Free life insurance or a disaster in waiting; those outcomes are the extremes but somewhere in between may be a well thought out and effective use of leverage. No advisor promotes an impending disaster, but our clients HAVE been presented “free” life insurance. As with many intricate life insurance presentations to wealthy families, promoters too often project optimistic scenarios tending toward best case without adequate consideration of the complexities, risks, and consequences thereof. Premium financing proposals require several assumptions projected over long periods of time, leaving room for material deviations from reality. Highly favorable outcomes are possible but not without risks that should be planned for to avoid potential disasters.
The overly optimistic presentation: You could use someone else’s money (borrow) at historically low interest rates, to fund a large trust-owned life insurance policy. New life products will allow you to achieve returns commensurate with the S&P 500 (or some other market index) without downside risk. If the index is up, your cash value is credited with the return of the index capped at a maximum of 12% (varies by product). If it is down your return is 0% (varies by product) – you cannot lose money. We have back tested the product over 20 years including 2008-2009 resulting in average returns exceeding 8% (varies be product). Historically, the crediting rate on cash value exceeds the borrowing rate (fixed spread above LIBOR or some other benchmark) by more than 4 percentage points. You will have to post collateral in addition to the policy in the early years when cash value is not yet equal to the loan plus accrued interest. Over time as the cash value and death benefit grow, your collateral will be released and then your trust will withdraw from the cash value, enough to bay back the loan plus accrued interest. In the end, your family’s trust will have $50,000,000 of life insurance requiring no further premiums without any cash outlay (free!). There are no gift tax consequences because there are no gifts unless you decide to fund some of it yourself.
Worst Case: Five years into the plan, your trust has borrowed $20,000,000 of the $45,000,000 total anticipated premiums. Market returns and cash value growth have languished at or below the average borrowing rate in an increasing interest rate environment. Though told you could not lose money, your cash value has declined due to ever-growing internal charges while interest was credited at 0% due to negative market returns. To add insult to injury, the insurance company has reduced the maximum crediting rate on cash value from 12% to 6% (yes, they can do that) dimming the prospects of a turnaround and the bank decided they are no longer lending to finance life insurance premiums. You can’t walk away because you already posted $7,000,000 of collateral which would be forfeited along with the insurance policy, to repay the lender. The collateral lost would now be a deemed gift with potential gift tax consequence. Unsavory choices may include, posting additional collateral, paying off the loan with other assets, paying future premiums to cap the debt, or some combination thereof. Paying off the loan or paying premiums may require unanticipated taxable gifts (not free!)
Outcomes are probably somewhere between these extremes. It is possible that a favorable spread may exist between cash value crediting rates and borrowing rates, depending on the timing of the transaction and a number of other favorable variables. For the client who could otherwise afford and is considering a large life insurance purchase for estate planning or other reasons, understands and is willing to take risk, but believes returns on other investments will dramatically exceed the internal rate of return inherent in life insurance, financing may be a highly effective alternative. However, in our view, financing should not be implemented without a well devised exit strategy to pay down the loan in the event the economic advantage is lost. This typically requires coordinating the plan with other estate planning.
Other minimum criteria should include (approximate):
- $10 million of net worth
- Sufficient liquidity to meet collateral requirements without impacting lifestyle
- Credit worthiness
- Minimum loan amount aggregating $1,000,000
We at Mazars USA Wealth Advisors, are skeptical of some of the big promises being made by others, but we do believe that a cautious approach presents an outstanding opportunity to implement these plans and enjoy an economic advantage, at least for some period of time. If your financial, business or estate plan could benefit from the use of life insurance but you believe your capital is better deployed elsewhere, talk to us about how properly structured premium financing might work for you.