By Josh Gottlieb
As we continue in our series, Thinking Outside the Nine Dots, today our blog explores premium finance, a method of paying for life insurance that has become pervasive in the life insurance industry in the last 10 years. Premium finance is a method of paying for a life insurance premium using third party debt and some equity or cash contributions. Historically people have purchased their life insurance with after-tax dollars, paying premiums, or sometimes paying through instruments like pension plans with pre-tax dollars. Utilizing premium finance as a strategy enables a client to apply their assets to pledge as collateral while another party puts up the money for life insurance — allowing the client to have life insurance and experience the living and death benefits it provides.
One of the things that creates a higher level of risk for those that use the premium finance instrument is the inherent potential conflict with how most insurance brokers design or position the policies they sell. In a typical life insurance plan, the premium will develop very little cash surrender value from the outset, particularly because the design of the policy has significant commissions and expenses built into it. Depending on the structure, a client might pay a premium and that premium might be paid for two years without any cash surrender value allocation for several years before you see some developed assets in the policy.
Why does cash surrender value matter?
Cash surrender value matters because that cash surrender value is an asset I can pledge to secure the loan. If I had a $ 1 million premium and there's zero cash surrender value, the lender says, I need a $1 million of collateral. Because the loan is paid at death, the lender needs the collateral to support the loan. The lender wants protection in case the insured quits. The collateral supports the policy plus the interest or any fees that are accruing on that loan.
We've reconstructed and deconstructed policies, and we look at premium finance a little differently. Our view is, if you're a healthy person being underwritten for new insurance today, you're likely not to die in the immediate future. You're likely to be alive for your life expectancy or beyond, which might be 20, 30, 40 years hence. Given that, we found that a much more efficient way for you to buy insurance when you're financing, is to have very high, early cash values. For example, if I paid a $1 million premium and I have zero cash value with one type of structure versus $900,000 of cash value from our type of structure, then the collateral needs are reduced. Our design promotes the least amount of insurance with the most amount of cash value, particularly for our clients who have a desire to build a living benefit and use this as an alternative asset class.
In our experience, most of these 30 or 40 year programs are implemented with a lot of front-end of compensation, which isn't necessarily wrong or makes it bad but because the person selling it gets compensated upfront he/she may not be involved in the fifth and 10th and 27th year to support this, which is what clients think they're buying. TGO has spent enormous amounts of resources, talent, money, energy, relationships, to build out this incredible ecosystem of program support long after they're sold. Our strategies are not something you put on a shelf. You have to look at the cost of borrowing and continually monitor and move if you need to, to different lenders. A lot of these programs and policies have the opportunity for you to pick different types of investments — such as an indexed, universal life, where there are different indices that I can invest in, or being a fixed income account. We've built this amazing structure that allows us, and I believe obligates us to work with our clients and their advisors to make sure a.) they understand what they have; b.) they know what the risks are; c.) they understand what the opportunities are to manage it.
We created MAID Financial Technology — Managing Assets, Insurance and Debt — which is the culmination of 40 plus years’ work. We continue to build additional tools that allow us to make sure that we're balancing our client’s financing with their needs, that predict change throughout the course of their lifetime.
When I talk about the least persistent pool of business that these carriers have, what I mean by that is, a life insurance carrier builds a product with an assumption of it being on the books — of it staying alive, of it being in force — for typically, not less than seven years, typically eight or more years. In fact, they build the product so that the insurance company believes they've achieved all of the profits they will earn within the first seven or eight years. If it doesn't stick around for that duration they're going to lose money. If it stays longer, it's great, but they've already booked their gains, their profits. In fact, some carriers build programs with a hope that this business will go off the books. They won't stay on after a period of time because they don't want to end up paying the insurance proceeds. And they all say we don't build it that way, but some do.
So part of our diligence, part of the work that we do is not just looking at what these illustrations project, but also looking at, who are the people running the carrier? What's their ethic? What's their behavior been? How have they responded to adverse economic environments and how have they treated policy holders? Who are the people running it? What is the culture of that company?
Because when you're in these programs, you're in this for life — or that's what your expectation is when you buy it.
Having a support system for you, for your plan that keeps you in the loop on that, that's not going to be something that a client or their attorney is going to necessarily know. It is with professional organizations that are supporting these things. And we've built an incredible set of tools that we use for that to make sure this happens. The persistency issue is when I buy something with an expectation of X and my expectations don't get met, and they don't get met repeatedly over time, I'm going to say, I need to get out, this isn't working. So part of what is critical in what we do and what you should be doing with anybody you're working with on any financial instrument is making sure that they understand what you want. Make sure that they take the time to understand what matters to you and what your limitations and objectives and constraints are. And everything that they do should be centered around that. And it doesn't stay static, it moves.
When TGO puts these premium finance plans in place, we believe that we have a relationship with our clients “‘till death do us part.”
We are creating value today and in the near term but it's a long term play. I tell people, if you're going to do this for less than a decade, don't do it — it's a bad deal. This is not a hedge fund or a private equity fund or an investment that's going to return a rapid return in the near term. Other than if you die, it's a great return, except for you — not something you want to necessarily think about or invest in. But in time, if your program is managed well, the results will achieve what we promise.
Joshua A. Gottlieb is the Chairman and Chief Executive Officer of The Gottlieb Organization.