In many situations in which the client requires a significant amount of life insurance coverage for estate or business-planning purposes, he objects to paying hefty annual premiums to the insurance company. Many times, financing premiums through a third-party lender is an excellent option because it minimizes the annual out-of-pocket cost and allows the premium cost to be invested elsewhere. However, in some cases, financing premiums through a lender may not make sense because of a variety of reasons, including the fact that the client may have collateral constraints, may not be eligible for a particular program, or may be debt-averse.
In these and other situations, it makes sense to self-finance a policy on a guaranteed basis to lower the total annual cash outlay and potential gift tax.
Self-financing is a method of paying minimum premiums into a life insurance policy to keep the policy viable until a future date. At that point, the difference between the full premiums required to guarantee the policy to age 100 and the actual minimum amount paid to keep the policy in force is made up by the client in a lump sum. Typically, the lump-sum amount, sometimes referred to as a “catch-up” amount, includes an interest charge on the unpaid premiums and is usually paid into the policy at life expectancy. In the meantime, the client can invest the difference in premiums. As long as the client’s return on the money he has invested elsewhere is higher than the amount required to pay the lump sum at life expectancy, the client benefits from this low-cost, guaranteed life insurance coverage.
Unlike the premium financing approach, in a self-financed policy, the entire death proceeds remain intact and are guaranteed to be paid out to the beneficiaries even if the lump sum has not been paid into the policy because the client died before the catch-up amount was due. Under premium financing, the lender must be repaid the premiums it loaned, usually through the death benefit proceeds, either increasing the initial cost of the coverage to account for the loan repayment or minimizing the amount of death proceeds passing to beneficiaries.
An attractive feature of the catch up is that it is a moving target. That is, the client can pay a lower amount of the catch up and buy just a few more years of guaranteed coverage. He can decide, as time goes, on how much more to pay into the policy, depending on how far out into the future he needs to have the policy guaranteed to last. The client has virtually locked in insurability and has maintained a guarantee that is flexible.
Deciding if it makes sense to use the catch-up option under an insurance company’s contract will depend on the client’s profile. The typical self-financing client has cash flow constraints, a mindset to invest his money in instruments other than life insurance contracts or the feeling that the estate tax will go away and so will the insurance need.
An attractive feature of the catch up is that it is a moving target.
The analysis of the catch-up feature inherent in the self-financing approach takes into account the minimum net rate of return required to self-fund the catch-up amount at or around life expectancy. For example, Nathan and Olivia Trudeau, ages 52 and 47, respectively, have met with their financial advisor, Thomas Carver, who has recommended they secure $10 million of survivorship universal life insurance coverage to cover their estate tax exposure. Nathan is a very successful executive. He understands the need for life insurance but does not like the idea of paying the stated $64,412 of annual premiums to the insurance company for the rest of his and Olivia’s joint lives. He would rather reinvest premiums in his investment portfolio. Besides, they think the estate tax may be eliminated and don’t want to take on the burden of an unnecessary expense. However, they understand the need to lock in insurability with permanent coverage and to purchase insurance now rather than later.
The catch-up solution
Thomas suggests going with an insurance company that offers a catch-up provision so that the Trudeaus will have more flexibility in what their out-of-pocket costs will be to fund the policy. He explains that they can fund the policy minimally, for $27,000 annually instead of $64,412, which would guarantee the policy until Olivia’s age 100. The annual difference or opportunity cost is $37,412, which can be reinvested in their investment portfolio. The catch-up amount required in year 36, joint life expectancy (Nathan’s age 88 and Olivia’s age 83), is $3,625,389. However, Thomas points out that the minimum net rate required to fund the catch-up amount in year 36, assuming that the $37,412 is invested annually, is 5.05 percent. If Nathan and Olivia believe they can achieve this rate in their portfolio, they should self-fund the policy. Given that they have experienced a net average annual rate of substantially more than this in the past, they are intrigued by the flexibility of such a plan. Further, Thomas explains that the contract is guaranteed, providing that the minimum premium is paid into the policy and that the catch-up amount is paid as illustrated in the year of life expectancy. This is regardless of the actual rate credited to the cash value account of the policy. Under the life insurance contract, even if the policy’s cash value goes to a value of zero, the payment of the annual minimum premium and the catch-up amount at life expectancy will guarantee the policy to last until Olivia’s age 100.
Thomas’ plan is very appealing to the Trudeaus because of the idea of paying a minimal premium amount while still maintaining the guarantee that the death benefit will last, regardless of the actual rate credited to the policy’s cash value account. They also like the idea of funding the catch-up amount at a rate that can be reasonably achieved, and paying a minimum premium amount in case estate taxes go away.
Minimum Fund Premium
|Total outlay year 36||$2,383,244||$4,634,801|
|PV of total outlay at 6% year 36||$1,006,179||$894,528|
|Death benefit plus self-financed
account year 36
|PV of death benefit plus self-financed account at 6% year 36||$1,157,932||$1,272,558|
|Net cost/benefit at 6%*||$151,753||$378,031|
*Net cost/benefit refers to the net life insurance plus side fund benefit to the net cost of the benefit (premiums).
Thomas further shows (in chart below) that even at a meager annual net return of 6 percent, use of the catch-up feature results in a $226,278 advantage over paying the guaranteed premium on this particular survivorship case.
|IRR||Self-Financed Account Balance (EOY) at 5,0516%**|
Lina R. Storm, CLU, ChFC, provides advanced case design for Manulife distribution channels and the field force. You may reach her at firstname.lastname@example.org.