The old adage "neither a borrower nor a lender be" has a contemporary ring to it these days. Faced with a credit crisis that resulted in a near meltdown of the financial sector and the worst economic contraction since the Great Depression, more financial institutions and high net worth clients are questioning a much-touted life insurance funding technique: premium financing.
"Premium finance facilities depend on access to credit," says Bill Hager, founder and president of Insurance Metrics Corporation, Boca Raton, Fla. "As that access tightens, premium finance facilities are boosting lending requirements for borrowers. Institutions are imposing more rigorous credit underwriting and showing more prudence when extending credit."
James Sorebo, president and CEO of Four Seasons Financial Group, Mt. Laurel, N.J., agrees. "Most brokers understand there isn't as much money to be made in this space now. At this time last year, we were reviewing more 400 applications for premium financing. Now, we're looking at fewer than 100."
Until the current recession, sources say, many affluent clients were turning to this technique–taking out a loan from a bank or other lending institution to pay premiums on a large life insurance policy–to meet short-term cash flow or investment objectives. This strategy frees up money for clients with large estates, typically those valued at $10 million-plus and comprising mostly illiquid holdings, such as real estate or business assets. Funds that otherwise would be used to pay policy premiums can instead be conserved or invested in vehicles to produce a higher rate of return than what the client would pay on the cost of the loan.
Premium financing is additionally compelling, experts say, because the technique lets clients minimize gift taxes on wealth transfers facilitated through an irrevocable life insurance trust or ILIT. Absent financing, premium payments on ILIT-owned policies are subject to gift tax. With premium financing, policy holders reduce their gift tax liability because only interest on the policy loan is gifted to the ILIT annually.
All well and good. But with many banks now focused on boosting their reserves and riding out the credit crunch, they're raising the bar for premium financing applicants.
That's evident, for example, in the cost of financing. Christopher Layeux, director of premium financing at ING-U.S. Financial Services, Windsor, Conn., says the fees bank charge on letters of credit, which may be required of borrowers before a loan is issued, have risen to 3% or more from 1% only a year ago.
Premium financing is also taking more time to secure because lending institutions, which have grown increasingly protective of their balance sheets amid the downturn, are exercising greater due diligence when weighing applications. What was an already lengthy and complex process–establishing the need for life insurance, underwriting the policy, applying for a loan and posting collateral–has slowed, taking upwards of several months to complete.
In many instances, sources say, prospective borrowers are unable to provide the requisite collateral or letter of credit because their portfolios, having taken a beating during the recession, are much diminished. Or they are opting out of financing because the opportunities for arbitrage are fewer than in years past. With fewer buyers in the life settlement market, policy owners are having difficulty selling premium-financed contracts at a profit.
Observers say the recession has hit so-called hybrid loans the hardest. In these transactions, the lender uses part of the value of the insurance policy (often 25% or greater) as collateral for the loan. Today, in most cases, banks are insisting that clients furnish all collateral from other assets, such as cash, brokerage accounts and real estate.
In some instances, institutions are pulling the plug on financing programs–or calling in the loans–because of their own financial troubles.
"Most of these premium-financed loans are callable," says David Howell, a life insurance consultant and broker to advisors based in Harbor Bluffs, Fla. "And right now, loans are being called in faster than they're being made. The people that owe money are scrambling to placate the lenders, sometimes by refinancing with another institution."
