It is well-known that the interest rate environment has changed dramatically over the past three years. Specifically, for those who took out loans that renew each year, the rising interest rates can be a sticker shock. This is especially true for those who purchased permanent life insurance and took advantage of favorable lending rates to finance a portion of, or all, of their policy premiums. Some policyholders may be finding themselves “underwater” in these transactions, where the lending rate on the premium loans exceeds by a little, or a lot, the performance of the policy’s cash surrender value.
Cedar Point Financial Services LLC works with these policyholders and their advisors in mitigating unexpected expenses and diminished benefits arising from life insurance policy premium financing situations that might not be meeting projected expectations.
What is Premium Financed Life Insurance?
Premium financing is a financial strategy that allows qualified individuals and businesses to acquire large life insurance policies without tying up significant capital. Instead of paying the premiums directly, the insured borrows the funds from a lender to cover the policy premiums. When interest rates were significantly lower and when money cost less to borrow, premium financing was positioned as a cost saving tool for not only death benefit-driven planning but also for standalone retirement income strategies.
At one end of the spectrum, affluent clients were able to obtain preferred lending rates from their banks to finance sizable policies intended for estate and wealth transfer planning. Often, policies were financed for the dual purpose of furnishing needed death benefit and, potentially, to provide future retirement income.
Many premium financing arrangements projected that the premium loans would be repaid from either the policy’s cash values during the insured’s lifetime or from the policy’s death benefit at the death of the insured. Depending upon the design of the arrangement, loan interest is either paid when charged by the lender or the interest is accrued and paid in the future.
Premium financing designs vary widely and once implemented, can be difficult to track. The life insurance experts at Cedar Point Financial Services LLC can analyze existing premium financing transactions and determine if they are performing as intended.
Be Aware of the Risks
Generally, for a premium financing arrangement to be successful, a policy’s cash surrender value rate of growth must exceed the lending interest rate being charged. This arbitrage is usually what attracts policyholders to financing premiums. Though, this is not always the case as there is a segment of policyholders who earn a high rate of return on their money deployed elsewhere and might not necessarily rely upon this arbitrage. For those who do rely on this arbitrage, a significant and rapid increase in lending rates can cause several problems for the policyholder in the form of:
- higher interest payments,
- depleting net cash surrender value and the possibility of a policy lapse,
- a call by the lender to post more collateral, and
- the need to pay additional premium out-of-pocket.
In 2021, lending rates for borrowing to finance policy premiums averaged around 3.5% and many premium financed life insurance illustrations did not project borrowing rates to increase much more than one percent over the policy’s duration. Today, these rates are hovering around 7%, far above what was projected or anticipated.
While life insurance policy cash surrender value crediting and dividend rates have also experienced increases over this time, these increases have generally not kept pace with the rise in lending rates, putting some policies whose premiums were financed in jeopardy.
Some policyholders may not realize there is a problem until they receive a policy lapse notice or a call from their bank asking for more collateral. By this time, the cost to fix the situation could be a significant burden. Cedar Point Financial Services LLC encourages policyholders who financed their policy premiums to contact its team for a complimentary review so that any problems may be identified, and corrective measures can be presented.
What Can be Done?
Mitigating the impact of rising interest rates on premium-financed life insurance policies requires careful consideration and proactive measures. Here are some strategies Cedar Point Financial Services LLC employes to help policyholders navigate this challenge:
Refinancing Options. One approach is to explore refinancing options with the existing lender or to seek alternative financing arrangements. Refinancing at even slightly lower rates or negotiating more favorable terms can help alleviate the burden of higher borrowing costs. However, it's essential to weigh the potential savings against any associated fees or penalties.
Policy Adjustments. Reviewing the policy structure and making adjustments can help optimize its performance in the face of rising interest rates. This may involve modifying the death benefit, premium payment schedule, or cash value growth strategy to better align with current market conditions and financial objectives.
Supplemental Funding. Consider supplementing the existing financing with additional capital to reduce the loan-to-value ratio and mitigate the impact of rising interest rates. This could involve injecting personal funds or securing financing from other sources to lower the overall borrowing costs and improve the policy's sustainability.
Cash Surrender Value Optimization. Evaluate the performance of cash surrender value to determine how either dividends are applied or how the crediting rate is determined. For example, having dividends in a whole life insurance policy applied to the cash surrender value and not used to increase the death benefit can be helpful. In an index universal life policy, evaluating and changing index crediting options can make a difference.
Policy Conversion, Life Settle, or Surrender. In some cases, policyholders may choose to convert their premium-financed life insurance policy into a different type of coverage or life settle for market value if greater than surrender value. While this decision should not be taken lightly, it may be necessary if the policy is no longer viable or if more cost-effective alternatives are available.
Regular Review and Monitoring. Regularly reviewing and monitoring the performance of premium-financed life insurance policies is crucial, especially in a changing interest rate environment. By staying informed and proactive, policyholders can identify potential challenges early and implement timely adjustments to mitigate risks and optimize outcomes.
We are Here to Help
Rising interest rates present challenges for policyholders who financed or who are continuing to finance their premiums. By being proactive and seeking help from an experienced life insurance professional like those at Cedar Point Financial Services LLC, existing and potential problems may be fixed or otherwise mitigated.
At Cedar Point Financial Services LLC, we work with clients’ legal, accounting, and other advisory professionals in developing and implementing strategies that optimize their individual and business financial plans.