LIBOR 12 M onth LIBOR + 200bps

Tax Issues TAX DEFINITION OF LIFE INSURANCE A policy will qualify as life insurance under IRC Sec. 7702 if the policy qualifies as life insurance under applicable state law and meets one of two alternative tests: (a) the sum of premiums paid at any time does not exceed the greater of the guideline single premium or the sum of the guideline level premium at such time, and the death benefit payable under the policy at any time is at least equal to an applicable percentage of the cash surrender value (the guideline premium and cash value corridor test ); or (b) the cash surrender value of the policy must not at any time exceed the net single premium which would be necessary to fund future benefits under the policy (the cash value accumulation test ). Failure to qualify as life insurance will result in taxation of all cash value increases, and only the excess of the death benefit over the net surrender value will be excludable from the income of the beneficiary as a death benefit. MODIFIED ENDOWNMENT CONTRACT As defined in IRC Sec. 7702A, a Modified Endowment Contract ( MEC ) is a life insurance policy in which the cumulative premium payments in any one of the first seven policy years, exceeds the sum of the net level premiums which would have been paid to provide a paid-up policy after the payment of seven level annual premiums (the 7-pay test ). Distributions from a MEC, either a withdrawal or loan (or use of the policy as collateral for a loan), are taxed to the extent there is a gain in the policy. Also, a 10% penalty will be assessed on the taxable amount of any distributions made prior to the policy owner s attaining age 59 ½, unless the policy owner is disabled or receives the cash value under a life annuity settlement option. Note, however, that the 10% penalty tax is always applicable if the policy owner is a non-natural person (e.g., a corporation or trust). If there has been a material change in the terms or benefits of the policy, the 7-pay test will be applied as if this was a new contract at the date of the material change. Generally, once a policy is a MEC, it is always a MEC. However, if premiums in excess of the 7-pay limit are paid, the MEC rules will not apply if such premium payments, plus interest (which is taxable), are returned to the policy owner within 60 days after the end of the policy year in which the premium payment was made.

Tax Issues TAX-DEFERRED GROWTH OF CASH VALUES Annual increases in the cash value of a life insurance policy are taxable only upon withdrawal, surrender, or other distribution. T.H. Cohen, 39 TC 1055 (1963), acq. 1964-1 CB 4; IRC Sec. 72; IRC Sec. 7702(g). WITHDRAWALS Assuming the life insurance policy is not a MEC as described above, withdrawals are taxed under the cost recovery rule and are taxable only to the extent the withdrawal exceeds the cost basis of the policy. Basis equals the gross premiums paid less prior untaxed withdrawals. IRC Sec. 72(e)(5). POLICY LOANS Assuming the life insurance policy is not a MEC as described above, policy loans from a life insurance policy are not treated as withdrawals or distributions and are not subject to income tax. 1 If a life insurance policy loan is still outstanding when a policy is surrendered or lapses, the loan is automatically repaid from the cash value of the policy. This generally results in taxable income to the extent the net surrender value plus the amount of the repaid loan exceeds the cost basis of the policy. If a life insurance policy loan is still outstanding at the time of death, the loan is automatically repaid from the policy s death benefit. The use of the death benefit to repay a policy loan does not cause the recognition of taxable income. Loan interest on life insurance policy loans or the financing for life insurance premiums is generally not deductible. DEATH BENEFITS Proceeds from a life insurance policy because of the death of the insured are generally excluded from income taxes. IRC Sec. 101(a)(1) 1 For a life insurance policy that is not a Modified Endowment Contract as defined in IRC Sec. 7702A: Withdrawals in the first 15 policy years may be taxable under IRC Sec. 7702(f)(7)(B); after 15 years, withdrawals up to policy tax basis are not taxable; and policy loans are not taxable provided that the policy remains in force until the insured dies.

Tax Issues GIFT TAX ISSUES Where the donor of an Irrevocable Life Insurance Trust (ILIT)-owned policy guarantees the loan, there is concern that the value of the guarantee constitutes a gift by the donor. There is no direct authority on this issue, although the IRS in a Private Letter Ruling, PLR 9113009, held that the value of the guarantee, (which might be measured by the difference in the interest charged with, versus without, the guarantee) is a gift. This ruling was later withdrawn by the IRS, on other grounds. Also, a U.S. Supreme Court case, Dickman v. U.S., holding that interest free loans may be gifts, may be read as supporting the conclusion that a guarantee, without consideration, constitutes a gift. ESTATE TAX ISSUES In the usual case, the donor will be the insured as well as the guarantor of the loan. As such, he/she might at some time succeed to ownership of the contract, for example by having a claim against the ILIT in the event he/she has been obligated to pay the loan as guarantor. There is no direct authority on this issue, although a private letter ruling (PLR9009032) has expressed the position on that such interest does not constitute an incident of ownership, which would cause inclusion of the policy proceeds in the insured s estate. We recommend that the client consult with his/her tax adviser(s) on the gift income, and estate tax issues related to this transaction. NON-DEDUCTIBILTIY OF LOAN INTEREST In general, interest on loans taken to pay life insurance premiums is nondeductible for income-tax purposes under IRC Section 264.

The Economics of Premium Finance Premium financing, as conventionally designed, may entail overfunding of the policy, i.e. maximizing the premium per dollar of death benefit, in order to repay the loan out of cash values, while leaving sufficient cash value to continue the policy to maturity. Whether this strategy is utilized, or a more traditional ( pay all years ) premium plan is implemented, the following should be noted: INTEREST RATE ARBITRAGE To the extent that the policy premiums and resulting cash values exceed the corresponding values for a conventionally funded policy, the policyholder will be engaged in an arbitrage play (i.e. the additional cash value fund is derived from loans bearing an interest cost). To the extent that the interest cost of the loan is less that the net interest crediting rate of the contract, favorable arbitrage takes place. However, if the cost of borrowing exceeds the interest credited on the cash value by the borrowed funds, the policyholder s cost is increased. LIBOR RATE BORROWING AND PORTFOLIO CREDITING There may not necessary be, in any given year, a close correspondence between the borrowing and policy crediting rates. LIBOR rates represent a short-term borrowing cost, which historically is generally lower, but more volatile, than long-term rates. The crediting rate in the policy is based upon the economic performance of an insurance company s general account, comprised primarily of fixedincome securities such as corporate or government bonds and mortgages. A characteristic of the general account is that, from the standpoint of the policyholder, the principal value does not fluctuate and the interest-crediting rate is based upon the fixed value of the investments on the company books. In a declining interest rate environment, the nominal rate credited to the account will decrease as older higher-interest investments mature or are otherwise liquidated and replaced with new lower-interest investments. As a result, even if market rates have stabilized at a low rate, the general account rate may continue to decline, so long as higher-rate investments continue to mature. Correspondingly, if current market rates increase, the general account rate may for a time be lower, as lower-interest rate investments mature.

The Economics of Premium Finance TRANSACTION COSTS Premium financing entails additional costs derived from the bank loan, which include loan fees and possible costs associated with the provision of additional collateral beyond the policy cash values. Also, higher premiums than would otherwise be paid into the policy may attract additional percentage-of-premium charges including federal and state tax and sales charges. These increase the cost of the premium financing transaction relative to non-financed alternatives.