Industry Experience

Leveraged Life Insurance

The term “premium financing” describes a method of purchasing large premium life insurance contracts using money borrowed from a commercial bank or lender.

Low market interest rates usually bring increased attention to premium financing as a means of funding the termination of split-dollar plans. Premium financing is also used to fund company-owned life insurance and trust-owned life insurance. With an irrevocable life insurance trust, the loan is entered into between the trustee and the lender, and interest payments are often made from gifts to the trust by the trust grantor or others.

Where a policy is purchased using premium financing the loan is typically collateralized by the underlying life insurance policy, but additional collateral may be required. It is important to recognize that there are no tax advantages to premium financing, since the interest paid will not
be tax deductible (i.e., four out of seven years’ premiums will not have been paid from unborrowed funds).

The rate of interest is often based upon commercial loan rates using the one-year LIBOR (London Interbank Offered Rate), plus a spread and loan origination free totaling perhaps 1.5 to 2.0 percent. For example, the November, 2013, one-year LIBOR was 0.60 percent, meaning that the effective typical interest rate for premium financing would be approximately 2.6 percent. Although the spread is typically guaranteed for the loan’s duration, because the underlying LIBOR rate is subject to annual adjustments the loan interest rate can increase substantially (e.g., in November, 2006, the one-year LIBOR was 5.24 percent, or 4.64 percent higher). Also, unlike the loan provisions provided in most life insurance contracts, if the underlying
insurance contract requires ongoing premium payments, commercial lenders are unlikely to guarantee rates to be charged on future loans. However, lenders may not provide assurance that future loans will be made.

In order for premium financing to work over a period of years, it is essential that the rate of return on policy values (cash values and death benefit that are intended to repay the loan) exceed the interest rate paid on the loan. With interest rates at or near historic lows, there is often a differential between these loan rates and higher current (or projected, but not guaranteed) policy earnings rates. This arbitrage opportunity may at first appear attractive, but there are many variables that can negatively impact the results obtained. They should be carefully evaluated.