The Dangers of Premium-Financed Insurance
Premium financing is a method of purchasing insurance using borrowed funds. These funds normally come from a bank, and the loan is coordinated with a life insurance company or a property and casualty company. The benefit of premium financing is that it could potentially allow the insured individual to purchase insurance at substantially reduced cost because he is typically paying for an interest-only loan instead of insurance premiums based on his risk rating. However, there are some important downsides to this arrangement as well.
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Secured Policy Cash Values
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If you use premium financing to pay for cash value life insurance, the bank will take the death benefit and cash value to repay the loan. This means that you pay monthly loan payments, but while your beneficiaries will receive some of the death benefits, they will get what's left after the loan is repaid. Also, you generally cannot access the cash value of the policy while the loan is unpaid.
Interest Rate Risk
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While many premium-financed arrangements used fixed loans to purchase the insurance policy, some banks use variable rates. If so, and interest rates rise significantly, your loan payments will go up, perhaps higher than what you would have paid if you purchased the policy directly from the insurance company.
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Collateral Risk
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If the value of your collateral for the loan falls below the bank's requirement, the bank could call your loan due. This could force you to liquidate some of your investments to satisfy the loan at an inopportune time. Some premium-finance arrangements use non-recourse loans, which means no personal collateral is reqjuired. However, some premium financing used to pay for large property and casualty policies require outside collateral, usually a portion of the borrower's savings.
Investment Risk
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If your life insurance is a universal or variable life policy, and the policy does not perform as expected, then when you die, not only could your beneficiaries not receive any death benefit, but they may end up owing the bank for the balance of the loan.
For example, if your premium-financing arrangement allowed you to borrow $1 million to buy a variable life insurance policy, but when you died, the policy was worth less than $1 million, your beneficiaries would be responsible for the balance of the loan at your death.
This can happen because universal and variable life insurance policies are two kinds of policies that have one thing in common: the death benefits and cash values are not explicitly guaranteed against loss.
These policies use either assumptions about future insurance and policy costs (universal life) that are not guaranteed, mutual fund sub-accounts to enhance potential cash value and death benefits (variable life), or both (in the case of variable life and variable universal life insurance). However, if the projected cost or investment assumptions are wrong, or change, you could lose money in your cash value account, and your death benefit could decrease substantially.
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References
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