Given the number of premium financing cases that I review, in force and proposed, I’ve seen much of what’s out there and have a good grasp of the level of understanding in the consumer market. There’s one overriding commonality I see again and again, and until this is taken care of, there will continue to be problems: Are the numbers customers see real?
As I’ve written before, I’m not against premium financing. If I was, I wouldn’t have a mortgage on my house. I don’t pay off a 3% mortgage because I’m confident that I can do better over time in the market or invest that money back into my company, other real estate or whatever I believe I can invest in at better than 3%. Returns elsewhere that are better than my mortgage rate effectively discount the cost of the house.
Isn’t this often the communicated appeal of premium finance? If I can borrow at 1-year LIBOR plus 150 basis points today, let’s say that’s 2%, and I can make 5%, 6%, 7% or higher in a life insurance policy, why wouldn’t I if I’m shown that the spread will grow cash value to the point it can pay back the loan and I have significantly discounted, or even free, life insurance?
That would be great… if only it was true. Now wait a minute Bill, I can hear you saying, you’re not going to say that the gazillions of dollars of premium financed business aren’t real, are you? Well, kind of. Of the gazillions in premium financed business, some percentage is legitimate but I’ll suggest bazillions aren’t. (Sorry for the technical terms. I’ve defined them at the end of this piece.) How can I say that, you ask? Because I’ve seen the misrepresentation first hand.
This isn’t about the realism of the AG 49 regulations or the future performance of the stock market or legitimacy of proprietary indexes or performance of more realistic sequencing of returns or the efficacy of indexed loans or numerous other things we can argue about regarding modern life insurance and the financing of premiums. No, this is about something very simple… are the numbers consumers see real?
What Rates are Real?
This is where we can start getting into the area of Clintontonian parsing of language. Is that 6.2% whole life (WL) dividend rate or indexed universal life (IUL) crediting rate real? It depends on what the definition of “real” is. Is it an actual number that goes into the funnel along with all of the other contract variables? Yes. Does it bear much resemblance to the product coming out the other end? No. At least not in the sense that policy owners understand.
I’ve seen plenty of premium financed cases built around both traditional WL and IUL. In recent examples of each that I have analyzed, the internal rate of return on premium to cash value over 10 years was 0%. Let’s go back to the earlier question; Is the WL dividend rate or IUL crediting rate real? You tell me. If I’m supposedly being credited 6.2% and getting 0%, what’s real? Where’s that 6.2% going? Premium taxes and charges, policy fees, mortality charges, commission, etc. That’s to be expected because that’s how insurance works. A recent IUL case on my desk had $3.5 million of premium in the first decade and $3.7 million of expenses during the same period. That’s bound to put a dent in the returns.
That’s in the early years, so how about later? Over decades, the actual IRR on premium to cash value might be 3%, 4% or 5% based on current dividend rates and reasonable market returns, but we’re still not at the 6.2%. Is that a problem? It depends on how the deal was postured to the policy owner. What I can tell you is that over and over I see a deep misunderstanding on the part of the consumer that’s a result of misrepresentation. The arbitrage these deals are consistently built around is between the gross crediting rate and today’s borrowing rate. Moving into the arena of Trumpian language, there is almost no understanding that this is a fake spread.
It’s not real, people. It’s just not real. There, I said it. The gross WL dividend rate and the illustrated IUL crediting rate that so many consumers buy into, because that’s what they are sold, doesn’t mean much relative to the net rate after all expenses. I’m not saying this is typical of all cases, but one I’m working on right now, based on the actual original sales ledger, that has an IRR on premium to cash value that never exceeds one point something percent. I’m serious! The supposed arbitrage based on the original 6.25% projected crediting rate never even hits, under best case conditions, the borrowing rate. It’s a perpetual negative arbitrage that the client bought into because of how it was sold to him! It didn’t even have anything to do with the opportunity cost of any of his other assets.
What Can You Trust?
But what about the spreadsheets showing is all working out? Ask yourself how well you comprehend those spreadsheets. Do you really understand all the variables built into them? How realistic are the assumptions? Maybe it’s being built on an insurance carrier’s illustration system that’s being outlawed as we speak. Are you familiar with options pricing and how that affects cap rates and where they can go? When do you want to discover that? Maybe it was built off a baloney, nonetheless “real” dividend rate that someone who actually understands the markets, the industry and how life insurance works, would absolutely know is going down. Wouldn’t that be valuable and more so today than down the road after millions are sunk into it?
Let’s review. Does your client have needs and a risk tolerance profile that necessitates consideration of such a plan, or is this something “sophisticated” that rich people do? The advertised rate means almost nothing so your client should never make a decision based on the “arbitrage” or “spread” between the advertised dividend or crediting rate and the borrowing rate because it isn’t real; it’s a fake spread. Seek objective counsel from someone who understands the financial markets, the industry, the products, the programs, what’s driving these deals and who’s paid for advice.
Once again, I’m not saying premium finance is bad or can’t work, and I’m not saying to get out of what’s currently in force. What I’m trying to say clearly is that anyone who’s in a deal or considering a deal absolutely needs to understand what is real and what isn’t real. Is that so crazy an idea? The good news is that this is possible. All that’s needed is some objectivity and a calculator. If they move forward with something that isn’t as real as it’s understood to be, things fall apart, disillusionment prevails and they end up at my door. After I dive in and untangle things and show them what was real from the beginning, they tend to pay attention and get engaged. If only they were that engaged from the outset.
* Gazillion – A lot.
Bazillion – A lot but not quite as much.
Bill Boersma is a CLU, AEP and LIC and the founder and principal of OC Consulting Group. More information can be found at www.OC-LIC.com, BillBoersmaOnLifeInsurance.info or email at email@example.com.