#61 | Product Design and Premium Financing

Premium financing is a very simple idea – borrow money to buy life insurance. Doing so essentially allows the policyholder to trade premium payments for loan interest payments. The problem is that this simple story always comes along with baggage. The loan has to be fully collateralized, it eats into the death benefit payout and it has to be renewed in the future at uncertain rates (and sometimes the renewal itself is uncertain). These are inconvenient complications that can be somewhat handled by adjusting the policy design to have more early cash values and an increasing death benefit. The former reduces collateral requirements and the latter maintains a level death benefit net of the loan. Finding a policy that allows for both usually means choosing an accumulation product rather than a death benefit product. This is ironic because the point of a traditional premium financing sale is death benefit protection. Premium financing essentially requires the use of an inferior product in order to supposedly achieve superior results. If this strikes you as a bit strange, you’re not alone. Producers usually love the idea of premium financing until they actually look at the numbers and then they scratch their heads about why they would use it if the point is to provide efficient death benefit protection. Too often, the choice is between paying for a good product out-of-pocket or premium financing a bad one.

So why can’t we premium finance a good product? Good products for death benefit protection usually don’t provide enough cash value to cover the collateral requirements. Collateral is more than just an inconvenience – it strikes to the central reason why anyone would use premium financing. The central idea behind financing is that the client can keep capital at work in high-return, illiquid investments while still securing life insurance coverage. But if that premium financing required collateral at 100% of the loan balance, which is equal to premiums paid, then what’s the point of financing? Few banks will take highly illiquid and volatile assets as collateral without a steep discount and most of those types of investments are already leveraged. If the client is highly liquid, then why not just pay out of pocket? Premium financing revolves around the idea of borrowing money without having to post collateral. The only way to do that is to overfund a high cash product. The only high cash products around are bad for death benefit protection – therein lies the problem.

Let’s use a particular scenario (Male, 55, Preferred, $1M death benefit) as an example. The lifetime pay premium on a quality Guaranteed UL or CAUL product is about $11,500 and has an insignificant amount of cash value. The IRR at age 85 is 6.2%. A typical premium financing design would need high early cash values and a Return of Premium death benefit (where the death benefit grows at an amount equal to each premium payment). This design ensures that collateral is minimized and the client receives a constant $1M death benefit net of the loan. The 7 pay premium for this design is roughly $50,000 and has enough cash value to carry the policy but not endow. The IRR at age 85 is 5.1%, a full 1.1% behind the level pay policy. But don’t jump to conclusions – all short pay designs lag in IRR until the later years when they beat the level pay. The issue here is product choice. A product that fits the bill for premium financing yields 5.1% at age 85 but an efficient death benefit product paid out of pocket yields closer to 5.8% ($31,000 for 7 years). Using the same Return of Premium death benefit option as the financed policy, the efficient death benefit product yields closer to 6% versus the financed policy’s 5.1%. In other words, if you want full collateral offset, then you’re going to pay for it in terms of policy IRR.

If you don’t want full collateral offset, then why not just pay the premiums out-of-pocket? Borrowing the money will likely be more expensive than just paying premiums. For example, the annual loan interest costs on a loan balance of $350,000 ($50,000 x 7) at 4% are $14,000, which is $3,500 more than the annual premium cost for a $1M death benefit product. The loan interest rate would have to be about 3.15% for the interest cost to break even with the premium cost of a comparable product. The tradeoff for financing is that the client obviously pays much less in years 1-6, but that comes along with a truckload of interest rate risk. I ran the loan scenario under actual PRIME lending rates going from 2012 back to 1969. The average rate was 7.5%, which corresponds to an average annual interest expense of well over $30,000. Premium financing may lower costs in the very short term but it only does so by exposing the client to massive amounts of interest rate risk in the future. Contrary to popular received wisdom in the life insurance industry, premium financing does not lower costs. It merely pushes them into the future with an uncertain price tag. If you think loan rates are going above 3.15% in the future, then you’d be far better off paying for coverage out-of-pocket.

So how do premium financing proposals always look so attractive? There is usually one or more of four factors present. First, there’s a math error. I can’t tell you how many times I’ve seen a financing spreadsheet that miscalculates the cash flows, especially if the policy includes a 1035 exchange or the proposal shows a side fund. Second, the comparison is inaccurate. Premium financing proposals usually compare a financed policy to a non-financed policy. This is a bit like asking your mechanic if your car needs a check-up. The financing promoter has every incentive to show you why financing looks good because that’s how they get paid, so why should we assume that they’ve fully explored every possible non-financed option and presented the best one? I’ve found that, most of the time, the comparison is only partially accurate and always biased in favor of financing. Third, the financing proposal doesn’t include all fees and expenses. Some lenders make their money on the spread but many charge explicit arrangement fees. Additionally, some proposals don’t even show collateral exposure and the cost of collateral (at least LOC fees, at most lost opportunity cost of capital). This allows the promoter to use a good product that doesn’t actually fit well for financing without showing the full array of costs and risks. Fourth, the proposal makes egregious assumptions in either the loan rate or the policy performance. It’s easy to make financing look great if you assume the loan cost is 2% and the policy performs at 8%. What’s the probability of that actually happening? Near as makes no difference to zero.

In short, don’t be fooled by the idea that premium financing is a way to reduce costs or juice policy returns. Financing merely shifts the cost burden into the future at an uncertain rate and often requires an inefficient policy to do so.