What is Premium Financing, and Is It Suitable for You?

This was originally posted on Planner Bee.

Are you considering getting a new insurance policy but worried about the large single premium amount you must fork out upfront? Premium financing might be the answer to your concerns.

What is premium financing?

Premium financing is a type of insurance funding arrangement offered by financial institutions that allow you to be protected, but still enjoy financial flexibility. This is achieved by borrowing money to pay for your insurance premiums instead of paying them upfront with your own funds.

This arrangement is usually offered when a large single premium is required. Typically, that involves either one of these two types of insurance policies:

• Universal Life (UL) or Single Premium Whole Life Policy
• Single Premium Annuity Plan

It is important to keep in mind that premium financing is a credit facility and involves money borrowing. This will incur interest payments at a variable rate and can come with various risks including the risk of losing your rights under the insurance policy.

A closer look at how premium financing works

Let’s take a look at how premium financing works for a single premium UL policy.

Alan, a 40-year-old non-smoker, decides to get a US$1,000,000 single premium UL plan. The policy will grant him an estimated US$4,500,000 by the time he passes, allowing him to leave behind a legacy for his descendants.

The day one cash value of this US$1 million policy is valued at 80% of the policy, which amounts to US$800,000. For premium financing, banks can lend up to 90% of the day one cash value, which amounts to US$720,000 in this case.

For Alan, this means instead of forking out US$1,000,000, he only needs to pay US$280,000 to secure the single premium UL policy. However, the cash surrender value of Alan’s insurance policy becomes the collateral for the loan. The bank that gave the loan will become the main beneficiary of the policy.

In most premium financing cases, Alan will pay off the monthly interest from the loan until the policy is paid out. When Alan passes on, the bank will receive the estimated payout of US$4,500,000. The sum is used to net off the initial loan of US$720,000, and the remaining amount is then paid out to Alan’s estate.

Benefits of premium financing

The biggest benefit of premium financing is the better management of high-net-worth individual’s (HNWI) assets and cash flow. It also allows HNWIs to leverage their assets and preserve their capital for other uses.

By leveraging on the financing from banks, these HNWIs do not need to fork out a large sum of money upfront to finance their UL policies or annuity plans. Instead, the cash can be invested into funds with better returns, and a part of the returns is used to pay the interest incurred from premium financing.

For example, assuming the interest rate for Alan’s premium financing to be 1.2% per annum, the actual yearly cost of using this arrangement will set him back US$8,640.

To cover this cost, Alan can invest the amount (US$720,000) he saved from paying this UL policy upfront into a low-risk fund that yields an average of 3% per annum. This gives Alan US$21,600 in investment returns annually, which covers the loan interest and still gives him a US$12,960 profit.

Additionally, most of these HNWIs also have their money locked in real estate or assets that have lower liquidity. Using this financing model, they can purchase high-premium policies without liquidating their assets.

Risks of premium financing

Despite these potential benefits, it’s essential to be aware of the risks associated with premium financing. One of the biggest worries is the interest rates associated with the loan.

Borrowing funds to finance the policy involves interest costs. Interest rates can be volatile and are largely dependent on the global market economy. Should the return on the invested capital be lower than the interest rate on the loan, this strategy will not be financially beneficial.

There are also market risks involved. Should the investment portfolio not perform as expected, it may not generate sufficient returns to cover the borrowed amount and interest costs. It could take more than 10 years for the policy to break even, making it difficult for HNWIs to surrender the policy even if it is underperforming.

Additionally, taking up premium financing can cause one to have a weakened Total Debt Servicing Ratio (TDSR). In Singapore, a person’s total monthly debt obligation, which is a combination of all of their loans including housing, car, and other miscellaneous personal loans, must be less than 55% of their gross monthly income.

Taking up premium financing means they will hold on to the loan as long as the policy is in force, which could be for life. This could impact their ability to apply for other loans in the future.

Questions to ask before deciding on premium financing

Premium financing, if done well, can potentially be a great way for you to grow your wealth while being sufficiently protected. However, there are some questions you should ask yourself before using this arrangement.

1. Are you planning to take up more loans in future?

When you take up premium financing for a policy like Universal Life, you are most likely going to be financing this debt for life. Therefore, with a weakened TDSR, it could be trickier for you to take up new loans in the future.

So if you have plans to take up another loan soon, especially to finance something big like a housing loan, premium financing might not be the best option for you.

2. Does the risk of volatile interest rates bother you? Can you stomach these risks?

The interest rates for premium financing are not fixed and can fluctuate depending on market conditions. You need to be aware that your projected receivable amount may be lesser, or in the worst case scenario, suffer a loss, should interest rates rise. This should be a risk that you are prepared for before taking up premium financing for your policies.

3. Do you have sufficient cash to pay for the interest incurred?

Failing to repay the premium financing loan can lead to the cancellation of the insurance policy, potentially exposing you to financial risks.

Before considering premium financing, it is advisable to consult trusted financial advisors to evaluate whether this strategy aligns with your specific financial goals and risk tolerance. If you require more information about premium financing, feel free to drop us an email at [email protected] today!