Premium Financing for Insurance Plans: Is It Worth the Risk?

1. You can potentially earn a positive spread

The basic attraction is the difference between the financing cost and the return from the policy.

As a simplified example, suppose the effective return or distribution from an insurance policy is 3.7% a year while the borrowing cost is 2.0%.

There is potentially a 1.7% spread between the two.

And because the client has only put up part of the premium using his or her own capital, the return on the client’s actual capital can be enhanced through leverage.

When financing rates are low, the mathematics can look very attractive. Using a policy often used in premium financing, someone is able to earn of spread of $11,510 per year (Table 1) from Year 5 onwards.

Table 1: 10-Year Cash Flow Illustration

Based on a S$500,000 policy, 70% bank financing and a 2.0% p.a. financing cost. Policy cash benefits are based on the 4.25% investment return illustration.

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Note: The non-guaranteed cash bonus is not guaranteed. The financing cost is assumed to remain at 2.0% throughout the 10 years; actual borrowing costs may change.

2. Insurance policies are generally less volatile than equities

Another attraction is that the underlying asset is an insurance policy rather than an equity portfolio. A participating insurance policy, for example, does not fluctuate in value every day like shares do.

For someone approaching or already in retirement, this can be psychologically appealing. There is no need to watch markets moving up and down every day, and the expected cash flows can appear considerably more predictable.

However, lower volatility should not be confused with lower overall risk.

The policy itself may be relatively stable, but once borrowing is introduced, the financing arrangement introduces an entirely different set of risks.

3. It can provide a relatively passive stream of income

Certain insurance policies are structured to provide regular distributions.

After the initial arrangement has been put in place, there may be relatively little for the policyholder to manage compared with running an investment portfolio.

For someone who does not want to constantly monitor financial markets, rebalance investments or decide which assets to sell to fund retirement spending, this simplicity can be attractive.

4. A large policy can potentially fund a meaningful portion of retirement expenses

Premium financing also allows an individual to purchase a policy substantially larger than would otherwise be possible using only his or her own cash.

If the policy subsequently provides regular distributions, those payments could potentially contribute significantly towards retirement expenditure.

That sounds attractive. But this is also precisely where caution is required.

The larger policy has been made possible by borrowing. So alongside the larger potential income comes a larger financial obligation.

1. Your retirement plan becomes dependent on interest rates

This is probably the biggest concern I have with using premium financing as part of a retirement strategy.

Interest rates are a variable that the retiree cannot control.

When financing rates are low, the arrangement can work very well. But when borrowing costs rise substantially, the positive spread can quickly disappear.

We saw precisely this during the sharp rise in interest rates in 2022 and 2023.

Clients who entered premium financing arrangements when money was cheap suddenly found themselves paying substantially higher financing costs. In some cases, most or all of the expected spread disappeared.

That is particularly important for retirees.

If I am constructing a retirement income plan, I generally want to reduce uncertainty where possible. Premium financing does the opposite in one respect: it introduces future borrowing costs into the retirement equation.

You are effectively making at least a partial bet that financing costs will remain manageable.

2. The illustrated bonuses and distributions may not materialise

The second variable is the performance of the insurance policy itself.

For participating policies, part of the projected returns may depend on future bonuses declared by the insurer.

These projections are not the same as guarantees.

If investment returns, claims experience or other factors affecting the participating fund are weaker than expected, insurers may reduce future bonuses.

The problem becomes more significant when the policy is financed.

Without leverage, lower-than-expected bonuses simply mean that the policyholder receives a lower return.

With premium financing, the interest on the bank loan still has to be paid.

So the margin between what the policy earns and what the financing costs can become much smaller — or potentially negative.

3. Early surrender can be particularly painful

Insurance policies are generally designed to be held for the long term.

Surrendering during the early years can result in a surrender value substantially below the original premium. In Table 2 below, early surrender, in the first 9 years, will result in substantial early surrender losses.

Table 2: Illustrated Surrender Value and Gain/Loss

Based on the 4.25% investment return illustration for a S$500,000 policy, with cumulative financing cost calculated at 2.0% p.a. on S$350,000 of bank financing.

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Note: This table focuses on the policy surrender value and financing cost only. It does not add back cash benefits or bonuses received during the period.

With premium financing, this problem can be magnified because the policy purchased is typically much larger than the amount of capital the client actually contributed.

Table 2 uses a $500,000 policy as an illustration; in reality, some policies can be even larger, leveraging a bigger loan quantum, and surrender losses will be even bigger. If circumstances subsequently force you to surrender the policy when surrender values are still low, the bank loan still needs to be repaid.

Leverage amplifies gains when things go well.

It can also amplify losses when they do not.

4. The financing arrangement itself can change

There is another risk which is sometimes overlooked.

The insurance policy may be long term, but the financing arrangements offered by banks are not necessarily fixed for the entire life of the policy.

Interest margins can change. Lending criteria can change. Collateral requirements can change.

Depending on the financing structure, the client could potentially be asked to provide additional collateral or repay part of the loan.

That creates a liquidity risk.

This is particularly relevant for somebody in retirement who may no longer have employment income and may have much of his or her wealth committed elsewhere.

5. You will be out-of-pocket during the first few years

Insurance plans that lend themselves to premium financing arrangements are whole-life plans, that usually pay out after an accumulation of a few years. In Table 1, I have used a real whole-life plan for such an arrangement, and the plan only pays out after 3 years, with the payout in Year 4 being too low to offset financing costs. Hence, you will be out-of-pocket in the first 4 years with this plan.