Speaker 1 (00:07):
Hello, this is Bill Bosma of OC Consulting Group. This is part two of what’s going on with premium finance I U L. We left off after discovering that the client’s premium finance i u transaction was falling apart even though it has been enforced during a hot run of the stock market and the actual crediting of the policy was greater than projected. With an index policy, the policy holder’s cash value is credited with a portion of the return from a specific market index. Often as in this case, c s and P 500 index. The crediting to a policy’s cash value is based on an index appreciation over a set period, often a year. In the details of how policies are credited are described in the insurance contract, which is typically delivered to the consumer after the policy is issued in the policyholder has paid his or her premium.
Speaker 1 (01:03):
When looking at computer generated projections of future cash value, what’s often not clearly communicated or disclosed is that the insurance company has a contractual right to lower these caps rates at their discretion. This has a material impact on what levels of returns the consumer will receive from the product. In fact, despite the relative novelty of IUL policies, caps have fallen on most of these products since they were introduced less than a dozen years ago, some as much as 50%. This means that the cash value crediting can be significantly throttled regardless of the appreciation of the index. Understanding this moving element of caps in an I U L product is critical to understanding a downside risk of this contract caps are fundamentally based on what insurance companies can earn on their portfolios as well as the market cost of options. The more money that’s available to spend on options and the lower the options pricing, the higher the caps that can be offered in the policy.
Speaker 1 (02:07):
When insurance carrier portfolio rates drop as they have been and or option prices go up as they have been the carriers generally lower caps. The defining aspect of index products is that they have upside potential without the downside risk. When the policy in our example was issued, the cap rate was 12% and that allowed a significantly higher crediting rate. However, this policy’s cap has since come down as has the cap of almost every I U L product in the market. The cap on this contract to date is 8% and this reduces the allowable projected rate to 5.18%. When you take all the market returns over 8% off the table, the realistic return must come down substantially. If the cap is further reduced, as experts believe will happen in the future, the crediting rate will also be reduced accordingly. To put this into context, I recently reviewed a policy where the current cap rate is lower than the original projected crediting rate.
Speaker 1 (03:14):
That original rate was a few hundred basis points higher than it is now, and hundreds of points lower than the cap rate at the time. I imagine most people never thought that that even could be a reality, but going forward, the lower caps indicate the policy to be veering off course with almost no chance of meeting initial projections. As a result, the client will have purchased a very expensive insurance policy that must be canceled in order to pay back the bank loan, and depending on policy design might be hit with an unexpected tax bill. Along the way, millions of dollars a loan interest already paid will have been lost, and if the rate is lowered further or if actual market performance is not as forecasted in the projections, even the posted collateral could be in jeopardy. Furthermore, it’s important to understand that the current 5.18% projected rate is the maximum regulatorily allowed crediting rate per AG 49 and AG 49 A.
Speaker 1 (04:19):
The crediting rate is based on a geometric mean of thousands of data points over many years, which means the 5.8% itself is in the big picture, a 50 50 proposition. As ridiculous as it might seem, the regulations also allow the insurance company to assume a 45% profit on its options. This is one of more controversial assumptions under the regulations. What’s the bottom line? If this client purchased the policy because he needed the coverage and he is making 20% done his invested assets and needs only a liquidity event in the future to pay back the loan and skate away with the balance after taking advantage of positive arbitrage well played, but that wasn’t the case in this situation and it’s rarely how I see it positioned. Rather than being positioned as playing the spread or taking advantage of the arbitrage between borrowing rates and the opportunity cost of money, I almost always see it as the spread between borrowing rates and the supposed crediting of the policies cash value.
Speaker 1 (05:27):
Let’s take a closer look at this. The original projections assumed a six and a quarter percent rate of return year in and year out, but at the end of five years, the internal rate of return on premium to cash value is actually negative 5.15%. At the end of 10 years, the return is 0.1% and at the end of 20 years, it’s 1.8900000000000001%. Remember, this is based on a continuous crediting rate of six and a quarter. The actual rate of return on premium to cash value is less than any conceivable borrowing rate. So the critical question is where’s the arbitrage what this policy owner thought he understood, and reality is separated by an infinitely wide gap. The real story as opposed to the marketing story is sobering because immediate action is necessary. What the market needs is independent analysis and ongoing monitoring by someone other than the promoters who sell the transactions.
Speaker 1 (06:36):
Because the cash values right now are generally not too far off from what was projected. No alarm bells are going off. Much of what I see promoted today is not any different than what I’ve seen promoted in years past. Some are better, some are worse, but they all have something in common. Index, universal life policies are all built on the same foundation and that foundation is constantly shifting and substantively misunderstood. The new Ag 49 a regulations that affect new policies but not those enforced before December of 2021, leave a vast majority of index contract owners relying on projections that regulators have effectively declared misleading and too aggressive, but I U l contract owners may have no knowledge of this. None of this means that every premium finance deal is going south or that there aren’t some that are in the best interest of the client, but far too many aren’t making the cut. The bottom line is there is no downside to an independent objective review and analysis while not doing so could result in the loss of millions of dollars. I see it happen regularly. As usual, thanks again for your time and please don’t hesitate to ask questions or let me know if there is anything I can do to help.