Part 2 of this series dug a bit deeper into the details of whole life and premium financing as it pertains to what policyowners are presented and what’s reality.
After highlighting the facts and figures that show this doesn’t really work as presented, I get the response “But Bill, that’s why we have the client pay loan interest out of pocket. It makes the program more conservative.” Frankly, that’s true, but how does that help relative to the misrepresentations I regularly see? All it does, it makes the policy look like it’s working on arbitrage, allow it to pay its loan off and keeps the collateral requirements lower. It doesn’t actually change the important dynamics of the transaction. If you add a couple hundred bucks to your mortgage payment every month, it’ll be paid off earlier, but it doesn’t change the deal. Putting more money down on a real estate transaction doesn’t improve the return on the property. The return is the return. Extra money down may make it less risky, but it absolutely doesn’t change the return.
An insurance policy is an inanimate object. It doesn’t care or know if premium is being borrowed or who’s paying what from where. Paying interest out of pocket doesn’t affect the borrowing or crediting rates of the deal. It has to be paid or the proposal won’t work as positioned. Some years back, many proposals didn’t require paying interest, but they do now because crediting rates are lower and borrowing rates are higher. I recently reviewed a proposal showing loans being paid off by policy cash value down the road while leaving enough cash value to continue funding the policy, and this was being touted as arbitrage. But … no one was mentioning the $5 million in interest being paid out of pocket in the meantime. Anything can be made to look good if one ignores 100% of the out-of-pocket contributions.
I find the only way to explain this is by changing the players.
Scenario 1: I borrow $1 million for 10 years at 3% with accruing interest to buy a piece of real estate that will purportedly appreciate at 10%. After 10 years, I’d have a piece of real estate valued at $2.594 million with a loan of $1.344 million. I sell, pay back the loan and have a lot of money left over. (All calculations ignore taxes and time value of money.)
Scenario 2: My loan is 5%, and the real estate appreciates at 5%. At the end, I have a loan and real estate worth the same $1.629 million, so there’s no play.
Scenario 3: Take Scenario 2, and I pay interest out of pocket rather than accrue it. After 10 years, the real estate is worth $1,628,894, and I sell it to pay back the $1 million, so now I have $629,000 burning a hole in my pocket. But is it real? Was the deal meaningfully different or was it simply made to seem different?
Scenario 4: The loan is at 10%, and the appreciation is 3%. I pay the interest out of pocket, and the real estate is worth $1.344 million after 10 years. I sell it to pay off the $1 million loan and pocket the $344,000. What a deal … if I’m a moron. Again, anything can be made to look good if one ignores 100% of the out-of-pocket contributions.
It may seem like I’m being facetious, but I just shared the gist of a premium financed life insurance deal presented to a client. It was postured to be a good deal because the commercial loan could be paid off by cash value, but the loan interest paid out of pocket was completely ignored. Wouldn’t that be kind of important? Now someone is going to tell me: “The loan interest was less than the premium would have been so it was a positive deal.” That may be so, but that’s not how the deal was positioned. The deal was positioned on the positive spread between borrowing and crediting, so if there isn’t a positive spread, don’t position it that way. If the interest really is less than the premiums, then position it that way.
Important to Assess Risk
We haven’t even discussed risk yet. What if the appreciation in any of these scenarios didn’t pan out? The loan would still be payable, but it might have to come out of pocket. This is why a true candidate for premium finance has the money to pay the premium out of pocket but chooses not to. In that case, if things go south, the money to pay off the loan is actually available. In the real estate examples, if the investor borrowed because he didn’t have the money and the appreciation didn’t materialize, he’d be in trouble.
If the $1 million was borrowed because the opportunity cost of the $1 million he does have in play is meaningfully better, that would be entirely different, but the interest paid out of pocket clearly has to be considered. If not, the asset in question could appreciate at less than the borrowing rate and still be made to look “good.”
But maybe we’ve stumbled onto something here. The conversation surrounding premium financing should be about risk, not about some ridiculous “opportunity” for a sophisticated consumer to take advantage of other people’s money. If one knowingly takes on risk, understands it, has the ability to deal with it and is opportunistically taking advantage of other more attractive uses of money, therein lies the opportunity for premium financing; assume risk through leverage to increase gain. It shouldn’t be an effort to take advantage of policy crediting that isn’t real in the way most consumers understand.
I don’t suggest all premium financing deals are based on misrepresentation, as certainly they aren’t. However, every one I’ve ever seen is shown to be “self-completing.” Even financed deals accompanied by a realistic conversation regarding a client’s opportunity cost of capital always show the financed deal to be self-completing. I’d love to see a proposal with the Excel spreadsheet showing a lot of red ink because the proposal is realistic and underwater, and the client still wants to move forward. This would be a person who understands the big picture and realizes that success is measured by the sum of the parts.
A life lesson is realizing that wealthy and financially sophisticated aren’t synonyms. The biggest marks for premium finance proposals are the wealthy who are sucked up to but aren’t sophisticated enough to understand what the programs are built on.
A Note About Policy Loans
I’ll wrap up with a note on policy loans. More than a few of my clients never realized that the commercial loans were presumed to be paid back with policy loans. They never realized what they were sold because they were never told. A typical case on my desk shows a loan payback in the neighborhood of $10 million, so now their life insurance policy has a $10 million loan with interest accruing for decades, maybe even 50 years. At even 5%, the loan can grow multiple-fold and possibly exceed $100 million. I’ve seen ledgers showing hundreds of millions of dollars in loans.
Where else in life would you move forward with loans like this with no intention of ever paying them off and just letting them accrue indefinitely? What if the policy doesn’t perform and lapses at some point? Those loans on a lapsed policy become forgiveness of debt, and I imagine you understand the tax consequences of that. Have you ever seen someone literally bankrupted by the taxes due on a failing, loaned-out life insurance policy? I have. Still, even a policy loan isn’t definitively bad, but you’d better understand it before taking one more step. I can assure you this aspect of the deal isn’t told as much as it’s sold.
The ultimate arbiter of an honest deal is when told and sold are the same thing. The further they drift apart, the more skeptical clients and advisors need to be. The problem? Most clients and advisors don’t have the wherewithal to measure the daylight between the two. Therein lies the need for independent advice. It’s like having a big piece of spinach in my teeth. I can’t see it, but I sure would appreciate it if someone told me, even if it’s uncomfortable.
As negative as I sound when I write about this, I’m not against premium financing. I’m against the misrepresentation I too often see during the sales process. I’d bring a well-designed and realistic financed deal to the right client. It could be a fantastic opportunity but only if the client came to that conclusion based on the truth. The other truth? That won’t sell as many deals.