After writing a few pieces on loan refinancing, I’ll now share some examples. Over the years, I’ve seen many situations in which policies have significant loans. These include whole life (WL) policies, universal life (UL) policies and others. Some are modest, and the policies can handle the loan, while others are overwhelming and will drive the policies into the ground. Some have reasonable rescue strategies, and others are all but loss causes.
These situations often involve a lack of understanding about how the policies fundamentally work, how loans affect the contracts and how to manage the policies over time. In some situations, the initially chosen policy management features, which have caused the problems to escalate over time, have never been changed. Sometimes I've been able to simply make a dividend option change, and a failing policy can be self rescued with the trajectory of the cash value, loan and death benefit reversing itself over time. For example, when a policy has an 8% loan interest rate in today’s market, why would a dividend option be set to buy additional paid up insurance while ongoing premiums are added to the loan and loan interest accrues? Again, it’s a lack of understanding and too often an abandonment of the policy owner by the agent. What may have been true a number of years ago may not be true today given the meaningful changes in the financial marketplace and policy crediting. Policy management is an ongoing responsibility.
Look to the Future
Unfortunately, many policy owners are so out of touch with their contracts that they don’t even realize there are loans on the policies. Some who are aware of the loans don’t understand the interest rate and the effects the loan has on the policy. Among those who do, many don't understand what, if anything, can be done about it.
It's not always about how the policy is doing today but about how the policy will be doing in the future if nothing is done. Many years ago, I was brought a second-to-die WL policy with a $5 million death benefit. The contract was originally sold to a couple with a $40,000 annual premium on a 10-pay basis. Of course, as is all too common, these people understood the 10-pay to be the deal and not just a projection. They referenced their policy as “paid up.” As would be sensible, they stopped paying the premiums in the 11th policy year. Only the policy didn’t stop needing annual premiums, it was just a matter of where those premiums came from. When they didn't pay premiums out-of-pocket, the policy borrowed the premiums from the insurance company. Too many policy owners simply understood this as "using internal policy values" to pay the premiums. This is where common vernacular can cause problems. There are different ways people consider internal policy values to pay premium. The true way is when dividends pay the premiums or the premiums are paid by surrendering paid up additions, that is, cash value. Paying the premiums through loans isn’t paying premiums from internal policy values. It's paying the premium through a loan. Also, this is one place where a WL policy can get in more trouble more quickly than a UL policy.
If your client didn’t know this, it’s easy to understand how he could get in trouble. Back to our example: I ordered in-force ledgers on the above referenced policy and saw that a number of years down the line, but well within life expectancy, the premium column, which had been zeros for decades, all of a sudden had numbers reappearing. These numbers reappeared at $400,000 a year; 10 times the annual premium paid originally. But in a WL policy, the premium can’t change because it’s guaranteed, right? Don’t get me started. Technically, the premium is still $40,000 with $360,000 of loan interest. Show me one person who’s writing a check that actually cares about differentiating those two parts of the $400,000 number. That’s what I thought. Therefore, I will move forward referencing $400,000 as the premium.
Furthermore, the death benefit that was supposed to have grown over the life of the contract has now shrunk to $3.5 million and every payment of $400,000 results in the death benefit shrinking even more until the point it bottoms out at $1.9 million due to the growing loan. The gross death benefit had actually grown at this point to $15.5 million but with a $12 million policy loan, the net death benefit was $3.5 million. When I first presented this to my clients, they responded that I was clearly mistaken because they had never taken any money out of the policy so it couldn't conceivably have a loan. Unfortunately I had to burst their bubble. Next they asked why they would ever consider paying a $400,000 annual premium when their death benefit was sinking like a stone. Good question. And the answer… you don’t have a choice. If you don’t pay that $400,000 premium every year, then the policy will lapse because the insurance company will collapse the contract to get its $12 million of collateral back, and the policy will fall off the books.
A Tax Catastrophe
Oh well, it will have been a bad deal, but such is life. But wait, there's more. Another aspect regarding the misunderstanding of life insurance policies is the gain embedded in a contract like this. When that policy crashes off the books, there would be over $10 million of taxable gain at ordinary income tax rates. The gain in this policy would be the same as if they had voluntarily terminated it. Whether one calls it taxable gain or taxing forgiven debt, it doesn't really matter. The taxes due and payable to the federal government would exceed the entire net death benefit. Mind you, this was many years ago when the dividends were significantly higher than they are today so the results would have been even worse with the tax consequences hitting sooner. And don’t forget this is phantom gain. When the policy collapses and the insurance company takes the cash value that was collateralizing the debt, the policy owner gets the tax bill but not the cash value the tax bill is on.
Yes, this is the way it works, and it's not hypothetical as I’ve seen it happen in real life. In fact, I've seen a situation in which the tax payable on a collapsing policy exceeded the client’s entire worldly net worth, inclusive of the equity in their home and their retirement plans. They were bankrupted by a collapsing life insurance policy.
The lesson learned should be to get on top of this before you’re at a point of no return.
One Success Story
Here’s one case currently on my desk. One client has a $2 million mutual WL policy though with greater than an $800,000 loan. The client and his wife didn’t know the loan existed. They were told years ago by the agent that the policy could pay the premium from internal values. While it did pay premiums from dividends and surrendering paid up additions for some time, it turned to borrowing the premiums when those sources were tapped out. Once they discovered this, they were at a point where the accruing loan, between premium and loan interest, was 100,000 a year and gorwing. If left untouched, in 10 years the loan would grow to over $2 million. The policy would eventually collapse on itself driving a 7-figure taxable gain.
I worked with the insurance company to run a number of different scenarios and initially we changed the dividend option to keep the problem from getting worse. We then explored options with other insurance companies through an Internal Revenue Code Section 1035 exchange in an attempt to manage the loan more effectively and separately analyzed externally refinancing the loan. While the refinancing strategy raised eyebrows initially, they eventually understood that a loan interest rate of 8% would be unmanageable over time. Also, given the exceedingly low interest rates available in the market today, they could dramatically reduce the debt service on this contract and start to get on top of things. I performed some modeling that showed a newly unencumbered policy with a changed dividend option could not only support itself without premiums paid out-of-pocket, but also the dividends were enough to cover the interest on the external loan. Effectively, with no change in cash flow, a failing policy headed for a tax disaster was turned into a solid life insurance policy with a savings of tens of thousands of dollars a year, a restored death benefit and a mitigation of devastating tax consequences.
Whether the solution is maintaining the status quo, changing up policy management, bailing on a policy, exchanging for a new contract, paying the premium, loan interest or loan principal out-of-pocket or externally refinancing, there is a best solution for any given situation and it pays to spend the time and effort to find it, independently and objectively. Heads buried in the sand will not solve any problems.
Bill Boersma is a CLU, AEP and LIC. More information can be found at www.LifeLoanRefi.com, www.oc-lic.com, www.BillBoersmaOnLifeInsurance.info and www.XpertLifeInsAdvice.com or email at [email protected].