Believe me, there is nothing wrong with a chocolate molten lava cake. In fact, it’s probably my most favorite dessert, both to make and eat. But with a slight change to the recipe we can leverage the lava cake into one of the world’s most beloved desserts: the chocolate soufflé. Using the exact same ingredients and carefully adding a few very well beaten egg whites, we can transform the not so lowly molten lave cake into the prized and adored chocolate soufflé. Spoon in a little whipped cream as you open the warm center and you have heaven on a plate. So what is it about the soufflé that causes most home cooks to head for cooler rooms in the house rather than making this dessert? The truth is that it’s not much more complex or difficult than the lovely lava cake, it just takes care to leverage it into a soufflé.
By now most of you know I have a passion for cooking, and I’m blessed by having various avenues to weave this passion into my profession. One of these ways is through this blog. So, you may ask, how is it possible that the sublime soufflé finds its way into the analogous mix?
For the last several years I’ve had the very good fortune of working with clients of substantial wealth and/or income. In many cases I’ve created and implemented wealth accumulation and preservation strategies using specially engineered life-insurance products to provide enormous benefits to these clients. These include equity-linked products offering market performance with no market risk, along with complete tax-efficiency. These strategies need to be properly and carefully engineered in their design and implementation in order to provide the highest value and benefit to the client. If built properly, there are few financial instruments that can compare. Having said that, there is another ingredient that can be added to the mix to potentially enhance the outcome – leverage. Leverage, or the use of third-party financing to make the contributions to the plan, can produce the perfect outcome. But much like the soufflé, if done incorrectly, could result in a disastrous collapse of the strategy.
Third-party financing is typically used when interest rates can reasonably be predicted to be lower than the crediting rates achieved inside the life insurance container. In the current environment this is particularly feasible, especially if the funding vehicle is an Indexed Universal Life (IUL) Policy. Without going into the specifics of an IUL structure in this piece, it will suffice to say the following: IUL provides long-term equity-based returns without any risk of losses through market declines, while providing complete tax-efficiency during both accumulation and distribution. (To fully understand how IUL works and why I’m such a strong crusader of this product, I’ve written a white paper which I’d be happy to email you upon request.) When third party financing is added to the advantages inherent in an IUL structure, the results can be exceptional. However, the reverse is also possible. So how can one take the necessary precautions not to have the strategy collapse? Here are the rules one must follow when considering a leveraged (Premium Financed) life insurance strategy:
- Most importantly, a financed strategy should never be used by anyone who, but for the financing, would not be able to pay the underlying premium on the policy without the financing. In other words, leverage is simply a way of enhancing a result, not creating it. Premium financing should only be used for those insured’s with substantial balance sheets, and would rather deploy their personal assets elsewhere. The quickest path to a failed leverage strategy is to short-cut this Rule #1. Just don’t even think about it! The inherent risks of financing make this a fool’s path.
- Interest to be paid as you go. No financing strategy should be undertaken unless the illustrated plan includes full out-of-pocket payment of interest on the funds borrowed to finance the plan. This is the second most significant risk factor. Many promoters of premium finance will illustrate the accrual of interest into the loan balance once the interest cost begins to grow to amounts that may otherwise dissuade the buyer from entering the plan. The risk of financing failure significantly increases under an interest accrual approach. Usually unmentioned by the promoter suggesting to use an accrued interest approach is the risk, in the event of a collapse of the strategy, for significant taxable income, at ordinary tax rates. Beware of accrued interest.
- Illustrated borrowing rates. Make sure the analysis depicts loan financing interest rates that are sufficiently stressed over the years the loan remains unpaid. Interest rates remain at all-time lows, but they will not stay that way. And while increased interest rates, over the long-term, would positively impact the underlying IUL strategy, this benefit could lag several years, during which time the rate at which interest is being paid on borrowed funds may be greater than the rate at which cash accumulates in the underlying policy.
- Illustrated policy crediting rates. Until recently, the illustrated future crediting rate in an Indexed Universal Life policy had been subject to significant abuse, and thus created a false inducement to proceed with a premium financed strategy. As of September 1, 2015, new illustration regulations have finally been implemented that mitigate this concern, by limiting the crediting rate at which illustrations can be prepared. While this has definitely lowered the inherent risk of overly optimistic crediting rates, this risk still remains, and proper care and evaluation must be given to the future crediting rates illustrated in the underlying IUL policy. When entering into a financed plan, the policy owner needs to thoroughly understand how the illustrated crediting rate was determined.
- Illustrated loan payoff method. Of significant importance is the illustrated method of paying off the loan to the third party lender. Most typically, the loan is illustrated to be paid somewhere around year 15-20. Premium financed loans are almost always paid off from the accumulated cash values in the policy through distributions and very favorable policy loans. Many carrier’s marketing an IUL product have both fixed loans, usually with a net cost of 0% to 0.1% (also called wash loans), and various forms of arbitraged loans. It is essential that policy loans be illustrated at the carrier’s fixed rate loan regime. This risk can be the most difficult to determine by the untrained purchaser, and the question should always be asked as to how the loans from the policy are structured. Never enter into a financing strategy based on an illustration of arbitraged policy loans. Issuing carrier. The carrier issuing the policy is a huge factor in ultimately having the strategy work as planned. There are many carriers that have an IUL product in their portfolio, and some are head and shoulders above the others when it comes to delivering on their illustrations.
- Financing partner. Every financing strategy requires ongoing administration, with regard to both the internal policy values and, in particular, loan renewals. This should not be under-estimated. No premium financed loan will have a term that will run as long as the strategy is scheduled to be in place. The loans will need to be renewed regularly, perhaps even annually. There are many third-party providers of premium financing. Some of these players are fly-by-night while others have been around for decades. The latter are the folks who manage the annual policy administration, renegotiate the loans as they come up for renewal and have the very best available financing, and is evidenced by the billions of dollars they have in in-force premium financed policies. Make sure the agent is working with a solid and reputable third party premium finance company, preferably one that does not accept any fees or commissions from the financing bank, but instead shares in the policy commissions with the writing agent. This will naturally reduce the interest cost of the program, and enhance the ultimate leverage from a premium financed strategy.
As evidenced above, many of the risk factors revolve around the method in which the strategy is illustrated. Remember, an illustration is just that, and enormous care should be taken prior to entering into a premium financed strategy such that the illustrated values are carefully designed to set proper expectations. The alternative is to create a false inducement into the strategy. If properly designed, leveraging can produce exceptional results. And under these circumstances, if by some chance the soufflé does collapse, the policy owner will still have the molten lava cake. Not a bad result.