For clients who’d like to get a life insurance policy but don’t have the liquidity to pay the full purchase price, premium financing is a good option. But when someone proposes that it could help them get a policy essentially for free, it’s best to do some digging.
In a column for WealthManagement.com, OC Consulting Group President Bill Boersma described how clients could be led to believe that they can apply for premium financing for a life insurance policy, use the cash value of the policy as loan collateral, and be able to pay off the loan and more with a cash withdrawal from that policy down the road.
Boersma noted that such promises are made in conflict with fundamental rules of premium financing: the buyer must actually need or want the policy; they must be able to afford it even without the financing; and there should be a model for the worst-case scenario, as well as a viable exit plan.
“[T]oo often it’s not what is happening in the marketplace,” he wrote. “[W]hen the same millions and the same risk is on the table, these transactions are handled very differently from real estate transactions, business acquisitions, private equity deals or any substantive investment.”
As an example, Boersma shared his experience analyzing a proposed deal for a family office. Under the proposal, premium financing would be used for a new US$20 million whole-life policy, as well as the future premiums of millions’ worth of existing insurance; the existing cash value of the new policy would serve as collateral.
“The proposal assumed financing rates lower than they actually were at the time and the rates, by all accounts, were going up,” he said. The earnings on the cash value were also assumed to be perpetually stable, when in fact they may continue to slide downward for another two years. Rather than there being a spread of a few hundred basis points between rates of return on cash value and financing rates, Boersma believed the spread would be inverted within a couple of years.
Even if the assumed rates were to hold, he found that the policy had no bail-out option. The new policy would have inadequate cash value to pay off the loan even if it were totally cashed out; the family would have to forfeit massive cash value from their existing insurance if they wanted to bail.
“Numbers aren’t always really the numbers,” he added. The declared dividend on the proposal was 6.2%. But according to Boersma, the internal rate of return on the premium to cash value for the new US$20-million policy would be 0.56%, 1.93%, and 2.43% at 10, 15, and 20 years, respectively, assuming the dividend rate didn’t change. Expenses, mortality charges, commissions, and other costs impact the spread, he added.
“You can’t have positive arbitrage when the real crediting rate is actually significantly lower than the financing charges,” he said. “Premium financing is fine. How it’s often presented, implemented and managed isn’t.”
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