Life insurance premium financing involves taking out a third-party loan to pay for a policy’s premiums. As with other loans, the lender charges interest, and the borrower (the insured, in this case) repays the loan in regular installments until the debt is satisfied or the insured passes away, in which case the balance is typically paid off with insurance proceeds.

This strategy may be useful to high net worth individuals (HNWIs) who don’t want to liquidate assets to pay for costly life insurance premiums outright. But is the practice too risky?

Why Go For Insurance Premium Financing?

First, let’s look at why people would even consider insurance premium financing. About 60% of Americans have a life insurance policy to make sure their loved ones would be financially secure if the insured passed away. Premiums vary greatly depending on policy type, your age, your health (and health habits) and, of course, the size of the policy. A 47-year-old nonsmoking man, for example, could get a 30-year $100,000 term life policy for about $29 per month; the premium would go up to about $40 per month for a $150,000 policy.

HNWIs, however, are typically looking for coverage in the millions or tens of millions of dollars to address business, inheritance and tax issues. (For related reading, see How does life insurance help high net worth individuals protect their businesses and their personal wealth?) A $25 million 30-year term life policy for the same person might run about $4,700 a month, and – here’s where it can get really expensive – a whole life policy would start closer to $15,000 a month.

Because premiums can easily cost upward of $100,000 or more a year, premium financing can make sense since it allows people to borrow at a rate close to the Libor while keeping the money they would have spent in investments that yield a higher ROI. Premium financing can also prevent the insured from triggering capital gains taxes had they liquidated assets to let them pay for the premium upfront.

The Risks

Although the strategy is appropriate for some individuals, it does pose certain risks that should be considered before making any decisions. These risks include (but are not limited to):

  • Interest rate risk. Interest rates are low now, but if they rise it could spell trouble. “Most of the time a premium finance loan will have a variable interest rate,” says James Holtzman, a certified financial planner at Legend Financial Advisors. “Right now that’s a great thing. But when [interest rates] rise, it could really eat into the advantages you were trying to accomplish in the first place.” The big concern is that the cash value of the policy may not increase as fast as the interest rate, in which case the loan balance could exceed the value of the policy.
  • Qualification risk. Lenders typically require borrowers to re-qualify each time the loan is renewed, at which time the loan’s collateral is re-evaluated (collateral might include real estate, stocks and other assets and investments). If the value of the collateral has fallen below a certain threshold, the insured may have to provide additional collateral against the loan. Otherwise, the loan could become due or offered for renewal at a higher rate. Since the loan is renewed at the end of each term until the insured passes away, qualification risk is always present, whether it’s related to collateral value or some other factor under the lender’s underwriting standards.
  • Policy earnings risk. If the policy’s cash surrender value underperforms, the loan balance could exceed the value of the collateral, in which case the insured would be forced to provide more collateral to avoid default. Likewise, if the death benefit fails to grow, the policy could provide less coverage than expected when the loan is finally satisfied. In the worst cases, the insured’s estate would have to repay the loan if the death benefit could not.

The Bottom Line

A qualified financial planner or advisor can help you mitigate some of these risks. Interest rate risk, for example, can be reduced (or eliminated) if the lender puts a cap on how high the interest rate can rise, or if it offers a fixed interest rate. And to reduce policy earnings risk, the insured could add a special death benefit rider.

Measures such as these typically add to the cost of the policy, but they do help lower the risks associated with insurance premium financing and can provide peace of mind. To avoid these risks completely, you might consider a home-equity loan. “You should be able to write it off on your taxes, and you’d be dealing with a locked-in rate that is very attractive these days,” says Holtzman. “Or just get a personal loan from a bank.”

For further reading, see Understanding Taxes on Life Insurance Premiums.

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