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Why borrowing money to fund insurance policies can prove detrimental
Assoc Prof Jonas Chen says that borrowing at rates close to the benchmark short-term rate could present some challenges for policyholders given interest rates are on the rise.
Interest rates are going up and this could spell trouble for insurance policy holders who took up loans to pay off a large premium upfront.
Financial institutions offer premium financing so customers can fund insurance policies with a large sum assured.
Years of low interest rates have made this option highly appealing but some borrowers might be feeling the pinch now that rates are heading north and could even lose their insurance policies.
Policies that attract premium financing are typically either universal life policies, which are used for legacy planning purposes to leave an inheritance to loved ones, or lump-sum whole life plans that give a lifelong retirement income.
The large amounts involved mean premium financing is usually used for high-net-worth individuals, entrepreneurs and business owners.
Increasingly, however, others are getting in now as premium sizes come down, noted Mr Derrick Yip, second vice-president (public relations) at the Insurance and Financial Practitioners Association of Singapore (Ifpas).
"For the minimum premium of the single premium policies, it is usually $150,000 (may vary a bit across insurers)," he said.
Mr Yip added that some banks will loan up to $100,000, leaving the policyholder to cough up $50,000 cash.
Financial advisers are seeing the same trend.
Mr Eddy Cheong, head of the solutions team at wealth management and advisory firm Providend, said that as premium sizes come down, such financing has become more accessible to what is called the mass affluent segment.
Mr Lee Meng Choe, executive director (advisory) at Gen Financial Advisory, said more and more mass and emerging affluent individuals are using premium financing to set up their insurance plans.
Low interest rates over the past two years enabled this practice to flourish even more.
Associate Professor Jonas Chen from the division of banking and finance at Nanyang Business School, said people borrowed at rates close to the benchmark short-term rate and invested their cash in higher-yielding investments.
But this method of financing could present some challenges for policyholders given interest rates are on the rise as central banks around the world go on an aggressive drive to stamp out inflation.
Ifpas' Mr Yip said the interest rates on premium financing loans are variable but the main lending benchmark - the Singapore Overnight Rate Average (Sora) - has gone past 1 per cent this month.
That is a jump of 0.8 percentage points from the 0.2 per cent levels before the United States Federal Reserve started its rate hiking cycle in March.
Providend's Mr Cheong said policyholders will have to fund the higher interest payments to keep their plans going otherwise the bank will terminate the policy to recover the loan.
This is because the insurance policy is the collateral for the bank loan and the lender is usually entitled to up to 90 per cent of the policy surrender value.
Early surrender of insurance policies also usually comes with penalties, so it is not good for the policyholder at all.
Mr Yip also warned that because the insurance policy is pledged to the bank, if the life assured dies today, the bank would receive the sum assured amount first to write off the premium financing loan.
The remainder would then be paid to the policyholder's estate to be distributed to beneficiaries.
There are two other clauses in premium financing loan agreements that policyholders should be aware of, said Mr Yip.
The uncommitted clause allows the bank to call back the loan any time it feels the policyholder's credit-worthiness is in doubt.
If the policyholder does not have the money to pay back the loan, he will be forced to liquidate his insurance policy.
The unlimited clause allows the bank to use the death benefits or cash values of the policy to clear the premium financing loan, as well as other liabilities held with the bank.
Gen Financial Advisory's Mr Lee cited the example of an elderly couple who did not get proper advice about premium financing.
They purchased a US dollar-denominated universal life policy in their early 50s, attracted by the high amount of coverage at comparatively low premium.
When they retired, they realised they had not budgeted for the loan instalments and surrendered the policy early at a loss, he said.
However, if used correctly, Mr Lee said premium financing can bring benefits.
Policyholders have to ask themselves four questions: Do they need the insurance policy; can they pay the loan instalments or will the instalments eat into their cashflow and budget; can they handle an increase in interest rates; and do they have the means to make a partial or full repayment of the loan if they are no longer comfortable with higher interest rates.
"Definitely, you need a good adviser who is able to critically review your financial situation, and lay out the options for you than one who merely wants to sell you a product," said Mr Cheong.
Source: The Straits Times
