I have been doing this a long time; 38 years, in fact. What I discovered during a recent review for one of our AgencyONE 100 advisors was mind blowing! Please review the below premium financing arrangement that was presented to our advisor’s client by a competitor, just as our advisor was attempting to finish placing the needed insurance on the client – a wealthy 67-year-old foreign national – after a lengthy underwriting process. I do not know who our advisor was competing against, what broker, what insurance company, what lender …. nothing. But I do know that the following was shown to the unsuspecting client WITHOUT a compliance illustration from the carrier. The answer to the question – Premium Financing Life Insurance , What can go wrong? A lot!
The first problem is that the client is NOT 65, he is age 67. Whoops! On the face of it (ignoring the age screwup), the transaction looks like a GREAT deal for the client. I mean, really …. look at the Return on Investment (ROI) at age 90, assuming the client dies in that year. It is 27.2%!
AgencyONE took one look at this illustration and vowed to figure out how anyone could deliver such spectacular results. If they are real, every hedge fund manager, pension fund, endowment and sophisticated investor would want to offer this regularly to their clients.
After doing some digging and running dozens of illustrations, we believe that we figured out which carrier and product was used to create the above scenario. One of the challenges we encountered during the process was that the product already included a cap rate change and had some assumptions that were impossible to recreate exactly. We choose not to mention any carrier or product by name in this ONEIdea, as is our custom.
Premium Financing Life Insurance Assumptions – AG 49, S&P Index, and LIBOR
This is an Index Universal Life (IUL) product whose crediting rate at the time it was run was 5.67%. But, what does that really mean? Simply, it is the maximum crediting rate allowed based on the Actuarial Guideline #49 (AG49 for short). In and of itself, this is not an unreasonable assumption, but one could argue that this maximum rate is on its way down (more on that later). Furthermore, the world of Indices does not operate in a sequential manner. This means that an option on the S&P Index in an IUL product will NOT return 5.67% year-over-year sequentially and will, usually, generate returns of 0% in negative equity markets (typically the S&P 500) or the designated cap rates in big market return years. Seldom does the index return anything between the two. As stated, these products, for the most part, have floors and caps. They cannot return less than ZERO (the floor) and are capped at some return, say 9%. The ZERO floor can also be misleading in some products that have spread or strategy fees, so ZERO may not always be ZERO, and, due to expenses, these fees can certainly produce a reduction of the cash value of the policy.
In the illustrated example, the bank is lending money for 12 years at a 3.2% fixed interest rate. This is unusual for a premium finance arrangement since most premium finance lenders lend based on a spread over the London Interbank Offered Rate (LIBOR). Many lenders have options to fix the rate via a Swap (often higher than LIBOR plus a spread), which goes way out of the context of this discussion, but for arguments sake, fixed rates may last 5-7 years, maybe 10 if you are lucky, but not 12 years, certainly not in this interest rate environment. Regardless of the reality, it is not explained in the presentation. What does the cash flow and the ROI look like in an environment where the interest rate on the loan goes up?
The loan payoff occurs in year 12, using a loan from the policy. To be clear, it is NOT a withdrawal from the cash value of the policy, it is another loan FROM the IUL policy to pay off the loan due FROM the bank. Robbing Peter to pay Paul is what I have heard this called. OK, so why not borrow with better terms to pay off another loan? One would consider this concept a “refinance” in the mortgage world, right? And usually, it is done for a more favorable financial result (lower interest rate, shorter duration, lower cash flow, etc.). The problem is how these loans operate. The loan illustrated is a “participating loan” from an IUL contract, which means that when the money is borrowed at interest, the “loan value” stays in the index and can “participate” from any positive results that exceed the loan interest rate. So, for example, let us say that the owner of the policy borrows $1,000,000 from the policy at a 5% interest rate. If the Index delivers a 9% capped return, then the client has the benefit of a 4% net return on their money, but the opposite is also true. If the Index return is ZERO, then the client has an interest expense of 5% of $1,000,000 or $50,000 against the cash value, plus any other expenses such as spread or strategy fees, cost of insurance, administrative expenses, loads, etc.
We cannot overlook this participating loan issue because it is very hard to illustrate future results of an IUL contract due to the sequential nature of illustrations and the fact that we cannot illustrate anything over the AG49 rate. Furthermore, many par loans are fixed interest loans with guaranteed maximums. With that said, we can illustrate a ZERO percent Index return in a given year, or in some sequence, for example, every 6 years. We re-ran the illustration showing a ZERO percent Index return in year 6 and again in year 12 with the loan taken in year 12 to pay off the bank loan. This caused the illustration to lapse immediately in year 12!
This shows how sensitive these illustrations are and how dangerous they can be to unsuspecting clients who are being pitched premium finance arrangements using par loans to pay off bank loans.
Finally, in the short time that this proposal was being considered, the carrier reduced their cap rates; in fact, they dropped cap rates twice since the onset of COVID in March. The impact of a cap rate reduction is that the illustration rate allowed under AG49 was also reduced. The illustration at the “current illustration rate” did not perform at all, never mind inserting two ZEROES in years 6 and 12. It just, flat out, lapsed when the loan was taken to pay off the bank. Again, this goes to the sensitivity of these products.
In this period of low interest rates, general account yields of the insurance industry are being impacted dramatically. The insurance industry invests a very large portion of the portfolios in 10-year Treasuries, which, as of this writing, are at historical lows. There are two factors that impact IUL cap rates – the carrier’s portfolio yield and the S&P Volatility Index or the VIX, for short. So, with low interest rates for the foreseeable future and continued market volatility, I would not be surprised to see a continued reduction in cap rates, which of course will further impact the upside for capped IUL products.
Ways to Avoid Premium Financing Pitfalls
How do we prevent the illustrated scenario above and provide a more obtainable solution?
- Thoroughly review and understand the product. Know how the indexes credit (floors/caps), what charges apply, and how they can be impacted.
- Obtain more accurate or realistic loan rates for the financed proposal.
- Understand the loan strategies available and how they can be used. Par loans can be good options but require quite a bit more policy management.
- Stress test your illustrations using lower or varying rates. Make sure the client understands that if the illustrated rates are not obtained, they may need to provide more premium or delay using the policy values to pay off the loan.
AgencyONE’s analytical expertise, advanced markets specialization, and significant experience with premium financing uniquely position us to assist you with the planning of your next case.