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.

According to Wuensch, these gifting issues were the original motivation behind the development of premium financing. Under current tax law, an individual may give a total of $1 million tax free over the course of his or her entire financial life. Any gifts beyond that amount are subject to tax. Furthermore, an individual may give only $11,000 annually per person. For most of us, our estate plans already surpass the $1 million limit, leaving no room for additional tax-free gifting of wealth. Since gift taxes run up to 55 percent, depending on the size of the gift, this is a considerable problem.

Questions to Ask Your Financial Advisor about Premium Financing 1. At what rate of interest would the transaction no longer work? What happens if rates breach that level? 2. What are my alternatives if my bank declines to refinance my loan? How much time would I have to secure other financing? 3. Should I consider personal financing to fund the premium? 4. How much control do I maintain over the collateral I put up for the loan? 5. Given my age and the size of my estate, what alternatives to premium financing can accomplish my financial goals?

“Understandably, clients are not enthralled by the prospect of paying such taxes,” says Douglas Moore, national director of estate and charitable planning at Citigroup Private Bank in New York. He relates the experience of a client who established an insurance policy with a $3.5 million premium cost. “If he gifted funds to the trust [to pay the premium], he would be gift-taxed for $2.5 million at a 48 percent rate and the following year, the entire $3.5 million would be subject to gift tax. This significant additional cost provides no benefit to beneficiaries.”

Wuensch says premium financing offers us a way around these taxes. “The gift is considered to be the interest paid on the loan, not the premium,” he explains. This means that in funding a trust, the only money taxed is the amount of the interest itself.

But leverage comes with a health warning, especially when used in premium financing: Investors should only borrow money that they can afford to do without. Remember that borrowing costs, the performance of the insurance policy and the performances of other assets will constantly change. Experts agree that before pursuing a premium financing strategy, investors should stress test their finances under high interest rate and low stock market conditions. “[Inves-tors] should never get into a situation where they might be forced to sell an asset they don’t want to,” says Pamela Hendrickson, managing director and global head of lending and liquidity products at JP Morgan Private Bank in New York, “especially one where the loss would be as great as letting a life insurance policy lapse.”

Credit Options
The terms of loans used to finance insurance premiums are often as short as one year and rarely over five years. Banks, unfortunately, do not guarantee that they will renew the loans, so we must choose our lenders with care. Since life insurance policies typically last well over five years, if our lender decides not to renew our loan (say, its parent company sells the lending arm, or it changes its lending policies), we may have to repay the loan, obviating the strategy’s cash management and tax benefits.

Therefore, it is important to have alternative sources of financing available. We should also obtain quotes on loans from more than one lender, whenever possible. These can come from a variety of institutions, including our private banks. These institutions often structure premium finance transactions themselves, and can either source third party insurance for their clients seeking to finance premiums, or offer their own policies. However, as Kevin Warner, director of New York-based premium financing intermediary Isthmus Capital notes, not all banks understand life insurance, and many insurance companies do not understand premium financing. We should ascertain how much expertise and experience our bank has in this field before signing up.

Another somewhat novel option is to become our own lender. “A privately financed life insurance plan, also known as personal financing, is the funding of life insurance premiums through a personal loan between an insured or a family member and an irrevocable life insurance trust,” explains Richard Wuensch, first vice president and estate planning specialist at Merrill Lynch. The benefits of such an arrangement are that the loan does not count as a gift (since it must be repaid) and the interest payments can be kept within the family, thus minimizing costs. Typically, in private financing, we lend at the applicable federal rate, which the IRS publishes each month, so the arrangement is considered a fair market loan.