The borrower should understand that financed insurance is NOT free insurance and using this method to pay for life insurance may expose the borrower to additional risks that are not associated with traditional life insurance policy purchases. Those additional risks include fluctuations in the loan interest rate, fluctuations in the policy crediting rate, valuation of the life insurance policy, the potential need for additional collateral held outside the policy, and the potential gift tax exposure if the insured is forced to repay the loan on behalf of an ILIT (or some other individual or entity who is the policy owner).
The policy owner borrows the funds. In the majority of cases the borrower will be an entity – either the client’s ILIT or his/her business. In rare instances the borrower can be an individual, but this structure will require prior approval from the program.
Programs utilize capital from large, highly rated and well-known financial institutions that have pre-authorized a significant level of funds to be used for financing life insurance premiums.
In some cases, clients may elect to rely on their own personal banking relationships for financing life insurance premiums. These clients and their banks will then be solely responsible for establishing the terms and conditions of their financing arrangements.
Loan interest rates are typically based on a recognized benchmark interest rate plus an additional spread. The most commonly used benchmark rate is the 12-month London Inter-Bank Offered Rate (LIBOR), although other rates (i.e., the Prime Rate) may also be used. LIBOR is the interest rate at which banks offer to lend money to each other in the London wholesale money markets. It is a common rate used in global capital markets, and is published daily in the Wall Street Journal.
The spread above the benchmark rate typically ranges between 100 and 300 basis points, and varies by the amount of the loan, the credit-worthiness of the borrower and the collateral that is posted. While the benchmark rate used is expected to fluctuate on an annual basis, once negotiated, the spread typically remains constant for the life of the loan. Interest will typically be charged annually, though some programs will negotiate other durations.
For most loans, the interest rate will change annually, corresponding to changes in the benchmark interest rate. However, borrowers may wish to negotiate a long-term or short-term lock-in period where the interest rate will be fixed. Lock-in rates are subject to market availability and come at a premium.
No, the loan interest in premium financing falls under the category of “personal interest,” and that deduction was eliminated by the Tax Reform Act of 1986.
This will vary by product, client age and profile, and ultimate need. Programs typically use a term-loan structure, where the loan amount includes a multi-year premium payment pattern that can cover between 1 to 10 year terms.
We do not charge any origination fees for the structuring of the loan.
The funder will typically require that the life insurance policy be assigned as collateral. If the policy’s cash surrender value is less than the amount of the loan, then the borrower will be required to pledge additional assets. Each funder will establish its own individual collateral requirements, which may vary depending on the type of assets being pledged. Acceptable collateral normally includes cash, cash equivalents, and liquid or readily marketable securities. Letters of Credit (LOCs) are also acceptable and are actually preferred by some programs. Cash and cash equivalents are likely to be valued either at or close to 100% of the asset’s current fair market value (FMV), while stock portfolios may only be valued at 50% of FMV.
Normally, collateral will be provided by the borrower. If the borrower is an ILIT with no assets other than the policy, the insured/grantor or some other source will need to provide the collateral.
In the event of adverse performance by either the life insurance policy or the initially pledged assets, the program may require additional collateral to secure the loan.
Providing a personal guaranty should not be recognized as an incident of ownership in the life insurance contract nor be considered a retained right, power, or interest in the policy that could cause the proceeds to be included in the insured’s taxable estate.
No. There is no gift until a payment is made. If a person guarantees another’s debt, there is only a gift if payment is required pursuant to the guaranty.
The above estate and gift tax discussions are intended to provide guidance only and should not be considered legal or tax opinions. Clients should always refer all legal and tax questions to their professional legal and tax advisors.
The loan must be repaid when it reaches maturity (unless renewed), upon the death of the insured, or in the event of a default. Maturity may be defined as an event (i.e. death of the insured), or after a specific period of time (i.e., a term of 5, 10, or 15 years). In the case of most term loans, the balance is due and payable at the end of the term, unless the loan is renewed. Renewal of loans after the original term is not guaranteed and is subject to the program’s discretion.
Conditions of default will be described in the loan agreement. Most common examples of default are failure to pay interest when due or failure to provide collateral when required by the program.
There are a number of exit strategies that may be implemented, including:
example of this would be the sale of a business.
No. While the client’s legal and tax advisors must ultimately determine whether such a structure is advisable, a life insurance policy that is considered a MEC is typically not an appropriate asset for premium financing.
Under Internal Revenue Code §72, placing a collateral assignment on a policy characterized as a MEC is treated as a distribution from the policy (even though no withdrawals are actually made), and that distribution is taxable as ordinary income to the extent that the policy’s cash value is in a gain position immediately before the distribution (disregarding the effect of any surrender charges). Because programs usually require that at least a portion of the life insurance policy be assigned to the program as part of the loan collateral, any cash value growth that is in excess of premiums paid will be treated as taxable income and taxed at ordinary rates. Additionally, if the insured is younger than age 59 ½ or the policy is owned by a non-grantor trust or other entity, a 10% penalty tax may also be imposed. This tax liability exists whether or not an IRS Form 1099 is generated for the reportable income.
