#287 | Peak Premium Financing?

gray and brown mountain

Last weekend, I was up in the mountains of North Carolina and happened to run into a guy from Tampa who I knew from overnight camp when I was a kid. I hadn’t seen him since we were both counselors at that same camp in college. After the usual pleasantries, I asked him what he was up to these days with work and he said that he was “an advisor to advisors on premium financing for life insurance.” I was momentarily speechless. What are the odds? But then it hit me. When my camp cabinmate who I just happened to see after 15 years is getting in on the gig – that’s the peak of premium financing.

There’s evidence aplenty that the life insurance industry is awash in premium financing. Years ago, there were just a couple of shops successfully marketing themselves as premium financing experts available for joint work with agents to design, facilitate, implement and service premium financing transactions. Now, there are almost too many to count, ranging from several serious operations with dozens of employees to, as one President of one of the largest firms bemoaned to me recently, a multitude of “one-man” premium financing shops. Premium financing is everywhere.

Traditionally, premium financing was restricted only to high-net worth clients qualifying as accredited investors many times over, meaning that they are presumably financially sophisticated or at least have financially sophisticated advisors. Now, premium financing has gone down-market, like Ferrari making a mid-sized sedan with cloth seats in the base trim and a CVT. There are a proliferation of so-called “small case” premium financing programs in the market that require a contribution from the client but finance the majority of the premiums. From what I understand, the financial qualification for some of these programs is simply being employed. A friend recently told me that her broke, “struggling actor” brother-in-law was planning to do a premium financed Indexed UL through one of these programs. Like I said, this is peak premium financing.

It’s even worse than that, though. The proliferation of premium financing is turning it into a weapon. The established firms see themselves as something like stewards of the business, trying to keep out of the muck and generally do things in a way that will keep their franchise going for a long time with happy advisors and customers. Not so for the multitude of flies who have been attracted to the bright light of financing. In my experience, they see premium financing as a weapon to win sales. In the same way as we have illustration warfare amongst carriers, there is spreadsheet warfare amongst illustration vendors.

Many major players have bemoaned the “ridiculous,” “absurd,” “completely unrealistic” proposals that cross their desks on a regular basis from smaller shops “who have no idea what they’re doing.” I’m paraphrasing, but that’s the common theme and it’s becoming a real problem for the credibility of the firms who have actually built a business and infrastructure to support what they acknowledge is a complex, sophisticated, risky and long-term financial arrangement.

Why is premium financing – in the words of Will Ferrell’s iconic Mugatu – so hot right now? Money is cheap. Really cheap. 3M LIBOR is at 12 basis points. 12M LIBOR is at 25 basis points. Borrowing money has never been better. At the same time, life insurer portfolio yields are still generally hovering around 4%, meaning that any type of portfolio rate permanent product looks like an arbitrage opportunity.

It’s not, of course. Those portfolio rates are high because, as I wrote recently, life insurers have the benefit of old invested assets but those assets are being rolled over and reinvested at significantly lower rates. Over time, portfolio rates will drop and, long with them, crediting rates on Universal Life, Dividend Interest Rates on Whole Life and Caps on Indexed UL. It ain’t rocket science. Precisely the same factor that makes premium financing so attractive right now – ultra-low rates – will also prove to be its undoing, at least for clients who thought they were getting something for nothing or don’t have the financial capacity or endurance to handle the strain.

By that definition, however, peak premium finance is a long way off. It’s going to be quite some time before portfolio rates converge to new money rates and the “arbitrage” disappears. So why am I calling the peak right now? Because there are three things conspiring to clamp down on the market – capacity constraints, litigation and ratesetting.

It’s hard to get good metrics, but my sense is that the sheer volume of premium financing going through the system these days is unlike anything we’ve seen since STOLI. Last month, financing juggernaut Allianz publicly shut off new premium financing business in a move that surprised and rattled the market. The rationale wasn’t entirely clear, but the easiest way to interpret it is that Allianz has a capacity limit on premium financing and obviously bumped up against it. Curiously enough, however, Allianz is still accepting small-case premium financing flow, which I would argue is just as risky as high-net worth business. I’ve heard that other companies have also put in capacity limits, more stringent requirements or have stopped accepting premium financing outright.

Premium financing is all about trust. Life insurers have been burned too many times by transactions and programs that have gone awry to just accept any premium financing case that walks in the door. That’s why carriers that are serious about writing premium financing limit their relationships to firms they can trust – and vice versa. Stick around for a little while and you’ll start to see who likes to work with who. Succession Capital has Pacific Life. Northstar has National Life. Cool Springs has Zurich. Schechter has Penn Mutual. NIW has Allianz. Capacity may be shrinking for a lot of premium financing shops, but not necessarily for the established players with engrained relationships. If anyone can just show up and start putting business with a particular insurer, then you know that insurer is going to pull back at some point. Why? Because the carrier is going to get burned.

This brings us to the second point – litigation. For as long as premium financing has been around, folks who are fundamentally skeptical of these transactions (like me) have predicted that mass litigation is right around the corner. But like the fit, well-paid and fun-loving college graduate prowling the gyms and bars of some hip part of town, premium financing, and particularly premium financed Indexed UL, has had a heck of a decade. Ultra-low rates have combined with gangbuster equity returns to deliver the perfect scenario for premium financing. By any measure, there should be no problems, no litigation, no black eyes for premium financing.

And yet, we have seen some fairly high-profile cases hit dockets with resounding implications for the rest of the industry and involving some well-known and prolific insurance agents and carriers. Most recently, two lawsuits involving two different plaintiffs have been filed against one agent – a self-proclaimed premium financing expert – in Texas. The expert was affiliated with a top-tier producer group and the life insurers writing the policies were all household names, so this isn’t some obscure thing. The cases read like how-not-to documents for premium financing – wealthy but illiquid and ill-informed clients financing huge amounts of life insurance under the supposition that it would be free, only to be met with continuously increasing collateral calls that eventually pushed the clients into litigation.

These cases may be a harbinger for premium financing, particularly with Indexed UL. The clients were sold policies under the supposition that they would receive “free insurance,” as was described in one of the cases, with limited collateral exposure. As collateral unexpectedly increased, the clients didn’t have the desire or fortitude to stick with the transaction, arguably because they never understood it in the first place. How many other clients are out there who don’t really understand the deal but have been willing to ride along with it because it’s worked so far? Probably quite a few. The real test comes when times are bad. We’ll see how many people are still sporting Bama gear after Nick Saban retires and there’s a 2-11 season.

There’s another interesting angle to these cases, though. The premium financing expert didn’t have a direct relationship with either of the plaintiffs in these two cases. Instead, he worked with agents who knew the clients. One of the lawsuits goes to great lengths to describe how exemplary the agent’s relationship had been with the client prior to bringing in the expert. This sort of thing happens a lot. Most agents are, first and foremost, relationship builders. If you can’t prospect in this business, you’re not going to make it, so relationship-building and prospecting is a shared trait across successful agents. This expert – and the multitude of other experts like him – position premium financing as a reason to get back in front of established clients for new sales. In my experience, the agents often don’t really understand the transaction being proposed to their clients by the expert they’ve brought in to explain it. They’re relying on the expert to do what he does best.

Who bears the liability in these sorts of arrangements? Judging by these two lawsuits, everyone does. That’s a real problem for both the expert agent and the relationship agent because most Errors & Omissions coverage excludes premium financing transactions from claims coverage or put a very low limit on the coverage amount. I spoke with an E&O broker who confirmed the exclusion for premium financing for most policies for independent agents and specifically tied it back to litigation and claims experience. In his words, premium financing transactions often have “7-figure” settlements or judgements and “it doesn’t take very many of those to cause an E&O carrier to exclude a practice from coverage.”

He also pointed out that E&O coverage is annually renewable and applies at the time of claim, not the time of sale. So if you sold a premium financing IUL policy 5 years ago when your E&O covered it but you get sued when your E&O no longer covers it. That means the vast majority of independent agents selling premium financing are exposed to being sued. As a friend of mine said about this issue, “skydiving without a parachute isn’t a problem, but it is a problem if you plan to skydive twice.” With E&O, though, it’s as if the parachute can disappear mid-fall. In fact, it’s almost a certainty if there is more litigation on premium financing. Perhaps it’s better just not to jump at all.

The final factor conspiring against premium financing is ratesetting. I’ve written so many times about falling Caps in Indexed UL that my fingers practically hurt. Falling Caps obviously are a problem for premium financed Indexed UL. Any client who bought a premium financing policy in the past 2 years and hasn’t seen a current in-force illustration is going to be in for quite a shock. Most illustrated rates for new business and in-force policies have dropped by at least 1% and some have dropped even more. For some transactions, that’s enough to be a death blow for both new sales and anything in-force.

We’ll tackle the question of renewal ratesetting next week but, for now, suffice it to say that renewal rate integrity is the key to making premium financing work. Without it, these deals don’t stand a chance – and we’re not far enough into Indexed UL to know what real, long-term renewal rates look like. That should strike fear in the heart of anyone selling Indexed UL, but especially those doing premium financing. One of the arguments that folks make in favor of financing is that clients finance all sorts of other assets, so why not life insurance?

Because, unlike an office building, equipment or a private company, you don’t control the life insurance policy. You have exactly zero inputs – nada, zilch, nothing – into how the life insurer sets rates and costs in that policy over time. You are entirely at their mercy. Leveraging a life insurance transaction is always and forever a bet on both the product and the insurer’s integrity and goodwill. In an age where life insurers are changing ownership constantly, that’s a real risk that often goes unaccounted for in premium financing transactions.

Where does premium financing go from here? I would argue that it’s the feast before the famine. There has never been an easier time to sell premium financing and that has led to massive growth in the space and its tentacles extending far beyond the old-line premium financing shops serving high-net worth individuals. Now, premium financing is everywhere and for anyone. That can’t last. The reason why premium financing has traditionally been only for folks with brains and means is because it’s a complicated strategy that requires deep pockets to ride through the inevitable cycles. Restrictions, litigation and adverse ratesetting aren’t going to kill premium financing because there will always be planning applications for using leverage with life insurance. But they will push the new, aggressive and unprepared premium financing sellers out of the market and refocus the strategy to its core value. And when that happens, the industry will be better for it.