Premium Financing

From Wikipedia, the free encyclopedia

This article is an orphan, as few or no other articles link to it. Please introduce links to this page from other articles related to it. (February 2009)

Premium Financing involves the lending of funds to a person or company to cover the cost of an insurance premium. Premium finance loans are often provided by third party finance entity known as a "Premium Financing Company"; however insurance companies and brokerages occasionally provide premium financing services. [1]

To finance a premium, the individual or company requesting insurance must sign a premium finance agreement with the premium finance company. The loan arrangement may last from one year to the life of the policy. The premium finance company then pays the insurance premium and bills the individual or company, usually in monthly installments, for the cost of the loan.

Contents 1 Types of Premium Financing 2 Benefits 3 Dangers 4 Current Environment

[edit] Types of Premium Financing

• Traditional - The client enters a fully collateralized loan arrangement with the intention of holding the life insurance policy to maturity. Traditional financing arrangements are generally purchased for estate liquidity needs and offer the most advantageous loan rates, fees, and spreads. The client may have an exit strategy using other assets in the estate. Traditional finance is particularly effective for clients who have a large but illiquid net worth.
• Non-Recourse - A third party purchases insurance on the client and assumes the death benefit and premium payments. Non-recourse is not an acceptable life insurance sale in many circumstances due to a lack of insurable interest. Non-recourse transactions may pose hidden tax and liability risks to the insured.
• Hybrid - Partial recourse financing that is generally designed for a short time horizon (2-5 years). Hybrid financing is typically designed for an exit via the secondary (settlement) market. Loan terms may include substantial arrangement fees (up to 2% of the death benefit), large loan spreads, and a cut of the producer's compensation.

[edit] Benefits

There are a number of benefits to financing an insurance premium. [2] These include:

• Eliminates the requirement for a large up-front payment to an insurance company.
• Multiple insurance policies can be attached to a single premium finance contract, allowing for a single payment plan to cover all insurance coverage.
• Premium financing is often transparent to the individual or company insured. Brokers transmit the completed premium finance agreement to the premium finance company, and the policy holder is billed as they would be for any other typical insurance policy.
• Allows for clients to obtain needed coverage without liquidating other assets.

[edit] Dangers

Dangers of premium financing:

• Interest Rate Volatility Risk - Since the interest due on the money lent to pay premiums is tied to an index, usually the LIBOR (London Interbank Offered Rate) if interest rates rise, the total interest charge will rise as well. If the policy owner can't afford to pay interest payments then they stand to lose their insurance and be left with significant debt if the surrender value of the policy is less than the interest owed.
• Renewal Risk - The lender has the right to call the loan at the end of the term. Virtually all premium financing loans have terms of a duration less than the life of the policy.
• Carrier Credit Rating Risk - Financing terms are sensitive to the credit rating of the carrier holding the financed policy. Carrier downgrades may result in the lender choosing to not pay additional premiums and/or call the collateral for the loan.
• Crediting Rate Risk - Carriers choose the crediting rate of in-force blocks of business at-will. Current crediting rates are not guaranteed. As such, any illustrated arbitrage in interest rates between the policy crediting rate and the loan interest rate may not exist in the future.
• Credit Spread Risk - Life insurance carriers and premium finance lenders use the same fundamental financial instruments. Carriers fund insurance contracts with corporate debt. Lenders provide liquidity at personal debt rates. Corporate debt yields are less than personal debt rates. As such, premium financing is necessarily a negative spread for the client financing the premiums. There is no historical support for a long-term positive arbitrage between a loan rate and a life insurance contract.
• Collateral Risk - Most premium financing arrangements that are designed to provide liquidity to the client at death are 100% collateralized. In most cases, the client must either post a Letter of Credit (LOC) or hard assets to satisfy collateral. Collateral requirements may vary with economic conditions and could force the client to liquidate positions in order to post collateral. Furthermore, a decrease in the value of collateralized assets (such as real estate or securities) may force additional collateral.
• Settlement Risk - Some premium financing programs are sold under the assumption that the policy will have a substantial market value at the end of the term. The client can then exit financing arrangement and realize a gain on investment. The secondary life insurance market is highly volatile. Settlement offers will vary with the interest rate environment and the degree to which capital will "wait" for a return.

[edit] Current Environment

Premium financing arrangements are currently under intense pressure. Lenders often obtain capital from hedge funds and private sources, which are particularly sensitive to convulsions in the credit markets. Many lenders have ceased financing or added substantial fees to new programs. In-force financed policies are being called for collateral in large numbers. Clients who are "underwater," where the loan balance exceeds the policy cash value, are being forced to post additional collateral at low risk-weighted rates and/or surrender the policies and pay the outstanding loan balance out of pocket. Additionally, several carriers who were active in the financing marketplace have been downgraded, causing large-scale exchanges or surrenders from in-force policies.

Hybrid arrangements that planned for a settlement exit are also coming undone. Settlement investors are severely discounting financed policies, especially from carriers with falling credit ratings.