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 (in this case, the insured) repays the loan in regular installments until the debt is satisfied or the insured passes away. In the latter 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?
Key Takeaways
- Life insurance premium financing uses borrowed money to fund insurance policy premiums.
- Those with very large life insurance policies may find this option more attractive than liquidating assets to obtain cash.
- The higher the amount of your life insurance policy, the more costly its premiums.
- Three areas of risk for insurance premium financing are qualification risk, interest rate risk, and policy earnings risk.
- One concern is that the cash value of the policy may not increase as fast as the loan interest rate does.
Why Go for Insurance Premium Financing?
First, let’s look at why people would even consider insurance premium financing. Some 52% of Americans have a life insurance policy to make sure their loved ones will be financially secure if they pass away.
Premiums vary greatly depending on policy type, your age, your health (and health habits), and, of course, the size of the policy. A 40-year-old nonsmoking man, for example, could get a 10-year $250,000 term life policy for an average of $11.64 per month. For a 20-year term, the premium would go up to $17.29 per month, while 30-year term averages $28.01 for a 20-year-old male.
HNWIs, however, are typically looking for coverage in the millions or tens of millions of dollars to address business, inheritance, and tax issues.A $25 million 20-year term life policy for the same person might run about $2,100 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 $100,000 or more a year, premium financing can make sense. It allows people to borrow at a rate close to a benchmark short-term rate to pay for life insurance while keeping their savings available for investments that yield a higher ROI. Premium financing can also prevent the insured from triggering capital gains taxes because they don't have to liquidate assets to pay for the premium upfront.
Taking out a personal loan to pay for high insurance premiums may carry fewer risks than using insurance premium financing.
Premium Financing 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 were low for several years before rising in the early 2020s. Such an increase could spell trouble for premium financing arrangements that began when rates were low. “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. “When [interest rates] rise, it could really eat into the advantages you were trying to accomplish in the first place.”
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 may include real estate, stocks, and other assets and investments.) If the value of the collateral falls below a certain threshold, the insured may have to provide additional collateral against the loan.
Otherwise, the loan could become due or be 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 other factors 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.
Managing Premium Financing Risks
There are ways to mitigate some of the risks with premium financing. 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. 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.
In the recent past, financial experts might have recommended taking out a home equity loan to support high premiums on life insurance. However, under the 2017 Tax Cuts and Jobs Act, it is no longer possible to deduct the interest from a home-equity loan if the money is used for something other than purchasing, building, or renovating a home. As a result, this strategy is not as useful for tax savings as in the past.
What Is Premium Financing Life Insurance?
Premium financing uses borrowed money to pay for life insurance premiums. This is most often done in conjunction with policies that pay very large death benefits, enabling the policy owner to avoid tying up their own capital to pay premiums. Instead, they use that capital as collateral for the loan.
How Do You Qualify for Premium Financing?
Lenders involved in premium financing will want to ensure that the following criteria are met:
- A financially savvy insured person with a high net worth (but with limited liquid assets).
- The insured is under age 70.
- A clear insurable interest and financial need.
- Existence of additional collateral being pledged beyond the insurance contract.
- Outside legal or financial counsel are involved.
- A demonstrated exit strategy beyond the death benefit payoff.
How Do Premium Finance Companies Make Money?
Like other types of loans, those engaged in premium financing earn money from the interest payments charged on the borrowed money.
The Bottom Line
Life insurance premium financing can make sense if you'd like to purchase a very expensive life insurance policy without spending down your savings and investments. However, you need a plan for managing the risks behind this complex strategy. A financial advisor can help you determine how to properly manage both your life insurance policy and the loan financing the premiums.
