What if you could get all the money that you wanted at 4% and knew that you could turn around and invest it at 5%. How much money would you want?
All of it, right?
Or, if we look at it another way, what if you could get a loan for a million dollars from the bank that you could use to fund a retirement plan? That would be pretty awesome, right? This page will cover why banks want to do just that. Its called Premium Finance.
The premise here is having a permanent life insurance that builds cash value. Permanent Life Insurance has Insurance (Death Benefit) + Cash Value (savings/investment feature that can earn interest).
Believe it or not, banks want to loan you a million dollars, or more, to purchase High cash value life insurance policies like indexed universal life, for example.
The Wealthiest 10% of individuals/Families own HIGH CASH VALUE Life Insurance
The Largest Fortune 500 Companies PLUS Many Others Purchase COLI
The Largest Banks in the U.S. Purchase BOLI
What is Premium Financing?
If you are a financial nerd or not, things like leverage, compounding interest and interest rate arbitrage would be fascinating. Premium Financing is the Mack Daddy of interest rate arbitrage.
You can see just how beautiful it would be if a bank was willing to loan you the money to start a maximum over-funded life insurance policy.
Life insurance is the perfect collateral for a loan. It is principal-protected and the bank gets an assignment of collateral against the policy’s cash value (plus some outside collateral/letter of credit to cover the loan balance). If you default on the loan, their name is already on the policy. It is one of the most secure ways of lending for the bank.
With Premium Financing, we are going to look at using leverage to purchase the life insurance.
How Does Premium Financing Work?
Banks will happily loan you money to pay for life insurance premium in a maximum over-funded, high cash value policy, knowing that the cash value of the policy is the collateral for the loan that they make to you. Cash value is the perfect collateral for a loan. The bank gets an assignment of collateral against the policies cash value along with some outside collateral, so they don’t need to worry about foreclosing on the loan.
Ofcourse, there has to be a legitimate purpose for the life insurance death benefit. Remember, the primary reason for purchasing life insurance is the death benefit protection.
In this case, one needs to have a high net worth and income to justify the large death benefit and should be reasonably healthy.
But from an interest rate arbitrage perspective, it is all about the beauty of Simple versus Compounding interest.
Over time, the cash value of the policy would be much more than the amount of the loan principal. Compounding interest is the most powerful force in the universe.
Starting Insurance Amount: $5M
Goal: Tax-Free Retirement Income
Bank Funded Premiums: $100K Year 1 and Year 2, $201K Years 3-10
Out of Pocket: $200K Year 1 and Year 2. This is the only Out Of Pocket amount that the client ever puts in. The more the client contributes up-front, the better the policy would function in the long term. Other option is that the Client pays only the interest on the bank loan balance during the premium financing years.
Assumed non-guaranteed interest: 5.92%
The cash vlaue is compounding every year. In Year 17, we can use the cash value (Column 4) to pay off the loan (Column 6). It can be done earlier too. Now the policy becomes free and clear.
Potential tax-free income: ~$348K from Age 65 (Column 6) and could potentially sustain until the age of 120!
The beauty of this solution is that, after the loan is paid off, all the cash value is available to the client at any age to do whatever they want! Client now has his own “Bank”.
Which financial vehicle can generate ~$348K tax-free every year in retirement while the only out of pocket funding from the Client is $400K!
If the Client lives to age 100, he/she could have potentially taken out $16M tax-free and still leave behind $10M to their loved ones!
Win-Win-Win for everyone!
This illustration assumes all values shown are not guaranteed and continue in all years. This is not likely, and actual results may be more or less favorable.
This illustration is not valid unless accompanied by a full illustration. Please refer to the full illustration for guaranteed values and other important information.
If you would like to better understand the above example or if you would like us to run a scenario specific to your case, please feel free to reach out by Call, Email, SMS, WhatsApp, etc. by clicking on the widget blinking on the right of your screen.
Pros and Cons of Premium Financing
The beauty of Premium Financing is that you can put the bank’s money to work to build tax-free wealth and purchase large amounts of death benefit protection. The cash value grows with no risk of ever losing any money to the market fluctuations.
The catch is that you need to have income and net worth that are high enough to justify the amount of insurance and to afford the interest payments or a portion of it on the loan. If you are borrowing a million dollars at 5% interest, for example, your annual interest expense could be $50,000.
Leverage also increases risk.
Historically, Premium Finance programs have only been made available to people with a five to ten million dollar net worth or more. However, in recent years, programs have been made available for a class of individuals known as “emerging affluent”.
Another con is that the loans must be 100% secured. This means that if $1 of Premium turns into $0.85 of cash value, then the policy owner must have to have other assets to make up the other 15%. This can be accomplished with a letter of credit or an assignment of collateral. This highlights the need for a properly designed and maximum overfunded life insurance policy.
A very big “pro” that is often overlooked is the Disablity Protection like Critical, Chronic, Terminal Illness that the policy provides in the event that the client faces health issues. In this case, instead of tapping into their assets, they can now use the “Death Benefit” within the policy to take care of financial needs.
To overcome the potential “cons”, the policies we design use fairly conservative numbers.
The interest rate is the primary risk in premium financing. The loan rates are typically based on LIBOR plus a spread. Changes in the interest rate will mainly impact the interest payments on the loan or the required outside collateral.
People often mention the potential for a negative interest rate arbitrage as a risk. But, keep in mind that as long as we are comparing simple interest versus compounding interest, premium financing will still work even with a negative arbitrage. Again, compounding interest is the most powerful force in the universe. it may take longer for the cash value to surpass the loan balance, but it will eventually surpass.
Also, keep in mind that loan rates are a function of the Debt markets: Bonds, Treasuries, etc. So if interest rates rise, it will impact the cash value of the policy in a positive way too because the yields on the life insurance company’s investments will also rise.
Strategy 1 – One of the most popular strategies is to use the cash value to pay off the loan.
Strategy 2 – Since this is primarily applicable for High Net Worth individuals, outside assets can be used to pay off the loan. Eg. liquidity event like sell the company/get acquired, sell property, etc.
No Rendering of Advice: The financial content in this document is provided for your personal education. It is not intended for trading purposes, and cannot substitute for professional financial advice. Always seek the advice of a competent financial professional with any questions you may have regarding a financial matter. Information in this document is not appropriate for the purposes of making a decision to carry out a transaction or trade nor does it provide any form of advice (investment, tax, or legal) amounting to investment advice, or make any recommendations regarding particular financial instruments, investments, or products.
The primary purpose of life insurance is for the death benefit protection. Any other benefit is ancillary.