Financed Life Insurance—the Emperor Has No Clothes
November 20, 2017 by Jerome M. Hesch, Bradley Barros
Today, with over 20 trillion of dollars of life insurance in force, sales presentations have morphed into highly complex illustrations, which has made it nearly impossible for most life insurance agents to develop a deep acumen in the products that they sell.
Nowhere is this lack of awareness more apparent, and potentially more dangerous, than in the area of financed life insurance.
In our practices, we are repeatedly approached by attorneys, CPAs and family offices to review financed life insurance proposals received by their clients. One recent example included a 163-page illustration from a leading insurance carrier, using interest rates permanently capped at 3.5 percent for over 50 years. While one might imagine that such suspension of reality would be uncommon, we assure you that it is not.
The aforementioned illustration was generated by a carrier whose projections are otherwise restrained by Actuarial Guideline 49. Yet, when it comes to financing premiums, agents selling the policies can deploy company ledgers with near unbridled flexibility relative to loan interest rates. The unassuming client, holding what they perceive as a brand name insurer’s “proposal” in their hands, feels secure, when in fact they may not be. A seed has been planted. Its fruit, in 20 years, may take the shape of a lapsed policy effectuating the inability to pay estate tax, the destruction of a multi-generational business and a catastrophic tax consequence that wreaks havoc on an elderly policy holder.
But what if interest rates are stagnated for years or decades into the future? Policy holders aren’t necessarily out of the woods. Those purchasing Index Universal Life policies risk suffering the same fate as index annuities from greatly reduced index caps.
It was barely a decade ago when index annuities afforded upside caps approaching 10 percent. Today those same policies offer participation rates at barely 4 percent. If the historically low cost of money continues, at what point will carriers no longer be able to use manufacturing profits and lapses to artificially support inflated index caps? Further to this point, as surrender charges fall off IUL policies over the next decade, carriers will need to allocate a growing amount of capital to guarantee values, and it therefore will become more expensive for them to buy the spread between cash value and face value.
In 15 years, will IUL policies look like today’s index annuities? And if so, what would this mean for financed life policies?
In certain aspects, agents selling financed policies are caught in the middle with no good solution. Given the relative uncertainty with either stagnant or rising interest rates, one wonders what advisors can do to predict policy performance under changing conditions. Importantly, if the advisors are either uncertain or overconfident in their ability to convey risk, what can clients do to protect themselves?
It was this very question that led one of our colleagues to a recent presentation by a Southern California Broker General Agency. The BGA stress tested a group of competitive policies, examining the impact of mercurial conditions. Most notable was the unpredictability and lack of coloration in performance among carriers. Without computer analysis, it would be a near impossibility to predict which policies best weathered differing types of adversity. This study drives home the added fragility when financing life policies a decade or more into the future.
Consider the breadth of the problem. It is estimated that approximately 40 percent of in-force, non-guaranteed, trust-owned life insurance policies are carrier-illustrated to lapse during the insured’s lifetime, or within five years of estimated life expectancy[i]. Many of these policies were financed. Critically, when financing one’s life insurance, a client’s exposure isn’t limited to the loss of insurance protection (although such loss could be devastating to the continuation of their business and the family’s financial survival). A lapsed policy in this framework can place clients or their loved ones at an impossible risk of repaying the loan and the related potentially catastrophic tax cost stemming from the lapsed policy.
We ask how, at the dual-apex of carrier oversight and a lack of understanding in everchanging and elaborate product designs by agents, can unbridled ledgers and Excel charts be used to pitch long-term, multi-million dollar debt to unassuming clients? Aside from the occasional lack of ethics, agents, most of whom we believe are well-meaning, are often left to their own limited understanding in the prediction of future interest rates and market performance. Unfortunately, cases typically come to us for help years after a policy delivery and there is no painless solution available for the client and those involved in the sale.
In fairness, not all carriers allow their illustration systems to generate financed ledgers, and some lenders apply their own best practices. There are also exceptional agents who back-test multiple time periods that include inverse relationships between high borrowing rates and bear equity markets. These comparisons are typically part and parcel of a comprehensive analysis that stress tests the financing of insurance premiums. And while such work is analogous with best practices in the financed premium space, there remains a great inconsistency in its application.
Some lenders are taking a more responsible role as well. In our wheel-house one notable insurance funder requires a 200 basis-point increase in the cost of funds over the first eight years in all projections. A large wealth management firm with whom we work requires clients to post cash today in an amount that they deem as a “predicted possible deficit” as far as 20 years into the future. And one of our preferred bank and trust companies requires that ledgers assume a minimum interest rate that comports to long –erm projections of LIBOR by Reuters. Lenders such as these understand the moral and legal ramifications of unmitigated lending projections by agents. We hope others continue the trend.
Another way for clients to minimize interest rates and performance risk is to work with professionals who have extensive planning experience. According to Kevin White, a wealth advisor located in Jacksonville, Miss., “clients should never finance premiums for the sole purpose of financial arbitrage. What can justify and minimize risk are two factors. First, if there is not enough liquidity to purchase the insurance and second, if paying the annual premiums unnecessarily reduces one’s lifetime exemption or makes gift tax onerous.” Kevin suggests three tools that may use smaller levels of the lifetime gifting credit. His favorites include the sale of assets to a defective grantor trust, the use of a leveraged grantor retained annuity trust or a leveraged charitable lead trust. In his practice, as we have seen with others, clients that are most ideally suited for premium financing are those with sizeable real estate or business interests that earn a high return on investment. These clients may have the inherent downside protection to offset negative arbitrage with the financed policy.
Do we support the use of financed life insurance? Yes. But only when clients and their advisors fully understand the inherent risks of the transaction.
Making a leveraged bet on premium financing can be catastrophic. Based on a long history of Black Swan events, when something is so obvious everyone is doing it, perhaps it is time to rethink the obvious.
