#331 | Cue the Premium Financing Lawsuits
What does the recent spate of lawsuits on premium financed IUL tell us? In my view, five main things – choose your premium financing specialist wisely, absurd assurances about performance are a predictor of future problems, make sure clients are actually qualified, get a third-party opinion of a proposal and don’t believe anything about what a bank will or won’t do unless you have it in writing from the bank. All five of those things went wrong in the five lawsuits I reviewed for this article. How many other cases are out there like these? Probably more than we’d like to admit. As times get tougher, the case count is only going to increase. But we should hesitate to paint all of premium financing with the same brush. Prime premium financing clients (high net worth, reasonable expectations, clear planning need for insurance) will very likely be able to ride the current economic environment out – as long as they have the will or desire to do it.
For as long as premium financed Indexed UL has existed, there have been plenty of folks – myself included – who have believed that there would eventually be a spate of lawsuits at some point over some of those transactions. It is common knowledge that somewhere between 20% and 40% of all Indexed UL premium involves some sort of third-party financing. Over the past decade, that equates to north of $5 billion in financed first year premium. If there was some sort of systemic issue with premium financed IUL, it would take only a small fraction of those sales to go sour for there to be significant litigation activity.
But until recently, that hasn’t happened. The last decade has been incredibly conducive to premium financed Indexed UL, with record equity returns, ultra-low interest rates and historically high IUL Caps supported by elevated portfolio yields and cheap options. However, all of those factors are coming undone. Clients are getting 0% indexed credits, lending costs are through the roof and Caps have fallen significantly. Financed deals that “worked” last year no longer “work” now.
As a result, we’re finally beginning to see meaningful litigation activity on premium financed Indexed UL. From what I understand, dozens of cases have been submitted across the country, several of which have crossed my desk and made for some pretty interesting reading. It is very tempting to point to this increase in litigation activity – not to mention the handful of cases that I’ve seen first-hand that are essentially settled before formal lawsuits are filed – as evidence that the entire enterprise is about to cave in.
We should resist that temptation, at least for now. In reading these lawsuits and seeing some of these situations first-hand, there seem to be some common storylines and factors that are not universal across the premium financing spectrum. We can’t paint every premium financed IUL transaction with the same brush. Instead, what we’re seeing, in my view, is the subprime corner of the market – the fragile transactions that crumbled at the first application of pressure. What are the key markers for these fragile transactions? I’m relying on five recently filed lawsuits (Johnson, Marenzi, Thabet, Munzer and Griffith) for clues. All of these lawsuits regard policies sold more than 5 years ago.
I should also note that I am relying exclusively on the lawsuits as filed, which may or may not ultimately be proven in court to be accurate or worthy of damages. My goal isn’t to opine on whether a particular suit has merit. My goal is to point out what fact patterns are common across all of these lawsuits that led to the lawsuit itself in the attempt to answer the question of what makes a premium financed IUL transaction susceptible to failure that leads to litigation.
In all but one of the cases, an agent with a longstanding relationship with the client brought in an external premium financing specialist to communicate the benefits of the financing, prepare documentation and ultimately execute the transaction. As one lawsuit put it, “[the agent], the [Plaintiff’s] trusted financial and insurance advisor for over 20 years, had endorsed [the financing specialist] without disclosing that he himself knew nothing about premium financing.” This sort of thing is extremely common in premium financing. Few agents have the background and experience to execute a premium financing transaction start-to-finish. So what do they do? Bring in a “trusted” expert that they likely saw on stage, talking in not-so-subtle terms about their success in the premium financing market and seeking joint work opportunities. There are dozens of firms out there using that model.
The specialists know far more than the agents about how to sell these arrangements. That’s what they’ve been brought in to do. But as we know, premium financing arrangements are highly complex. They require long-term commitment and management. Without that, as these lawsuits show in excruciating detail, the transactions easily go awry. Unfortunately, some specialists don’t see themselves that way. As one specialist is quoted as saying in one lawsuit, “I was paid to sell policies and I did. I’m not paid to manage [past] sale or [put] up with any of this s—t…I have no obligation to do anything [as to the long-term stability of the program].”
I personally know that there are high quality premium financing specialists who have an entirely different view of long-term policy and transaction management. However, I think the quote in the lawsuit is somewhat emblematic of some specialists who are portray themselves as credible, successful and proven when, as the lawsuits show, the reality is that they simply employ a well-worn bag of tactics to get clients to sign on the dotted line, make a substantial commission and then essentially disappear.
The cautionary tale for advisors is this: choose your financing specialist wisely. If you choose poorly, then it will cost you a client and potentially a lot more than that. So how do you choose wisely? If these lawsuits are any indication, there’s a clear red flag that you should always avoid.
Absurd Assurances and Promises
Take a look at some of the language in each of the lawsuits regarding the purported benefits of premium financing an Indexed UL policy:
Defendant email – “You are getting $14,000,000 in premiums paid for 15 years on a 20mm universal life ins policy & the only thing u have to do is post an $855,000 letter of credit for 90-150 days. U will NEVER personally make a pmt.”
“[Defendant] assured [Plaintiffs] that [they] would not have to pay premiums or interest out-of-pocket…the loan would ultimately be repaid from cash values or death benefit…[Defendant] said that they were getting $40,000,000 of essentially free life insurance indefinitely.”
“Defendants promised they would design an IUL program under which [the Plaintiffs] would not be required to invest any monies beyond their contribution of $1 million…Defendants assuaged those concerns and assured [Plaintiffs] that if they were able to maintain a spread of 3% between the borrowed interest rate and crediting rate the program would perform.”
“[Defendant] represented to [Plaintiffs] that using this type of policy would lead to great wealth…that other than a very small amount of interest paid in the first two policy years, the planned premiums would be paid for by external bank loans…that the policy would produce a significant death benefit that would pay back the bank loan and provide a substantial net benefit to the family…[with] very little or no risk in the transaction.”
“In short, [Plaintiff] was told that the policies would earn a rate far exceeding the premium financing costs, and that, in essence, [Plaintiff] would have free insurance indefinitely…[and] that he would be able to withdraw significant sums from each policy on a tax-free basis in the future.”
In each lawsuit, there was express assurance that the client would never be asked to pay more than a certain amount of money or post a certain amount of collateral as a part of the transaction. These assurances form the crux of all five complaints. Without them, it seems to me as though most of these transactions would never have happened.
The red flag, in short, is a deal that sounds too good to be true. But then again, that’s also exactly what gets agents interested enough in the deal to allow the specialist to pitch their client. The agents see the specialist pitch a deal from stage at a conference, talk about all of the commissions they’ve generated, start to feel their mouth water a bit and then think “you know, maybe this guy really does have it all figured out.” If the pitch from stage even remotely smells like free insurance, then I can assure you that he doesn’t have it all figured out and if you bring him in to a case, you’re asking for trouble.
Contrast that with quality premium financing vendors who, in my experience, are hesitant to make assurances about any sort of free insurance and are more focused on the planning applications of premium financing for the client above any sort of perpetual arbitrage. The best financing vendors are, in my experience, the least willing to make performance promises. They focus on structuring the most advantageous deal possible and then let time do its work. They also do one other thing that is really, really important, which leads us to the next point.
Talk to any established, high-quality premium financing vendor and they’ll tell you that only clients with net worth north of $10 million – and, realistically, more like $20 million – are true candidates for premium financing, particularly with IUL. Why? Because they can handle the risk and a failed transaction won’t bankrupt them. They’re not stretching to post enough collateral to get the deal off of the ground. They understand that they may have to post a lot more or pay a lot more and they can do it. They have financial shock absorbers. The best premium financing vendors are the ones who are willing to say no to an unqualified client precisely to avoid situations like the ones described at least 4 out of 5 of these lawsuits.
The most egregious example is one lawsuit where the client was promised that they would only have to post a certain amount of short-term collateral to kickstart the transaction, but they didn’t have sufficient funds, so they surrendered their in-force life insurance policies and took out a mortgage on their house to do it under the assumption that their collateral would be immediately returned to them. Unfortunately, that never happened, the deal failed, their company could no longer receive financing for operating capital and the client ended up losing over a million dollars on a transaction that was supposed to cost them nothing.
The others are not much better. One client had to take margin loans against his brokerage account to satisfy the ever-increasing collateral calls, leading to a situation that “had begun to affect [his] health and [his] sleep and [he] wish[ed] to consider an exit as soon as possible. Another client had to assign an annuity to cover unexpected collateral, which triggered a tax bill, because “their net worth is illiquid…[and] not permitted by the lender to be used as collateral.” The stress from the additional calls resulted in “extraordinary stress and anxiety, depression, headaches and other physical symptoms, worry that their retirement funds will be exhausted, loss of sleep, embarrassment, humiliation and severe emotion distress.” All from a “free” premium financing transaction.
Why would the life insurance companies issue premium financed policies on unqualified clients? Great question. We’re not talking about fly-by-night operations, here. The companies listed in these lawsuits are decidedly blue-chip and well-versed in premium financing and underwriting wealthy individuals – PacLife (3), Lincoln (1), Penn Mutual (1), Securian (1), Equitable (1), John Hancock (1), with the numbers being the case count where a policy from the company was involved. There’s a bit of a subtext in these lawsuits about agents not shooting the life insurers straight about what was really going on, so let’s give them the benefit of the doubt. You would hope that these life insurers wouldn’t issue, for example, a $30 million policy on someone with $300,000 of income if they knew that was actually the situation. You would hope. That sort of thing seems like a program that is destined to fail, which leads us to the next point.
Designed to Fail
The final commonality across these lawsuits is bafflement at the fact that although equity returns have been stellar and interest rates persistently low, the banks kept asking for more collateral. As one lawsuit put it – “interest cannot be lower and returns greater and the program still require additional collateral contributions beyond those committed to unless the program was destined to fail from the outset.”
In one case, the 1-page proposal that was used to sell the client on the economics only showed hypothetical values for 10 years. On that proposal, the required collateral jumped from $780k in year 1 to $2.78M by year 10. The presumption was that it showed peak collateral. Of course, it didn’t. The biggest collateral requirements were after year 10, as another agent showed the client a few years later. Chances are good that because of the age of the client, the underwriting class, the nearly all-base policy structure and Option 2 death benefit, the policy was likely illustrating at-issue to lapse around age 100, but that wasn’t part of the pitch shown to the client.
Other transactions have similar fact pattern. One transaction was funded only with Target premiums and essentially left to die on the vine, netting the agent a full commission and the client a $1M+ loss. Another one of the lawsuits points out that even the insurance agents “discussed with each other that the program was ‘too thinly priced’ and that they would convince [Plaintiffs] to contribute additional money…but failed to advise [Plaintiffs] that the IUL program procured would not be sustainable.”
Another transaction was predicated in part on a series of complex banking handoffs that ultimately would release collateral posted back to the client, but the banks failed to follow through on their agreement, which caused the collapse of the arrangement. Still another describes the situation this way – “the true facts were that assuming historically low interest rates for the loan…and the non-guaranteed credited interest rates projected by the insurers for the policies, [Plaintiff] would need to post an estimated $3,500,000 of collateral by the 10th policy anniversary…increasing annually to an estimated $10,754,294 at his age 80…the collateral requirements would eat up 30% of the [Plaintiffs} net worth in the short term, and ultimately potentially their entire net worth!”
Any agent or client who understood the basic economics of life insurance and premium financing would have been able to spot the deficiencies in the design. But they didn’t. Why not? Because, unfortunately, premium financing is often portrayed as some sort of complex, magical solution where the normal rules don’t apply. It isn’t. Had any of these clients simply asked for a second opinion – even from another agent or premium financing specialist – the deficiencies of the program would have been called out and the clients likely would never have gotten into them in the first place.
It is shocking to me that clients will put millions of dollars on the line without spending a thousand dollars, at most, for a third-party perspective of the proposed transaction. And yet, that happens all the time. It’s absolutely baffling. The other interesting piece is that most of the clients, it seems, at some point voiced concerns about whether or not the deal would actually work. Their gut was telling them that something was amiss, but the agents assuaged their concerns with promises about conservatism, stress-testing, past successes, you name it. In one case, the agent actually promised to post collateral on behalf of the client in exchange for partial ownership in the policy or even buy the policy outright if the collateral stress became too much for the client to bear. When the time came for the client to ask the agent to make good on that promise, he balked, saying that his net worth was too tied up in houses and cars. I’m not making this up. Clients may not understand life insurance, but if their gut says something is wrong, they should probably listen to it.
Representations about Banking Relationships
Another recurring theme throughout the lawsuits are assurances made by the specialist about how the lending institutions will handle fees, loan rates and collateral. One lawsuit describes a situation where “[Defendant] continued to assure [Plaintiff] that there was nothing to worry about…he had spoken to [Bank], which had agreed to increase the collateral crediting on [Plaintiff’s] loan from fifty percent to seventy five percent at [Defendant’s] request. In fact, [Bank] had not agreed to a higher collateral crediting…[Defendant] had entirely concocted [it].”
Two other lawsuits describe situations where the agent assured the client that they were done posting collateral, only for the client to receive hundreds of thousands of dollars in collateral requirements. And one lawsuit is almost entirely built around a series of complex banking transfers that involved LOCs, short-term debt being issued by one institution but bought by another, drawing on lines of credit – all of which proved to be a problem from day one, despite the assurances from the agent (who also worked for one of the banks) that it would all get sorted out.
In short, the banks are the bucket of the cold water on the hot promises made by the agents and specialists in these deals. The reality is that the banks are going to follow the covenants. If you see a financing deal that looks too good to be true, then go straight to the bank and get it in writing. Otherwise, assurances from a third-party to the transaction – such as the agent and specialist – are irrelevant, regardless of how much business they’ve brought to a particular lending institution.
These lawsuits are, in my view, the equivalent of subprime mortgage debt – unqualified clients buying massive policies based on impossible return expectations with no ability to absorb losses. When the going gets tough, transactions like these are the first ones to go belly-up. The question is what percentage of the premium financing space looks like these policies. In my experience seeing a lot of these deals, I would say that it’s probably higher than most people would like to think. I recall one client with a $6 million net worth on the verge of retirement who was pitched an arrangement with a $12 million premium financing loan commitment. That is absolutely and completely inappropriate. But it happens.
However, it’s a mistake to extend what happens in the subprime premium financing market into what might be termed the prime premium financing market, where high net worth clients are buying moderately sized policies based on reasonable return expectations, have the ability to absorb losses and, perhaps most importantly, view financing as a play to give them the coverage they need without liquidating their prize assets. These clients can handle stress. They’re in it for the right reasons and have the capacity to get out of it any time they want to. What percentage of the premium financing market checks all of those boxes? In my experience, it’s smaller than most people would like or want you to believe.
Most premium financing clients probably fall somewhere between subprime and prime. They’re wealthy, but not willing to post lots of collateral, especially now that valuations across asset classes have dropped, and are now being asked to do so because they just got (or are about to get) a 0% indexed credit for this year. They were sold an arbitrage expectation based on “reasonable” assumptions that no longer look reasonable as 12-month Term SOFR has jumped from 0.06% this time last year to 3.7% yesterday and, simultaneously, their Indexed UL Cap (and therefore in-force illustrated rate) has dropped. What looked like a good deal last year, 5 years ago or even 10 years ago doesn’t look like a good deal right now. Or, to put it another way, the stress test scenario at the time of the original proposal is now the base case scenario.
The question is whether or not they’ll even see that. In speaking with a few premium financing vendors, the protocol for showing “re-proposals” is all over the map. Some do it as a matter of course, some do it only on request. I can understand why a premium financing vendor wouldn’t want clients freaking out over relatively minor changes to illustrated rates and loan interest rates and, instead, would want them focused on current loan costs and actual performance. That said, though, what we’ve seen in the market over the past 3 years is not minor. The economics have completely changed. If the original proposal was taken as an accurate future view based on the assumptions used at the time, then a re-proposal should be seen as equally as accurate, despite the fact that the re-proposal is bound to look far worse than the original one. In my opinion, every single premium financing deal that was proposed more than 4 months ago needs to be re-proposed to reset baseline expectations.
What will these clients do? Some of them will stay in the deal even if it starts to go south just because they feel like they should stick it out and they still think it might work. Some of them will take their lumps and go quietly because filing a lawsuit is public and embarrassing. But some of them will get litigious. As the stress on these deals increases and the losses start to mount, more and more clients will likely look to litigation, especially if they start googling around and seeing other lawsuits. We might even see some sort of a massive class action regarding the programs supported by certain vendors, particularly if there’s any sort of uniform documentation, proposals, lending arrangements, anything that binds the clients together. It’s not out of the realm of possibility.
Does all of this mean that premium financing doesn’t “work”? That depends. Premium financing based on an assumption of perpetual arbitrage will never work. Perpetual arbitrage doesn’t exist. There will always be times of stress – like right now – even if the long-term arbitrage materializes. The question is whether the client will choose to persevere in the transaction or not. But for prime clients who used premium financing as a way to keep their prized assets at work elsewhere, this shouldn’t even be a blip on the radar. Those clients should simply weigh whether the cost of the loan is greater than their opportunity cost of capital. That’s it. If the answer is no, then they should stay the course. If the answer is yes, then they should sell assets and retire the loan.
Prime premium financing is robust. Subprime premium financing is extremely fragile. The eerie silence in the premium financing space is everyone hold their breath to see just how fragile most of these deals really are. And that ominous creaking, cracking and popping sound? That’s these lawsuits – and the dozens of others like them.