• Third-party premium financing enables individuals to secure a life insurance policy without paying large upfront premiums, enabling them to invest the funds elsewhere. 
• The policy is typically owned by an Irrevocable Life Insurance Trust (ILIT), though it may also be owned by a business or the individuals themselves.
• The borrower is responsible for paying ongoing loan interest to maintain the outstanding loan, with the assumption that the loan will be repaid with the policy’s cash value or other means.

Third-party premium financing enables one or more individuals to secure a significant life insurance policy without paying large upfront premiums. This approach preserves capital and cash flow, allowing the policyholder to allocate funds for other investments. It also helps with gift tax mitigation as it reduces the required gift to the trust from the life insurance premium itself down to just the applicable loan interest each year (unless the interest is being accrued).  This is particularly useful for clients that have a diminished gifting capacity or want to preserve their gifting for other uses.  

Typically, a third-party premium financing arrangement utilizes an Irrevocable Life Insurance Trust (ILIT), which owns the policy on the individual(s), though the policy may also be owned by a business or the individuals themselves. 

In a premium financing arrangement, the policyholder secures a loan for the value of the insurance premium from an outside lender and is responsible for servicing the loan on an annual basis. The loan interest can either be paid in full each year or can be accrued and rolled up into the cumulative loan, which will be repaid in the future.

How third-party premium financing works

Third-party premium financing is commonly employed as an estate planning tool, though it may also be utilized to help meet some business needs. This financing option offers policyholders flexibility, which allows for lower up-front costs, better cash flow management and customizable terms. 

In financing a life insurance policy, an individual may be able to obtain significant life insurance coverage without needing to liquidate investments to pay the premium. The strategy may also enable individuals to allocate the funds that they would have used to pay premiums to higher yielding investments. When compared to traditional financing options, premium financing may lead to higher long-term costs and risks due to fluctuating interest rates.

If the policyholder passes away before the anticipated rollout, the death benefit will be used to remunerate the lender before the remainder is distributed to the beneficiaries. Otherwise, the cash value of the policy can be used to repay the loan. In some circumstances, individuals may also wish to use a liquidity event, like the sale of a business or an inheritance to pay the loan.

To establish a premium financing arrangement, borrowers work with lenders—often specialized financing companies. The borrower acquires the insurance policy and assigns it to the lender as collateral. The insurance carrier coordinates with the lender for payment.

The loan amount usually corresponds to a series of annual premiums. Interest rates on the loan can be either fixed or variable, with the exact rate depending on factors such as the loan amount, the borrower's creditworthiness, and the assets posted as collateral. 

The rate is usually tied to the Secured Overnight Financing Rate (SOFR) plus a certain spread, which is determined by the lender. Loans are made on a schedule, often in periodic installments that align with insurance policy due dates. The loan term can vary and may be tailored to the borrower's needs.

Mapping a typical premium financing arrangement

The chart below illustrates a typical premium financing arrangement. In such a scenario, the steps would be as follows:

1. The insured individual pledges assets as collateral for the loan.
2. The lender pays the loan to the ILIT for the life insurance premium.
3. The life insurance premium is paid to the insurance carrier by the ILIT. 
4. Once the premium is paid, the policy is issued to the ILIT. At this point, the carrier assumes responsibility for paying a death benefit on the insured individual. 
5. Each year, the insured individual pays annual gifts to the ILIT for loan interest.
6. The ILIT is responsible for paying interest to the lender until the loan is repaid.
7. Once the insured passes away, the ILIT pays death proceeds to heirs.

Policy ownership 

The most critical element of any premium financing arrangement is a sound exit strategy. Repayment of the loan can take a number of forms: 

• If the policyholder passes away before the loan is repaid, the death benefit will be used to pay back the third-party loan. 

• Because it is unlikely that policies taken out on younger individuals will pay a death benefit in the near term, the cash value of the policy may be used to repay the loan. 
• A Grantor-Retained Annuity Trust (GRAT) may be implemented. Here, assets in the GRAT provide the grantor with a series of annuity payments. At the end of the GRAT term, the remaining interest is received by the beneficiary, usually an ILIT, and can be used to repay the outstanding loan while minimizing the gift tax consequences. 
• A liquidity event, such as an inheritance or the sale of a business, can also be used to repay the third-party loan. 

Exit strategies

The most critical element of any premium financing arrangement is a sound exit strategy. Repayment of the loan can take a number of forms: 

• Older individuals in their 70s and 80s can potentially use the death benefit as the means to pay back the third-party loan. 
• Because it is unlikely that policies taken out on younger individuals will pay a death benefit in the near term, the cash value of the policy may be used to repay the loan. 
• A Grantor-Retained Annuity Trust (GRAT) may be implemented. Here, assets in the GRAT provide the grantor with a series of annuity payments. At the end of the GRAT term, the remaining interest can be used to repay the outstanding loan while minimizing the gift tax consequences. 
• A liquidity event, such as an inheritance or the sale of a business, can also be used to repay the third-party loan.  

Additional considerations

Collateral requirements

In a premium financing arrangement, the policy must be 100% collateralized, meaning the policyholder needs to provide sufficient collateral to cover the loan amount. The policy's cash value can be used to offset this requirement, but any additional collateral needed must be provided by the individual. High-early cash value riders can be added to the policy to further reduce the collateral needed (although this can cause a drag on policy performance).

Various forms of collateral are accepted in premium financing arrangements, including, but not limited to:

• Cash or cash equivalents
• Securities (may result in a discount in the value of the securities by as much as 50%)
• Letters of credit
• Personal guarantee
• In-force life insurance policies
• Income-producing real estate (limited basis)

Potential risks

Premium financing arrangements do come with several potential risks:

• Interest rate risk: Fluctuating interest rates can impact the loan cost
• Refinancing risk: Lenders may not offer refinancing when the initial loan term ends
• Duration risk: The arrangement could last longer than expected, delaying repayment
• Adverse policy performance: Additional collateral may be required if the policy does not perform as expected
• Negative arbitrage: For premium financing to be successful, the rate of return on the investments made by the policyholder must be higher than the loan cost. If investment returns are suboptimal, the policyholder could owe more than the cost of the insurance premium. 

Insurance product selection

The life insurance product used in a typical premium financing arrangement should have at least some cash accumulation, so products that cater towards guarantees and ones with a small amount of cash value typically are not appropriate. Both individual and survivorship policies are able to be financed.

• Indexed universal life policies can build significant amount of cash and can offer flexibility not just in the funding of the policy but also the exit strategy if the cash value is utilized as the rollout
• Current assumption universal life generally does not build up as much cash as other insurance products
• Variable universal life typically not allowed in premium financing arrangements as lenders will not approve them for compliance reasons
• Whole life policies can offer guaranteed cash value but may be less flexible than other forms of insurance

Case study

Robert, age 45 and in good health, is widowed and has two kids.  As a real estate entrepreneur, he has amassed a significant amount of wealth and is concerned about potential estate taxes.  

Bob realizes that he needs life insurance, but has most of his money tied up in business dealings and is fairly illiquid. He also realizes that the life insurance policy will likely require a substantial gift to the trust (that will own the policy), but he has used up most of his lifetime gifting capacity.  Bob’s advisor mentions premium financing, which would address both of these issues.

Bob decided to apply for an indexed universal life policy* with $5,000,000 of death benefit coverage. The premium is $325,000 per year, paid for 7 years. The policy will be owned by his Irrevocable Life Insurance Trust (ILIT). 

Bob secures funding with a third-party lender with an initial loan rate of 4%, increasing by 8 basis points each year**. In Year 1, the ILIT is responsible for $13,000 of loan interest, which Bob gifts to the trust. The trust uses these funds to pay the loan interest back to the lender.

With each subsequent premium, the outstanding loan and the annual loan interest increase. By Year 14, the loan interest is $112,840. However, in Year 14, the policy has sufficient cash value that the trust can take a withdrawal to pay back the entire loan to the lender. The policy then remains in the trust and does not require any additional funding under current assumptions.

* Assuming an indexed universal life policy at preferred nonsmoker rates with Lincoln National with an assumed crediting rate of 6.27%

** Loan interest is purely hypothetical and is subject to change given current economic conditions and case details