Premium Financing Gimmicks To Avoid
When it comes to Premium Financed Life Insurance, all that glitters ain’t gold. There are several gimmicks that some premium financing designs use to make their value propositions appear greater than what they actually are.
There is no such thing as a free lunch in Premium Financed Life Insurance. In addition, there are some gimmicks that I believe lure the wrong type of clients into premium financing, creating an unsuitable arrangement for all parties involved. Not everyone should finance their life insurance premiums, but not because the math doesn’t work, and not because the risk is too high.
The reason I say that Premium Financed Life Insurance is not a suitable strategy for some people is that it typically requires substantial liquidity – not stated liquidity or future/aspirational liquidity – but current liquidity.
But if a client’s net worth is truly equal to or greater than the carrier’s requirements, and their current liquidity is greater than the projected peak collateral in our Leveraged Hypothetical Synthetic Asset (the proxy for the premium financed IUL) during the 40-year period with the Worst Compounded Annual Growth Rate… AND assuming the client doesn’t mind posting that amount as collateral (not touching it until the lender’s collateral requirement outside the policy value is zero), premium financing is most likely a suitable strategy for them.
However if the client does not have the assets required by the lender to use as collateral, premium financing is just not a viable option for them.
One exception to the rule is that if they can get their own lender to post a Letter Of Credit against one of their illiquid assets – like real estate for example – perhaps Premium Financed Life Insurance is suitable for them. We do have a few lenders that will accept real estate equity as collateral, however it is still important to make sure the client has the ability to weather short-term financial hardships in the event that their cash flow is negatively affected for whatever reason.
Another exception to the rule is if they use our Second-Year Financing (2YF) design or our Third-Year Financing (3YF) design wherein we introduce financing in policy year two or three. The chances the client will have to post any sort of significant collateral is slim to none. Keep in mind, they still must have the cashflow to afford the annual contributions, whether they be interest payments or partial premium payments. If their cashflow dries up due to challenges in their business (which certainly happens with all entrepreneurs from time to time), they must have the liquidity to draw from to make their payments/contributions to the plan. If they do not have this liquidity for rainy days, perhaps they should not commit to any sort of premium financing arrangement.
In most cases, when a client says they have the liquidity but just don’t want to post it as collateral, it usually means they don’t truly have the liquidity they say they do. When this is the case, the first request I most often get from life insurance agents is to use a High Early Cash Value Rider. There are several reasons why I am not a fan of using this gimmick.
The first reason is this rider comes at a substantial cost that acts as an eroding factor, making the cash value accumulation suffer over time. As an example, I once reviewed a carrier illustration that assumed a 5.47% index return, $1,000,000 annual premiums, using a First-Dollar Financing design. In that design, it showed the policy value paying off the third-party lender in policy year 16 using a Participating Loan, plus income drawdowns using the same Participating Loan structure.
I built a clone model of this design not using the High Early Cash Value Rider (HECVR), and compared it to the version WITH the rider.
This was a LIRP design (Life Insurance Retirement Plan) built primarily for cash value accumulation and future retirement income drawdowns using participating policy loans.
The policy WITH the HECVR produced $414,103 annual drawdowns compared to $453,380 annual drawdowns from the policy WITHOUT the HECVR. Over this 40-year period, it was a cumulative difference of $942,648 in total income drawdowns (favoring the design without the HECVR).
The reason for this huge disparity in income drawdowns was due to the additional charges the policy incurs with the HECVR. In this particular comparison, there were $260,606 in additional charges in the policy due to the HECVR.
$3,979,862 Total Policy Charges with HECVR
- $3,719,256 Total Policy Charges without HECVR .
$260,606 Additional Policy Charges with HECVR
There is only one reason why someone would ever use a HECVR despite the charges creating such a drag on performance: They want to minimize the outside collateral required in the early years.
There is definitely a trade-off that comes with lowering expected collateral requirement amounts in the form of lowering expected income drawdown amounts (and cash value accumulation) when it comes to using a HECVR in an IUL. In a death benefit-focused design, this rider will also reduce the cash value as well as the death benefit in the later years of the policy.
The decision to give up $942,648 of income (or accept lesser cash value and a lower death benefit) could only be justified if the client had significant illiquid assets that the premium financing lender would not accept as collateral (e,g., real estate farm land, crypto currency, privately held business equity, etc.), and they just didn’t have the liquidity.
However for the most part, a client financing a large amount of premium should only be doing so if they have the liquid collateral to do so. In many cases, lenders will allow the client to keep the assets with the current custodian, and if the assets are marketable securities, they can usually keep those assets exactly as they are. So if the client has enough liquid collateral sitting in an investment account that they don’t need to touch for 7-10 years anyway, there should not be an client reservation from posting it as collateral on the premium financing loan.
Personally, I think many advisors project their own insecurities about posting collateral onto the client, wherein the client would not have had an issue with posting more collateral if the issue had not been portrayed as a negative element by the advisor. I can’t tell you how many times I have seen advisors worry about their client being reticent or upset about an issue, and then I get on a Zoom call with the client, and the client has no problem with the issue.
But perhaps the biggest reason I am not a fan of HECVRs has nothing to do with how the drag of the additional charges erode cash value accumulation.
It isn’t the chargeback liability for the agent either.
The biggest concern I have regarding HECVRs is the message it sends to the client, which is, “You can exit this arrangement with little or no penalty.”
In theory, this flexibility sounds like a good thing, however using this flexibility as a selling tactic sends the wrong message to the client. Any financial strategy that uses a cash value life insurance policy – financed or not – should be a long-term strategy. If the client enters the arrangement under the wrong premise – focusing on early exit options as an example – a life insurance-based solution is probably not appropriate for this particular type of client.
Though this analogy may be a crass one, if a single person just won the lottery and walked into a bar with a t-shirt that said, “I’m a $100,000,000 lottery winner, and I’ll buy you anything you want,” I’m not so sure they are going to attract the right person. Now, there is nothing wrong with being a $100,000,000 lottery winner, and there is nothing wrong with buying someone you love anything they want, but if that is the message a person leads with when engaging in a new relationship, it is harder to know what the other person’s true intentions are.
Remember, I’m the guy that brought up my requirement of signing a prenuptial agreement on the first date with my wife, only to combine all assets as soon as we got married.
Under-promising then over-delivering, combined with a transparent, full-disclosure approach is what builds long-lasting relationships – authentic relationships.
As a Premium Financed Life Insurance intermediary, I believe it is my duty to identify whether or not the client’s true intentions are to utilize this strategy for what was designed to do – to provide a long-term wealth building solution, or to be used as an effective estate planning tool. This is not a get-rich-quick scheme, a get-something-for-nothing ploy, or a short-term investment.
I want to know that the client is committed to this as a long-term strategy and that they have the liquidity and emotional fortitude to stay the course and weather any short-term financial storms should they come.
Yes, there is an element of risk in premium financing, but if designed properly, it is no more risky that buying a home with a mortgage loan. In fact, I could make the argument that a well-designed Premium Financed Life Insurance arrangement is far less risky because the likelihood of the policy value deteriorating as drastically as the housing market can is infinitesimally smaller.
But as I repeatedly profess over and over, the only way to really understand whether or not a premium financing arrangement is mathematically sound is to create a proxy for the IUL, build in pessimistic assumptions, and backtest the design throughout different historical periods of time wherein the index experienced volatility.
I am literally the only premium financing intermediary in the entire life insurance industry that has the ability to do this. In my humble opinion, this is the only true test of whether or not a Premium Financed Life Insurance arrangement is a prudent financial strategy.
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