A major Hollywood producer—you’ve seen the movies—needed $7.5 million of life insurance for liquidity at death. Now in his 70s with considerable wealth in real estate and film rights, the client had already consumed his $1 million lifetime gift-tax exclusion. His annual exclusion gifts were spoken for, too, explains Los Angeles wealth manager Nicholas Stonnington, president of the Stonnington Group LLC. Therefore the producer would have to pay gift tax on the $250,000 annual premium, given that his heirs or a trust benefiting them would own the policy to keep the death benefit proceeds out of his estate.

Instead, the client chose to lend the money to an irrevocable grantor trust, which then used the cash to buy the insurance. “That is not a gift,” says Stonnington. At the client’s passing, the trust will use some of the death benefit to repay the loan to the estate, plus interest accrued at the Internal Revenue Service’s Applicable Federal Rate.

For decades, premium financing, whether utilizing an intrafamily loan (sometimes called private financing) or one from a commercial lender, has quietly helped affluent clients reduce the gift taxes associated with removing life insurance from their estates, says attorney Lawrence Brody, a partner at Bryan Cave LLP in St. Louis. There is also the possibility of an arbitrage for the client. Policy returns might exceed the borrowing rate.

But wrong-way changes in interest rates, poor policy investment performance, or a too-long-lived client can turn this strategy upside-down, says Charles Aulino, director of financial planning at Glenmede Trust Co. in Philadelphia, who has considered this sophisticated transaction for several clients but never actually implemented it. “We were particularly concerned about rising interest rates a few years ago,” Aulino says.

Indeed, adds Stonnington, “You have to work whether the family is likely to gain more from the insurance than its cost plus the cost of borrowing, figuring in all the tax consequences. Premium financing is all math.”

This sleepy planning niche gained visibility early in the decade when clients could borrow for a song. “Before the Fed started raising interest rates,” Brody says, “a number of clients lent their trusts all the premiums they thought would ever be due, to lock in a low rate. Those who didn’t have the cash to do it intrafamily borrowed from the bank.”

Now rates are down from their 2007 peaks and savvy wealth advisors are again mulling the technique for their insurable clients. In December, the mid-term AFR for related-party transactions was a slender 4.13%, while 1-year LIBOR, to which commercial floating-rate loans typically add between 75 and 300 bps, swam below 4.50%.

Advising about premium financing starts with overcoming two frequent misconceptions. One is that premium financing is just for the older crowd. Not true, says Mark Storms, an assistant vice-president at A.I. Credit Corp., the premium-financing arm of AIG and reputedly the largest player in the field. “We do a good amount of business below 60 years of age,” Storms says.

There is also confusion between traditional premium lending and stranger-owned life insurance, a controversial new technique that often involves borrowing. The sidebar, “What It Isn’t,” differentiates the two.

Complex To Advise
Mixing a high-dollar insurance contract with taxes, financing, and client objectives makes for a unique transaction every time. “There is no one way to do premium financing,” says Brody.

You’ll need to work with the client’s attorney, who drafts out the insurance trust and prepares the loan documentation for private deals or reviews the commercial lender’s agreement. Experience is critical here, because if the trust isn’t drafted properly, the death benefit could wind up in the insured’s estate – probably not the desired outcome.

But it all starts with the insurance producer who establishes a need for coverage. Estate liquidity and business succession are common objectives. What about endowing the family office?

One couple in their early 70s wanted to ensure that after they passed their descendants wouldn’t have to shoulder the cost of the FO, says Mike Cohn, who advises on family wealth issues as managing director of CFG Business Solutions LLC, in Phoenix. To achieve this, $50 million of second-to-die variable insurance was purchased on the parents’ lives by an LLC owned by the adult children. This policy’s $400,000 annual premium was based on a 15-year horizon and funding at a level that just covered the death benefit.

Meanwhile a $30 million policy was purchased on the couple’s 38-year-old daughter. Here, the smallest death benefit was chosen. But this policy was aggressively funded with $1.5 million annually in order to build significant cash value over the next 15 years – after which time it can be borrowed against or withdrawn to pay the premiums on the parents’ policy until they are both deceased. Ultimately, a portion of the death benefits will have to go toward paying off a recourse loan to Northern Trust that effectively financed the purchase of both large policies. The remaining proceeds endow the family office.

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WHAT IT ISN’T

"Some wealth managers and clients think all premium-financing programs involve stranger-owned life insurance (SOLI), and that is not the case,” says Ted Bernstein, president of Life Insurance Concepts, a full-service insurance agency that specializes in premium financing in Boca Raton, Florida. Traditional financing differs markedly, beginning with its premise that the applicant has a bona fide need for the insurance.

Lenders in the traditional space don’t take an ownership interest in the policy, only a collateral interest. They don’t look to participate in the death benefit beyond being repaid their due. Nor do they ask to share in any profits the client may reap from selling the policy later because it is no longer needed. (Estate tax repeal, anyone?)

Those tips may help advisors protect clients from SOLI-style lenders. Insurance companies, for their part, have recently introduced a new form, Statement of Client Intent, to ferret out applicants who are trolling for insurance they can sell in the life-settlement marketplace. Some questions on the form, such as, “Is your intent at the end of the financing term to sell the policy into the secondary market?” have obvious preferred answers.

Others are more cryptic. It’s fine to respond affirmatively to, “Have you considered financing this policy?” “No” can sometimes raises eye-brows. “They’re trying to catch situations where the agent tells the client to put the policy in force with his own money and then borrow starting with the next premium, as a way of getting around acknowledging to the carrier at inception that the insurance is financed,” Bernstein says. Applicant, owner and agent sign the Statement of Client Intent.

Despite the advent of SOLI, carriers remain enthused about clients financing policies when appropriate, Bernstein says. Indeed, some insurers now publish lists of approved financing programs. "

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Borrow From Whom?
The next step for advisors is deciding whether it’s better for the family to lend money to the trust or for a third party lender to. From an income-tax standpoint, it generally doesn’t matter which. Interest on a commercial loan counts as investment interest that clients usually can’t deduct, says Cohn, while any trust would be structured as a grantor trust to eliminate income tax issues.

Some clients won’t borrow from outsiders. In these cases, “the lender is whoever in the family has cash,” says Brody. One of his clients who purchased $150 million of insurance owns a cash-rich private company. It is loaning the premiums to her trust, which will repay the business with death benefits. While the client is alive, she is making a gift of cash to the trust each year so that it can pay the company interest on the loan, Brody explains. But if her trust held other cash generating assets, this gift would not be necessary, he adds.

The primary cautions with family loans revolve around collateral. “If the insured takes back the policy as collateral from the trust using an unrestricted assignment, that is an incident of ownership which causes the death benefit to be included in the client’s estate,” Brody says. “The way to avoid this problem is either have the attorney use a restricted collateral assignment, or use other assets as collateral.” Variable life presents a separate issue for private as well as commercial loans. Federal Reserve Regulation U limits borrowing to 50% of the cash value of a variable policy taken back as collateral, since it is a security.

Going Commercial
Third-party loans make sense for clients who prefer not to liquidate assets or who seek to minimize their out-of-pocket costs for insurance. Here the terms are completely negotiable. Banks in particular predicate premium-loan terms on “the relationship with the client, or the potential relationship,” says Phoenix-based Rob Gardiner, senior credit officer for the Arizona/Colorado region of Northern Trust, NA.

Your clients shouldn’t have to settle for a loan riddled with borrowing expenses such as origination or set-up fees, says Alex Cano, executive vice president of A.I. Credit. Floating-rate deals ought to be free of prepayment penalties and offer renewal options at the end of the term, subject to the client remaining creditworthy, obviously.

The client will of course have to suffer loan underwriting. Expect to divulge tax returns, personal financial statements and the like, says Cano. A personal guarantee is often necessary; that’s what was used in the family office case described earlier. And collateral beyond the policy cash value, such as marginable marketable securities or posting a letter-of-credit, may be required.

When a fixed whole-life policy serves as collateral, Northern Trust’s Gardiner looks at the carrier’s financial health in addition to the client’s. Diversifying across several insurers? That shouldn’t be a problem “so long as the total collateral package is sufficient and all the carriers are highly-rated,” says A.I. Credit Corp.’s Storms.

Getting into a third-party loan is one thing. Getting out is another. From a planning standpoint, it’s vital to have an exit strategy at the outset in case circum- stances move against the client. Replacing the bank debt with an intrafamily loan is always one possibility. Or the client could pay off the bank with other assets that are in the trust. Cohn says, “We often put into the trust assets we expect to either create cash-flow or capital gains that can be used to repay the loan in the future.”

Brody offers a twist on that strategy. “The client can use the trust as the place to make annual exclusion or lifetime exemption gifts. This lets the trust accumulate funds to repay the lender,” he says.

Yet another way out is to fund a charitable lead trust. When the CLT assets revert to the family down the road, they can extinguish the loan.

Clearly there are beaucoup ways to skin the premium-financing cat—a planning animal with many moving parts. “It is dynamic,” says Stonnington. “The wealth manager must therefore constantly monitor the strategy to make sure it stays on track to meet the client’s objectives.”