|Financing Premiums vs. Paying Cash
Which is better?
May 20, 2010
With the estate tax looming around the corner there is a need to review your client’s estate planning. As of publication, on January 1, 2011 the top federal estate tax for estates over $1 million ($2 million per couple) will be 55 percent. Many advisors recommend that clients purchase life insurance as part of their estate plan. This article will discuss the pros and cons of financing the premiums as compared to paying cash.
Premium financing is an alternative to paying cash when a client needs to purchase permanent life insurance coverage. There are generally five parties involved in a premium financing strategy:
Let’s review a recent case. The family had a net worth of $30 million and was advised by their CPA and estate planning attorney to purchase $15 million of life insurance inside their irrevocable life insurance trust. The husband was uninsurable, so we evaluated the pricing on the wife. The cost for $15 million of life insurance on a 71-year-old female was $348,041 per year. If the wife died in 20 years (age 91) the cost would have been $6.96 million, which would have resulted in a 6.85 percent internal rate of return (IRR) to the trust.
The second option reviewed with the client involved borrowing $5 million from a bank and paying it directly to the insurance company. In this option we added a return of premium rider to the life insurance contract, so if the client died in year one the family would still net $15 million after paying back the lender. The interest rate on the loan was 4.5 percent, so the client’s outlay at the end of year one was $225,000 (we accrued interest). The client in option 2 did not have to pay the $348,041 to the insurance company so they still had the $348,041 sitting in their checking account. In two years to 20 years, the trust will pay the lender $225,000 per year, so the cost is $123,041 less than paying cash of $348,041. That cumulative difference over 20 years is $2,685,820 to net the same $15 million to the trust. The IRR on option 2 is 11.46 percent if the wife dies in year 20 (age 91). This does not include the savings of $2,685,820. If the client dies at age 100 the IRR on cash is 2.53 percent and the IRR on financing is 4.98 percent. The cumulative savings of financing at age 100 is $2,662,753.
So what are the benefits of paying cash? First, it’s very simple. You do not have to go through a loan approval process. Second, there is not a need to post outside collateral need. In option 2 if the cash surrender value is less than the loan amount the family will have to post collateral. Collateral can be bonds, stocks, cash value of other life insurance or a letter of credit from a bank. With cash, the client does not have interest rate risk. However, in our case design the interest rate risk is offset or hedged by the $2,662,753 premium saving by financing the policy.
Financing a Policy
What are the benefits of financing a policy?
Note: There are other strategies to transfer the cash inside the trust, but they are beyond the scope of this article and would require additional structuring for the client’s advisors.
If your clients are purchasing permanent life insurance, premium financing should be an option presented to them. An ideal candidate for premium financing is someone who has a permanent need for life insurance and could afford the premium on a cash basis.
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Cory Chmelka, CFP, is managing partner and a founding partner of Capstone Wealth Management, LLC and heads the firm’s Risk Management and Financial Alliance Groups that services accountants, attorneys, trust officers & financial advisors. He is nationally known for his expertise in structuring and implementing advanced life insurance and estate planning strategies for high-net-worth (HNW) clients. Chmelka is a regular contributor for numerous industry publications, including the Journal of Accountancy, The CPA Journal and the Journal of Financial Planning. Prior to founding Capstone, he was a managing director of Cowan Financial Group; one of the largest privately held wealth management firms in the country.