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| Risk & Reward |
Financing the Future
Laurence Neville
09/01/2004
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It sounds too good to be true: a financial arrangement in which a loan funds
the premium on a life insurance policy that, in turn, pays off the loan and also
delivers a tax-free death benefit to our heirs. While some skeptical eyebrows
have arched at what sounds like the financial equivalent of a perpetual motion
machine, for some of us, under specific market conditions, these so-called
premium finance transactions can make sense.
They are particularly useful for
those with estate planning challenges stemming from having wealth locked in
illiquid assets. Those who fear that their children will have to sell a precious
asset—a family business or art collection, for example—to pay estate taxes
can structure the premium financed insurance policy’s payoff to cover the estate
tax.
The advantage of this approach over simply paying the premium is
twofold. First, it frees up cash. This is important to those whose wealth is
tied up in an illiquid or volatile asset (say, a family business or concentrated
stock position). If we borrow to finance the insurance premium, we may free up
millions of dollars in cash, which we can invest in assets that outperform those
in the insurance policy. It also allows us to avoid gift taxes on the amount we
would otherwise pay into a trust to fund an insurance policy’s premium.
Spreading Virtues
We typically secure a short-term loan to finance the
premium in one of these transactions. These can range from one-year
renewable loans to five-year facilities. They are often “pay-in-kind,” meaning
the lender adds the interest charge to the principal each year. For example, a
$100,000 loan with a 4 percent annual interest rate becomes a $104,000 loan the
following year.
The cash value of the life insurance policy has to grow at a
faster rate than the loan for these types of transactions to work. In the
example above, the value of the insurance policy might grow by 6 percent. Since
only part of the premium is credited to the insurance policy’s cash value when
we first buy it (the rest compensates the insurance company for providing the
insurance’s death benefit), the value has to grow faster than the loan to catch
up and pass it in value, before the loan finally comes due.
Those who sell
premium finance transactions say they are only available to those with
investable assets over $5 million; they make most sense for those whose
premiums will top $300,000 a year. They work best for those over 65 who expect
to live long enough to build up enough cash value to pay off the loan; of
course, the full benefit of this product only becomes apparent when we die, and
our heirs enjoy a tax-free payout.
“Premium financing can be a wonderful
strategy for the right client,” says Richard Wuensch, first vice president and
estate planning specialist at Merrill Lynch in Houston. His colleague Andrew
Bucklee, director of sales for life insurance distribution at Merrill Lynch in
Hopewell, N.J., adds, “The exceptionally low interest rates of recent years have
helped to raise its profile.” However, both caution that the financial logic of
premium finance may change as rates rise.
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