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| Risk & Reward |
Financing the Future
Laurence Neville
09/01/2004
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The engine that drives this product
is the spread between the loan rate and the policy’s return. Consequently, both
the cost of the loan and the yield on the policy are crucial to success.
Currently, lending rates on these transactions are between 1.25 percent and 2.5
percent over the one-year London Interbank Offered Rate (LIBOR), or up to 5
percent overall. This cost varies considerably by lender and by the relationship
between the lender and client.
TOP VIEW
Borrowing to pay a premium on a life insurance policy may be an attractive way
to conserve cash while establishing a legacy that our heirs can use to pay
estate taxes. If all goes well, the yield on the investments in the insurance
policy remains higher than the rate on the loan, so the value of the former
grows to where it can pay off the latter. If interest rates rise, the economics
of these transactions become far less compelling. |
The rate of return on the insurance
policy, often called the crediting rate, is the other half of the equation.
Universal life contracts—the most common type used within premium financing
transactions—currently offer between 4.5 percent and 6 percent. This means that,
at the most advantageous current costs and returns, premium finance can deliver
a spread of 2.5 percent. Most experts consider a 2 percent spread to be
good.
Since both borrowing costs and crediting rates will change over time,
we need to assess how a proposed transaction will perform if rates go up, or if
investment performance lags. “LIBOR is now around 2.5 percent and borrowing
costs might be 150 basis points [1.5 percentage points] on top of that, which
means that a policy earning 6 percent creates some leverage,” says Ernest Barry,
managing director of Wachovia Insurance Services in Charlotte, N.C. “But what
happens,” he asks, “if LIBOR hits 8.5 percent? Clients need to ensure that they
can afford the borrowing costs when rates rise.” As universal life contracts
have up to 80 percent of their assets in bonds, returns should rise as interest
rates rise. But, as Merrill Lynch’s Wuensch notes, the crediting rate will
usually lag the markets by approximately 18 months.
Lenders for premium
financing transactions require loans to be 100 percent collateralized. The
collateral often takes the form of securities held in an account at the lending
institution. The securities remain fully tradable, and many lenders are flexible
about the movement of assets in and out of collateral accounts. Lenders may also
charge an origination fee, usually around 1 percent, though this varies and some
institutions do not collect this fee from existing clients.
Successfully
navigating these complexities requires expert advice. When determining the
overall cost of such a transaction, we should include fees for services we may
need from a certified public accountant, a tax planner, our private banker and
an insurance specialist.
Taxing Calculations
The first step is to establish whether a life
insurance policy will benefit us, advises Alice Odorico, vice president at
Advice Lab Insurance in JP Morgan Private Bank in New York. Traditionally, she
says, the main attractions of life insurance are tax advantages. “Cash values
grow without tax, and death benefits are paid free of income tax. If the life
insurance is owned outside the insured’s estate, the benefits are even greater.”
By establishing an irrevocable trust to own a standard life insurance
policy, we may pass the proceeds to our beneficiaries without incurring estate
taxes. However, because these trusts have no assets, the funding for the
premiums must come from elsewhere. If policyholders fund the premiums by paying
money into the trust, they will have to pay a gift tax.
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