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Collateral Issue

The last time we visited the topic of life insurance premium finance, the focus was on the changing dynamics of the industry following the tumultuous economic period of 2008/2009 and the resulting credit crisis. As we reviewed, premium finance was dramatically affected as a broad range of market participants reduced their exposure or simply vacated the market. Some of those deciding to exit included very prominent organizations that were considered leaders in the industry with established market share. For those that persevered, it was a challenging period and many had to introduce revised business models to address the business climate and maintain service levels.

The current environment would not be considered ideal, although there are certainly indications that the credit markets are operating more effectively and capital oriented to premium finance is more available. Challenges remain, however, and lenders have taken a variety of approaches to tailor their offerings to certain market niches and to differentiate their product and service mixes. When compared and contrasted to the period before the credit crisis, interest rates, fees and other loan features are a bit more expensive and restrictive. This simply reflects a changed macro lending environment, somewhat similar to how the mortgage industry has been transformed in the wake of a massive upheaval. The general situation is certainly not poor, but there have been undeniable changes that should be expected given the scale of market disruption that occurred.

Some of the primary changes and characteristics the insurance professional will encounter include:

• Average interest rates of 5 to 6 percent- either prime or LIBOR-based references.

• Increased focus on the client's credit history.

• Heightened scrutiny regarding sufficient liquidity on the client's personal finance statement.

• Less flexibility in facilitating collateral, particularly real estate and other nonliquid sources.

• More adherence to net-worth minimums, which have gravitated to $5 million. Among the emerging and more prevalent trends has been an increasing emphasis on high-cash-value products with the primary objective to reduce "outside" collateral; that is, collateral beyond the funded life policy cash surrender value (CSV).

This dynamic is an extension of the increasing use of indexed universal life (IUL) insurance in tandem with premium finance. The basic operating premise of using IUL is to potentially benefit from the higher crediting rates projected with IUL policies vis-à-vis traditional (fixed) policy architectures. The hypothetical spread between the policy crediting rate and loan interest rate creates an arbitrage between the two variables with the anticipated outcome being policy CSVs that equate and ultimately exceed the loan balance. This conceptual framework is being used with increasing frequency, although this should not negate conscientious longterm planning, as we will outline below. The application of high-CSV products is the result of several dynamics, including market forces and a series of new product features. From the market perspective, the recent economic malaise negatively affected high-end life sales which, by definition, is the domain of premium finance. As a general rule, most lenders prefer funding annual premiums of $100,000+. Although not always by design, high- CSV products (IUL in particular) garnered attention as a method to ignite sales activity. From a product development standpoint, this usually entails the use of riders to increase the early CSV on a guaranteed basis. To facilitate this from a pricing standpoint, the life companies often modify commissions or payout schedules to control the cost structure and contractually support the higher CSVs.

So, how does this all relate to premium finance? The big connection here, as hinted at earlier, is to address what most financial services professionals would consider the main impediment to completing premium finance assisted sales:

initial collateralization and the management of collateral over time. Collateral is often the "boogeyman" of any deal and to use a life policy design that carries the burden (at least in the early years) can have a certain appeal. There are a few variations, although in some instances the policy CSV can fully collateralize the loan for a period of time if interest and other applicable fees are paid out of pocket and the loan structure offers maximum credit for policy the CSV. Each life product and loan has its own nuances, although the basic premise is to offer clients relatively large life insurance policies with minimal out-of-pocket costs. All good, right? Well, it can be attractive (to both the client and the agent), but there are important points of consideration.

Before recommending such an arrangement, it is a good idea to balance the shortterm intent of minimizing collateral obligations (beyond the allowable life policy CSV) and the long-term planning objective. Specifically:

• Clearly define the long-term need for the insurance and take strides to match the product and financing to those circumstances.

• Avoid an approach that borders on "free insurance"-the industry and consumers have experienced far too many challenges with this tactic.

• Prepare clients for the inherent variation in product performance that will ultimately occur-even the most attractive high-cash-value IUL will encounter index-based crediting rates.

• Pay careful attention to clients' current and projected financial positions and take measure of their ability to provide collateral beyond the life policy CSV.

• Work carefully with the lender to ensure that the loan terms and other specifics meet the planning and endstate objectives.

From a more general perspective, there are some basic rules that should be followed in each situation:

• Keep a long-term view and manage clients' expectations accordingly. Financing is a powerful mechanism and it can be misapplied. Poor planning can create a difficult and potentially negative financial outcome.

• Run different interest rates and product projections. This is often referred to as stress testing and helps to avoid the tendency of presenting "best case" scenarios.

• Do not lead with financing as the primary sales driver. Start with a sound insurance plan and use financing only when appropriate.

• Involve other advisors such as attorneys and accountants. Their input and guidance will provide a more complete picture of the client's situation and lend support for the ultimate recommendation.

• Develop exit strategies for the loan well in advance and gain acceptance to the approach.

• Pay attention to after-sale service. Premium finance is a commitment and the lender will need to review the loan on at least an annual basis. Working with the client during these periods is an essential element of your services.

• It is OK if premium finance is not ultimately used. The process of creating the design and working with a higher level of complexity often solidifies the recommendations and generates higher levels of client satisfaction.

Premium finance is a dynamic approach to facilitating life insurance sales and should be handled accordingly. Keeping everything in perspective and tailored to the client's situation is a baselevel requirement and will set the tone for moving forward.

Dale Humphrey is the president of Insurative Risk Solutions US Inc., the U.S.-based marketing and sales organization for Insurative Premium Finance (Jersey) Limited, an international life insurance premium finance and lending company based in St. Helier, [email protected].

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