#269 | Tackling an Aggressive Premium Financing Proposal

Over the past year, I’ve seen somewhere around 50 proposals for new life insurance transactions from all corners of our business and sent to me by brokerages, agents and even consumers who find me on the internet or are referred to me by another advisor. I relish these opportunities. Each proposal is a keyhole view into what is actually happening in our industry beyond the rhetoric and fluff of what’s said by a “well respected” agent or a corporate executive on a panel.  Some of what I’ve seen keeps my faith that there are good people in our business doing the right thing for clients, but a lot of what I see is agents pushing highly complex products and structures on smart but uninformed clients on the basis of mountains of mischaracterizations – and that’s never truer than when premium financing is involved.

There’s nothing inherently wrong with premium financing. The concept is sound. There are plenty of circumstances where a client may choose to borrow money from a third party to purchase life insurance because of liquidity, tax or planning considerations. Premium financing can be a powerful tool for clients to acquire the coverage they need without having the premium payments disrupt their current cash flow. Where premium financing goes wrong, however, is when it becomes the reason for buying life insurance. Premium financing is a means, not an end. And yet, for so many proposals that I see, premium financing is combined with life insurance to create something that looks so fantastical on paper that it’s difficult for a client – even a smart and discerning one – to not feel their mouth watering at the prospect (as I saw on a proposal last week) of 16%+ internal rates of return on the transaction.

These types of strategies have been around for a very long time, but recently they’ve started to change in a rather strange way. In the old days, there were a lot of life insurers dabbling in the premium financing space using a variety of different kinds of programs. These days, however, something like 90% of the premium financing proposals I see use one company – Allianz, now the #3 writer of Indexed UL. I’ve been told from a reliable source that financing makes up less than 25% of Allianz’s business and yet, I see it all the time. I decided to write this article in part because I received three premium financing proposals using Allianz and totaling over $2M in premium in less than 24 hours a couple of weeks ago. I know that there is a lot of premium financing being placed at other insurers, but I only know first-hand what I can see – and what I see is a whole heck of a lot of Allianz.

Allianz has 3 particular advantages in the premium financing space. First, they have a well-defined platform and process for approving and supporting premium financing vendors. Allianz requires that every case be placed in conjunction with a premium financing vendor and that the vendor go on for a minimum of 15% of the case. Why? Because it means that Allianz avoids working with rogue agents who aren’t going to service the policies and allows Allianz to formally approve and regularly audit their vendor partners. Premium financing vendors working with Allianz have to attest that they’ve been personally involved in every single transaction, which means that if something goes wrong they’re going to be the first one on the hook. It’s hard to fault Allianz’s approach to premium financing. They have far more oversight and control than any other carrier I’ve seen.

However, what they have in process and oversight they lack in stringency of requirements for the deals. Allianz is one of the very few life insurers that allows for proposals that show no out-of-pocket costs to the client, the much-maligned “free insurance” programs that have been floating around our industry for over a decade now, although they do have some minimally intrusive guardrails for these transactions. No-outlay designs aren’t allowed above age 60, for 7 Pay designs above age 50 or any design using a 5 Pay. For 7 Pay designs from 18-50 and 10 Pay designs from 51-60, Allianz requires a blend of 30% term to reduce the compensation and overall policy charges. Requiring some level of blending essentially lowers the hurdle rate for the deal to “work” and mitigates a bit of the risk to the consumer in an underperformance scenario. And, of course, the policy has to be maximally funded. These guidelines don’t fundamentally change the “free insurance” nature of the proposal and the vast majority of premium financing business would flow through unfettered, albeit with slightly lower compensation to the agent, distributor and vendor.

Allianz’s second advantage is that it pays an abnormally high percentage of Target premium as compensation. Most life insurers are in the neighborhood of 125-135% of all-in compensation to both the agent and the distributor. Allianz, by contrast, reportedly pays 155%. Even though the total compensation for Allianz is similar to other carriers because their Targets are on the low side, the way they’ve split up compensation is particularly conducive to having multiple parties on the same application as is required if you’re going to do premium financing with Allianz. There wouldn’t be enough juice at a carrier with, say, a 125% payout to require 15% to go to the premium financing vendor. But that’s not a problem at all for Allianz.

Third, Allianz has a highly competitive product for illustrated long-term performance – and now more than ever. As I’ve written in previous articles, Allianz has been a long-time user of proprietary indices to generate stellar illustrated performance. The current AG 49-A regulatory environment is particularly conducive to those strategies. Combine these three factors and it’s little wonder why Allianz shows up so often as the “institutional” premium financing partner of choice. If you’re a premium financing vendor and you want a reliable, consistent and competitive carrier partner who will take your business as long as you play by their rules, look no further than Allianz. You’ll just have to put up with them occasionally auditing your business to make sure you’re staying within the lines.

If there’s been something of a coalescing in terms of the carrier of choice, there’s also been a coalescing of the premium financing designs themselves. The vast majority of what I see is what I’ll call “limited contribution” premium financing strategies. Below is a representative sample of what one of these arrangements looks like, taken from an actual proposal without the formatting from the vendor:

These types of transactions aren’t quite the pure “free insurance” of old, but they’re in the same style. I would argue that they’re actually an evolution of those deals and having the client pay a marginal amount out of pocket solves a couple of marketing problems that cropped up with “free insurance” deals. First, the client is paying something, which means that an agent can say to a client with a straight face that it isn’t “free insurance.” Second, the agent can also say to his peers and the life insurer that the client is “paying out of pocket” for the coverage. Third, the agent can now calculate an IRR (which you can see in the far right-hand column) that looks incredibly attractive because the client is putting some cash into the deal. A small contribution from the client paints a thin but often impermeable layer of credibility over the deal, blinding the client to what is really going on.

These deals cross my desk so often that my responses to them are almost muscle-memory at this point. They might have different vendor names on them, but the deals themselves are all essentially the same. I regularly get asked to talk to clients about these transactions (which I happily do) and the conversations pretty much all go the same way. I spend the vast majority of the time simply unwinding and correcting the numerous mischaracterizations of the product and the transaction that the client has taken as fact, sometimes skeptically and other times not. In general, clients are led to believe that these are reliable, proven and relatively low-risk transactions. The reality is that they are volatile, speculative and extremely risky. Reshaping the client’s understanding is tough and delicate work, but because the deals and the carrier are so consistent, there are certain topics that almost always need to be addressed as a part of the conversation. Hence, the reason for this article.

Let’s start from the top. The first type of mischaracterization has to do with the fundamental nature of the product. Virtually every time I talk to a client who is being pitched or who has purchased one of these deals, the client will make a comment about the fact that the product “can’t lose money,” which understandably gives them a high degree of confidence about the certainty and low-risk nature of the deal. I wish that were true, but it’s obviously not. The crediting strategy usually has a 0% floor (although not always), but the product will absolutely lose money every single time there’s a policy credit that is less than the policy charges. It’s that simple. I usually flip to the policy charge page of the illustration (which is automatically included in Allianz illustrations) to show the amount of money that the account value will decline if the credit is 0% in that year and make the point that a Universal Life policy is just a series of monthly charges and credits. Or, to put it differently, the illustration is not the product. The charges and credits are the product. The illustration is simply one of an infinite number of paths that the policy charges and credits could take over time.

Clients who grasp that point then jump immediately to the next one, which is that a drop in account value means that they have to post more collateral for the bank financed loan, which almost certainly they were not told as a part of the sales process. Instead, the vendor showed a nice, smooth collateral exposure that increases to a manageable amount and then decreases over time. In reality, the client will experience higher and lower collateral calls based on actual policy performance. I tell clients that they should be prepared to post 2-3x the illustrated maximum collateral before the loan is “exited” with a policy loan – and I’m probably being a bit conservative. There is significantly more risk inherent in a basic Indexed UL structure than clients are being told, at least in my experience, and that risk is magnified with a premium financing structure where collateral has to make up for the difference.

This leads us to the second mischaracterization – the premium financing loan illustrated as being “paid off” at some future date through policy values. Virtually every premium financing pitch I see has language about some sort of a loan exit and the producer tells the client either verbally or in writing that the financing side of the transaction has ended at that point. As I wrote in a previous article, that is patently false. What actually happens is that a policy loan is used to extinguish the external bank loan. In other words, the loan is refinanced from a bank – where the client has the ability to negotiate the rate and post collateral for a shortfall – to an insurance company, where the client can do neither of those two things. This is disadvantageous to virtually all high net worth clients because they’ll get a better rate from their bank than from the insurance company and with more flexibility. So why do premium financing promoters do this? Because they want to pretend like the transaction is de-levered at some point in the future, which it most certainly is not. With these modern premium financing deals, leverage is eternal. Otherwise, the deal wouldn’t work. But creating the impression that the risk and leverage is being eliminated at some point in the future is a key part of creating confidence in the sales pitch.

At this point, a lot of clients will start talking about the “stress testing” that was performed by the vendor to make sure the deal would work. These “stress tests” usually come in one of 3 forms – rising loan rates, a couple of 0% years and a worst-case, 0% all-years scenario. All 3 of these stress tests are designed to appear worse than they actually are so that the client (and the agent) build confidence in the robustness of the strategy. It’s worth going through each of these different stress test variants individually.

For a rising loan rate, the spreadsheet often shows a loan rate that increases from 1.5-2.5% today to something like 5.5% by the time the policy loan wipes out the bank loan. This sounds extreme, but think about it – the rate is gradually increasing and the policy is illustrating (as you’ll see) nearly 7% returns in the interim. Little wonder why the deal “still works” in this scenario. The loan rate is a risk factor, but not the risk factor. The policy has more structural volatility than the loan if for no other reason than that it has index-linked crediting. This type of stress test has one reason and one reason only – to create the perception that the policy is not risky and that the loan risk itself can be managed with a rate-lock or ceiling strategy.

The other types of stress testing have to do with the policy performance. The most common is to throw a couple of 0% years into the illustration, but they almost always choose the first two years to do it. That’s a smart choice. Using 0% for the first 2 years means that the policy has the smallest amount of account value available to earn 0%. Using year 14 and 15 to show two consecutive years of 0% returns just before the loan exit would have a much more dramatic impact on illustrated returns. Clients have said to me that the deal was “conservative” because of the first 2 years of 0% credits – but that’s obviously not the case if all remaining years in which the policy is accruing the vast majority of its value and where the leverage is highest is illustrated at 7%.

My favorite, however, is the “stress test” that shows either guaranteed values or 0% returns all years using current charges. The policy obviously and catastrophically implodes under that scenario. A vendor using this type of disclosure must be doing real stress testing, right? I mean, why would anyone who just wants to sell a policy and earn a commission show something like that? Precisely because it’s so bad. Painting that ledger as the “worst case” then opens the door for the agent to show that there’s no way it could ever happen. By assigning a 0% probability to the worst-case scenario, the client feels like the risk has been disclosed (and dismissed). They’re more confident than ever about the illustrated scenario at the maximum AG 49-A rate being the most likely outcome.

Stress testing in these forms is simply a way for premium financing vendors to defuse potential objections to the deal. They are not rigorous risk analysis. Premium financing vendors are paid to close deals, not disclose risk – and the good ones who do a lot of risk disclosure do it in spite of the financial incentives, not because of them. However, it’s worth noting that Allianz requires the client to sign certain stress-tested illustrations and proposals, although I don’t always see premium financing vendors strictly adhering to the Allianz requirements in their proposals. My hunch is that a lot of the vendors have one package that they show to start the process and then later have the client sign the proposals that will be sent over to Allianz for final approval that adhere to the guidelines. Allianz, at least for its part, forces its vendors to at least do some level of risk disclosure and it’s hard to fault them for that.

From here, we move into common mischaracterizations about the illustration and the product. Invariably, the client is told that the illustrated rate – which is almost the AG 49-A max rate or close to it – is “conservative” and “reasonable” based on “historical” returns. As I’ve written in numerous articles, there is nothing conservative about the maximum illustrated rate in AG 49 / AG 49-A. For the sake of argument, let’s assume that the maximum illustrated rate in AG 49 is 6.0%. What kind of things would you have to believe and assumptions would you have to make that future performance will be 6%? You’d have to believe, first, that future equity returns are identical to past returns in terms of both their average return and how they materialize over time. If you were to run the AG 49 calculation over the S&P 500 with dividends, you’d get an illustrated rate of 10.5%. In other words, VUL at 10.5% uses the exact same historical return data and applies the exact same calculation method as Indexed UL at 6%. Yikes.

But beyond that, you’d also have to assume that the cap in the product never changes, even though caps have been declining consistently basically since the dawn of Indexed UL. And if that wasn’t enough, your 6% rate is the average return, with about a 46% chance of performing worse and 54% chance of performing better. Nothing about this methodology or the illustrated rates it produces is “conservative” or “reasonable” or even “historical” because it relies on applying current caps. What the methodology produces instead is aggressive, speculative and purely hypothetical returns. The maximum AG 49 rate is possible to achieve. But for the purposes of making a baseline expectation, it’s wildly aggressive.

The counter-argument to everything I’ve said is that Allianz is different and that, in particular, the proprietary indices that Allianz uses in its products are different. What I’ve said applies to the S&P 500, but not the Barclays US Dynamic Balance II ER Index (BUDBI). The story for the BUDBI is pretty simple – it has fantastic backtested performance and a participation rate over 100%, so what’s not to love? As I’ve written extensively in other articles, this is a gross and misleading oversimplification of the truth. The BUDBI (and all other indices like it) have limited real-world performance history stretching back no more than 10 years. There is effectively no history of performance one way or the other. The index itself dynamically allocates between equities and fixed income in order to maintain a volatility target, which is why it can have a 100%+ participation rate. But what are you getting 100%+ of, actually? You’re getting – at the time of writing on 4/12/2021 – an index that is 87% allocated to bonds and just 13% allocated to equities. Since 2004, it has been invested 63/37 in bonds and equities on average. The headline participation rate of 100%+ is meaningless. What matters is the actual equity participation in the index, which you can find here. See what’s going on? If you were to ask a person if they’d like 50% or 150%, the natural next question is “of what?” And yet it seems that many otherwise smart and savvy clients don’t stop to ask that question when it comes to proprietary indices.

To make matters worse, the vast majority of proposals that I see these days have a 100% allocation to the Classic accounts that Allianz offers. Again, I’ve written an article that goes through these accounts, but I’ll paint the quick story here – they’re designed to illustrate well at the expense of actually performing well. If you believe in the power of the proprietary index options that Allianz offers, then you want as much participation in them as possible, right? That will deliver the best performance in the long run. What the Classic accounts do (relative to the Standard accounts) is reduce the participation rate on the proprietary index options in exchange for a 0.9% fixed interest bonus. Why in the world would they do that? Because AG 49-A doesn’t restrict adding fixed interest bonuses on top of maximum illustrated rates and illustrated loan spreads. This gives the Classic accounts a huge illustrated advantage, bumping up illustrated income out of Allianz’s product by something like 20-30%. Thanks to the bizarre way AG 49-A works, the accounts that illustrate the best will actually perform the worst – and life insurers seem to have no problem using this paradox to their competitive advantage even though they all know that it’s to the detriment of the client. That fact alone is an indictment of the current state of the Indexed UL market and, I would argue, the entire regulatory regime for life insurance illustrations.

When it comes to the actual case and transaction design, the nature and goal of the premium financing transaction has changed significantly in the last few years and the designs reflect that. The premium financing of yore was about death benefit. The premium financing proposals of today are about “low-risk,” tax-free income for life. The basic setup is that income begins a few years after the external bank loan is “exited” via the policy loan. Income is almost always taken as variable/indexed/participating loans and extends for life or close to it. In speaking with clients about their perception of what they’re getting, they usually believe that the illustrated income is “no risk,” “low risk” or “guaranteed.” That should make you shudder. They do not understand that they are taking policy loans that actually increase the risk of the transaction and increase their leverage. I’ll often point to the illustration and show that they might have (for example) $50 million in account value in year 50 but only $2.5 million in net cash value – that’s a 20-to-1 ratio of debt to equity. With margins that thin, just a couple of years of underperformance will result in a policy lapse that will stick them with a multi-million dollar phantom income tax bill. They do not understand the income they’re seeing is based on purely hypothetical results and that very few – if any – Indexed UL products have actually been around long enough for people to actually be taking systematic income from their policies. No one told them that they were taking huge amounts of risk. They were just told they’d get income for life.

And this leads to an overall conclusion that is universal in every single case low-outlay premium financing cases I’ve ever seen where I’ve actually spoken to the client – the client actually doesn’t know anything about what is happening. To paraphrase one client recently who had decided to do one of these deals, the “agent said that he does it all the time and it works great so I did it.” My goal in talking to these clients is not to dissuade them from doing the deal. I have no incentive if they do or don’t do the transaction. My goal is simply to set right the numerous and pervasive misunderstandings about the transaction that the client has as a result of what they’ve been told by the agent.

The final piece to ensuring that the client understands both the product and the transaction is to ask for a re-proposal in two parts. First, in the case of an Allianz product, is to have the proposal re-run with an illustration that allocates 100% to the Standard S&P 500 option rather than the Classic options. Doing so will eliminate the illustrated benefit of the fixed bonus. Second, and more importantly, is to have the proposal re-run with a 100% allocation to the fixed account (or at 4%, whichever is higher). Allianz actually requires this stress test but, curiously, I almost never see it in the initial packages shown by the vendor to the client. The way I explain this to clients is pretty simple – the fixed account rate, especially with Allianz, is reflective of what Allianz is actually earning on it’s assets. Any spread between the fixed account rate and the indexed crediting rate is due to options. By this point, I’ve usually explained the basic idea behind an Indexed UL of the carrier taking an earned rate and buying call options to produce indexed exposure, so the logic here is that the client should see the baseline return without making any assumptions about long-term profits from the options strategy. For a client without any experience in options, which is to say virtually all clients, this recommendation makes a lot of intuitive sense.

If, after developing a clear understanding of the product and structure and reviewing the re-run proposals, the client still wants to do the transaction then you can feel confident that low-outlay premium financed IUL is right for that client. In my experience, about 1 in 10 clients who have been pitched or who own low-outlay premium financed IUL come to that conclusion, but they tend to frame it differently. To paraphrase one high-income client in Kentucky, “I’m willing to roll the dice on this and I can handle it if it blows up.” Fair enough. Have at it.

But those clients are few and far between. The vast majority of the time, the conversation ends with a client somewhat disappointed to now understand that they can’t get something for nothing. That’s why blowing up premium financing deals isn’t a business model for me or anyone else. The clients generally aren’t interested in these deals because they want or need life insurance – they are doing it because they think it’s free, low-risk and high-return. Until it isn’t. And unless you have another free, low-risk and high-return strategy to take the place of the now-debunked premium financed IUL deal, the client is probably not interested. Prospects for low-outlay premium financed IUL are usually not prospects for life insurance. That’s the great irony of this breed of premium financed Indexed UL – these folks were sold a highly speculative, extremely risky, dubiously presented and unbelievably complex financial arrangement. The fact that it uses a life insurance policy is purely incidental.

And that’s the real problem. We are in the life insurance industry. Premium financed Indexed UL is so complex that I’ve spoken to folks managing billions of dollars in hedge funds who were completely stumped by it. Agents are simply not equipped to understand what they’re selling. Neither are the premium financing vendors who have facilitated hundreds of millions of dollars of these types of low-outlay deals. And neither are the folks at the life insurance companies who, before Indexed UL, were pricing and selling term insurance and Whole Life products.  When it comes to Indexed UL, we are all in way over our heads.

Therefore, we should exercise caution – especially when it comes to premium financing Indexed UL. And that means paying interest out of pocket, being prepared to post significant collateral, understanding the likely lower return scenario and having a full or partial exit strategy aside from the policy values. It’s hard to fault a premium financing deal structured like that – but, unfortunately, it’s also hard to sell a premium financing deal structured like that. But that’s the world we’re living in and it’s up to us, those of us who aren’t doing these kind of deals, to make right the misunderstandings pervasive in these transactions.