#353 | Premium Financing & Rising Rates

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Quick Take

Premium financing is facing what feels like an existential threat in the form of high interest rates and lagging policy performance. In my experience, the vast majority of premium financing is sold to clients who expected leverage to work in their favor, giving them huge benefits at relatively little (or no) out-of-pocket expense. But leverage cuts both ways. In today’s high rate environment, the “arbitrage” sale no longer works. Why then haven’t we seen evidence of significant damage in the premium financing space? One explanation is that premium finance is more resilient than many people think thanks to highly qualified clients who are able and willing to handle higher interest costs. There are certainly cases where this is true, but I think there’s more to the story. Based on what I’ve personally seen in numerous cases and heard about from other folks who see significant premium financing deal flow, another phenomenon is occurring – agents, brokers and premium finance vendors are assuming that interest rates decline in the future for the purposes of selling new deals and servicing in-force transactions. They’re showing clients that things will go back to the “normal” of the past 15 years, which saw record low lending rates, record high equity returns and abnormally high caps in Indexed UL. This practice is dangerous and ultimately untenable. Clients deserve to be told the real story and shown the real economics of their transactions as they stand today. If the assumptions of 2021 were valid then, then the assumptions of 2023 are certainly valid now.

Full Article

There is no doubt that today’s rate environment poses a fundamental challenge to all forms of premium financing. When capital is cheap, selling premium financing is easy – and capital was never cheaper than in 2020 and 2021. To put it into perspective, 12 Month Term SOFR didn’t crack 10bps from March of 2020 until the middle of October in 2021. With a typical 2% spread, all-in loan rates for premium financing were likely below 2.5% for the vast majority of highly qualified borrowers. I don’t think it’s a stretch to say that there has never been a better time to sell premium financing than during and in the immediate aftermath of Covid.

However, all of that changed in 2022. Term SOFR jumped from 40bps in January to 4.87% at the end of December. And the increase has continued unabated. Since January, rates have continued to climb, with 12 month Term SOFR currently sitting at nearly 5.4%. And it seems as though we’re not done. The Fed has continued to offer perspective that more rate increases are in the pipeline and potentially even increases on the order of 50bps or more through the next several meetings. There seems to be a broadening consensus that rates will have to go above 6% before things level off. If that happens, lending rates above 8% may become the norm for premium financing transactions.

This should spell disaster for premium financing. It is the worst possible scenario. Theoretically, every premium financing deal that “worked” over the past 15 years no longer works. Any sort of illustrated arbitrage between the policy performance and the loan interest rate has absolutely evaporated. There is no life insurance policy that illustrates at 10%, enough to cover the cost of an 8% premium financing loan and internal policy expenses while still offering net benefits that make the deal worth the effort.

The curious bit, though, is that there hasn’t been an audible pop in the premium financing market. The conditions have been extremely difficult for premium financing for at least 9 months. Why hasn’t there been a reckoning? As I wrote in a post last year, we’re starting to see more premium financing lawsuits, but they’re still few and far between. Premium financing promoters still seem to be selling policies, holding conferences and generally conducting business as usual. Although I’ve heard that premium financing flows are down, many life insurers are still seeing a fair bit of financing come in the door.

So how in the world is premium financing effectively defying the gravity of high interest rates? Perhaps this market is a lot more resilient than a lot of people, including me, think. Or perhaps there’s something else going on entirely.

Resiliency in premium financing comes from two sources – the client profile and the premium financing design itself. Quality premium financing clients tend to have particular characteristics. They tend to be very wealthy, with net worth well above $10 million. The clients tend to have concentrated, illiquid and high performing assets such as closely held businesses and real estate. The clients are familiar with leverage and recognize its ability to serve as a bridge between future needs and current capacity. They’re in it for the long haul – premium financing is about securing permanent insurance without sacrificing investments elsewhere.

Crucially, they also have the capacity and willingness to pay out of pocket and post collateral in order to keep the long-term deal intact. These characteristics theoretically make these sorts of clients very resilient to changes in the structure of the deal. Theory, however, isn’t always practice. Some clients fit all of these characteristics but did the premium financing deal because they thought they were getting something for nothing, which means their willingness to post collateral or pay out-of-pocket is less than their ability. Some clients fit the characteristics when the deal was sold, but external factors – falling valuations, a recession, liquidity concerns, increased financing costs, unexpected expenses – change their willingness and ability to do premium financing. Ultimately, there is no way to know what percentage of premium financing clients are truly resilient and of the ones that look resilient now, how many of them will stay that way.

As a result, the only objective measure of the resiliency of a premium financing program is the out-of-pocket outlay made by the customer. Period. The greater the outlay, the more resilient the premium financing program.  To get a feel for the resiliency of certain financing structures, I ran a simple model on a representative Indexed UL policy. The measure here is the net equity position of the client. Positive net equity means that the cash value exceeds the loan balance and the amount of money contributed by the client to the transaction. Zero net equity is break-even. Negative net equity means that the client has to take a loss to exit the transaction or post additional collateral (or pay out of pocket) to keep it going. For this graph, I’m assuming that the all premiums are paid out of pocket. This is the baseline net equity position for the insured assuming no premium financing. Take a look:

If the client pays all premiums out of pocket, then they build a lot of very resilient net equity in the policy. It takes a 0% crediting rate to push to net equity negative and keep it there (as a result of policy charges being deducted). This supports the overall point – if you want resilient net equity, you have to pay for it. But if you want leverage, then you have to accept the fact that the structure itself becomes less resilient. The highs are higher (relative to what’s been contributed) and the lows are lower. Take a look at the exact same scenario, but this time with the client borrowing money and paying interest out of pocket at an assumed 7.4% rate, which is a 2% spread above current 21 Month SOFR.

You’ll notice right away that net equity is much more sensitive to the underlying crediting rate than if premiums are paid out of pocket and, crucially, there is now a clear break-even effect going on in the results that hinges on the cost of borrowing. Crediting rates below the cost of borrowing create clear and consistent negative net equity. Crediting rates above the cost of borrowing create positive net equity that accelerates as time goes by. The fact that loan rates are 7.4% in this model simply means that all of the deals that were sold over the past 15 years or so that now have 5% or 6% crediting rates are on the path towards creating significant negative net equity.

The resiliency in programs where clients pay interest out of pocket is that there is an expectation of an annual outlay and the understanding that more client contributions will lead to better (and more consistent) long-term outcomes. But leverage always creates fragility. The long-term benefits of the plan still rely on arbitrage between the policy crediting rate and the loan interest rate. There’s short-term fragility as well – as rates go up, so does the out-of-pocket cost of carrying the transaction. As loan renewals have come through and interest costs have skyrocketed, some clients decided to stick with the program because they are bought in on the overall planning concept and still bullish on their other invested assets. But I’ve also heard of clients who balked and either decided to pay down the loan out of cash or to simply walk away from the transaction. Paying interest out of pocket creates a palpable pain point and check on the economics of a premium financing transaction.

What if there was a way to avoid that pain point entirely? One of the big trends in premium financing over the past decade has been the advent and growing popularity of premium financing structures designed for folks who are well below the net worth and income thresholds for traditional premium financing. Typically, these programs tout a 3-to-1 “match” concept where the client pays 25% of the premium (50% in the first 5 years, 0% thereafter) and borrows the remaining 75%.

The pitch is simple – why fund your retirement with $100 when you can fund it with $400, courtesy of premium financing? As long as the performance of the policy exceeds the cost of the loan, then the net benefit to the client is positive. But if that doesn’t happen, then the 3-to-1 match concept would actually produce lower policy performance than if the client had simply paid the 25% of premiums himself into a non-financed policy. Leverage cuts both ways. Take a look at the results for this plan using the same scenario as the charts above:

You’ll notice that this chart looks virtually identical to the one showing interest being paid out of pocket. These 3-to-1 deals are effectively pre-funding the interest payments over the first 12-15 years of the transaction, with the added benefit that the client comes out of the gate in a better net equity position because less of the initial premium is being financed. If these 3-to-1 deals are essentially the same as paying interest out of pocket, then why have they become so unbelievably popular?

The primary appeal, in my view, is that these arrangements don’t have some of the obvious pain-points of a typical premium financing transaction. Unlike traditional premium financing, some of these 3-to-1 deals actually don’t involve the policyholder borrowing the premiums because they likely wouldn’t be qualified to borrow money to finance premiums on their own. At least one life insurer in this space has a single financial underwriting criteria for 3-to-1 deals – a minimum income of $100,000. There is no way that a person making $100k a year can do a “real” premium financing structure.

Instead, these 3-to-1 deals have come up with some pretty clever arrangements for making the financing work. Some of them have the client borrow a single lump-sum amount in the first year and then dole it out over time. One uses a complex trust ownership structure where the master trust borrows on behalf of the sub-trusts that actually own the policies. I’ve heard that some also have the client pay the first two premiums and then finance the rest in a lump sum. Regardless of the details of the structure, all of them seem to have the same basic pitch – they’re focused on designing financing arrangements that don’t look or feel like typical premium financing and are sold as pension-alternatives in order to generate a large stream of retirement income.

In doing so, these structures remove two of the key pain-points in premium financing – collateral and out-of-pocket interest payments. Collateral is handled through the 3-to-1 upfront contribution because it puts the client in a position where the loan value is half of the premium on day 1. The upfront contribution also front-loads the interest payments, which allows all future interest to be accrued. Using the same policy and structure as listed above, take a look at the interest rate strain it would take in order for there to be an additional collateral requirement on a 3-to-1 deal illustrated with a 6% rate:

In other words, it would take a gap of 2% between the loan interest rate and the policy crediting rate to produce a collateral requirement within the next 15 years. The risk of that happening consistently over the span of 15 years is very low (although it is absolutely happening right now). The programs seem to have different ways of treating that possibility. Some allow collateral. Some would require additional premium payments or else the policy would be forfeit. But all of them more or less make the same case – it’ll never happen. Probably.

As a result, the pain point for these 3-to-1 deals isn’t collateral or interest payments – it’s illustrated benefits. Rising interest rates reduce future illustrated income benefits, which was the whole point of doing the deal in the first place. From what I understand, these programs have demonstrated very low lapse rates and high resiliency. Why? Because the real moment of truth comes decades from now when the income either materializes or it doesn’t. These programs kick the can down the road. Maybe that’s a good thing. Clients need to be focused on the long-term. But maybe it’s not such a good thing if clients ultimately get blindsided and because these are programs where all clients essentially get the same deal, they’re easily classed for litigation purposes. The likelihood of these programs blowing up is relatively low, but if they do, it’s going to be quite the explosion.

These programs also have another very effective backstop shared by many other premium financing transactions – they illustrate a “loan exit” in a future year. As I’ve written in a previous article, these illustrated “loan exit” strategies are not actually loan exits. They simply refinance the external bank loan with an internal policy loan. The are some benefits to doing the refinancing (primarily the fact that the insurer can’t call the loan like a bank can), but the chief benefit is that policy loans can always illustrate positive arbitrage even if the external policy loan can’t. As a result, the damage to the transaction might look relatively benign even with higher interest rates because the negative arbitrage of the external loan is ultimately “saved” by the illustrated positive arbitrage of the policy loan.

Despite the fact that many life insurers require the client to contribute out-of-pocket outlay to the transaction, what I see most often cross my desk is some form of “free” or near-free insurance proposal. Some of these deals show the client making a level contribution beginning in year 1 and accruing any interest above that amount. Some of the deals show token out of pocket payments in order to meet the insurer’s requirements for the first couple of years and then accruing remaining interest. Some deals even show clients paying the first couple of premiums out of pocket and then financing all past and future premiums and accruing all the interest in the future, which seems to be a way to get around checking the premium financing box on the application. And some of them show no interest being paid out-of-pocket at all.

Regardless of the specific structure, all of these deals have the same thing in common – they minimize out-of-pocket outlay in order to maximize leverage. And, in doing so, they’ve made these deals very, very fragile. Take a look at the same chart as above but this time with all interest being accrued:

Without contributing any equity, the economics of the deal are entirely dependent on perpetual arbitrage of greater than 1% between the performance of the policy and the loan. Without arbitrage, these deals very quickly go very sour. And there are a lot of those deals out in the marketplace. Virtually all of the lawsuits I’ve seen thus far are transactions with minimal out-of-pocket outlay. The expectation from clients is that they’re going to get something for nothing. That’s a pretty high bar. An impossibly high bar, in fact.

I think there is merit to the argument that premium finance is more resilient than some people would think. Clearly, premium financing attracts a lot of very wealthy clients who can ride out bad economics for a while if they’re committed to the transaction. Clearly, some premium financing structures have built-in resiliency that creates a buffer for poor performance, especially designs that pay interest out of pocket or require a large percentage of the total premium to be paid out of pocket. Perhaps very few people actually bought the “free” insurance deals that I see on what feels like a weekly basis. Perhaps these are the reasons that premium financing hasn’t gone pop.

But resiliency is not the goal of most premium financing transactions. The reason clients do these deals is because they see the allure of the potential upside that comes from premium financing. A financing structure may be resilient, but that doesn’t mean that it is still doing what the client wants it to do in terms of delivering performance. From a client’s vantage point, there is arguably no difference between actual loss and underperformance. Both constitute failure. This brings us back around to the central question – why hasn’t there been an audible pop in the premium financing market? Here’s where the story takes a bit of a strange turn.

For not being directly involved in the premium financing space, I feel like I have a pretty good pulse on the market simply by virtue of seeing a lot of premium financing deals – both in-force and proposed – cross my desk. I have relationships with a few other independent folks who themselves see quite a bit of premium financing dealflow. I spend a bit of time talking with life insurers who are active in the space. And, of course, I am friendly with a few premium financing vendors. Over the past few months, I’ve started to see one consistent narrative come out of all of these sources about why premium financing hasn’t blown up despite the fundamental economics going sour – a lot of clients aren’t actually being shown the economics.

Think about it. How would a client know that the economics have changed? Unlike with actual life insurance illustrations, there are no rules about how premium financing proposals and re-proposals should be constructed*. It’s up to the agent, brokerage and/or premium financing vendor to put the spreadsheet together and demonstrate reasonable assumptions. And unlike with in-force illustrations, clients aren’t contractually owed a re-proposal of their in-force premium financing transaction.

There is no contractual obligation that I’ve seen for a premium financing vendor to show anything to the client. As one premium financing vendor was quoted in a recent 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.” Exactly. Short of the agent/brokerage/vendor actually telling the client what’s going on – which, undoubtedly, the good ones do – the client is left to pick up the breadcrumbs about the current economics of their transaction.

The biggest pain point that I’m hearing in the market is that clients are being asked to post more collateral than they’d been told they’d have to post. Why? Because the loan interest rate has shot up and virtually every Indexed UL in the market got a 0% credit last year. On a low-outlay premium financing design, collateral is the status check for the transaction. More collateral means the client is deeper underwater. For the multitude of clients who were told that they would only post a certain amount in collateral and then ride the perpetual arbitrage gravy train, additional collateral calls are a triggering event. A moment of truth. They’re usually the time when the client picks their head up and says something like – “wait, what exactly did I buy?”

However, the breadcrumbs for transactions that have some buffer, whether through past strong performance or out of pocket outlay, are a little bit harder to pick up. The client will certainly see a higher rate on their loan renewal (unless, of course, the premium financing vendor facilitated a very well timed interest rate lock). The client should be able to figure out that a higher rate will be detrimental for their economics. But beyond that, there’s no triggering event in the way that there would be with a collateral call. Everything seems normal. Business as usual. Carry on.

Except, of course, that’s not what’s actually happening. These are highly levered transactions that were entered into under the presumption of receiving a stream of future benefits. For every point that interest rates go up without an offsetting increase in the performance of the policy, the stream of future benefits diminishes. And thanks to leverage, the results are very sensitive to the underlying assumptions. The margin between riding off into the sunset and falling into a black hole is 200 basis points. With 200bps of perpetual arbitrage, policies illustrate massive long-term benefits from premium financed leverage. At 0bps of perpetual arbitrage, leverage is a net negative relative to paying premiums out of pocket. The margin is very, very thin.

Agents and premium financing vendors know the stakes are high. Last year, I saw a presentation from a major life insurer and a major premium financing vendor with a slide entitled “What needs to happen to make Premium Finance work” and the first bullet was “IUL must have greater net credits than the rate of the bank loan.” That is correct. Without positive arbitrage, many premium financing deals don’t “work.”

What I’ve started to see a lot of over the past year – and this has been validated by other people who see premium finance deal flow – is a lot of agents/brokerages/vendors essentially attempting to assume away the problems posed by today’s environment. I have seen numerous projections for both proposed and in-force premium financing transactions that simply assume that the loan interest rate drops back down to 2-3% over the next several years. I can’t think of a single proposal or re-proposal that I’ve seen over the past 12 months that doesn’t assume some sort of future reduction in interest rates

This tactic has been defended in numerous ways. The agent/broker/vendor might say that expected and originally illustrated positive arbitrage is 2% so if they can’t illustrate the crediting rate on the contract at 9.5%, which would be enough to get the 2% arbitrage over a 7.5% cost of the loan, then they’ll just fabricate the result by dropping the illustrated loan rate to 3% with a 5% illustrated interest rate. Or maybe they’ll argue that interest rates “have” to come down in the future and, when they do, the positive arbitrage will return.

What these agents/brokers/vendors are doing is saying essentially that the economic environment since the beginning of 2022 is a fluke and that things will get back to normal in short order. They base this view on their experience over the past 15 or so years in selling Indexed UL with premium financing, which they have come to perceive as normal. It was not normal. Since 2009, the Fed Funds rate has averaged 0.65% against a long-term average since 1954 of 5.6%. Over the same period of time, the S&P 500 Total Return has averaged 16% (measured by calendar years) with just a single calendar year of negative returns against a long-term average of a little under 10% with about 25% of years in the red. And to top it all off, Indexed UL caps were abnormally high relative to interest rates because of the power of portfolio yields in a persistently falling rate environment. It was a perfect environment for premium financing, but now it’s gone.

Clients who used premium financing to buy life insurance under the premise of positive arbitrage between the policy performance and the loan rate deserve to be told the truth and the truth is this – positive arbitrage is gone. For how long? Who knows. Maybe for a couple of years. Maybe for a decade. Maybe forever. To the extent that agents/brokers/vendors pretend and assume it away on proposals and re-proposals, that’s the extent to which they are setting their clients up for failure and themselves up for lawsuits, complaints, chargebacks and reputational damage. It’s time to get real. If people selling premium financing were comfortable using the assumptions of 2021 to make projections then, then they damn well better be comfortable using the assumptions of 2023 to make projections now.

From my vantage point, the worst is almost certainly to come for premium financing. The longer the current conditions persist, the more problematic these transactions are going to become. One year is bad. Two years is far worse. Three years is unimaginable. Clients who have had collateral calls are going to get bigger ones. Clients who haven’t had collateral calls are going to get them. Agents, brokers and vendors who sold these deals based on perpetual positive arbitrage can only keep the illusion of a return to “normal” for so long. There are a lot of things that theoretically work in the long-run, but never make it that far because of what happens in the short-run. Premium finance sold on the premise of perpetual positive illustrated arbitrage is one of them.

I would also argue that the damage is already worse than it appears. What we’ve been able to see so far are the cases that couldn’t be resolved quietly and ended up in lawsuits. From what I understand, some life insurers are doing absolutely everything they can to quietly make these situations go away. Typically, that means a policy recission. I’ve even heard that one carrier has had so many problems with its in-force financing block that it now has an internal policy to simply rescind any contested premium financing sale in order to avoid litigation. I’ve personally seen a couple of cases where a premium financed policy was rescinded, even one that was several years old.

And then, of course, there are the numerous clients who take their lumps and move on. I saw a case recently where a “free” premium financing proposal went south, the client got spooked, took a $1 million loss that he couldn’t afford and is now on a payment plan. I’ve spoken with numerous policyholders who are looking at 7-figure losses and debating whether it makes sense to litigate, which means exposing their financial folly to the public, or writing down the loss. For every 1 lawsuit, it feels like there are a hundred similar situations that don’t get litigated. At least not yet.

But despite all of this, I’m still a believer in premium financing. Premium financing is an incredibly powerful tool for a client to get what they need in the future without having to liquidate today’s assets. It works for ultra-high net worth people who have assets generating outsized returns elsewhere. Increasingly, I’m hearing folks in the financing space acknowledge there’s still opportunity for premium financing for external arbitrage, even though internal arbitrage is gone. I’d put it differently. Fake financing is dying, at least for now. Real financing remains very much alive. And that’s exactly the way it should be.