Premium Financing: It's The Retained Capital, Stupid!

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In the estate planning and wealth transfer markets, much attention has been given to life insurance premium financing. Some commentators have highlighted the strategy?s perceived risks and pitfalls. Others have focused on financed life insurance as a stand-alone transaction.

I believe these discussions ignore the most important attribute of the transaction: the cash flow savings component, or what we call retained capital.

Much of the misunderstanding can be attributed to gimmicky marketing that portrays premium financing as a “cheaper” way to buy life insurance. That naturally leads to improper evaluation of the strategy where the economics can seemingly break down when applying adverse variables, such as rising loan rates.

Simply stated, when clients finance a life insurance policy, the capital they would have allocated to the premium will instead be retained in their own capital base. This retained capital should continue to accumulate and compound, providing an additional but separate capital base.

If the life insurance policy is designed with an increasing death benefit to offset the premiums loaned, the economic results can be significant compared to traditional insurance funding – even when the performance of other strategic variables is less than expected.

Before we illustrate, let’s review the mechanics of financing a life insurance policy. The true cost of a policy is not the premiums paid but the amounts the insurance company deducts periodically to cover policy costs.

Insurance premiums for permanent policies typically represent significant overpayments in the early years to accumulate a cushion within the policy to help offset the much higher costs that will be deducted later as the insured approaches or exceeds life expectancy.

Paradoxically, the initially overfunded premiums, while necessary for long-term viability of the policy, can be inefficient for the client, considering the opportunity costs and the fact that the client’s beneficiaries don’t get any remaining cushion back when the client dies.

Financing the insurance premium, then retaining and investing the capital the client would have otherwise paid out of pocket, uses the same capital more efficient.

Consequently, the appropriate premium financing scenario exists when the client has already made the insurance decision. Financing is simply a more efficient alternative for employing the capital they will commit to the insurance decision.

To illustrate, consider a typical 70-year-old female widow who has 14 Crummy beneficiaries and who needs $5 million of insurance coverage in an irrevocable life insurance trust (ILIT) to help pay estate taxes. The following 6 examples the first using traditional funding, and the subsequent 5 using premium financing (summarized in the table)?will explore the differences between the two approaches.

Assuming the policy requires annual premiums of $150,000, the client could, in our first example, fund the premiums out of pocket by making annual exclusion gifts to the trust. The trust would then transfer the gifted amounts to the insurance company to pay the premiums, and the proceeds would provide the liquidity to pay estate taxes.

If, however, the trustee chooses to finance the same $5 million policy with the $150,000 premium, the trust will instead borrow the annual premium from a lender at an assumed 4% annual loan interest rate (scenario 1 in table). In the first year, the client transfers in the same $150,000 in annual gifts; however, the trustee only pays $6,000 in interest due to the lender, leaving $144,000 to retain and invest.

Let’s also assume that the trust investment advisors can deliver a 4% net of tax annual return on the retained capital (the same as the loan rate).

If the client died in the first year, the first $150,000 of the policy’s $5 million death benefit would go to the lender, leaving $4,850,000 of the policy’s proceeds for the trust. Also, the $144,000 saved by financing the premium would have grown back to roughly $150,000; when combined with the insurance net death benefit, the savings would yield roughly $5 million in capital for the trust.

Premium financing in this case offers no economic benefit over traditional insurance funding, no matter when the client dies. The retained capital saved by financing must therefore (absent a change in the strategy design) be invested at a net return greater than the loan rate (a.k.a., arbitrage) to realize an economic benefit.

Assuming the retained capital generates a 6% net return versus the 4% loan rate (hence, an arbitrage opportunity of 2%), and assuming the client died in year one, the $144,000 retained by the trust after paying loan interest would grow to $153,000. This, combined with the $4,850,000 net insurance benefit after loan payoff, provides an additional net benefit to the trust beneficiaries over the $5 million level benefit provided via traditional funding.

If we project the numbers to the client’s life expectancy in year 16, the retained capital would grow to $3 million. Now the financed transaction would provide approximately $5.5 million to the trust versus the $5 million provided in the nonfinanced and no arbitrage examples (scenario 2 in table).

So we have now dispelled the smoke and mirrors reputation of premium financing by demonstrating that unless the opportunity for arbitrage exists, there is no economic benefit, agreed? Wrong! The single greatest misconception is that the client must have an arbitrage opportunity for the financed transaction to provide a benefit over traditional funding.