A premium-financed insurance policy is a financial strategy that involves using borrowed funds to pay for the premiums of a life insurance policy. High-net-worth individuals and business owners often utilize this strategy to obtain substantial life insurance coverage without having to tie up a large amount of their capital. 

The benefits of premium-financed insurance policies

Premium-financed insurance strategies are popular for several reasons:

1. Leveraging capital: One of the primary reasons for using this strategy is to leverage borrowed funds to acquire a more extensive life insurance policy than would be possible with just the individual's capital. This allows individuals to maximize the potential benefits of their life insurance coverage without tying up a significant amount of their own money.
2. Gift tax mitigation: For individuals with a limited gifting capacity or those who want to preserve it, premium financing can reduce the size of the potential gift from the premium amount itself down to the applicable loan interest on the outstanding loan in any given year. This assumes that the policy is owned inside of an Irrevocable Life Insurance Trust (ILIT).  
3. Estate tax mitigation: For individuals with substantial estates that could be subject to estate taxes, a premium-financed insurance policy can provide a way to create liquidity that can help heirs pay any estate taxes owed without having to sell other valuable assets, such as property or businesses.
4. Wealth accumulation: The cash value component can grow over time depending on the policy's structure and performance. This growth potential can attract individuals looking for opportunities to accumulate wealth.
5. Business succession planning: Business owners often use premium-financed insurance policies to plan for the smooth transfer of their business to the next generation or key employees. The death benefit from the policy can provide a source of funds that can be used to facilitate the business transition.
6. Interest rates: When interest rates are low, borrowing money to fund insurance premiums can be more attractive. The cost of borrowing is lower, which can make the strategy more feasible and potentially reduce out-of-pocket interest expenses.

It’s important to note that this strategy is not just for the ultra-wealthy. Premium financing gained popularity when interest rates hit historic lows a few years ago. However, as interest rates are on the rise, it’s become imperative for clients and their advisors to evaluate the risks of this strategy. 

How does a premium-financed policy work?

Here's how a premium-financed insurance policy typically works:

1. Life insurance policy: The individual purchases a life insurance policy, such as a universal or whole life policy. These policies have a cash value component that can grow over time.
2. Borrowing funds: Instead of paying the premiums out of pocket, the policyholder borrows funds from a third-party lender, often a bank or a specialized finance company. These borrowed funds cover the insurance premiums.
3. Collateral: The policyholder typically uses the insurance policy's cash value as collateral for the loan. This collateral provides security to the lender in case the policyholder cannot repay the loan. For any amount of collateral not covered by the policy cash value, the individual would have to post personal assets to make up the difference.  
4. Interest payments: The policyholder is responsible for paying the interest on the borrowed funds. The interest could be accrued in some cases, but this does affect the overall structure and exit strategy.  
5. Policy cash value growth: The insurance policy's cash value grows over time, and some or all of this growth can be used to offset the interest payments and/or pay off the outstanding loan at some point in the future. In some arrangements, the cash value can also be used as a source of income, although it depends on the structure and ownership of the arrangement.  
6. Exit strategy: The policyholder generally plans for an exit strategy to repay the loan by utilizing the policy's cash value or selling other assets like a business. The ultimate goal is to repay the borrowed funds while maintaining the desired life insurance coverage. Aside from utilizing the policy cash value, a Grantor Retained Annuity Trust (GRAT) is another viable exit strategy.  A GRAT is an irrevocable trust that allows an individual (the grantor) to transfer assets into the trust while retaining the right to receive an annuity payment for a specified period. The annuity payment is determined at the creation of the trust and is typically a fixed percentage of the initial trust value. Once the term of the GRAT is up, the remaining assets are distributed to the ILIT that holds the financed life insurance policy.  This provides the ILIT with a source of funds to pay back the outstanding third-party loan. 

Qualifications for premium financed insurance policies

Qualifications for a premium-financed insurance policy can vary depending on the insurance company, the lender, and the specific terms of the policy and loan agreement. However, there are some standard qualifications that individuals need to meet: 

1. Insurability: To qualify for any life insurance policy, including premium-financed ones, the insured individual must meet the insurer's underwriting requirements. This involves assessing the individual's health, age, medical history, and sometimes lifestyle factors like tobacco use and avocation.
2. Net worth: Premium-financed insurance policies are often designed for individuals with high net worth, as they involve borrowing significant amounts of money to fund the premiums. While there's no strict definition of "high net worth," individuals with assets of at least five million are more likely to be considered suitable candidates.
3. Creditworthiness: Since premium-financed policies involve borrowing funds, individuals must demonstrate good creditworthiness to secure the necessary loans. Lenders will likely assess the individual's credit history and financial stability before approving the loan.
4. Financial planning: Individuals interested in premium financing should have a comprehensive financial plan, including an understanding of their cash flow, assets, liabilities, and overall financial goals. 
5. Ability to repay the loan: Lenders want assurance that the policyholder can repay the loan. This often involves demonstrating sufficient income and assets to cover interest payments.

The risks of premium-financed insurance policies

Using a premium-financed insurance strategy has several potential risks that individuals must consider carefully before pursuing this approach. 

1. Interest rate risk: If interest rates rise significantly over time, the cost of borrowing can increase, leading to higher interest payments and affecting the overall affordability of the strategy.
2. Policy performance risk: The insurance policy's cash value is crucial to premium financing. Suppose the policy's investment returns or underlying performance do not meet expectations. In that case, the policy's cash value might be insufficient to be able to utilize as a possible exit strategy, or the anticipated rollout may have to be delayed for a few years. In some instances, there is the risk that the policy could also lapse without value.
3. Long-term commitment: Premium financing typically involves a long-term commitment and sometimes could span decades. The individual's financial situation and goals could change over time, potentially making the strategy less suitable.
4. Refinancing risks: Depending on the loan terms, a lender may require that after a set period, the loan must be refinanced. If the original lender decides not to let the borrower refinance, they must find another lender to take over the arrangement.

Given these risks, individuals considering a premium-financed insurance strategy should conduct thorough due diligence and seek advice from experienced financial professionals, including insurance advisors, estate planning attorneys, and tax experts.