Leverage, Arbitrage & Premium Finance
Premium finance (borrowing premiums from a third party) is popular and fitting in the estate planning and income replacement markets. Part of the recent excitement in the marketplace is due to the low interest rate environment and insurance policies outperforming what is called the interest rate arbitrage.
In a nutshell, premium financing is when a loan is obtained to pay the premiums on a life insurance policy. By using this type of leverage, allows you to keep your cash invested in higher earning investments.
The loans are paid back from the policy’s cash values in the future, or from the death benefit at the insured’s passing. Best, is that the collateral for the loan is the insurance policy itself. Many banks and lenders will loan up to 100% of the policy cash value.
When the low interest rates are combined with the insurance policy purchase can outperform the loan interest rate, premium financing looks great. We have created positive arbitrage with no outlay from the insured.
In today’s world, the product of choice is an insurance policy which links the policy’s performance to an index (S&P). These contracts are designed with a floor and a capitalization rate. Losses are protected and maximum return rates have ceilings, however, the landscape provides a strong opportunity for positive arbitrage.