What you see isn’t necessarily what you get.
Wealthy people and business owners have always leveraged money and assumed risk but starting about a decade ago, after the 2008 crash, premium financing has been driven by very low London Interbank Offered Rate (LIBOR) based borrowing rates and aggressive return assumptions on insurance products that are easy to manipulate.
Indexed Universal Life (IUL) made a strong showing marketed by a particularly attractive story, if not altogether accurate. Upside potential of the stock market without the downside risk sounded great with the memory of 2008 still fresh in minds. These products can be illustrated at unrealistically high rates while appearing to be modest because few understood how they work. Abuse is rampant even after the regulatory action of AG 49.
Though IUL policies make up an overwhelming majority of premium finance transactions, I’ve always seen deals built around traditional WL. Many of these plans could never work from inception but were misrepresented to policy owners.
Wealthy clients have been approached to buy vast amounts of life insurance for “free” or greatly reduced contributions by taking advantage of the perceived arbitrage between low borrowing rates and high crediting rates. Models show growing policy cash values paying off the loans down the road, leaving fully funded policies with little or even no money out of pocket. It’s often presented as a very sophisticated strategy with smart people using other people’s money. But it’s not that simple.
The Market Today
With rising borrowing rates and lower projected crediting assumptions, you’d think this strategy would go by the wayside, but it seems to actually be ramping up. The numbers are huge, and the deals tempting when well postured. Policies are generally much larger than consumers usually need to jam the vast amounts of money (millions of borrowed dollars) into them in an attempt to grow cash value at attractive rates to repay loans. The policies must be large enough to support the desired net death benefit after million of dollars have been withdrawn and/or borrowed out to pay the loans back. Some programs don’t even assume paying the loan back until death. These policies assume tens of millions of dollars, or even hundreds of millions of dollars of internal policy loans. Every case I have on my desk has or will drive six and seven figure commissions, which I have no issue with if they brought value and worked as presented. With these kind of paydays, even the good guys can be tempted.
Again, the concept is sound, but the explanation and implementation is largely abysmal, and what many families are being sold stands little chance of working out. Few understand the financing, the internal workings of the insurance contracts, the collateral requirements and the risks. Your clients may be more sophisticated than average, but you’d be surprised at the decisions they’re making and situations they’re getting themselves in to. It’s not pretty. I’ve seen the counsel for billionaire families get snowed.
But why is WL the vast majority of what I’m seeing if it’s the significant minority of what’s in force?
First, most of the time premium financing is, rightly or wrongly, marketed as being all about arbitrage or “the spread.” However, many professionals who really understand this feel the spread needs to be between borrowing rates and time value of money, not between borrowing rates and the life insurance crediting rates. Playing the spread is fine, if there is a spread. This is why I don’t pay off my 3.5% mortgage as I’m confident I can do better in the market with my money. I won’t every year, and I need to understand the risks and be able to cover my mortgage regardless of whatever else is going on in life, but I’m comfortable with that.
There needs to be a spread, and here’s the rub. With WL, there isn’t a spread. It may look like it, and you or your client may have been told there is. But, there isn’t, so let’s dissect this. A WL policy’s dividend rate isn’t something to focus on. That being said, every case I’ve seen was sold on the dividend rate. More precisely, it was sold on the dividend rate relative to borrowing rates. An agent doing so is either ignorant or willingly misrepresenting the numbers.
Real Numbers for Real Analysis
The dividend rate is the gross crediting rate on cash value of a policy, but there are many charges and expenses that come out, so the effective crediting relative to premium is much lower. In fact, in most cases, it takes a decade or more for the cash value of the policy to even equal the cumulative premiums. The cash value is underwater for years even if the dividend rate is 6% or higher, actually, regardless of the dividend rate. Incorporate the borrowing rate and it’s even further underwater. There’s certainly a spread here but not the spread the client understands there to be.
I just pulled a couple of ledgers from my active files and did some internal rate of return (IRR) calcs. The IRR on premium to cash value at 10 years is less than 1% for a product with one of the highest dividend rates in the market. At 15 years, it’s 2.5% to 3%. At 20 years, it’s in the mid threes, and at 30 years, we’re still under 4%, and that’s as high as it gets.
The Role of LIBOR
Now let’s look at LIBOR. We all know that LIBOR rates can be quite volatile. Just look at a LIBOR historic rate graph, and you can see it’s all over the place, and it can change very quickly. From 2008 to 2009 it went down 90%, and at other times, it shot up like a rocket. From 2017 to today it’s tripled, and today’s rate is over 15 times that of 2014. Often, the borrowing rates on premium financed deals are in the neighborhood of 150 to 175 basis points (bps) over one month LIBOR.
What does this tell us? That borrowing rates are substantially greater today than they were not long ago. But who didn’t know this was eventually going to be the case. Did anyone really think that one month LIBOR at 0.15 was the new norm?
The Role of Policy Dividends
What else was at play? The dividend rate of a WL policy is a portfolio rate that lags the market. As older, higher interest rate bonds fall off the books, they’re replaced with new bonds at lower rates. I’ve seen instances in which an agent actually told the policy owner that she would want interest rates to increase because this meant the policy dividend rate would increase. There’s going to be a multiple year lag, and the dividend rate will always be tempered on the low and high ends.
Let’s put all of these numbers together. If the borrowing rates today have reached 4% or higher and the IRR on premiums to cash value for WL policies put in force in the past decade are literally negative, where’s our arbitrage? As an aside, I’ve actually read an email from an agent to a policy owner “confirming” a multi-hundred bp positive spread after Year 1 when the cash value was actually about a third of the first year premium/loan. I must say, that’s quite the spread but unfortunately it’s significantly negative. At today’s borrowing rates, assuming no more increases, a contract that will never hit a 4% IRR on premium to cash value will be underwater indefinitely. It can’t work the way it was explained. The only reason it originally looked like it is going to work is because the client is paying interest out of pocket. But certainly that’s still a cost, is it not?
In a ledger in front of me, the borrowed premiums over 10 years total $10 million, and the interest paid out of pocket totals $5 million at the purported roll out date. However, the gross cash value is $14.5 million at the same point. That isn’t a positive spread.
In the presentation, it looks like it’s going to work because the $14.5 million of cash value has to pay for only the $10 million loan. It didn’t take the $5 million into account, which is kind of important when evaluating the “goodness” of the deal and whether there really is a positive spread. Ignoring the risks involved in the transaction, the whole game was built on a positive spread and that doesn’t exist. Anything can be positive if you pay enough money out of pocket. If I bought a house for $1 million and had a $700,000 loan when the value of the house plummeted to $500,000 as I sold it, but I paid off the shortfall with other funds, does that mean I didn’t lose money?
Difference Between Then and Now
I bring this up because the numbers above are only part of the story. These deals weren’t going to work as proposed from day one, but the deal has changed since then. Borrowing rates have increased much more and faster than projected, and dividend rates have come down significantly. So much for policy crediting rates tracking with the interest rate markets, huh? Some of these clients assumed very low interest payments that have now increased multiple fold to a point where it hurts and may not even be feasible to pay, and the cash values are shrinking to a point where the expected insurance won’t be supportable any more. Tons of insurance for little cost is turning into, relatively speaking, little insurance for tons of cost, and certainly not enough to make the pain and risk worthwhile.
Remember that often premium financed life insurance is marketed to those with little cash flow even though they may be very wealthy. I’ve seen this first hand repeatedly.
WL vs. IUL
So why are the WL policies ending up on my desk? Because they can’t be fudged.
The policy dividend rates are what they are, and the borrowing rates are what they are. The cash value growth of the policies and the loan interest due is what it is. The policy owners and their advisors and family offices see that the numbers aren’t working, and they’re confused because they don’t know why. Yes, the dividend rate might have come down from 7% to 6%, and loan rates might have increased from 2% to 4%, but that purported 500 bp spread should still be 200 right? Except for the nasty little thing no one acknowledges… expenses. If the expenses of the policies total about 300 bps, there isn’t a 200 bp positive spread, it’s 100 bps negative, and the numbers prove this out.
I’ve stated that these deals couldn’t work from day one as explained. Undoubtedly some will take issue with this because if policy dividend rates didn’t come down and borrowing rates didn’t increase, the transactions would have panned out like they looked on paper. However, the way they’re explained and sold is often based on misrepresentation, and this causes a transaction that would “work” on a razor’s edge to fall apart with normal and expected market gyrations. That deal that purported a 500 bp spread was really only 100 bps, and I imagine that advisors and clients who actually understood this wouldn’t have pulled the trigger as quickly, if at all.
This might all be great if your client is making 20% on money in her company or on his real estate portfolio. She needs the insurance and doesn’t want to take money out of the game? Full steam ahead. Now you’re playing the spread between borrowing costs and time value of money, not policy crediting.
Why not the IULs? Because IUL contracts can be fudged. WL can be projected based solely on what it’s experiencing today or less. IUL can be projected based on back testing and illustrated higher than many responsible professionals believe it should be illustrated. Many IUL contracts can be illustrated in the neighborhood of 7%, and almost all of them over 6%. That may not sound aggressive until you understand how IUL policies work. Almost no one does, and that’s the focus for another day.
Some of your clients are the perfect target for premium financing, and I invite you to reach out to an objective expert to better understand what your client has and the chances of success. This is a good time to be proactive.
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 email@example.com.