Reviewing a premium finance annual report
By Bill Boersma
In the past couple of weeks I’ve received for review two premium finance annual reports that cover four policies. The point of these reports is to show the agent and the policy owner how the transaction is panning out, including how it’s doing relative to original projections. Obviously, it’s important to manage such transactions.
These reports include name, rank and serial number like death benefit, cash value, loan amounts, loan rate, etc. They also put, side by side, a summary of the original projected policy performance and the actual policy performance. There is some graphical information as well.
I’ve repeatedly related that there’s a significant amount of misrepresentation in the premium finance market. I’ll repeat that I’m not saying the concept doesn’t have potential sound footing for limited scenarios and I’m not universally slamming indexed universal life (IUL) insurance. However, I’m up to my neck in reviews, analysis and litigation support for premium financed IUL policies and I can assure there is significant misrepresentation. Some of it is on the financing side and some of it is on the insurance side.
When people ask what I mean, I’ll share examples. Today, I provide some detailed information.
Details of a Current Case
In a case I’m currently working, the client has two significant polices; $20 million each. The policies are three and four years in. One of them has a variable loan interest rate and one has a fixed loan rate for a limited number of years. For each of them the policy owner is making an out-of-pocket contribution, but not the full loan interest. Frankly, I don’t even know where the numbers came from, but it’s a minimal annual payment; $30,000 for one and $100,000 for the other. Seeing that the cumulative annual premium for these two policies is $3 million annually, this out-of-pocket amount is quite modest.
he thing I’ll focus on is the actual vs. illustrated comparison. I’ve recreated it below for each policy. There are two aspects of this I’m going to take issue with. The first is that the actual policy performance stops after the current year. This may not seem like an issue, but it is. You can see that the actual is slightly behind the original illustrated. We know that the original illustrations are absolutely, positively going to be different. They will be either better than or worse than the original projections, so this, in and of itself, shouldn’t cause concern.
Putting It into Perspective
Before we go further, let’s talk through something that is easily understood by most. We’ll assume a 30-year-old is saving for retirement and putting away $10,000/year and is assuming a 10% return for planning purposes. During an annual review with their financial advisor, when they see they’re getting 8%, they understand why their balance since they started at age 25 is $63,359 when the modeling initially showed $67,156. Behind, yes, but not the end of the world. But what if we look at the modeling on the same assumptions at age 65? The balance is $2,797,810 vs. $4,868,518. Now that’s a big issue, isn’t it? The point is the modest spread in the early years is seemingly irrelevant until it’s understood how this manifests over the along haul.
Understanding how minor changes can mean big differences over time when it comes to time value of money, it seems imperative to compare actual policy performance to illustrated policy performance over many years by using the forward projected numbers from the actual policy performance ledgers, but many insurance agents and premium finance promoters are not doing this.
Not doing so allows the shortcomings of the premium finance transaction to be buried until it’s too late to do anything about it. This isn’t hypothetical; I see it all the time. Keep this in mind as we move towards discussing the long-term effects on the life insurance policies.
Where’s the Spread?
Let’s move to the more obvious issue. Refer again to the table. You’ll notice that for both the illustrated and the actual policy performance there is an average at the bottom. Here’s where the misrepresentation starts. The first table shows $5,880,000 of applied premium paid over four years with a cash accumulation value of $5,292,000. I’ve never been mistaken for a genius, but ending with a lower value than contributed capital shouldn’t result in a positive return.
What the table is showing is the average gross crediting of the policy. When I pull out my financial calculator the rate of return on premium to cash value is negative 4.16%. That seems more like it. The question is, why advertise a decent positive return when the the number that matters is negative? The gross crediting number is relatively pointless. If I offered you a guaranteed 10% investment opportunity but then took 15% in fees, what would you say if I was crowing about the double digit return I got you? Yeah, I thought so.
When the whole point of most premium financed deals is about the spread between the policy crediting and the lending rate, the only number that matters is the net rate. But because the deal is initially built on the unrealistic number, it must keep being positioned that way in the reviews or else the policy owner would realize everything is under water. Look at the original illustrated policies; the cash value doesn’t project to exceed the cumulative premiums until five or six years in. Yes, this is shown in black and white, but I can assure you that the policy owners who have this pointed out and understand it are few and far between. The majority of them only understand what they’ve been told and what they’ve been told over and over again is to focus on the spread between the gross policy crediting and the loan rate. However, in real life that’s negative for years.
For a plan built and sold on positive arbitrage, understanding the
actual realized negative arbitrage might be nice.
Another Example
Here’s another example in the table below. The initial projected crediting for both policies in this case was 8.10% and the average actual return is listed as 5.55%. Today the gross crediting on the two policies is 4.18% and 6.03% respectively, significantly down from the original 8.10%. This review is combining the two policies as opposed to reviewing them separately in the case above. We can calculate the initial assumed gross 8.10% crediting to result in a net 5.19% projected return on premium to cash value over nine years. This can be determined simply with a financial calculator, though it was never brought to the policy owner, who, rightly or wrongly, believed there was 8.10% earnings, not just gross crediting. After all, if we’re focusing on spread in these deals, why pay attention to gross crediting rate at all? The net return is the only thing that matters. Per additional calcs, note the actual gross crediting of 5.55% that is listed has resulted in 2.28% net in reality.
Question: how many prospective clients would have moved forward with implementing the plan had they know an 8.10% projected crediting rate projects to result in a 5.19% return, assuming we take everything else at face value? Now look at the next table. While they are “admitting” the proposed 8.10% gross ended up being only 5.55%, as discussed above, those numbers aren’t meaningful anyway. It’s the net 5.19% net originally projected relative to the net 2.28% net actually earned that matters. Remember, don’t look for those numbers on this report because they’re never shared. I calculated them based off of the original sales ledgers and the current in-force ledgers. How many would continue moving forward with the plan if they were informed that the actual achieved net earnings were half of what the report related, or significantly less than the lending rate? For a plan built and sold on positive arbitrage, understanding the actual realized negative arbitrage might be nice.
Because of the low lending rates in the earlier years, the actual average lending rate has been lower than originally projected, purportedly resulting in an actual realized spread of only about 100 basis points less than originally projected. However, this is ridiculous.
The actual spread is negative .14%; the actual net return of 2.28% less the actual loan rate of 2.42%. There is literally no above-board way to posture the spread as positive because it is definitionally negative. But this is the data provided to “prove” everything is on track. This isn’t simply a misrepresentation, but an outright lie.
Why It Matters
For this second case, the original plan was to pay back the loan from the cash value in 19th year at age 70. The payback is projected to be $58,748,000. The policy initially had a projected cash value of $74,903,000 at that point, so there’s cash value to do so and leave enough juice to support the policy moving forward. The problem is, based on current in-force ledgers run assuming the maximum allowable crediting rate (which isn’t responsible in my estimation) the cash value is now projected to be $48,183,000 at age 70. That’s clearly not enough to pay back a loan that’s $10 million greater, let alone keep the policy in force. Additionally, the current lending rates are higher than the projections used so the loan will be even bigger.
This is why I related the retirement planning of the 30-year-old above. Exceedingly small differences today can get magnified into giant swings down the road. It’s tremendously important for these transactions to be thoroughly examined. I spend my time crawling up the you know what of these deals to figure out how they’re working… or not working.
The interesting aspect of this one is that the collateral required by the policy owner over and above the cash value of the policy was looking decent for a number of years, due to the low loan rates. Then it turned on a dime and the client was a couple million underwater almost overnight. One could assume that maybe the agent and premium finance promoter were just as surprised as the client. However, I was able to get in-force ledgers for multiple years while the policy was in force that were not shared with the client. If a fair assessment of the deal was performed and shared annually, which is exactly what I did after the fact, we can see that it’s obvious this deal was going sideways from the get-go. There was a conscious decision to posture everything so that it was papered over.
Don’t be tempted to think that these were a couple of premium finance promoters engaged in dirty tricks and your or your client’s deals are different. These are from two of the major players in the market that account for a significant percentage of premium financed cases out there.
Bill Boersma is a CLU, AEP and LIC and the founder and owner of OC Consulting Group. More
information can be found at www.OC-LIC.com or email at bill@oc-lic.com or call at 616-456-1000.
Securities offered through Valmark Securities, Inc. Member FINRA, SIPC.
Investment Advisory Services offered through Valmark Advisers, Inc. a SEC Registered Investment Advisor.
OC Consulting Group and its affiliates are separate entities from Valmark Securities, Inc. and
Valmark Advisers, Inc.
The examples given are based on actual client experiences and are for illustrative purposes only. Actual results may vary from those illustrated.
The information provided has been derived from sources believed to be reliable but is not guaranteed as to accuracy and does not purport to be complete analysis of the material discussed.
