Top 5 Mistakes to Avoid in Premium Financed Life Insurance
What is Premium Financed Life Insurance
Premium financed life insurance can be a powerful tool for high-net-worth individuals looking to secure large life insurance policies without tying up or liquidating their assets to pay premiums. At its most basic level, premium financed life insurance involves taking out a loan from a lender to cover the cost of the often-substantial insurance premiums. The life insurance policy itself commonly serves as collateral for the loan. While this can be a beneficial financial planning tool under the right circumstances, this sophisticated strategy comes with significant risks and complexities that must be carefully navigated. Missteps in structuring or managing a premium financed life insurance arrangement can lead to financial strain, legal disputes, and even policy lapses. To help you avoid these pitfalls, we’ve compiled a list of the top five mistakes people make when engaging in premium financed life insurance—and how you can steer clear of them.
- Underestimating Interest Rate Volatility
One of the biggest risks in premium financed life insurance is the volatility of interest rates. Many borrowers opt for variable-rate loans, which can initially seem like a cost-effective choice. However, if interest rates rise, the cost of the loan can quickly escalate, leading to significant financial pressure. It’s crucial to stress-test your financing arrangement against potential rate increases and have a plan in place for how you will manage higher costs.Example: Imagine a high-net-worth individual, John, who takes out a premium financed life insurance policy with a $10 million death benefit. He finances the premiums with a variable-rate loan at an initial interest rate of 3%. After a few years, the interest rate rises to 6%, doubling John’s interest payments. John had not planned for this increase, and as a result, he struggles to keep up with the higher costs. This financial strain forces him to liquidate other assets at an inopportune time, leading to significant losses or face defaulting on the loan and the potential lapse of the policy.How to Avoid It: Consider securing a fixed-rate loan to mitigate the risk of rising interest rates. If a variable-rate loan is necessary, ensure you have adequate liquidity or other financial resources to cover potential increases in interest costs and additional collateral requirements. Regularly review your loan terms and market conditions to anticipate any changes.
- Over-Reliance on Policy Performance
Premium financed life insurance often relies on the assumption that the policy’s cash value will grow at a rate sufficient to cover the loan interest and eventually repay the principal. However, insurance policies, particularly those linked to investments, can underperform due to market fluctuations or poor investment choices or poor investment options offered by the insurer. Relying too heavily on optimistic projections can lead to unexpected capital calls or even policy lapses. Example: Sarah, a successful entrepreneur, purchases a $15 million life insurance policy using premium financing. The policy’s projected growth rate is 6%, based on optimistic market conditions. However, after several years of market downturns, the policy only achieves a 2% return. As a result, the policy’s cash value is insufficient to cover the loan interest, and Sarah is required to provide additional collateral or risk the policy lapsing. This puts Sarah in a difficult position, as she had not anticipated needing to contribute additional funds.How to Avoid It: Base your financial planning on conservative growth estimates rather than best-case scenarios. Regularly review the policy’s performance and adjust your strategy if necessary. Consider diversifying your investments or choosing an insurance company with a variety of tested investment options with years of historical returns to reduce reliance on the policy’s performance.
- Failing to Understand Legal and Regulatory Requirements
Premium financed life insurance is subject to various legal and regulatory frameworks, particularly concerning insurable interest and disclosure requirements. Failure to comply with these regulations can result in legal challenges, policy invalidation, or penalties. The complexity of these transactions often leads to oversight, especially if the legal implications are not fully understood.Example: David, a real estate developer, purchases a premium financed life insurance policy but fails to properly document the insurable interest between himself and the beneficiary, a business partner. When the business partner passes away, David attempts to claim the death benefit, but the insurance company denies the claim, citing a lack of insurable interest. David’s oversight not only results in the loss of the policy’s benefits but also leads to a costly legal battle.How to Avoid It: Engage with legal advisors who specialize in premium financing and insurance law to ensure full compliance with all relevant regulations. Properly document all aspects of the transaction, including the insurable interest, to avoid potential legal disputes.
- Ignoring the Agent’s Incentives
Insurance agents earn substantial commissions from selling premium financed life insurance policies, which can create a conflict of interest. Agents are typically incentivized to recommend larger policies or specific products that may not align with your financial goals. While this doesn’t mean that all advice is biased, it’s essential to be aware of these incentives.Example: Lisa, a high-net-worth individual, is approached by an insurance agent who recommends a $20 million premium financed life insurance policy. The agent emphasizes the potential benefits but downplays the risks, particularly the potential for increased interest costs and the need for additional collateral. Lisa later discovers that the agent earned a substantial commission from the sale, which may have influenced the recommendation. Unfortunately, the policy’s performance does not meet expectations, leading to financial strain for Lisa.How to Avoid It: Work with an independent financial advisor who can provide unbiased advice on the best insurance options for your needs. Always seek a second opinion before committing to a significant financial decision, and make sure you fully understand the incentives behind the recommendations you receive.
- Failing to Understand Potential Tax Implications
While premium financed life insurance may offer significant benefits, it is essential to understand and manage the associated tax issues and risks and seek the advice of knowledgeable professionals.Potential Issue: When you finance the premiums of a life insurance policy with a loan, the loan proceeds are typically not considered taxable income. However, the interest paid on the loan may not be tax-deductible, particularly if the loan is used to finance a personal life insurance policy.Potential Issue: Premium financed life insurance policies are often used in estate planning to help cover estate taxes and provide for heirs. However, if the policy is owned by an irrevocable life insurance trust (ILIT) to keep it outside of the taxable estate, premium payments made by the insured (or the loan repayments) could be considered taxable gifts.
Potential Issue: If the life insurance policy accumulates cash value, the policyholder may have the option to take withdrawals or loans against the cash value. However, these withdrawals could have income tax implications, particularly if the amount withdrawn exceeds the premiums paid into the policy.
Potential Issue: The transfer-for-value rule is an important consideration in the context of premium financed life insurance. If the policy is sold or transferred to another party for valuable consideration (such as in a loan arrangement), the death benefit could become partially or fully taxable.
Conclusion
Premium financed life insurance can be a valuable strategy for preserving liquidity while securing significant life insurance coverage. However, the complexities involved require careful planning, expert advice, and ongoing management. In addition, it is essential to understand and manage the associated tax issues. The complexities of these tax implications underscore the importance of working with experienced financial, legal, and tax advisors. By avoiding these common mistakes and understanding the potential risks, you can better navigate the risks and make informed decisions that support your financial objectives. As always, consulting with experienced financial and legal professionals is key to successfully managing premium financed life insurance arrangements.
Mr. Kibort practices in business litigation and financial-services litigation, including defending financial advisors, financial planners and investment advisors, financial planning firms, investment firms, fund managers, funds, hedge funds, and brokerage firms, including in SEC and FINRA investigations and lawsuits, FINRA arbitrations and mediations.
This blog entry is not legal advice and does not create an attorney-client relationship; it is merely an example to provide some legal education and general information. Each case is fact specific and requires its own unique solution. It is strongly recommended that you seek the advice of a qualified attorney to help you with any questions you have.
Parker Daniels Kibort is a full-service litigation law firm located in Minneapolis, Minnesota. We have a proven record of success at the highest levels for our clients. We can handle your matters in Minnesota, Wisconsin, Iowa, North Dakota, California, and Washington D.C. If you have questions about Premium Financed Life Insurance, business litigation or other financial-services litigation, give us a call at 612.355.4100.
