#167 | Don’t Be Fooled by VRDO

I’ve seen more than a few proposals and pitches recently from companies with ambiguous, financial-sounding names promoting strategies with life insurance that sound like premium financing, but the promoters are insistent that they have something different and better (and usually “proprietary”). They usually even go so far as to bash traditional premium financing for all of its well-known flaws before presenting their strategies. But if it looks like a duck, walks like a duck and quacks like a duck, then it’s probably a duck. Except, in this case, it’s a hyper-complex and fee-laden financing structure called VRDO.

VRDO, which stands for Variable Rate Debt Obligation, is a strategy commonly used in municipal debt but has been poking around the life insurance world since at least 2007, if not earlier. For life insurance applications, it operates like a variant of premium financing. Here’s basically how it works:

1. Client secures a demand LOC that is collateralized with policy cash values and other assets
2. The LOC is used to secure a short-term note (usually 7 days) that is sold on the open bond market using the bank’s credit rating
3. The note is continuously rolled over and sold (“re-marketed”)
4. The client is on the hook to either pay interest out of pocket or continuously refinance interest payments by securing, collateralizing and issuing larger and larger notes to cover the accrued interest

The upside of VRDO is obvious. Rather than paying a bank 12-month LIBOR plus 1.5% to borrow money for 10 years, the VRDO structure allows for the note to be rewritten continuously in the very, very short end of the bond market and therefore paying (theoretically) much lower rates, depending on the shape of the yield curve. The client’s pure interest rate costs should be lower with VRDO than with traditional financing.

The downsides of VRDO, though, are legion. First, it’s a rather complex transaction that involves multiple parties that have to work in concert. The bank has to maintain its rating and continue the demand LOC, the investment bank has to continuously remarket the note, the client has to post varying levels of collateral, the policy needs to perform well and the bond market needs to stay stable and pay market-rates for these types of instruments. Managing a VRDO transaction in the real world is like a middle school dance – lots of bumping into one another without a lot of rhythm. The sheer number of moving parts required in VRDO relative to a traditional financing arrangement should be reason enough to view it with some skepticism.

But the bigger problem is that all of these parties have to get paid. The typical charge for a demand LOC is about 1% per year. The re-marketing fees for the investment bank are based on a variety of factors beyond just the size of the note and can vary as the deal progresses but, as you can imagine, they’re not cheap. And then, of course, there’s the yield paid on the note. How do you know the investment bank is trading your note hard to get you the best rate? You don’t. Just take a look at this massive lawsuit against major investment banks for collusion on markups for LOC fees, remarketing fees and overpaid interest. If major municipalities are getting hosed by big-name banks on huge transactions, what do you think is happening to your tiddlywinks five million dollar VRDO deal issued by a tiny investment bank out of Montgomery, Alabama?

The other problem with this design is that it is fundamentally a bad fit for life insurance. Getting a note big enough to float usually means that all of the premiums are borrowed in the first year. That means all of the fees are also based on the full premium amount on day one. How do VRDO promoters get around this little problem? They show that the client can reinvest the money in something else that earns a higher rate than the cost of the VRDO. That seems reasonable. If VRDO is cheap financing, surely the client can invest it elsewhere and get a higher yield? Not so fast. If that was true, then why bother with life insurance at all? Why not just use VRDO to fund all sorts of other purchases and investments? VRDO has nothing to do with life insurance. It’s just a financing mechanism. The simple fact that VRDO is not a regularly used strategy for HNW individuals is a tell-tale sign that it has major problems that life insurance VRDO financing promoters seem to conveniently forget. After all, who wins in a VRDO deal? The bank gets a fat LOC fee. The investment bank gets fat remarketing fees. The insurance company gets a big policy on the books. The agent and the financing promoter get commissions. Everyone wins. Everyone, of course, except the client who is left holding the bag.

Don’t be fooled. VRDO is premium financing. More accurately, VRDO is a more complex and fee-laden version of premium financing – exactly what your clients are looking for, right?