In the interest of building newer and sexier ways to entice you to buy life insurance, agents and marketing organizations think it would be great if you could use the extra purchasing power of a bank's money to make the policy you can buy even bigger! The idea is something like this, buying more life insurance gives you even more cash value. So if you borrow money from a bank and use the money to buy an even bigger policy, you can activate your savings plan with even bigger pot-o-money with OPM – other people's money.
This is not a particularly new concept. Premium financing originated decades ago and a select group of rich people used it as a way to buy life insurance – at a discount – they had to pay transfer tax. But as Congress and several states cut taxes levied on a death, the life insurance industry's sales arm needed new ways to continue selling life insurance, so they decided to take leveraged life insurance purchases for a spin.
This led to imaginative presentations that promised great results for the smart and special enough to borrow lots of money and plan their retirement as Rockefellers. We expressed doubts about the profitability of such a plan as early as 2015. But anytime there is money to be made – and there is a lot to do here – details like the huge risks you take when you borrow money to buy more life insurance than you normally had advice are minor annoyances and we need to bury them during a flood of meaningless facts and figures used to obscure online retrieval.
I always wanted premium financing to work
I think some people think I hate premium financing. That I want it to die in a fiery accident that is only competed by Hindenberg. Not true. I actually long for unique solutions to problems and I welcome out-of-the-box thinking. I'm the guy who once said, "I want to start a blog that talks about how people can tactically accumulate personal wealth with life insurance."
There is also money to be made with premium financing. A lot of money. We will read more about how much a little later in this article.
For several years I have tried to get premium financing to work in a number of different scenarios. For most of them … it just does not. This is not because there is never a situation that justifies the strategy. This is because there are simply not as many situations that justify premium financing as the answer to a current problem. It does not make it good, bad or anything in between. That's just the reality.
More people want to sell it than there are people who can buy it
Unfortunately, we are in a situation where there are more insurance agents who want to sell a premium funded case than there are people who actually fit the fact pattern that qualifies them for such a plan. Premium-funded life insurance candidates are, I can assure you, a very rare breed. And finding someone in such a situation for whom you can solve a problem with the strategy gives you a beautiful pay day. I do not dislike the wealth an agent can get through premium financing when it makes sense to finance the premiums. There is a LOT of work involved, and I will argue quite strongly that said agent will earn every last dollar he / she receives.
But whenever there are huge payouts, there is an incentive to look hard for factual patterns that fit the bill for premium financing – and maybe just relax the guidelines for who exactly fits perfectly and who does not.
When middle-class professionals with a very low portfolio of seven figures – or less – start showing up at various personal finance forums and ask for guidance on life insurance financing premiums because their "financial advisers" only suggested it to them, we know that someone came past the watchtower.
Stress testing of the idea
I decided once again to give premium financing in its recently taken fashion a sixth time to win me over. I gathered some information about a typical situation to see what it can provide and how it would be compared to what other alternatives may be available for someone in the same situation. The details are:
A man, 45 years old, will borrow $ 150,000 a year for ten years and use the money to pay life insurance premiums. He will pay the debt borrowing costs for the bank loan. This means that he pays the interest on the loan and all other fees that the bank assesses. I used the insurance company's own software to estimate interest rates and banks' lending fees – they should know better than I do what is reasonable and common.
To give life insurance the best possible start for premium financing, I also chose an indexed universal life insurance with the highest possible indexing credit available.
I set the scenario for the insured / borrower to borrow for 10 years and then designed the life insurance policy so that it did not require a premium from year 11. I originally wanted the life insurance to pay the bank in year 11 but it turns out that would destroy the life insurance policy so I decided to let the loan exist for another ten years before the life insurance policy started paying the bank. I gave the insurance policy five years to achieve this goal – in other words, the life insurance policy starts repaying the bank loan in 20 and ends the payment of the bank at the end of year 25, here is a snapshot of the general ledger:
The year immediately after the payment by the bank, this policyholder now owns life insurance without bank income. But he has an outstanding insurance loan that is used to repay the bank. This is a fairly typical scenario used for premium financing, and the idea is that the loan will never grow to a point where it threatens a policy maturity. This general ledger confirms this – provided that the assumptions are correct and that this policy continues to earn 6.18% annual index credit and the insurer never increases the cost of the policy.
The cost of this policy was $ 1,260,000. This cost is the cost of paying the debt to the bank, and you can see the distribution of this in this screenshot:
Note that the policyholder has $ 1,472,843 in cash value and a death benefit of $ 3,439,514. These are net figures so they assume that the currently outstanding loan on the policy will be repaid. These figures are what is left after repaying the loan.
So the borrower borrowed almost $ 1.6 million and paid out $ 1,260,000 to arrive at just under $ 1.5 million in cash and just under $ 3.5 million in death benefits. His cost base is gone, as he exhausted the repayment of the original loan – a total of $ 1,726,662 in repayments of loans from the policy.
A gain on the cash value is achieved, but it is quite small. I calculate the compound growth rate using the out-of-pocket cost and the net cash value in 26 to 1.06% … how exciting …
So why would anyone else be able to use life insurance to build wealth? Glad you asked.
An alternative method of financing the premium
The individual in this example will pay out $ 1,260,000 – it is inevitable. So let's smooth it out over the same period and just buy a regular life insurance policy – without the luxury leverage part – and see what happens. This creates the following policy:
Please note that we start with a much lower death benefit and a lower cash value amount – we still pay a lower premium. But when we get to the year that the funded policy pays off for the bank, we have $ 1,355,779 more in cash value and $ 202,731 more in death benefits. Financing the premiums fails miserably against the non-funded scenario to create additional wealth through cash value and it even fails to come to the top with the death benefit – an area that is assumed to be its strength.
But wait … there's more!
Since many agents describe this idea as a way of overburdening retirement preparedness, I thought it was only fair to look at how these two scenarios stack up against each other when it comes to retirement income. So I decided to solve the maximum income scenario from 75 years to 100 years. Here are the general ledgers that show that scenario:
Premiere-financed income scenario
Non-financed income scenario
You read this correctly. The funded version provides $ 100,404 per year while the non-funded version provides $ 243,384 per year. That's an increase of $ 142,980 when you do not bother to borrow from the bank. Remember that out-of-pocket is the same in both scenarios. The underlying life insurance assumptions are the same in both scenarios. The same company, the same annual index credit, the same everything else except the financing part. Buying more life insurance does not create more benefits … yes at least not for the policyholder.
There is money to be made
I mentioned earlier that there is a serious financial incentive for premium financing. Mission? Oh yes, mission. But first, let's talk about the incentives for the bank. If you have not already done so, take a moment to list all the income that the bank generates in this scenario. The interest it collects while lending "OPM" to the policyholder who thinks he has orchestrated a major quarrel to enrich himself with "OPM." The bank's draw amounts to a total of $ 1,486,662. Not bad. And all the while, the bank had a 100% collateral asset – it is a non-negotiable provision of premium financing.
Commissions earned by the agent. They are not bad either.
Let us first talk about the commissions earned by the non-funded policy. I estimate they are about $ 27,000. Certainly nothing to sneeze at. But the funded version of this is all this and then a little. I estimate the premium-funded commissions at $ 64,685 – also known as more than twice as much as the second option. Boy how would that not be a nice pay raise.
I understand that the financial dividend is possible with premium financing. That's why I've spent countless hours over the last half decade trying to come up with a scenario that reasonably made sense. I continue to fail to achieve this goal. So I do not attack the idea because I have some strange personal beef with it. I would be more than happy to benefit from it financially. But I can not in good conscience give recommendations like the next million less in lifetime value, just to earn several 10 thousand dollars more on a client. Not everyone agrees with me on this.