Tier One: Financing Life Insurance Premiums in a Rising Interest Rate Environment
Using leverage to purchase life insurance has been a popular and effective strategy for over two decades. By borrowing to pay policy premiums, a policyholder can preserve liquidity, keep capital invested in higher earning investments and lower policy costs. Over the past 10 years, a prolonged, low interest rate environment where the arbitrage between a policy’s growth rate and the loan interest rate contributed to the success of most premium financing arrangements.
Today, economic conditions are changing, and interest rates are quickly rising leaving many prospective life insurance purchasers wondering if premium financing is a viable strategy. Recent media covering abuses involving taking loans to fund policies has added to the skepticism. Should someone buying a life insurance policy consider premium financing? The answer is “yes” if both the client and the life insurance sales organization take care to evaluate and monitor the three legs of a premium financing transactions: client suitability, product design and active service.
“Premium financing is not free insurance,” says Jeffrey M. Wasserman, Executive Vice President and the Managing Director of the Specialty Life Insurance Unit at Oswald Companies. “Using leverage involves risk and any client financing premiums should be able to afford to not use the strategy. By this, I mean that if the strategy is not as successful as planned, the client should not be financially injured by an increase in costs.” Wasserman points to a number of criteria related to client suitability that significantly increase the probability for success, especially as interest rates rise.
Clients should accept that premium financing is a long-term strategy with fluctuations in performance over at least 20 years.
Clients need to have at least $20 million in investable net worth so that the financing loan and the resulting policy asset do not make up a majority of a client’s liabilities or assets. This is not a strategy for a high earning professional who is considering borrowing money to pay premiums on a maximum funded life insurance policy purchased to supplement retirement income.
Clients should have some familiarity with using leverage. This could be from using leverage in their investment portfolio or with real estate dealings. At the very least, there should be a full understanding of the risks and rewards of applying leverage in a financial matter.
Clients should be able to pay, without financial injury, all planned premiums out-of-pocket instead of borrowing the funds should conditions make financing imprudent, or a loan cannot be obtained.
Wasserman adds, “Premium financing is not for everyone and having criteria for client qualification and adhering to that criterion is critical.”
For many years, either traditional whole life or universal life policies were purchased using premium financing. Both product types involve the insurance company investing policy premiums and sharing most of the return from the investment with the policyholder. For the most part, this means if the insurer’s investment yields did well, this was reflected in the policy’s dividend or crediting rate.
Until interest rates dropped to historic lows, the spread between what a policyholder earned in their policy and the premium financing loan interest rate made financing attractive. The life insurance industry introduced indexed universal life (IUL) as a solution that would help increase a policyholder’s return where the federal funds rate hovered near zero percent.
A IUL policy is a general account product that can lead to better returns – 9% or more – than a universal life or whole life contract because a policyholder can choose from a number of indices whose performance will be attributed to any premium allocated. Conversely, IUL contracts generally have downside protection with minimum, guaranteed returns of zero percent. Recently, life insurance companies having been making enhancements to their IUL contracts which are helpful to a premium financing arrangement.
First, many carriers are raising the ceiling on the maximum returns a policyholder can receive. These “caps” are moving from around 9% to double digits. Next, some IUL contracts have been repriced to lower policy expenses and to enhance yields. Finally, insurance companies have introduced low volatility indices that cost less and often perform better than popular S&P 500 indices.
While having a suitable IUL contract is helpful to a premium financing transaction, how the product is shown to a client and the client understanding of how a IUL contract works is equally as important. The National Association of Insurance Commissioners (NAIC) regulates how sales organizations can illustrate IUL and, unfortunately, the maximum performance that the NAIC permits to be illustrated may be half of what an IUL contract can do. Often, clients cannot see a model of what is possible in terms of the arbitrage between the policy performance and the premium financing loan interest rate.
Similarly, clients should make sure they are shown illustrative models of worst-case scenarios. For instance, historically, the S&P 500 has had three years of zero percent returns every ten years. A premium financing illustration where a S&P 500 index has been selected should reflect these years at the product’s zero percent guaranteed minimum.
Another historic statistic is that the spread between an IUL’s performance and the loan interest rate has been between three and three and a half percent. At least one of the conservative sales illustration a client receives should reflect this spread cut in half.
Additional illustrative models should show a combination of poor policy performance and high loan interest rates and volatility in performance. If a prospective buyer either finds these “worst case” scenarios too risky or does not agree these conditions are possible, they should not premium finance.
Client involvement in the management of both the life insurance policy asset and the premium loan is key to making the strategy work. An IUL policy must be managed. Indices performance will likely change annually, and the insurance company can make changes to any number of policy features, including yield ceilings, minimum guarantees or insurance costs.
Equal attention should be given to the premium loan. Lenders offer various types of loans that have different terms and rules. Some loans are annually renewable, and some can lock in rates for a period of years. Loans can also be called, and, in some financing arrangements, non-policy collateral will need to be posted.
“While a client should actively be involved in understanding policy and lending changes, it is the responsibility of the sales organization to monitor for changes and to communicate them to a client,” says Wasserman. “Ninety days in advance of a policy anniversary, Oswald Companies begins the process of analyzing the premium financing structure. This means ordering in-force illustrations to study policy performance, examining the lending situation and, if needed, applying for the next premium loan and seeing what collateral needs exist.”
Premium financing is a not a “set and forget” strategy and problems will almost certainly arise if either the client or the sales organizations fails to actively manage the transaction. By sticking to an annual process that involves both defined servicing activities and an open line of communication, incorporating leverage can be an extremely effective planning tool.
In today’s rising interest environment, premium financing remains a viable strategy for qualified clients to purchase large life insurance policies. Navigating the options available and explaining the risks involved, is where Life Insurance Strategies Group can help. We do not sell products, allowing us to provide independent and unbiased advisory. We help affluent clients and institutions make decisions about complex life insurance transactions. Visit us today at www.lifeinsurancestrategiesgroup.com.
Since its inception, Life Insurance Strategies Group has solely focused on the individual high net worth life insurance market. We do not sell products. This allows us to offer unbiased, pragmatic advice. Visit us at www.lifeinsurancestrategiesgroup.com.