How To Value Insurance Companies - Just as you can take out a mortgage to buy a home, you can use premium financing to buy permanent life insurance.
In this article, we learn more about what premium financing is, how it works, who can benefit from it, and the risks involved.
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Premium financing is a scheme where large insurance policies are paid for through loans from third parties, which are fully or partially secured by the cash value of the policy.
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Policyholders typically use premium financing to purchase large policies with a lower cash outlay and eventually pay off the loan, refinance it, or replace it with a life insurance company loan station
Like all forms of leverage, premium funding provides a return, but it also carries risks and is not suitable or available for everyone.
In a well-planned premium financing scheme, there will be a positive spread between the interest on the loan and the repayment of the cash value of the policy.
This essentially means that the loan will pay for itself as the policy it funds pays more than the cost of the loan.
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In a well-planned deal like this, premium financing will create a profit for the borrower equivalent to buying a home with a mortgage, renting it out and repaying the loan with the proceeds while maintaining a profit.
Because the policyholder has to pay less cash for a larger policy, the return on cash invested in a well-designed deal like this will be greater than if no loans were used, and the policyholder will be able to keep more money elsewhere.
Since the name of the permanent life insurance game is compounding returns, premium funding helps with this goal by allowing the policyholder to build larger amounts of cash value in the early years, which can then be compounded over time.
In addition to the cash value aspect, premium financing can also help policyholders purchase life insurance coverage that would otherwise have been prohibitively expensive.
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For example, instead of paying premiums on term life insurance (which most people never end up receiving any benefits from), premium financing can allow high-income earners to get permanent life insurance that provides the coverage they need beyond cash values that can, for example, be used to supplement pension income.
Similarly, for asset-rich, cash-poor families with much of their wealth tied up in illiquid assets such as private businesses or real estate, premium financing can help provide necessary life insurance coverage without requiring as much cash outlay.
Although premium financing began 25 years ago primarily as a method of personal financial planning, it is now also commonly used by businesses to obtain the benefits of permanent life insurance at a lower cash outlay.
Some of the ways companies use premium financing are to provide retirement benefits to executives, protect the company against the loss of a key employee, or finance a so-called buy-sell agreement that allows the company to buy out the heirs of a deceased owner.
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Essentially, while premium financing comes with limitations and risks that we'll explore later, it offers these benefits:
While regular policy loans, which use the pre-existing cash value of a policy as collateral for a loan, are available to everyone, premium financing, which uses loans to pay premiums that generate cash value, is only available to higher net worth individuals and businesses.
While the exact minimum requirements for eligibility vary, premium finance lenders generally require a six-figure salary and a seven-figure net worth.
While regular policy loans from insurance companies don't rely on credit checks, premium financing from third-party lenders does, so a good personal or business credit score is critical to good results.
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Although premium funding can generally be done to insure people up to age 70, it usually produces the best results when used to insure younger, healthier people, as these policies build cash value faster
In addition, premium financing will unlock, without paying back, a large portion of the cash value of the policy, making less money available for future policy loans.
If you already have highly productive investments outside the policy where you can earn significant returns, premium funding allows you to keep your assets in those investments and use loans to build life insurance holdings.
However, if you don't have very productive investments or want to keep some cash in your policy available for future investment opportunities, it may be more beneficial to pay the premiums out of pocket and then take out secured cash value loans. at a later time when you need it for a future investment.
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Whether you are borrowing against your cash value issued at the start of the policy (premium funding) or if the policy has already generated some cash value (ordinary policy loans), it will always work best when you "the amount per loan can be kept in an investment where the return reliably exceeds the interest on the loan.
Also, premium financing may not be the best strategy for someone looking to minimize risk with life insurance.
As with any leverage, the potential profit will come at the cost of additional risk, which we will discuss in a later section of this article.
Whole or index life insurance policies are generally used for premium financing as both have minimum guarantees that keep them safer for lenders.
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When one or more permanent life insurance policies are identified and stress tested through financial modeling, the policies are applied concurrently to premium financing loans.
Although the policies used for premium financing are designed for maximum allowed cash value accumulation, the cash value is usually less than the loan in the early years.
For this reason, borrowers will generally need to provide additional collateral from their other investments or, in some cases, pay the initial premiums themselves and then start funding the premiums that are fully secured by the policy.
Once the loan agreement is established, the lender will cover the premium payments, which are usually paid over 4-7 years.
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During this time, the borrower usually only pays interest on the loan payments, which are usually variable, but can also be fixed.
In other, more aggressive settings, the borrower may not make loan payments and instead let the loan balance grow with the expectation that the cash value will exceed the loan balance.
Typically, premium finance loans have a limited term of 5 to 10 years, after which the policyholder must refinance the loan.
This can be done with the same premium finance lender as the original loan, another premium finance lender or the issuing life insurance company if the cash value is high enough.
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The most common end goal of a premium financing scheme is to replace the external loan with a loan from the insurance company, which can be fixed or with an upper limit, reducing the risk of the financing.
Replacing the external premium finance loan with an insurance loan will give the borrower an unlimited loan that can last a lifetime and does not require ongoing payments, unlike many premium finance loans.
If done right, a premium funding scheme will over time build up cash value in addition to the loan balance, which the policyholder can use to fund other investments or supplement retirement income, for example.
When the insured dies, the money paid out will first pay outstanding debts with the life insurance company or premium lender before being paid out to the beneficiaries.
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As with any leverage, premium funding can be a double-edged sword and there are more risks associated with it that do not exist with regular life insurance.
Typically, premium finance agreements have an initial loan term of 5-10 years, which is then refinanced to years 11-20 before being replaced by an insurance loan.
Therefore, there is a risk as the premium financing loan usually needs to be refinanced at least once before it is replaced by a loan from the insurance company.
Although the risk is not high in most cases, there is a risk that the lender may choose not to refinance the loans if the borrower's or life insurance company's credit score deteriorates.
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However, as premium finance has become more common over the past 20 years, there are now many alternative premium finance lenders and it is likely that if you are rejected to refinance with one, you may be approved to refinance with another.
As with mortgages, it has generally been more advantageous for premium finance borrowers to borrow at variable rates than at fixed rates over the past 20 years.
The variable interest rate will generally be based on a lending benchmark, such as LIBOR, plus an additional percentage, with some minimum interest rate.
Because interest rates tend to change over time, there is a risk that interest rates will rise to the point where they are higher than growth.
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