StressTesting a Premium Financing Deal

I have to admit I am sometimes cynical of the strategy du jour in the life insurance sales and marketing world. While the industry is incredibly innovative regarding ideas and strategies and brings amazing opportunity to many consumers, sometimes the original, sound idea is bastardized into something which bears little likeness to its namesake.

This is especially frustrating for those in the market who play on the straight & narrow, even those on the cutting edge who have their client’s best interests at heart. None-the-less, it is not difficult to understand the temptation to push an idea to its limits and to over market and even misposture what it is and can accomplish.

Premium Financing has been a hot ticket for some time, especially when yoked to Indexed Universal Life (IUL). Financing insurance premiums is a perfectly sound concept. Think of the business owner or real estate developer with deployed capital earning well into the double digits annually, maybe even 20 or 30%. Would anyone, even those with a known insurance need, be eager to take capital earning those kinds of numbers and redeploy it into life insurance with much lower likely returns? Why not use OPM (other people’s money) to get what you need while your money is getting you what you want?

With financing, the insurance may be put in force while the high earning capital stays engaged. This sounds great and it can be great. There is, however, much more to it than that.

The concept has been around for a very long time but the (what I consider the sketchy) players today posture this as “free insurance” by focusing on the current potential arbitrage between market returns and loan rates. If one assumes an attractive ongoing stock market return and a long term continued low interest rate environment, the arbitrage tracks out indefinitely and nothing ever has to be paid back out of pocket. Most reasonable practitioners believe this is a stretch. The IUL policies backing the plan are more complicated than most people think… much more complicated. And they don’t generally work as simplistically as they are often held out to be.

Beyond that there is earnings risk, loan interest risk, collateral risk, policy design and pricing risk, loan underwriting risk, etc. There are conceivably many things which can go wrong which may or may not be able to be handled by the overly broad swath of consumers being drawn into these deals. If the risks are acceptable and the plan design and insurance contract is understood and the potential repercussions are tolerable, then, by all means, premium financing could be a fantastic opportunity.

More conservative plans include paying loan interest out of pocket and planning for a scheduled roll out. The aggressive programs accumulate loan interest and grow indefinitely while counting on death benefits decades into the future to pay back the loans. By many accounts, the “free insurance” plans are highly unlikely to be sustainable and the ensuing results could be disastrous. To understand how sensitive they are to markets and interest rate movements, perform some stress testing. If assumed crediting rates are reduced by 50, 100 or 200 basis points and/or loan interest rates are increased by the same, does the program hold? Often it does not.

If this is an “old fashioned” premium financing case, hypothetically one could pay 10% loan interest on a policy with 5% crediting and still come out ahead if the alternate use of capital is 20%. See what I’m saying? However, I recently had a plan in my hands where the accumulated loan and interest exceeds a billion dollars and was unlikely to be sustainable given historical norms. What if that plan went off the tracks?

To reiterate, I’m not against premium financing but I am skeptical of many presentations I’ve re-viewed. Some have been outright laughable if not so scary. Premium financing isn’t really much different than me not paying off my home mortgage though I have the funds to do so. I have decided that with 3.75% tax deductible money it is better to keep the mortgage and have my money in the market. Conceivably there is a risk but the upside potential over time is meaningful and I understand the risk and it is bearable.

The moral of this story is the benefit of independently modeling a proposal to fully understand the effect of stress testing a program under real world circumstances. I’ve helped head off a number of unrealistic cases built on baseless assumptions which would have likely fallen to pieces and I’ve offered confirmations on some of the more sound design plans where true arbitrage is reasonably attainable and the risks are fully known. Again, the plans and the products which back them are often exceedingly complicated and most of your clients have no practical ability to vet them on their own. Professionals are out there to help you and your clients navigate the options. The cost of doing so today could be a ridiculously tiny percentage of the costs of not understanding and being left in a mess if historical market equilibrium finds its way back to the streets. This is a potentially powerful concept but be careful… more than usual.

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