From: California Broker Magazine

The Advisor's Guide to Premium Financing

October 2008

by Lance Wallach

 

Premium financing allows your clients to purchase life insurance without liquidating their investments or changing their cash flow. Clients who are most likely to use premium financing are high net-worth seniors who are over 70. However, younger people can benefit with alternative forms of financing, other than through a bank.

 

It began in 1973 with the financing of property and casualty insurance policies. In1995, lending companies started financing life insurance policies. Ever since then, the life insurance industry and lending institutions have been developing innovative designs and products.

Premium financing can answer some of the objections people have to life insurance. Most have an aversion to paying premiums and to dealing with matters relating to death, especially when someone else is profiting. It allows clients to do the following:

 

• Retain capital for lifestyle and investment needs.

• Have additional liquidity for a family or business or additional liquidity to pay taxes on the value of a business.

• Eliminate unnecessary gifting or use of their unified credit. (Premium financing does not impede unified credit or annual gifting.)

• Avoid or reduce estate, inheritance, and generation-skipping taxes.

 

Why Premium Financing is Getting Popular

Many consumers are finding that it is not cost efficient to purchase life insurance by paying term or permanent premiums. Premium financing may provide more favorable financial terms for clients who are seeking to purchase life insurance.

 

Many people don’t have adequate protection for their financial legacies. People are living longer and our economy is producing many multimillionaires, which creates larger estates. At the same time, estate tax laws are subject to change. Premium financing does not interfere with estate planning strategies including generation skipping.

 

The granter/insured can loan annual life insurance premiums to the ILIT rather than gifting them when the ILIT owns the policy. IRS Letter Ruling 9809032 declares that a loan to an ILIT is not an incident of ownership. The granter/insured is not responsible for the premium finance loan. The ILIT repays the loan when it receives the death proceeds.

 

Premium financing eliminates annual gifting issues that can come up with an ILIT. It provides substantial leverage for the gift tax. Under IRC Code 7872, if paid by the granter, only the loan interest is considered an annual gift rather than the entire premium. There could be a gifting problem if the contract has been classified as a modified endowment contract. However, this issue should never arise unless the client tries to make a single premium deposit into the contract. When the insurance policy is issued, it is designed so that it is not classified as a modified endowment contract.

 

ILIT deposits are transferred irrevocably, which means that the money cannot be used for alternative investments or used to improve a person’s lifestyle.

 

Premium financing enables the trust to receive death proceeds income-tax-free without including them in the insured’s estate. Total death proceeds are not included in the insured’s estate if the ILIT trust has been arranged properly.

 

Premium Finance Loans

 

The four major steps of premium financing are to get a policy, create an irrevocable life insurance trust (ILIT), obtain a loan, and collateralize the loan. A third-party lending institution finances the life insurance premiums. A trust owns the policy, keeping the death benefit out of the estate. Through the trust, the insurance policy is assigned to the third-party lender as collateral.

 

The two general types of premium finance loans are “interest paid” and “inter-est accrued.”

When your client pays interest out of pocket, they avoid additional deferred risk by tying up collateral for a longer period .Also, your client does not need additional collateral. The disadvantage is that the money your client pays out-of-pocket could be used for investments or for maintenance of their lifestyle.

 

The following are the usual terms of an interest-accrued loan:

 

• Interest is accrued for the length of loan, which is generally five to 10 years.

• The borrower must show financial ability to pay the premiums and interest even though the premiums are being financed.

• The borrower must be able to post additional collateral for as long as necessary if the policy surrender values are insufficient in any given year. The lender per-forms a collateral analysis each year to determine if there is a shortage. This is normally is done 45 days before the anniversary date to give the client enough time to post additional collateral.

• The borrower must give the lender a cover letter explaining why interest is being accrued. They must also provide their estate planning strategy.

• The amount of life insurance the borrow-er purchases cannot exceed their networth. Also, the borrower’s projected net worth cannot be less then the projected accrued loan. If the lender’s risk analysis indicates that the borrower’s projected net worth is less, the borrower has to apply for less life insurance coverage.

The accrued interest loan creates future deferred risk. The London Interbank Offered Rate (LIBOR) is used as a base index for setting rates of some adjustable rate mortgages and other loans.

Suppose LIBOR loan rates continued to increase instead of leveling off and eventually decreasing to their long-term average rates. Every year, the corresponding life insurance product would be under extreme pressure to produce crediting rates that exceeded the LIBOR rate.

Collateral could be put at risk if the loan balance increased while the policy’s cash value did not. It could create the need for additional collateral, which the client may not have. When bank loans have com-pounding non-fixed interest, the annual interest payment could end of being high-er than the annual premium payment. This is particularly true with younger clients.

There are ways to avoid the pitfalls of the interest-accrued loan. Creative financing can offer interest accrued loans with the following advantages:

• Non-recourse

• Unlimited term

• Fixed interest rates as low as 3%

• Non-compounding of interest

• No additional collateral requirement Why Universal Life Is Not a Good Choice

Traditional universal life is the most common life insurance product to be used for premium financing and is most commonly accepted by lending institutions. However, it should not be used for premium financing in today’s interest rate environment for the following reasons:

• The current crediting rate for most UL policies is too low.

• The guaranteed rate for most UL policies is 4%. This is also the current rate for some companies.

• Long-term surrender charges cause additional collateral shortages.

• Death benefits are falling short of what was targeted.

• An insurance company generally invests in medium-term maturity fixed-income instruments, primarily notes. Bond fund yields tend to fluctuate more slowly than do money market interest rates. Short-term interest rates fluctuate rapidly while the portfolio yields are slower to react.

• The interest rates charged on premium finance loans are greater than current portfolio yields. This may continue for several years before portfolio rates catch up. Annual shortages will increase if this continues for many years while interest is accruing. There would be a concern about whether the premium finance arrangement could continue.

 

Equity-Indexed UL –an Acceptable Alternative

Equity-indexed universal life insurance is an acceptable alternative for premium financing. A critical difference sets it apart from other flexible premium UL products. The carrier can credit interest that is based partly on the potential growth of an out-side index (excluding dividends). At the same time, none of the policyholder’s cash value participates directly in an equity market. This probably provides better long-term values than a fixed universal life product can provide. It also creates less risk to principal than a variable universal life product brings.

There is a way to avoid losing the death benefit as interest accrues. Special insurance riders increase the death benefit each year by the amount of interest on the premium finance loan. This is called a“return-of interest/cost of money rider.”The death benefit will not get eaten away by accrued interest when combined with a standard return-of-premium rider. Beneficiaries always receive the original death benefit.

In short, premium financing can allow your client to protect their net worth and pass along their financial legacy to future generations without altering other financial strategies?

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Lance Wallach, CLU, ChFC, the National Society of Accountants Speaker of the Year, speaks at more than 70 national conventions annually and writes for more than 50 national publications about financial planning, retirement plans, and tax reduction. For more information call 516-938-5007.

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From: California Broker Magazine

Life Settlement Underwriting –

The Flip Side of the Coin

Life settlement amounts are determined by a multitude of factors to arrive at a “net present value.” The net present value is the value of future benefits from the death benefit minus the present value of future payments to sustain the policy until maturation. These expenses include premium payments, cost of capital, and administrative costs.

This calculation enables the purchaser to factor in the desired profit from the investment and propose an offer to the policy seller. The insured’s life expectancy is critical in assessing the policy’s value or sale price since the investor will be sustaining the policy premiums until maturation. If the assessment of an insured’s life expectancy is too short, the purchaser pays too much and risks a financial loss.

In contrast, seller gets a lower offer if the life expectancy assessment is longer than their actual life span. The result is an undervalued sale for the policy owner. Institutional life settlement investors generally get life expectancy reports from two or more independent life expectancy providers. Many of the larger institutions that ­invest in life settlements have underwriting personnel on staff.  Life expectancy reports can vary significantly based on interpretations, medical data on the insured and actuarial tables.     

Differences in Underwriting Methodology

Companies that provide life expectancy reports use actuarial experts and medical experts to calculate an insured’s probable mortality based on probability theory, actuarial methodology, and medical analysis. Many life expectancy providers use experienced life insurance underwriters who work actuarial and medical experts. Life expectancy reports from AVS, Fasano, 21st Services, ISC Services, and EMSI are among the most commonly accepted by institutional investors. These companies, which specialize in underwriting insureds over 65, have developed specified methods, underwriting manuals, and mortality tables.

The insurance industry customarily employs reinsurance underwriting manuals to rate insurability. However, reinsurance manuals reflect the traditional life insurance demographic and are gauged primarily for insurance applicants up to 65 with insurable impairments up to 500%. Conver­sely, life settlement underwriting, which is geared toward those over 65, can have impairment ratings much higher than 500%.

In order to cater to this market segment, adaptations were made to these underwriting manuals based on extensive research of current senior mortality data. They are scrutinized against recent medical ­advances and the treatment of diseases or disorders often associated with the elderly. In addition, companies that provide life expectancy reports also draw on proprietary data from previous assessments. Generally, the underwriter uses a traditional debit and credit methodology to determine an insured’s overall rating, resulting in a standard or substandard rating. Of course, this is an approximation since few impairments cause a uniform percentage increase in mortality.

The standard debit and credit method produces reasonable and quantifiable results. But, it’s not reliable for conditions, such as many forms of cancer, mainly because the impaired mortality curve is significantly different than the standard curve. Companies that provide life expectancy reports have different ways of calculating these impairments. Some use the debit and credit approach; others apply extra deaths for a limited time span; and still others use a combination of the two and apply them to actuarial calculations.. Clinical judgment may supersede the actuarial calculation for a policy with a high impairment and a short life expectancy. Life expectancy calculations use the underwriting assessment with the appropriate mortality table. However each life expectancy provider uses its own proprietary mortality tables based on sex; smoker or non-smoker status; and impairment and preferred class. Most life expectancy providers use a heavily modified version of the 2001 VBT or they use their own table altogether.

People with Alzheimer’s, congestive heart failure, and other serious medical conditions are likely to be declined for a life insurance policy. However, for a life settlement, it is possible to estimate the life expectancy of insureds with these medical ailments. Life expectancy assessments for insureds with serious medical conditions often take into account factors that contribute to healthy aging, such as regular exercise, social activities, the insured’s mental attitude, and their commitment to a healthy lifestyle. Access to caregivers and a support network are also considered. All of these factors can add complexity to the underwriting process that will affect the final mortality calculation

Differences In Underwriting Requirements

When submitting an application for a large life insurance policy on an older person, the application needs to be accompanied by medical data as outlined in the insurance company’s requirement guidelines. This medical data usually includes a physical examination, blood profile, EKG, and a statement by the attending physician. Many insurance companies also require functional assessments of an applicant, which include ability to carry out the activities of daily living. Financial underwriting is often part of this insurability assessment.

In contrast, life settlement underwriting is based on existing medical data and rarely requires a medical examination, EKGs, or blood work. A life settlement application should be accompanied by HIPAA and release of medical information forms. The application is followed by attending physician’s statements ordered from selected physicians by the company that is transacting the life settlement. After reviewing the attending physician’s statements and medical history, a life expectancy provider offers a detailed life expectancy report on the insured.

In traditional underwriting, it is preferred to get as low a mortality rating as possible on any medically impaired risk in order to get a lower cost of insurance. In contrast, for life settlements, a higher impairment rating would result in a shorter life expectancy. Thus, the insured would receive a larger settlement for the policy.

Seller Beware

With life settlements growing at an astounding rate, more and more companies are seeking to enter this market. Many states have some form of regulation regarding life settlements, while others are unregulated or pending regulation. Some life settlements, such as those on a variable policy, are considered securities transactions. With all of the regulatory variables, it is important to work with a reputable company. Look for a company that will facilitate and expedite the policy with professionalism and get competitive bids from a number of institutional investors. What may be even more important is a company that can do the record keeping to fulfill regulatory standards and has a compliance department that stays abreast with changing regulatory requirements and reporting. Most importantly, the company should have the applicable licenses in the states were it conducts life settlement transactions.

Not surprisingly, these attributes tend to coincide. A reputable company will hold all of the applicable licenses or will refrain from activities in states where it is not licensed. A compliance department that is also responsible for licensing and regulation will oversee reporting and record keeping capabilities. These kinds of organizations generally have the manpower to process settlements with precision. Processing large numbers of settlements according to a high standard will give a company a preferred status and leverage with institutional investors, which might even result in higher offers on a policy.

Be sure to ask the life settlement company if it is licensed and in which states. If it does settlements for variables, ask if these are cleared through a broker/dealer and their relationship to that broker-dealer. Use the Internet and other tools to research the company you plan on using for a life settlement. The issues may seem trivial, but guess who’s left holding the bag three years after a life settlement with an unlicensed company that has fallen off the face of the planet?

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