Smart tips on using premium financing
Premium financing involves the use of leveraged borrowing to purchase an insurance policy. As the borrowers, policy holders may suffer financial losses from the various potential risks posed and have their rights under the policy affected as the policy is pledged to the financial institution. To help you weigh the pros and cons before using premium financing to purchase your life insurance policy, we have prepared a list of risks that you should consider and some smart tips to help you along the way.
Risks of financial loss
Interest rate fluctuation
The loan interest rate for premium financing is usually not fixed, therefore a significant interest rate hike may substantially increase your repayment cost and interest burden. As a result, you may even fail to meet a scheduled repayment and consequentially, default your loan contract. Even if the loan interest rate is fixed, the financial institution may have the right under the loan contract to adjust that rate from time to time. If the interest rate is substantially higher than the policy return, you may suffer a significant financial loss.
Before signing the loan contract, you should assess your risk tolerance for interest rate fluctuations by understanding how the interest and interest rate will be calculated, and the circumstances that the financial institution can adjust the rate.
Even if there is a so-called “cap” on the interest rate, you should check whether this cap may be subject to change. For example, if the cap is based on the prime rate of a lending bank, then the cap will change simply due to fluctuations of the prime rate.
Non-guaranteed benefits fluctuation
The non-guaranteed benefits shown in the Benefit Illustration document are not guaranteed to be paid. They are determined by the actual investment returns and performance, claims experience, or operating expenses of the insurer. Under extreme circumstances, the non-guaranteed benefits can be as low as zero.
If the non-guaranteed benefits are worse than expected, you could suffer a financial loss, as the total return generated from the policy may be lower than the interest costs and the handling fee you paid (if any).
Pay attention to whether the policy return includes any non-guaranteed benefits. If so, understand its portion in relation to the total policy return. The larger the portion of non-guaranteed benefits, the higher the potential risk.
You can learn more about how to interpret the Benefit Illustration document and the fulfillment ratio on the Insurance Authority’s thematic webpage:"Understanding a Participating Policy".
Impact of early repayment requests from the financial institution and policy surrender
The financial institution may have the right to request policy information (such as the surrender value and loan information related to the policy) from the insurer and review your loan arrangement from time to time. It may request you to post additional collateral or even immediate repayment of the loan based on the relevant information reviewed and the particular circumstances. If you are unable to meet these requests, the financial institution may, within the ambit of the loan contract, terminate the policy without your consent and settle the loan with the surrender value.
In this case, the surrender value of the policy may be lower than the sum of the total premium paid, interest expenses incurred, handling fee (if any) and early repayment penalty, especially during the early years of a policy. You will also lose your insurance protection and may not be able to obtain the same insurance coverage later for reasons such as a change in your health condition.
Before signing the loan contract, you should take note of the various adverse circumstances set out in the clauses (such as being required to provide additional collateral or make immediate repayment upon request) and consider whether you can meet such requests in order to avoid a potential financial loss.
Exchange rate fluctuation
If the loan currency differs from the policy currency, you may be required to convert the proceeds from the policy into the loan currency in order to settle the loan repayments. Any adverse fluctuations in the exchange rate may result in a significant reduction in the overall return you would receive under the premium financing arrangement. In some circumstances, you may even suffer a financial loss.
To avoid exchange rate risk, you should choose a premium financing loan that has the same currency as that of your policy.
Shortfall in policy and death benefits
Under a premium financing arrangement, the policy benefits may be used to repay the principal and interest of the loan. Therefore, the actual net benefits received (including death benefits) will be less than the amount shown in the Benefit Illustration document. In the event of the death of the insured, the net amount of death benefits received (after deducting the premium financing loan and fees) may also be less than the sum of the total premium paid, interest expenses incurred and early repayment penalty.
It is important to note that the actual amount received from the policy in a premium financing arrangement will be less than the amount shown in the Benefit Illustration document (including total return and death benefits). You may have to make alternative arrangements for the corresponding savings or protection gap.
Payment timing mismatch
If the proceeds from the policy is not remitted to the financial institution on time for the scheduled loan repayments (e.g. if the loan maturity date is earlier than the policy maturity date, or if the insurer requires a longer turnaround time to distribute the policy benefits), you may be deemed to have defaulted on your repayments and would be liable for late penalty interest or default interest.
Get in touch with the insurer and financial institution to learn more about the arrangement for the distribution of policy benefits and repayment of loan respectively. You should discuss with them to resolve any mismatches in the payment timing.
Your policy is the loan collateral of the financial institution. If your insurer defaults on its policy obligations or faces an adverse change in its credit rating, the financial institution may, in view of the deteriorating quality of its collateral, require you to provide additional collateral or even repay the loan immediately.
Make sure you have a thorough understanding of the background of the insurer when considering whether to purchase a policy from it using premium financing.
Impact on policy rights
Rights under the policy
Once your policy is assigned to the financial institution as loan collateral, the financial institution is usually entitled to exercise a number of rights under the policy on your behalf, including termination of the policy before maturity, receipt of the surrender value and death benefits, and change the beneficiaries. You may not be able to exercise these rights unless a consent is obtained from the financial institution.
Apart from the loan contract, you are usually required to sign a separate assignment agreement to assign the rights under your policy to the financial institution. You should read it carefully before signing and be sure you have an in-depth understanding of the potential adverse consequences arising from this assignment.
Under a premium financing arrangement, your right to cancel your policy within the cooling-off period may also be assigned to the financial institution. Consequently, any cancellation requests made may require the consent of the financial institution first. Even if it agrees to your cancellation requests, you may still need to repay the loan principal, early repayment penalty and interest.
Check whether the consent of the financial institution is needed if you want to cancel your policy within the cooling-off period. Also, consult the financial institution on whether any repayment penalty or other fees will be incurred if the loan is repaid shortly after its drawdown (e.g. within the cooling-off period).
Market conditions are ever changing and the same goes for premium financing. Policy holders should keep in mind that historical records are not indicative of future results:
- The interest rate has been low for a prolonged period of time. Having that said, it could surge and rapidly increasing the cost under a premium financing arrangement.
- There is no guarantee that non-guaranteed benefits from the insurer will be paid. If the non-guaranteed benefits are substantially less than expected, it may disrupt your initial plan.
- Loan contracts for premium financing usually allow financial institutions to request for immediate repayment from you at any time. If you do not have any savings set aside, you may have to surrender the policy to repay the loan and in doing so, suffer a significant financial loss.
- The above scenarios may happen at the same time, resulting in an even greater loss for you as the policy holder.
- You should carefully weigh the pros and cons of using premium financing and make the final decision based on your risk-tolerance level.
Starting from 1 January 2023, all policy holders intending to use premium financing must read and sign the Important Facts Statement – Premium Financing (IFS-PF) before policy issuance. The IFS-PF sets out the factors to consider and the risks involved in premium financing. If you do not understand the contents of the IFS-PF or consider the advice or information provided by the insurance intermediary to be different from the contents of the IFS-PF, you should NOT sign the document, and you should immediately clarify this with your insurance intermediary to protect your interests.
For details, refer to Insurance Authority’s supervisory standards and requirements.