#241 | The Premium Financing Exit Mirage
Indexed UL has undoubtedly ushered in a new era of hyper-aggressive premium financing deals and the reasons why aren’t hard to figure out. Indexed UL allows for illustrated rates based on hypothetical historical lookbacks and the maximum rate is the hypothetical historical average, meaning that there’s a roughly 50% chance of underperforming the rate assuming historical equity returns (12%+ for the S&P 500) and unchanging caps. These illustrated rates were then levered up with multipliers and then sometimes layered on top of black-box, look-back engineered indices. At the same time, bank loan rates have fallen through the floor, which only enhances the appeal of using leverage. The net result is that there is an entire cottage industry devoted entirely promoting some form of free or limited-cost life insurance courtesy of the perpetual arbitrage illustrated in premium financing proposals.
But there’s an unsung hero (or villain, depending on your perspective) in the rise of financed Indexed UL – the indexed loan. One of the hallmarks of any financed IUL proposal is that, at some point, the external bank loan is extinguished using policy values. At that point, the story goes, the external bank loan is “exited” via policy values. Exiting the financing arrangement is a key part of the appeal of these structures because it creates the perception that the leverage is only short-term. Over the initial set-up phase of the transaction while the bank loan is still in place, the loan size seems manageable and, therefore, so does the potential for collateral calls. How bad, the thinking goes, could things really get over 15 years? Exiting with policy values ties a nice bow on the transaction. After that, the client owns a policy free-and-clear and can ride off into the sunset. Right?
Well, not exactly. When the premium financing vendor shows the client “exiting” the external loan in the 15th year, the client is doing no such thing. What they’re actually doing is refinancing the external loan with an internal, usually indexed policy loan. The debt transforms, but the economics are identical before and after the transaction. Before, the policy values were collateralized with a bank loan. Now, the policy values are collateralized with an indexed policy loan. Indexed loans operate independently of the policy itself. The loan asset is obviously co-mingled with the other invested assets supporting the policy, but there is no direct recognition of the loan in the policy values. Hence, the clunky terminology used for Whole Life non-direct recognition loans that work similarly.
Traditional fixed loans, on the other hand, are directly recognized in the contract in that the loan balance generally receives a crediting rate equal to the loan charge rate, which is why they’re often called “wash” loans. Wash loans have a similar impact on product economics as true product withdrawals. The loaned value is essentially removed from the policy and sent to the policyowner. Therefore, exiting an external bank loan via a wash loan is a true loan exit in the same way that taking a withdrawal from the policy would, net of taxes, allow for a true exit of the external loan. Indexed loans keep the loan on the books for life – literally.
In effect, exiting a bank loan with a policy loan simply switches the creditor and terms of the loan. In other words, it’s a new deal. So how does this new deal compare with the old one? Let’s look at that question in terms of customization and flexibility. Bank loans are generally designed to be both customizable and flexible. They can be designed with a variety of rate structures ranging from fixed to floating to collared to whatever your imagination can dream up. You can decide how long you’d like the loan to last. You can shop rates at a variety of different banks. Being able to tailor a loan is an advantage in and of itself relative to a policy loan, which is standardized.
For indexed loans, you’re paying a rate either set by an external benchmark index like the Moody’s Aaa Composite, the rate declared by the life insurer or a fixed, guaranteed rate. I’ve written a separate article on the costs and benefits of different indexed loan structures, but the fact regardless of the structure in the policy is that you don’t get to choose it. The carrier chooses it for you. And by that, I mean they’re choosing it for themselves because they book the loan as an asset on their books. You pay the rate that makes the most sense for the insurance company.
Losing the ability to customize the loan may or may not be a big deal for clients, so it’s the least important of the two factors. Far more important, however, is flexibility – particularly when it comes to collateral. Bank loans are designed to be very flexible on collateral requirements. The policy values obviously serve as the primary source of collateral for a bank loan, but any gap between the policy values and the loan balance can be plugged with a variety of things ranging from the simple and straightforward (cash and cash equivalents) to slightly more complex (real estate) to downright arcane (a multi-million dollar sneaker collection and, yes, that’s a thing). If it’s worth something, then you can post it as collateral. The only question is how much of a discount will be applied to it. So if the client gets in a pinch and wants to post his pair of signed Air Jordans, the bank can (theoretically) take it.
Flexibility in collateral is an enormous benefit for the client. It’s what allows premium financing arrangements to ride out bad sequences of return without having to liquidate the policy. However, policy loans have no such provision. Instead, policy loans can only be collateralized by policy values. If the loan ever exceeds the policy values, then the client has two choices – either walk away with nothing or pay the loan interest with cash out of pocket to (literally) buy time. Both of these choices are bad ones. In theory, one of the reasons why people do premium financing arrangements is precisely to avoid liquidating assets to pay premiums. I’ve seen real-life examples of people worth $100M+ being unable to pony up $1M in cash to deal with a failed financing arrangement. They can post collateral, sure, but they can’t make a cash payment.
And to make matters worse, the cash payments on these outstanding balances could be absolutely massive. Take a garden-variety financed structure of $1M in premium per year for 7 years with all-accrued interest. After 30 years, the loan has grown to something like $20M. One year’s worth of interest payments (at 4%) is $800,000. But the policy will unlikely just stay flat in value. Instead, it’ll get a 0% credit and the cash value will drop, tacking on even more of a loss that could be in the $2M range if the client is using a product with a huge charge-funded multiplier. The client is left with the choice of either walking away losing life insurance coverage and any money spent out of pocket until that point or paying $2.8M just to get the policy back to even. There is no other choice.
This is an immense problem that the industry hasn’t even begun to see yet. Indexed loans haven’t been around for more than 15 years. Clients are only just now beginning to swap out their bank loans for indexed loans. After that, it’s going to take a couple of bad runs in the market to start eating up the equity in the policy and force the issue of what to do with an underwater policy loan. The problem is made substantially worse by the fact that clients thought they were “exiting” the premium financing arrangement. Little did they know that they were making the same vow with the premium financing arrangement as they do at the altar – ‘til death do us part. But in this case, they’ve only seen their new spouse’s internet dating profile. I wonder how that will go.
This isn’t just Indexed UL’s problem. Whole Life can have the same issue when illustrated with non-direct recognition loans and premium financing, as is far too often the case for policies that allow it as we did at MetLife. I’ve seen some truly insane premium financing proposals that rest on the idea of a perpetual arbitrage between the net performance in a Whole Life policy and the policy loan cost. It’s not so dissimilar in form to financing with indexed loans in Indexed UL. But is different in terms of alacrity. To borrow the well-worn analogy, any problems in non-direct recognition policy loans in Whole Life will unfold like a train wreck – slow and predictable, with plenty of time to remedy the situation before it becomes an immediate problem. Problems with indexed loans in Indexed UL are more like getting T-boned while driving through an intersection with the light on green. And that’s certainly how it’s going to feel.
What can be done? The answer is very simple – eschew indexed loans in favor of standard fixed loans, as Pacific Life famously and persuasively argued before completely flipping positions later. They were right in the beginning, of course, but being right doesn’t sell. Illustrating well sells. The only give-up for showing fixed loans instead of indexed loans is a slightly less attractive illustration. And if the deal “doesn’t work” because the illustration is slightly less attractive, then you know it’s a very bad deal indeed.
