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Premium Financing of Life Insurance

Although it is customary to pay the premiums when purchasing life insurance, for some high-net-worth individuals needing large amounts of life insurance which in turn require significant premium payments it may be they have sound financial reasons for not wanting to pay these premiums with in cash. They may not want to disrupt normal cash flow or liquidate high yielding investments, or sell assets that would result in capital gains tax liabilities. These individuals find premium financing to be an appropriate solution, allowing them to borrow the funds from a third party to pay the premiums. Premium financing is often used when a life insurance policy is owned by an irrevocable life insurance trust (ILIT) which may not have enough cash or assets to make the large premium payments. There are usually four parties; the insured, the borrower (usually the ILIT), the insurer, and a lender. There are usually two steps: The borrower first applies for a life insurance policy, indicating that the premium will be financed. If the insurer indicates that they will offer the policy with financed premiums, the borrower then applies for the loan. The borrower generally makes a down payment, and the lender makes the balance of the premium payments to the insurer. The borrower agrees to repay the lender for the loan principal, annual interest, and other costs (e.g., origination fees). As with any other type of loan, premium financing loans generally have a fixed term. Under some arrangements, the loan is repaid in installments during the insured's life. More commonly, however, the loan is continually renewed during the insured's lifetime and repaid in full at the death of the insured out of the insurance proceeds. In the case of the latter strategy, the goal is to have enough death proceeds to both pay off the loan and provide sufficient funds to meet the insured's needs. Whether this goal is achieved depends upon the life insurance policy outperforming or at least keeping pace with the outstanding loan balance. The borrower can be an individual, a trust, a corporation, a limited liability company, or other specialized vehicle (although some lenders may lend to an entity only), but this strategy is appropriate for high-net-worth individuals only and the insured must:

  • Need a large amount of insurance in the hundreds of thousands or millions.
  • Meet the policy underwriting requirements
  • Meet the lender's requirements (e.g., minimum size loan, minimum collateral, and minimum net worth)
  • Be able to pay annual interest and costs (in the case of a non-capitalized loan)
  • Be aware of and comfortable with the risks.

There are generally three types of premium finance loans: (1) non-capitalized, (2) capitalized, and (3)non-recourse or partial recourse. With a non-capitalized loan, the borrower provides full collateral for the loan, which includes the cash surrender value of the life insurance policy, and additional collateral and/or a personal guarantee. The borrower pays the interest and other fees annually in cash, with the principal balance remaining relatively constant. With a capitalized loan, as with a non-capitalized loan, the borrower provides full collateral for the loan, which includes the cash surrender value of the life insurance policy, and additional collateral and/or a personal guarantee. However, the borrower does not pay the annual interest and other fees in cash. Instead, the annual loan costs are added to the loan principal. Although with this type of plan, the borrower does not need cash, it carries more risk because the loan costs compound, thereby increasing the chance that there will not be enough proceeds at the insured's death to both pay off the loan and achieve the goals for which the insurance was purchased. With a non-recourse loan, the borrower pledges the cash surrender value of the policy and the death proceeds only. No other collateral is posted. The lender can only use policy cash values and the death benefit to satisfy the outstanding loan balance. Partial recourse loans have minimal collateral requirements--for example, 25 percent of the loan balance. Higher interest rates and fees are generally charged to compensate lenders for the increased risk. The lender also retains the right to take ownership of the policy if the loan goes into default.

Tax Considerations

Income tax
Interest on a premium financing loan is generally not deductible for income tax purposes by individuals, as it is classified as personal interest. However, for business-owned life insurance, an exception may apply--for example as when the insurance policy covers a "key person." This is a very technical area. You should consult an experienced tax professional.

Gift tax
Money transferred by the insured to an irrevocable life insurance trust (ILIT) for the payment of premiums is a taxable gift. Crummey rights of withdrawal held by the beneficiaries of the trust, however, allow the transfers to qualify for the annual gift tax exclusion. Transfers that do not qualify for the annual gift tax exclusion are exempt from gift tax to the extent of the insured's $1 million lifetime gift tax exemption, which is automatically applied. Premium financing can help the insured leverage the annual gift tax exclusion and lifetime gift tax exemption because payments of annual interest and costs are less than the annual premium. If the insured makes a personal guarantee, the guarantee may also be considered a taxable gift. The IRS is currently considering its position on this issue.

Estate tax
Life insurance may be includable in the insured's gross estate for estate tax purposes if (1) the proceeds are payable to or for the benefit of his or her estate, or (2) the insured possesses "incidents of ownership" in the policy at the time of death or at any time during the three years prior to death, or (3) the insured transfers ownership of a policy within three years of death, and (4) estate taxes are imposed in the year of death (there will be no estate tax in 2010). Incidents of ownership is a legal term. It means any right to benefit economically or control the policy, such as: (1) retaining the right to change beneficiaries, (2) retaining the right to borrow on its cash value or pledge it for a loan, (3) retaining the right to surrender or cancel the policy, (4) retaining the right to assign the policy, and (5) retaining the right to elect or revoke a settlement option. A personal guarantee for the payment of premiums has not as yet been recognized as an incident of ownership, or a retained right, power, or interest in the policy. However, there is very little law established to support this position.