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Have You Stress-Tested Your Premium Financing Proposal?

Have you stress tested your premium financing proposal

In order to educate clients on the inherent risks of a premium financing program, it is important to “stress test” any plan proposals. Stress-testing may involve any of the following:

  1. Illustrating the plan using reasonable increasing future cost of borrowing
  2. Illustrating the policy with a lower than current crediting rate, we suggest using 85% of the current rate
  3. Illustrating the combined effect of 1 and 2

The best way to demonstrate the importance of stress testing your premium financing cases can be illustrated by using a real example. Highland was asked to opine on a financed supplemental retirement income design, using a leveraged indexed universal life product. The client, a male aged 40, was to borrow $200,000 a year for ten years, accruing 100% of the loan interest, and repay the third-party loan at the end of year 15. He would then take an income of $434,105 per year for 25 years, beginning year 26 via participating policy loans.

Quick math on the proposed plan design:

✓ $2,000,000 of premium borrowed

✓ $528,000 out of pocket interest payments by the client, amounts over $40,000 accrued

✓ $10,852,625 of tax-free income

✓ $3,157,092 of tax-free death benefit

What could go wrong?

A lot! First, it’s highly doubtful the carrier or lending institution would approve this transaction. Second, everything would need to go just right, including very low lending rates for the next 15 years and consistent policy performance for the next 60 years. To educate the client and the advisor seeking our assistance we stress-tested the design, by 1 basis point. Not 1.00% (100 basis points), but 1, single basis point.

Quick math on the proposed plan design -1 basis point:

✓ $2,000,000 of premium borrowed

✓ $528,000 out of pocket interest payments by the client, amounts over $40,000 accrued

✓ $4,775,155 of tax-free income

✓ $0 of tax-free death benefit

✓ A 1099 for $7,671,103

5.75% Assumed Rate of Return 5.74% Assumed Rate of Return
Year CSV DB CSV DB
1 $127,970 $5,865,197 $127,955 $5,865,182
10 $2,253,809 $7,997,036 $2,250,626 $7,987,853
20 $1,395,277 $3,038,317 $1,378,776 $3,015,648
30 $2,021,546 $3,619,724 $1,979,946 $3,570,098
40 $1,886,633 $2,897,080 $1,780,204 $2,783,460
41 $2,001,563 $3,083,813 Lapsed Lapsed
50 $3,157,092 $3,157,092 Lapsed Lapsed
60 $14,670,978 $14,670,978 Lapsed Lapsed

It’s important to stress-test your designs. A small change in a carrier’s cap, or regulatory changes on how products and participating loans are illustrated, could have a huge impact to your policy design. This would make for an awkward annual review with the client.

This is not to say that premium financing, leveraged Index Universal Life, or alternate loans are bad, or dangerous. It’s important to understand the risks of each separately, and to do your homework.

We can help! Contact Highland’s Advanced Planning team today at advancedplanning@highland.com.

Learn more:  Best Practices: Financing Life Insurance Premiums

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