Doing Premium Financing Wrong
"Premium Financing" refers to the use of borrowed money to pay life insurance premiums. In practice, some uses of this mechanism have been derided - likely with good reason.
The main issue tends to stem from variations on one common misunderstanding about (1) why leverage is being used and (2) whether it will or won't be beneficial.
In short, "internal arbitrage" or arbitrage internal to the policy is, in many cases, probably not a good reason to use premium financing. The way this would work in theory is if the policy being financed returns more growth than the interest rate paid out on the financing, then the policyowner would be better off borrowing money at low cost to fund a policy that grows at a higher rate than the cost.
There are a couple of problems with this. Perhaps most obvious is that (at the time of this writing), even in the long-term, few policies will return more than current market interest rates used to fund them. But a more pernicious problem has to do with the nature and timing of the interest cost and the returns from policy growth. While some insurance policies can provide healthy tax equivalent returns over the long haul (which, to be fair, is exactly how these policies are intended to be used for retirement distribution and/or estate planning), they are unlikely to do so early in the policy's life, when the borrowed funds are charging what's very likely to be a higher rate than that of the policy - even in lower general interest rate environments.
While unscrupulous advisors have suggested premium financing as a "no-lose" sort of proposition to take advantage of an interest rate arbitrage (which is wrong), there are actually some good reasons to do it when the situation is a proper fit.
Using Leverage and Premium Financing Correctly
The reasons to use premium financing turn out to be pretty similar to the reasons to use leverage, generally.
- Lack of short-term liquidity, for explainable and expiring reasons.
There are reasons to start the clock on the long-term benefits of a policy (such as taking advantage of an underwriting approval, lower cost due to younger age, and timing the maturation of the policy to be ready for life events changes like retirement), so it may not make sense for you to wait until the liquidity lines up just right for you. It's important to make sure that the reasons why you don't have the available cash flow are temporary conditions that you don't expect to continue.
Some examples might be:- You have strong and sufficient cash flow and income, but you just sacrificed short-term liquidity for a large one-time non-recurring expense.
- You are due a settlement or bequest that you haven't received yet.
- You will receive already-vested compensation from a job or business at a known future date that hasn't arrived yet.
- You will be receiving the proceeds of a business sale over time.
- Availability of stable options for predictable growth as an alternate use of funds.
If you have the available cash flow to fund premiums, but simply choose not to, it should be because of the availability of reliable alternate uses of those premium-paying funds to outpace the interest rate on borrowed funds over time.
Some key points for consideration of those alternate investment strategies should be:- Reliable, long-term, repeatable history of rates of return greater than the interest rate.
- Relatively low volatility.
- Why? Because the range of expected outcomes over interim periods should be sufficient for you to expect to have the money available in your side fund to repay the borrowed funds.
- The S&P 500 might be a bad example, because while historical rates of return have exceeded current borrowing rates, the range of outcomes over interim periods has shown that performance can be lower, flat, or even negative over shorter intervals. Depending on your exit plan, this may not be an acceptable outcome for leveraged investment.
- See more on volatility and exit plans below.
- Having a natural state of healthy returns with low or no liquidity.
This typically means that your work or a business that you have ownership interest in provides both (1) substantial compensation (relative to the premium or borrowed funds in question) and (2) in a primarily illiquid fashion. This is a growing asset that is not liquid, nor can it easily be liquidated in the short-term, or that may be liquidated on a known schedule over a number of years. Predictable value/growth, low volatility, and eventual liquidity are a must, as borrowed funds must be paid back.
The most common examples of the above are:- Hedge funds. Hedge fund compensation to employees may come in the form of investments in proprietary funds, with a schedule for becoming liquid (say, 3-5 years). This fits the criteria (depending on the investment strategy) of lower volatility returns, extremely illiquid in the short-term, and predictably liquid in the medium term to make funds available for repayment.
- Business ownership. A business owner with a history of growth and stable cash flows within the business may have a high proportion of their net worth tied up in illiquid business equity. Equally important, an owner may decide that reinvesting these cash flows into the growth of the business will be more fruitful than making premium payments directly and won't want to suffer the opportunity cost of funding premiums themselves.
- Other illiquid equity or performance-based compensation. Hedge funds are a clear and common example, but there are others. Any time compensation liquidity rolls out to the participant on a known schedule, it could be an application of this principle. One needs to be careful, though, that they understand the nature and reliability of the deferred equity's value. It should not be speculative or unpredictably timed (such relying on a possible future IPO with a wide range of possible future valuations).
What to Watch Out For / What to Consider
- What is the volatility / standard deviation of the re-invested funds?
- To return to the S&P 500 example above, let's assume for the sake of this analysis an 18% standard deviation and a 10% average return over some selected time period. Both of those figures are inexact and will vary, but they should be close enough to illustrate the point.
- Assuming a normal distribution of returns, this means that there would be a 68% chance that returns fall between +28% and -8%. There would be a 95% chance that returns would fall between +46% and -26%, and finally a 98% chance they'd fall between +64% and -44%.
- The point here is that while 10% might seem like an acceptable average or target return, in fact you can only be reasonably sure you'll get something very different from 10%. Negative 44% returns when you're relying on equity principal to pay down loan principal could be a disastrous outcome, and this needs to be considered in its proper place.
- What is the exit plan - when should premium financing or other leverage stop?
- First, timing questions are closely related to the above. You need to have an understanding of expected positive or negative returns over the correct time frame. A one-year plan, to extend the above example, that could result in a negative 44% return, would be an unreliable plan.
- Second, there's the liquidity element. Will the funds be available at the time they're needed for the exit plan? For hedge fund compensation that becomes cash in year 4, you can be reasonably sure. For equity in a growth startup that may or may not IPO some day, an exit plan can't reasonably be formed.
- Finally, there may be strategic considerations. Some policies will grow cash value that can be borrowed at fixed or capped rates that may be lower than the market rate on premium financing. Planning to pay off a loan once cash value fully covers it could make sense, especially when cash value can be re-leveraged (if you so choose) at better rates.
- Also consider, growth reliability and investment objectives can change over time. If you think you've vetted a sound reinvestment option today as part of this plan, it's not at all obvious that the same plan can go on indefinitely for 20+ years. Businesses change. The future is hard to predict, and tighter, written exit plans are a strong way to avoid becoming a victim of the unforeseeable.
- How reliably are you able to do what you intended to do with the premium-paying funds you've now borrowed instead?
- The main point here is that your "side fund" - the funds building and growing as part of the above exit plan - needs to be real, tracked, and not theoretical.
- Forced saving/investment options, like compensation that will be paid in illiquid fashion and can't be accessed for (let's say) 4 years, are a great fit - you can't help but set the money aside.
- Short of forced options, you must be accountable and stick to a plan to put aside and/or reinvest those funds that are intended for the exit plan. Scheduled deposits may work similarly to forced savings. It may sound silly, but it can't just be a nice idea that you'd rather put the money elsewhere. You must commit and take action to put the money elsewhere every time.
- It should go without saying, but it won't here: borrowing to pay premiums and spending the money that wasn't used to pay premiums is not an option.
It can be hard to assess exactly what situation you're in. For example:
- Is my liquidity problem short-term, long-term, or hard to judge?
- Is this alternate reinvestment stable and low volatility or risky in ways I can't recognize?
- How can I achieve or access lower volatility portfolios for these purposes for high-quality risk-adjusted returns?
These are all great questions, and they're great reasons to talk to someone knowledgeable before committing to complex strategies.
2024-7032328.1 Exp 09/26