Premium FinancingSuccess Or Not, It's All In The Design

In many cases, it may be desirable to pay off the loan prior to death. However, some carriers offer what is known as a return of premium rider. This rider allows a loan to remain in place indefinitely, yet the death benefit paid includes both the desired amount plus additional benefits due to this rider, which should be sufficient to repay the loans and any unpaid and accrued interest.

Charts Three and Four show variations in which the client changes the policy design to allow termination of the loan. Chart Three shows another 10-year premium payment design, but in this case more ($487,000) is paid into the contract each year than in the 10-year premium payment design in Chart Two. The reason: Additional value is built up inside the policy, providing an advantage. The overfunding produces an illustration that allows for the loan to be repaid out of policy cash values in the 20^th year and still carry the planned-for $8 million death benefit to the clients age 100. The downside is that there is a significantly higher premium and borrowed amount. As a result, when the loans are fully advanced for the premium, the total loan will be $4,870,000. At 5%, the interest payment after year 10 (and through the 20^th year) will be $243,000an amount more than double the premium costsimply due to the cumulative amount owed on the loans. If this were to be paid by the insured via gifts, the IRR of the arrangement is an even lower 4.29% by the 30^th policy year.

In Chart Four a slightly different approach is taken. Even more is placed into the contract to allow for stronger early cash values. An illustration utilizing this approach will show that the policy can carry itself to age 100. However, an equal amount (net of interest paid to carry the debt) is placed into a side fund (possibly gifted into a trust) that is assumed to grow at an after-tax rate of 6%. Again, interest is assessed in each year, and this reduces the side fund contribution, but after the first 5 years, the side fund is able to pay for the annual interest. By the 10th year, the side fund is sufficiently large enough to pay off the loan and eliminate future interest payments. The combined effect of the side fund and paying the interest charges out of a side fund, rather than out of the insureds pocket, boosts the 30-year IRR in this arrangement to 5.10%. This IRR is even better than in the lifetime premium payment strategy. However, it comes at a significant gifting cost, something many clients may be hesitant to undertake, despite a better financial return compared to the other scenarios.

Beyond the basic life insurance design, other planning also might affect a premium financing design. For example, assume a married couple and their advisors are comfortable with the couple gifting their life gift exemptions ($1 million per client, $2 million per couple) into a trust as part of their planning. The trustee might elect to use this gift in any number of ways. That amount could represent a large single premium into the life insurance contract, minimizing or eliminating any future premium payments.

In the particular hypothetical case used in this example, if the same clients made a $1 million gift into a trust and the gift was used as a single premium toward the same life insurance contract, future premiums would drop to $20,000 and still be able to illustrate as supporting the policy on a non-guaranteed basis to age 100 and beyond. The IRR on the policy in year 30 would be 4.29%a lower IRR than the baseline illustration due to the high upfront deposit. However, the client can avoid large future gifts.

Yet another variation would have the trustee hold the same amount as an investment account and use earnings either to defray annual interest expenses or cover a portion of the annual premium. For example, $1 million earning the same 5% after-tax amounts (admittedly an aggressive assumption in todays market environment) would result in $50,000 to contribute to the $121,600 premium in the baseline illustration. This lowers the need for future client gifts into the $70,000 range. Assuming the gift remains intact, this provides a larger benefit for a clients heirs (the trust beneficiaries) or might reduce the overall death benefit need. Some might suggest using that same gift to purchase an annuity, but advisors should be aware of potential concerns regarding non-natural person rulesIRC 72(u).

Issues to Weigh

There are many issues to weigh when considering a premium financing case. They range from cash flow and tax considerations to a determination of whether financing makes financial sense. Balancing these issues can be a challenge and, often, one might steer a client toward financing life insurance even if other considerations indicate a different direction.

A key consideration: Will a client want to finance their life insurance and possibly risk incurring higher interest charges than the cost of premium? In any client situation where premium financing is considered it is important to compare a standard, perhaps lifetime, premium paying design. Where funds are available for gifting, this option may be more desirable if it often carries an overall lower annual cost. Look at the baseline design in Chart One. A lifetime premium payment design for this policy carried a cost of $121,600. By contrast, at a 5% interest rate, all of the premium financing scenarios after the initial years reached a point, where the cost of financing was greater than the baseline design.

As mentioned previously, a client needs to weigh if he or she wishes to pay interest charges out of cash or gifts to a trust, or accrued and pay the accumulated interest out of death benefits. In the latter approach, the added costs of a return of premium rider can be crucial. Even though a higher cost comes with this rider, it also can be financed to preserve the death benefit required for client planning. Where a client can use premium financing and is able to accrue the interest, premium financing may be particularly attractive in the face of the uncertain future of gift and estate taxation. Whether or not gift and estate taxes will be repealed remains an open question, despite many economic signals that would discourage repeal. With that in mind, many clients might prefer premium financing to making large, irrevocable and possibly taxable gifts.

The internal rate of return (IRR) can be an important number. This is the rate by which the premium outlays would need to compound to provide the same death benefit in a given year. In these approaches, a higher IRR is better. In all but one example presented here, the IRR was lower under premium financing than the baseline design. Why? Most likely it was attributable to the large out-of-pocket interest expenses that occur after the early years in the premium financing approaches. Only one design (the example in Chart Four with the side fund) allowed for a better IRR than the baseline design. In this case, the interest was paid but it was paid out of the side fund earnings.

The design in Chart Four doesnt necessarily take into account taxation of the gifts into a trust, so the potentially higher IRR does have its design downside. And, in many cases there may be reasons why someone might be willing to incur the interest payments to have a lower IRR, such as their inability to liquidate assets, their wish to avoid capital gains taxation on assets, etc.

Interest rate risk is another issue to weigh. Because it is impossible to know which direction interest rates will take or when they will change over a period of time that might run for decades, most premium financing designs are based on a fixed interest rate. Watch what is being designed and assumed for your client. The 5% rate used in this example is higher than many may have used in premium financing designs even just a year ago, but it is important to examine the impact of interest rate increases before closing a sale. The 5% rate here, while not unrealistic, has triggered a higher interest payment in many years than simply paying the premiums without a loan. In fact, if a 4% interest rate had been assumed, the interest payments in many of these examples would have been less than the lifetime premium payment. Chances are, a client undertaking this type of planning approach is financially savvy enough to understand the risk of interest rate fluctuations. However, you want to be certain your client has a complete understanding of those risks.

Premium financing can be an attractive alternative to gifting. However, in many cases, design is critical to the success or failure of such an arrangement. Work closely with your life carriers to ensure that the proposed design works for your specific client situation. Clients must be aware of the risks and know that many of the assumptions utilized can vary over the decades following their acceptance of the design.

Mark A. Teitelbaum, JD, LLM, CLU, ChFC, is second vice president, advanced sales, at Travelers Life & Annuity. He can be reached via e-mail at [email protected].

Reproduced from National Underwriter Edition, November 11, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.