Digging into the numbers is exceedingly important.
More and more premium finance deals and proposals are making their way to my desk. Most have some common characteristics. First, they probably aren’t going to work, and second, consumers don’t understand them. When I say “don’t understand,” I don’t mean they simply don’t understand the details but that they have a misunderstanding of how the transactions will play out.
I’m a proponent of premium financing, when it’s done right and for the right reasons. Real-estate owners and developers have used OPM (other people’s money) very effectively because they’re often able to prove mathematically that the leverage makes sense. I’m doing the same thing when I don’t pay off my low interest home mortgage and keep my money in the market. However, when it comes to financing life insurance, I have an issue with much of what I see out there. First of all, I firmly believe that finance deals built around the arbitrage
or spread between the crediting rate of the life insurance policy and borrowing rates are too often not going to work. This occurs largely because of the vagaries of the securities, bond and borrowing markets and the internal machinations of the life insurance contracts.
The Real Opportunity for Premium Finance
The best premium financing plans are realistically based on the spread between borrowing rates and the opportunity cost of money. If I’m making 20 percent on my money and I can borrow at 10 percent to buy my insurance (that I purportedly actually need and am not just being talked into buying because the deal looks so attractive) why wouldn’t I, as long as I understand and acknowledge the risks and have the wherewithal to extract myself if the world changes? If I can borrow at 5 percent, it’s just that much better, and I might be able to pay off that loan someday with funds in the life insurance policy instead of counting on a liquidity event and paying taxes. Maybe the life insurance policy has performed well and I need the death benefit, and I’d rather pay the loan off from other assets and not reduce my death benefit.
Some Recent Reviews
Let’s look at a couple of cases brought to me: one is a proposal, and one is an in-force deal. These were both built around whole life (WL) as opposed to the more common indexed universal life (IUL). Nonetheless, they’re real, and they’re being proposed. The insurance company is fine. The insurance policy is fine. The financing is fine. So how do these stand-alone fine things meld into dynamite. (Dynamite in the bad way, not the JJ Walker way.)
The story told to the consumers sounds great. The problem is that it isn’t always true or at least complete. This isn’t my opinion but based on factual numbers. The WL product has a dividend rate north of 6 percent. Unfortunately, this is postured to the plan participants as a crediting rate on premium. But, it’s not. The actual internal rate of return (IRR) on premium to cash value is substantively less than the dividend rate. In fact, it takes a decade into the deal for the policy to have cash value projected to be equal to the cumulative premiums for an IRR of 0 percent. At no point during the financing does the IRR on premium to cash value equal the borrowing rates, and at no time in the life of the policy does the projected IRR exceed 4 percent. Reason: Commissions, overhead expenses, premium taxes, mortality charges, etc. The dividend rate is a relatively meaningless number. Actual performance is what matters.
The financing rates were higher than these IRR numbers at the outset of the proposals, and the policy crediting rate has decreased while the borrowing rate has increased. How can a client ever have enough cash value in the policy to pay back the loan when the loan rates are greater than cash value growth rates? This isn’t rocket science. With plan designs in which some or all loan interest is paid out of pocket, there may be a day when there’s enough cash value to pay off the loan and leave enough juice for the policy to move forward but those interest payments need to be accounted for. In one deal, the promoter retorted that there would be a liquidity event down the road to pay off the loan when I showed that the entire deal would be underwater (this deal was accruing interest). When was the last time you voluntarily entered a losing transaction because there would be money down the road to bail you out? It’s like saying I’ll pay a financial advisor 4.5 percent in fees to grow my money at a gross rate of 3 percent because in the future I’ll hope to get an inheritance that I can retire on after driving my retirement savings.
Understanding the Deal
If the mentality is that the play is between the borrowing rates and the opportunity cost of money, then we’re good, but in the situations I’m brought into, this simply isn’t the case. The pitch is on the play between policy crediting rates and borrowing rates. It’s likely this isn’t going to happen. Again, it’s not necessarily the deals that are bad but the understanding of the deals and the evasive and bogus rationale of the deals that are off base. There seems to be a pat answer for all questions, and the things are so complicated that most consumers and their advisors have no ability to penetrate the black box.
I keep hearing from clients that one reason for entering these deals is because paying the loan interest is less than paying the premiums (for those who are even paying interest out of pocket rather than accruing). I don’t know, is it? It might be in the early years but is it worth the larger costs down the road? Is it worth risking a few million in collateral? Is it worth hoping and praying that the markets and policy will perform as projected? If you have to tap out at some point, will you still think the same thing?
For most of their lives, policy owners have errantly looked at life insurance with a “set it and forget it” attitude. They don’t understand it, put it in a drawer, don’t manage it and suffer sometimes horrible consequences of lost death benefit and catastrophic tax ramifications. I’m regularly brought in to pick up the pieces when the train goes off the tracks.
Now, let’s introduce a product so insanely complicated that most of the people selling it don’t even understand it, let alone that it doesn’t work like most policy owners believe it to work, wrap it in a financing plan that dramatically increases the risk of the deal, extend the risk to other assets through collateralization and mandate ongoing and close management of the transaction to have a prayer of success when we’ve rarely been able to get that out of life insurance consumers before, even for simple plans. Additionally, in most cases, we use a product that’s dependent on ongoing attractive stock market returns when we’re at the peak of a record-breaking long bull market.
One thing I may never understand is why consumers who would never throw millions of dollars (their own or borrowed) at anything else without thorough vetting and consultative advice are willing to do so into a life insurance policy they don’t understand. This is especially riddling when life insurance is generally towards the top of the list of things most people are suspicious of. Where exactly do life insurance agents typically stack up on the trustworthiness scale relative to other professionals?
While there are fantastic life insurance professionals out there doing great work, there are also those who aren’t. While I’m often frustrated by the cynicism in the market regarding life insurance, at the same time I urge some to ramp it up a bit when vetting complicated deals involving enormous amounts of money.
Why is premium finance so popular today? First, the introduction of a life insurance product with the ability to illustrate higher returns in concert with historically low interest rate markets allowed deal projections that looked fantastic. Second, premium financed deals appear to use OPM, and it’s always easier to spend OPM. Third, premium financed policies are very large, and they drive very large commissions. I’m by no means suggesting these commissions are inappropriate, but it’s important to be aware of what’s driving marketing. Very high commissions will inevitably lure shady players to the game. It will even tempt some of the good ones to keep from looking at the details too closely.
For the most recent handful of cases I’ve vetted, the payable commissions ran from a low of a few hundred thousand dollars up to a few million dollars. If this doesn’t introduce the importance of a second opinion and objective advice, I don’t know what to say.
In the end, I see most people making decisions on proposals that I deem a best case scenario. In reality, someone needs to calculate the numbers for what things look like in a worst case scenario, a kind of bad scenario and even just a “not quite as good as best case scenario.” My prediction is that after internalizing these “alternate facts,” deals will lose some of their luster, more questions will be asked and the need for better vetting will become more apparent.
Keep your eyes open for more pieces in a series on diving deep into premium financing and the IUL products they are generally built around.
Bill Boersma is a CLU, AEP and LIC. More information can be found at www.oc-lic.com, www.BillBoersmaOnLifeInsurance.info and www.XpertLifeInsAdvice.com or email at email@example.com.