Clients should buy life insurance because they need it and not because they can finance it. Make no mistake, premium financing is a sophisticated technique and, as I often catch grief for saying, isn’t for everyone and isn’t for some clients all of the time. Inevitably, when I write about premium financing, prospective HNW individual clients will reach out and ask I take them through a transaction to see if it would be suitable for their life insurance strategy. Many times it just doesn’t fit and it could be for a number of reasons: too many moving parts, lack of confidence in the interest rate environment, lack of comfort with the life insurance product and/or not wanting to take on debt.
Lately, though, premium financing is increasingly fitting into the estate and income replacement goals of our clients. This is due, in part, to the low interest rate environment and life insurance product performance permitting the necessary interest rate arbitrage. Also, our clients better understand that the strategy calls for frequent attention.
Premium financing is when a client obtains a loan or a series of annual loans to pay the premiums on a life insurance contract. By using leverage, the client is able to keep their cash invested in higher earning investments. For example, if a client is earning 9% from an investment portfolio, taking out a loan at 3% or less to buy a policy may make sense. Mathematically, if the premium is $2 million a year, there is incredible value to paying quarterly interest on the cumulative loan amount rather than coming out of pocket with $2 million annually.
The loans are either paid back from the policy’s cash values in the future or from the policy’s death benefit at the passing of the insured. Most, or all, of the collateral for the loan is the policy itself since many lenders will lend up to 100% of a policy’s cash surrender value.
The third leg to this stool is the life insurance policy and how it performs. If the policy earns a crediting rate that is higher than the loan interest rate and the client’s cash remains invested in even higher earning investments, all is well.
However, if the policy’s performance falls below the loan interest rate, then the cost of financing the policy will have increased. This still might not be a bad thing if the client’s cash remains invested where it is performing well. It is when those investments are not doing well that it may be better to use cash for the life insurance premiums rather than credit. Even worse is when a client’s outside investments are not doing well, lending costs rise and the policy underperforms. This is called ‘getting upside down’ in the policy.
This is a lot of gloom and doom, right? Well, maybe not and let’s talk about the good news. Currently, we have a historic, low interest rate environment where our clients are obtaining premium loan rates of as low as 2.5%. The Federal Reserve has mentioned that these low interest rates will be around for some time so clients considering financing have a little bit more certainty about the early years of their strategy.
When the low interest rates for loans are combined with the purchase of a policy which, if properly understood and serviced, can outperform the loan interest rate, premium financing begins to look better than it ever has.
The life insurance product alluded to is Indexed Universal Life ("IUL") which permits a policyholder to link the policy’s performance to one or more indices like the S&P 500. IUL often comes with a minimum floor and a maximum cap to ringfence volatility. Recently, many carriers have been reducing caps from double digit rates of return to high, single digit returns - which still fits the premium financing arbitrage arrangement. This article is not about the good, the bad and the ugly of IUL but, suffice-it-to-say, we make sure all of our clients who are considering IUL demonstrate a fairly comprehensive understanding of the product and commit to AT LEAST annual service.
In the category of ‘nothing lasts forever’, this idyllic environment for premium financing probably won’t last forever. Then what? The client will be disappointed if they just elect to premium finance and then do not make adjustments as needed to account for changes to all these components. It may be that there are years where the client pays cash for the premium and takes a year or more off from making more loans. The client could also decide to repay some or all of the loan balance early from outside sources to reduce the impact of the loan on the policy (and to create more income tax-free death benefit).
In other words, it is untenable for a client to think the original premium financing model is going to be accurate past, most likely, the first year. This is why we are happy to see that all of the Tier One life insurance producers with whom we work ‘stress test’ models to show clients numerous ways premium financing could go very wrong or very right. These producers commonly show a 0% policy performance for several early years and then show volatility in the lending interest rate. In addition, techniques for how to with deal problems are communicated.
Clients should know that premium financing might work well for now but doesn’t always have to work well in the future to be effective.
Read our companion Tier One Interview with Michael Seltzer by clicking here.
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.