By Russell G. Roll, CPA, JD
There is quite a bit of attention in the media these days regarding what is commonly referred to as “Premium Financing” for life insurance. This attention has led some to believe that the concept is new, while in reality it is a concept that has been used for generations. What is new, however, is the type of financing now available for use in purchasing life insurance combined with (and in part created by) the existence of a potential “exit strategy” to pay off the loan that does not involve death.
The purpose of this article is to provide a brief summary of the history of premium financing, its evolution, and its potential connection to a living exit strategy, namely, the secondary market for life insurance.
Due to its ubiquitous nature, it would be impossible to point to a calendar and identify the birth date of premium financing. One would imagine it has existed, in one form or another, since the creation of the latter of life insurance or credit.
From its beginning, the process of financing the cost of life insurance was used primarily to provide individuals who had significant illiquid estates with the ability to secure needed life insurance for estate tax planning without sacrificing the earning power and/or value of their illiquid assets. This was, and remains, a perfectly legitimate way to approach the purchase of life insurance for certain individuals.
In its most basic form, premium financing for life insurance involves a structure under which life insurance is purchased on the life of an individual for a valid purpose. Typically, this purpose is estate liquidity planning. Contemporaneously, a financing agreement (loan) is entered into between the owner of the policy (usually the insured or a trust established by the insured) and the financier (the bank). Under the terms of the financing agreement, the bank agrees to advance additional loan proceeds periodically to mirror the due date for premiums payable on the policy. Interest charged on the loan is paid periodically by the owner of the policy or is accrued and added to the loan balance.
This structure may be perceived to provide a “free lunch” or the ability to acquire life insurance without actually paying for it. But, as my grandfather once rightly told me: nothing in life worth having is ever completely free.
In addition to the financing costs stated in the financing agreement, there were potentially two additional costs inherent in the first generation of premium financing plans, and they could not be hidden. Both costs were created and then magnified by the insured’s longevity.
First, in the early stages of this structure, the financing arrangement invariably called for collateral to secure the increasing loan balance in addition to the insurance policy itself. Because the financing arrangement was designed to create an ever-increasing loan balance, a long, healthy, physical life resulted in a not-so-healthy financial life (i.e., when the insured lived sufficiently long to result in a loan balance exceeding his or her net worth, that net worth was fully consumed as collateral for the loan). Likewise, the same long and healthy life would result in a loan balance which, many times, would far exceed the face value of the insurance. This difference resulted in a net liability to the insured. Both of these risks were caused by the lack of an exit strategy from the transaction other than the insured’s death.
The secondary market for life insurance has created, in essence, a profitable exit strategy for life insurance ownership that involves something other than the insured’s death. The coexistence of these two market forces dramatically changed the landscape available for individuals considering the use of a loan to finance insurance premiums.
Academically speaking, premium financing could be united with the exit strategy provided by the secondary market to produce a scenario in which the policy could be sold, during the life of the insured, for an amount in excess of the then existing loan balance. Again academically speaking, a profit was generated, ab initio, out of the difference between the life expectancy assumptions used by the life insurance industry and its cousin, the secondary market. Essentially, two different segments of the same industry (the insurance companies and the secondary market participants) evaluated the same human body and reached different conclusions as to how much longer that human body would continue to exist. Financially speaking, this difference of opinion represented arbitrage.
The financial markets quickly saw the profit potential in this life expectancy arbitrage and responded with “new and improved” programs to provide financing for life insurance premiums. These new and improved programs (some good, some not so good) are the subject of the hype mentioned at the beginning of this article.
Second Generation of Premium Financing
Very shortly after the marriage of the secondary market to premium financing, the financing end of the equation made a 180 degree turn. Financing became short-term in nature and was designed solely to enable healthy/wealthy individuals to “cash in” on the life expectancy arbitrage discussed above. Usually there was a two-year loan to survive the suicide clause in any insurance contract. The loan required absolutely no collateral other than the policy itself. This is commonly called “nonrecourse financing.” The loan also carried a usurious interest rate. In many cases, interest exceeded an effective rate of 200 percent. If the insured was “fortunate enough” to die during the term of the two-year loan period the insured’s heirs received the death benefit after the loan was repaid. However, at the end of the loan term, barring some significant change in health, the loan balance (which included the fees and interest at that time) was so costly that the insured was left to walk away from the transaction (at no cost of course). Practically speaking, the insured was provided with short-term insurance coverage at no cost or risk, a “free look,” so to speak.
Some of these “nonrecourse premium financing programs” went so far as to offer and pay substantial cash incentives to the insured – up front – to enter into the transaction. These programs offering cash inducements were very short-lived primarily because they were perceived by the insurance industry as the sale of an individual’s insurable interest – a concept viewed as abhorrent from time immemorial.
In addition to the insurance industry’s perception that this form of financing amounted to nothing more than the sale of an individual’s insurable interest, there were potentially significant hidden income tax costs associated with an exit strategy involving the effective abandonment of insurance. While the subject of taxes caused by the “walk-away” is far beyond the scope of this article, expect to hear many things on it from the press in the near future.
Third Generation of Premium Financing
To many people, the second generation of premium financing represented a form of “free insurance.” And in some cases, it produced a scenario where the insured received cash from taking insurance without understanding the hidden and sometimes significant tax consequences to the insured. When this generation was swiftly quashed by the insurance industry, a new generation emerged. This generation of “limited recourse” financing has no promises of up-front cash payments and represents the typical state of premium financing as it exists today.
As this non-traditional (i.e., not fully collateralized) financing exists today, the insured is required to risk some personal capital as part of the transaction. Stated simply, the insured must have some “skin in the game.”
This “skin” comes in many forms but generally exists by the insured guaranteeing some portion of the loan balance. While it may seem illusory, the current form of premium financing can and does work. And very importantly, it satisfies the concerns of the insurance carriers that the transaction is, indeed, more than simply a sale of the insured’s insurable interest.
Few things in life are guaranteed. However, it appears quite certain that as long as the primary players in this forum continue to exist (i.e., the life insurance industry and the credit industry), there will be a market for premium financing in one form or another. That assumption is absent a fairly dramatic and potentially unconstitutional change in the insurable interest laws of this country.
The future form that the transaction takes, however, is anyone’s guess. But there are two well-tested axioms that can serve as a litmus test for any such proposal. Again to quote my grandfather: nothing in life worth having is ever completely free. And second by author unknown: if it sounds way too good to be true, it is more than likely false.
Russell G. Roll, CPA, JD is a partner in the firm of LRA Advisors, located in Pittsburgh, Pa.