Premium financing plans between a financial institution and an Irrevocable Life Insurance Trust (ILIT) can be very complicated and risky arrangements. Wealthy individuals who are familiar with leveraged financial risk
may desire to borrow money to pay large premiums for insurance owned by an ILIT to offset federal estate taxes. Often, these individuals can afford to gift premiums outright to the trust but, nevertheless, may choose to finance the premiums.
There are some non-guaranteed financial advantages to a financing large premiums for life insurance owned by an ILIT:
- •The client may have to pay lifetime gift taxes on outright gifts to the ILIT because they have used all of their lifetime gift exemptions and annual gift tax exclusions
- •Premium financing can provide for the purchase of insurance owned by an ILIT with no current out of pocket cash flow
- •Financed life insurance can take advantage of the historically low interest rate environment on borrowed funds
- •Valuable liquid asset portfolios or real estate assets can remain intact rather than being liquidated to raise cash to make outright premium gifts to the trust
- •Financing may work well with rated insurance case of clients in their 70s and 80s because of shorter time horizons until life expectancy and earlier repayment of the premium loans
- •The financing method can work well with either single life policies or survivorship life policies owned by an ILIT
However, there are multiple downside risks that a wealthy client should understand before they seriously consider a premium financing transaction with a bank or financial institution:
- •An increasing interest rate environment going forward can make borrowing more expensive
- •A relatively small increase in the interest rate charged on renewed premium financing may reduce the anticipated net benefit. This can happen when the original projection shows a policy crediting rate that exceeds the loan interest rate.
- •The bank will require collateral from the estate owner to cover any shortfall between the amount of the outstanding loan principal and the policy cash value
- •The interest paid on the cumulative loans to finance premiums is not deductible
- •A premium financed plan requires continuous monitoring of the multiple moving parts and requires professional advice from attorneys, CPAs, and financial experts
- •The longer the insured lives, the greater the amount of cumulative loan principal and interest. This will reduce and even possibly eliminate any remaining net death benefit for the ILIT
- •Leverage can be positive or negative. If the policy does not perform as originally projected or interest rates rise on the cumulative premium loans over time, there may be a financial train wreck in the future.
- •The insured may live well beyond life expectancy and threaten the financial viability of the arrangement
- •The net death benefit could end up being less than the accrued loan. In this case, the ILIT will not receive any of the death benefit from the policy
- •The loan must be repaid. This repayment will come from the policy death benefit or out of pocket by the borrower from the personal collateral placed at risk
- •The lender has the ability to increase interest rates in the future as cumulative short term loans are rolled over.
- •There is no guarantee that the bank will renew the loan as each short term financing period expires
- •If the lender decides not to make future loans as each short term period expires, the policy may lapse.
- •If the net worth of the client falls or the income of the client declines, the bank could decide not to extend the loan. Or the bank may decide it needs more collateral in order to extend the loan into the next short term period
- •Financial institutions typically require the borrower to provide collateral from liquid assets such as securities portfolios
These potential disadvantages of the ILIT premium financing technique may cause even a wealthy person who is familiar with leveraged financial risk to pause and think twice about borrowing to pay insurance premiums. They may decide to simply make outright premium gifts to the ILIT allocating their lifetime gift exemptions on the Form 709 U.S. Gift Tax return. Keep in mind that the lifetime gift exemption for an individual in 2016 is $5,450,000 and $10,900,000 for a married couple. These lifetime gift tax exemption amounts can cover very large cumulative premiums over a period of time, and the lifetime gift exemption is indexed to inflation as well.
Clearly, the bank wants to make sure that their position as lender is well covered by policy cash values, policy death benefits, and additional collateral for any shortfall in case the loan is terminated while the insured is still alive. And because the premium financing may last for a long period of time, until the insured dies, the bank will want to renegotiate the terms of the loan every 5-10 years. Interest rates can change dramatically over an extended period of time as we have witnessed the decline of interest rates over the last 20 years. What if there is an upward trend of interest rates over the next 20 years? This potential increasing interest rate environment will make premium financing plans very hard or impossible to sustain over that extended period of time.
BSMG provides access to competitive single life and survivor life products and comprehensive insights into product design, risk appraisal, estate tax and income tax planning. We firmly believe that absolute clarity and a complete understanding by all parties is a prerequisite to reaching any conclusion about the merits and demerits of premium financing.
Russell E. Towers JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group