August 2022
In this edition of Policyholder Corner we look at the risk and complexities involved with premium financing and the considerations a policyholder should take into account before purchasing an insurance policy using premium financing.
What is “premium financing”?
“Premium financing” refers to an arrangement whereby a policyholder borrows funds from a lender (say, a bank) to pay the premiums under a life insurance policy which the policyholder is purchasing. As collateral for the loan, the policyholder assigns all or part of his/her rights under the insurance policy to the lender.
The attraction of premium financing stems from the ability (when borrowing rates are low) to borrow funds at low interest, and to use those funds to pay premium into a life insurance policy, with the objective that the return under the policy (i.e. the increase in value of the policy benefits under the insurance policy) will exceed the cost of the loan (i.e. loan interest and handling fee (if any)), resulting in financial gain for the policyholder.
Essentially, therefore, premium financing involves leveraging to maximize investment returns. As is the case with most leveraging arrangements, however, premium financing comes with potential significant downside (as well as upside) risks which policyholders should be fully aware of before considering entering into such arrangement.
Premium financing – the risks you need to know about
The main considerations and risks associated with premium financing which policyholders need to be aware of and consider are summarized as follows:
The risks associated with the lender’s rights under a premium financing arrangement
A policyholder should understand that by assigning rights under the insurance policy being purchased to the lender, as collateral for the loan, it is the lender who will be able exercise those rights (whilst the loan remains outstanding) rather than the policyholder. Indeed, if the policyholder wishes to exercise any of the rights assigned, he or she may need the lender’s prior consent. The policy rights affected could include:
The right to receive benefits under the insurance policy (including surrender value, death benefit, etc.) which are payable by the insurer;
The right to cancel the insurance policy within the cooling off period, surrender the policy, or make withdrawals;
The right to apply for a policy loan under the insurance policy, or exercise any options under the policy, or to make certain changes or amendments to the policy (e.g. appointment of new beneficiary, further pledge or assign the policy).
Similarly the loan agreement may give the lender certain rights to change or terminate the arrangement. For example, the loan agreement may be subject to review by the lender with the lender having the right to restructure or terminate the loan at any time. The lender may have the right to request the policyholder to provide additional collateral, or to partially or fully repay the outstanding loan under particular circumstances stated in the loan agreement. If the policyholder fails to meet the request, the lender may restructure or terminate the loan agreement or exercise its rights under the insurance policy by, for example, surrendering the policy.
The rights assigned under the insurance policy to the lender as collateral and the rights given to the lender in the loan agreement, are designed to protect the lender if the policyholder is unable to meet any of the scheduled loan or interest payments under the loan agreement. Any late payment under the loan agreement (including interest payment or principal repayment), therefore, may trigger the lender to demand the repayment of the loan immediately or enforce the collateral, by exercising the rights assigned to it under the insurance policy to recover the defaulted payment from the benefits in the policy. The consequences of this for the policyholder could be as follows:
Significant financial loss
The policyholder may suffer significant financial loss, particularly if the lender surrenders or terminates the policy after only a few years (when the benefits under the policy have not had time to grow or if the early termination triggers an early repayment penalty to be imposed under the loan agreement).
Loss of insurance coverage
The policyholder may suffer loss of insurance coverage and not be able to obtain the same insurance coverage easily from another insurer, if for example the policyholder’s health condition has changed since the insurance policy being surrendered was initially purchased.
Liability for the shortfall in recovery by the lender
The policyholder will remain liable for any shortfall between the amount of the proceeds of the insurance policy recovered by the lender and the outstanding amount of the loan agreement.
Risk of set-off
The lender may set-off any obligation under the loan agreement owed by the policyholder to the lender against any obligation owed by the lender to the policyholder (including credit balances in any account the policyholder maintains with the lender).
Consequential risks
If the insurance policy was used to satisfy a condition of other arrangements made by the policyholder (for example, the policy was required to support arrangements made as part of the policyholder’s business), the surrender or termination of the policy could trigger further events of default in these arrangements with adverse consequences to the policyholder.
Financial risks
As stated, premium financing relies on a strategy of borrowing at low interest, to buy an insurance policy with benefits that will increase to a value higher than the loan amount plus the loan interest. The assumptions underpinning this strategy, however, are not static and the policyholder considering premium financing should factor in these risks. In particular:
Changes in interest rates
Your interest rate at start of the loan may be low. But what if you have not borrowed at a fixed interest rate, and interest rates subsequently rise (as we are seeing now)? Or if the lender has a discretion in the loan agreement to increase the interest rate from time to time and exercises this discretion? Could you really continue to afford such increased loan repayments along with all your other financial commitments? And don’t forget: with the increased loan repayments, the difference between what you need to repay and the value of the benefits under your insurance policy may significantly reduce.
Non-guaranteed benefits under your insurance are exactly that - non-guaranteed
In any premium financing arrangement, the policyholder is intending that his cost of borrowing (the interest on the loan taken out) is going to be exceeded by the values of the benefits under the insurance policy being purchased. It is important to realize, however, that the benefits under your insurance policy may be “nonguaranteed” i.e. the growth in the value of the benefit (as shown in the benefit illustration) may not be guaranteed and may depend on a number of factors, for example, the investment performance, claim experience and operational expenses of the insurance company. If these factors do not turn out as originally expected (for example, if your expected investment return is not achieved), your non-guaranteed benefits may be lower than those illustrated to you at the time of your purchase, and may be substantially lower than the interest due on your loan. In certain circumstances, the benefits may even fall to zero (this is what “nonguaranteed” means).
Whilst the potential upside may make the premium financing arrangement tempting, you also need to consider the potential downside of, for example, the investment return under your insurance policy not performing as anticipated, and the downside, in this respect, could be significant.
Exposure to exchange rate fluctuation
If the currency under the loan agreement is different from the currency for the premium and benefits under your insurance policy, you could face exchange rate exposure. If the exchange rate has moved against you by the time you pay back the loan using the benefits under your insurance policy, when you convert the amount received under your insurance policy into the loan currency this may not be sufficient to pay back the loan plus outstanding interest.
Exposure to credit risk
Because you have used the insurance policy as collateral for the loan, and that collateral depends on the insurer being in a position to meet its obligations under the insurance policy, any significant change in the insurer’s financial position could impact your premium financing arrangement. For example, if the insurer’s credit rating is downgraded, this may trigger a right under the loan agreement for the lender to seek more collateral from you, or indeed to exercise its rights under the collateral (i.e. the rights under the policy which have been assigned to the lender, such as surrendering the policy). As the borrower under a premium financing arrangement you are, therefore, exposed to the insurer’s credit risk.
Other risks
Other risks you need to be wary of when it comes to premium financing are:
Payment timing mismatch
If you are relying on extracting value from your insurance policy to meet the loan repayments, you need to be aware of any potential timing mismatch between when benefits under your policy become available and the scheduled dates of your loan repayment. If you are unable to repay a schedule repayment on time because of this mismatch, you may be subject to late penalty interest or default interest.
Sufficiency of Death Benefits
As the insurance policy likely to have been purchased is a life insurance policy, death benefits will be payable under the insurance in the event of the insured’s death. However, you need to consider the potential that the death benefit payable under the insurance policy may be substantially less than the sum of total premium paid, the interest expenses incurred and any early repayment penalty imposed under the loan agreement, resulting in financial loss.
Privacy of Information
You also need to bear in mind that the lender is likely to have been given access to your policy information and may require the insurer to release information relating to your insurance policy from time to time, such as the surrender vale, cash value and any loans or advances on the insurance policy.
Is premium financing really right for you?
Premium financing, therefore, is not a simple matter and you should not embark upon a premium financing arrangement unless you have considered all the potential risks involved and understand how they may impact your position.
To assist with this, from January 2023 onwards, when arranging any insurance policy being purchased with premium financing, the licensed insurance intermediary or authorized insurer arranging the policy will be required to complete an “Important Fact Statement – Premium Financing” with the prospective policyholder to ensure all the risks are explained and understood. It is important, therefore, that policyholders considering premium financing take the opportunity to discuss the risks with those advising them.
Ultimately, if you do not understand the risks associated with premium financing, it probably isn’t for you.