For affluent people who don't want to liquidate other assets to pay for life insurance, borrowing funds from a third party to cover the cost of a policy and paying it back in installments -- a practice called premium financing -- can seem a practical solution.
But financial planners warn that such a strategy is vulnerable to abuse -- and the elderly in particular need to be wary of it.
How it worksA good prospect for premium financing might be someone who is still working and needs life insurance, but is not ready to liquidate his assets. For example, let's say Sam, age 67, wants to leave a legacy of $5 million to his wife and children. His business is worth a couple of million dollars, but he's not ready to sell it.
The premiums for a $5 million universal life insurance policy for a healthy 67-year-old would run about $100,000 per year, says Nicholas Gnad, managing partner of Beachwood Financial Group in Aventura, Fla. Rather than pay that in a lump sum, Sam might take out a premium finance loan, either from a premium financing company or, more rarely, from an insurance brokerage.
"It's no different from any other type of borrowing," Gnad says. "Premium financing allows very wealthy people whose assets are illiquid to borrow at a rate close to the Libor (London Interbank Offered Rate)."
However, though Libor rates are currently low and may stay low for awhile, they are subject to interest rate changes. From this level they would invariably rise.
Gnad says one advantage is that a universal life insurance policy accumulates value and will therefore become an income-producing asset.
"For example, the policy can be used as collateral for a bank loan," he says. "When you have a premium financing structure, if you die before that loan is repaid, the bank can attach the cash value or receive a portion of the death benefit, up to the loan balance."
Premium financing is a legitimate way for someone who needs a large amount of life insurance with a big premium to find ways to buy it, says Ellen Siegel, principal of Ellen R. Siegel & Associates, in Coral Gables, Fla.
"It's often a business deal, where a key person has to be insured for borrowing purposes," she says. "But it has risks."
Potential problemsFor example, there's renewal risk. Because most premium financing contracts have terms less than the life of the policy, they have to be renewed periodically, requiring refinancing.
For someone like Sam, that opens up the potential for the loss of other assets. "It used to be the loans were nonrecourse, meaning they couldn't attach any of your other assets," says Mark Kennedy, president of Kennedy Wealth Management, in Woodland Hills, Calif. "That has pretty much gone away. If at the end of five years the loan lapses, the lender can come after personal assets. It can get nasty."