Premium-financed life insurance can work. Under the right circumstances, with the right client, policy, financing arrangement, assumptions and ongoing management, it can accomplish legitimate planning objectives. Just because I have yet to see one doesn’t mean they don’t exist.
It can also become extraordinarily expensive, even financially devastating, when things don’t go according to plan. When these transactions get into trouble the culprit isn’t always the insurance policy, the lender or even the original strategy. Sometimes human behavior deserves part of the blame.
That brings us to the Seven Deadly Sins. With apologies to theologians everywhere, I offer a financial variation: The Seven Expensive Sins of Premium-Financed Life Insurance.
1. Pride
Let’s start with perhaps the most expensive. Successful people are accustomed to making good decisions. It’s part of what made them successful. Consequently, acknowledging that they may have made a bad one can be difficult.
Premium financing compounds the problem because these transactions are complicated. A client may have been surrounded by impressive professionals, sophisticated presentations and illustrations showing attractive long-term results.
Then reality doesn’t cooperate.
- Borrowing rates rise
- Policy performance disappoints
- Collateral requirements increase
- Loan isn’t renewed
- Exit strategy becomes less attractive
At that point, pride can become expensive. Instead of asking, “If I were looking at this transaction for the first time today, would I still do it?” the question becomes, “How do I prove that my original decision was right?”
The solution isn’t necessarily to unwind the transaction. It is to subject it to independent scrutiny.
If an independent analysis confirms everything you’ve been told, the fee was cheap insurance. If it doesn’t, it may be the best money you ever spent.
Pride is one of the few policy expenses that doesn’t appear on the illustration.
“The greatest obstacle to discovery is not ignorance, it is the illusion of knowledge.”
2. Greed
Premium financing often begins with a seductive proposition: “Why use my money when I can use the bank’s?”
There’s nothing inherently wrong with leverage. Businesses and wealthy families use it every day. But leverage isn’t magic.
The strategy generally depends on some version of a spread: money is borrowed at one cost while policy values are expected to perform sufficiently well to justify that cost.
When illustrations show attractive crediting rates, favorable loan terms and decades of compounding, enormous numbers can appear on the right side of the ledger. That’s when greed can show up.
If $10 million works, why not $20 million? If financing premiums for five years looks good, why not ten?
The problem is that leverage magnifies disappointment just as effectively as it magnifies opportunity. A strategy shouldn’t require optimistic assumptions to justify its existence.
“There are two times in a man’s life when he shouldn’t speculate; when he can’t afford it, and when he can.”
3. Lust
Lust is about seduction, and few things in financial services are more seductive than a beautiful illustration. Pages of numbers march confidently into the future. Cash value grows. Loans disappear. Death benefits remain intact. Interest rates behave themselves.
Everything works.
Unfortunately, the future has never seen the illustration. An illustration is not a prediction. It is a mathematical demonstration based upon assumptions.
Change those assumptions and the ending can change dramatically.
- What happens if borrowing costs are higher?
- What if policy crediting is lower?
- What if caps decline?
- What if collateral is required longer than anticipated?
- What if the planned exit doesn’t occur?
The question isn’t whether the original illustration works. The important question is how much can go wrong before it stops working?
“All that glitters is not gold.”
4. Envy
Nothing sells sophistication quite like hearing that other wealthy people are doing something.
- “Family offices use this”
- “Our ultra-high-net-worth clients are doing it”
- “Banks finance these transactions for some of the wealthiest families in America”
Maybe. But somebody else’s balance sheet isn’t yours.
Their liquidity may be different. Their borrowing capacity may be different. Their tax situation, estate plan, risk tolerance and ability to post additional collateral may be completely different.
Financial strategies shouldn’t be luxury goods. You don’t need a premium-financed insurance transaction because your neighbor has one any more than you need his Gulfstream.
Complexity isn’t evidence of sophistication. Sometimes the sophisticated decision is the simpler one.
“Envy is ignorance, imitation is suicide.”
5. Gluttony
If some insurance is good, more must be better. Premium financing can make enormous amounts of life insurance appear surprisingly affordable because the initial cash commitment may represent only a fraction of the premiums being paid.
That can obscure economic reality. The bank may be writing the premium check, but the bank isn’t giving anyone free insurance.
Debt is accumulating somewhere. Interest is being paid or accrued. Collateral may be pledged. Policy expenses are being deducted. Eventually somebody’s capital supports the transaction.
The appropriate question isn’t simply how much insurance can be justified or financed.
It is: “How much insurance should this client own, and what is the most economically sensible way to own it?”
Those aren’t necessarily the same question.
“Nothing is enough for the man to whom enough is too little.”
6. Sloth
Premium financing is not a “set it and forget it” transaction. Yet that’s exactly how some are treated.
A beautifully bound presentation goes into a drawer. Annual statements arrive. Interest gets paid. Another year passes. Nobody meaningfully revisits the original assumptions.
That is dangerous.
The lending environment changes. Policy expenses continue. Crediting rates vary. Index caps and participation rates can change. Collateral requirements move. The insured gets older, changing the available alternatives.
A transaction that made sense five years ago doesn’t automatically make sense today. Every review should ask brutally simple questions: “Where are we compared with where we were supposed to be?” and “Where do reasonably adjusted assumptions show we are headed?”
“You may delay, but time will not.”
7. Wrath
Finally, we have wrath. This usually appears when someone delivers bad news.
- An independent consultant reviews the transaction and questions the assumptions
- The lender raises concerns
- An attorney asks uncomfortable questions
- A CPA starts calculating the actual economics
Suddenly the messenger becomes the problem. I’ve watched situations where tremendous energy was spent defending a transaction when that energy would have been better spent objectively evaluating it.
Facts aren’t insults. A disappointing policy result isn’t a personal attack. Neither is an analysis showing that a strategy has deteriorated… or was never reasonable to begin with.
The appropriate response to uncomfortable information isn’t anger. It’s curiosity.
“Show me.” That may be the two most valuable words a policy owner can say.
“The truth will set you free, but first it will piss you off.”
The Eighth Sin
I’ll add one more: Blind faith.
Trusting an advisor isn’t inherently foolish. Good advisors are enormously valuable. But there’s a fundamental difference between trusting someone and outsourcing your judgment to them.
When millions of dollars of insurance, significant debt and substantial family wealth are involved, verification isn’t disrespectful. It’s prudent.
Premium financing can be an attractive planning strategy. It can also become an extraordinarily expensive machine for converting optimistic assumptions into real-world obligations.
The danger increases when pride prevents us from questioning the original decision, greed encourages us to maximize it, lust makes us fall in love with the illustration, envy convinces us sophisticated people should do sophisticated things, gluttony encourages us to do too much, sloth keeps us from monitoring it and wrath prevents us from listening when somebody finally raises a red flag.Maybe that’s the common thread running through all seven sins:
The numbers can create the problem. Human nature can keep us from fixing it.
“Trust, but verify.”
