Maybe you’re an estate planning attorney, a tax advisor or an investment advisor. A life insurance agent is proposing a premium financing program to your client. It involves a lot of insurance. Your client, Sally Smith, has made it clear to the agent that she won’t proceed without your approval. No pressure, right?
You’ve been following the premium financing saga for a few years. While not your favorite mini-series, you’ve been intrigued by the discourse among those who sell those programs, sell against them, contend that they work if properly designed or contend that due to certain metaphysical forces, they can never be properly designed. You figure that’s it’s just a matter of time before you see the word “existential” appearing in the discourse.
The Client Defines the Mission
The client’s on the phone, telling you to expect a call from the agent and some people who are involved in the program. Sally asks you, point blank, “ I assume you’ve seen these deals before. What’s your take on them?” You tell her that, generally speaking, third-party premium financing can be worth considering when someone wants to buy a significant amount of insurance but doesn’t want to use their own cash, taxably reposition assets to free up that cash or use up valuable gift tax exemption to pay premiums. The programs involve leverage, which offers upside or downside, depending on the interplay between the loan, the performance of the policy, the conscientiousness of program and policy management and the ability of the individual to exit gracefully from the program with the policy and the rest of their money more or less intact.
“Have your call and get back to me,” Sally says, “And get my other advisors in the loop. This is going to involve my irrevocable life insurance trust, which involves legal, tax and investment planning, so I want you guys to cover all the bases.”
The Right Questions
The agent’s assistant calls to schedule a video conference at which the agent and his associates will present a slide deck. The presentation usually takes 75 minutes, though you fully expect that the first 15 minutes will be devoted to introductions of the presenters and some assurances that their program bears no semblance to those poorly designed and hence, poorly performing, programs that you’ve been hearing about.
While not prejudging anything one way or the other, you know from experience that engagements like these involve two sets of questions (1) Those for the presenters, which start with words like “What,” “How” or “When”; and (2) Those your client will ask if it turns out that the first set wasn’t sufficiently incisive. These questions start with, “Why didn’t you ask…”
You’ve learned that by getting everything out on the table up-front, you can shave weeks if not months off of the usual timetable for reviewing one of these programs. So, you tell the agent’s assistant that you’ll be sending over a list of the topics that you and the other advisors want covered in the presentation and the items they need to provide as supplementary material. You then start drafting a message to the other advisors, with initial thoughts for that list and a request for their input. For now, it’s written in a stream of consciousness fashion, which you’ll upstream when you review your draft. Here’s what your message should include:
The Parties
You’ll want to know the identity, background and role of all parties to the transaction, including any who are not on the call but are otherwise involved in the insurance sale, the loan, program administration and so forth. We’ll check out each of those parties independently. You’ll also want to know how each of them is compensated.
One item that calls for your special attention is who will monitor and manage the program and policy, how they’ll do that and how and when they’ll report to and communicate with the client, you and each other.
You’ll want to know upfront whether, when, how and on what terms the client can replace any party to the deal with whom she’s unhappy. We don’t want Sally to be in a position where she feels that someone is no longer responsive or acting in her best interest, but can only remove and replace them at great cost and inconvenience. That’ll have to be on our checklist for due care and negotiation. In fact, it could be a showstopper.
The Program
You know they’ll have the usual high level presentation in words, numbers and schematics. But they’ll need to go deep on the terms and specs of the key components of the program, including the loan, the collateral, the policy and the servicing. You should see the prototype documents for the loan, servicing/administration and so forth.
You’ll want to see a comprehensive, integrated and, ideally, interactive exhibit that lays out the whole program on an annual basis through program maturity, discloses all the fundamental assumptions, etc. That exhibit will likely have more columns than the Parthenon, but will be invaluable to Sally’s ability to “see” a panorama of how the program works as a base case and then as stress-tested. Once she sees all that glorious complexity, she can ask herself if she really wants to get into something like this.
The exhibit also enables you to respond when the client says, “Suppose that 10 years from now, there’s a change in tax law, my own circumstances or whatever and I want to get out of the program, preferably without losing my proverbial shirt. Show me where things will stand at that time and what it’ll take to get me out, financially, tax-wise and any other wise. And yes, I know it depends.”
The Policy
They obviously have to select a product to work with in the presentation. it’s just a base case, that’s all. Of course, you’ll want to see the complete illustration for that policy so that you can tie the numbers to their exhibits, see what the policy looks like after an exit from the program and so forth. You’ll also ask for the carrier’s product guide so you can understand the way the product works, the cost/benefit proposition of any riders they suggest putting on the policy and all that.
Once you have some indications of underwriting and the contours of the program and exit strategy come together, you’ll lean a lot closer to this topic, basically doing due care on their due care. You’ll ask for their metrics for selection of the “right” policy and their rules of thumb for how the policy should be designed and funded to contribute to the program’s success, broadly defined. You should know why the characteristics of a proposed type of policy suggest that it’s more suitable for the program and the client’s temperament than other types. Talking points won’t suffice here. You’ll want to see illustrations for the other products as well so you can see the numbers, stress test them and compare the functionality of the competing types of products at pivotal stages of the plan, especially the exit while Sally is still alive.
Once you’ve arrived at the type of policy, you’ll return to their due care process and see their spreadsheet of the products they looked at to know what didn’t make the cut and why, both qualitatively and quantitatively. Of course, you’ll also ask for their metrics for carrier selection, beyond the ratings, I mean.
The point is to do what you can, with some help from friends, to determine if what they propose is selected and designed for utmost cost and operational efficiency as well as adaptability to change over the lifespan of the program. Incidentally, you’ll also check a couple of “compliance-type” issues about the policy and its use in a given program.
The What Ifs
It’s going to be crucial for you to work with them to construct a plan that isn’t designed or priced for perfection. So, you’ll hear the plan, address the risks and “what ifs” and then revisit and revise the plan accordingly. You might call that “20-20 foresight,” because you’ll have these what ifs in mind upfront as opposed to be wondering (and asked) why you didn’t consider and address them at program inception. Your list of what ifs should encompass anything that could take a turn for the adverse with one or more of the loan, the collateral, the policy, the exit strategy, tax laws, any subsequent required underwriting and anything else you can think of.
You need to understand these risks and, to the extent possible, depict them in that comprehensive exhibit. That way, you can have an idea of what we could be dealing with at each pivotal stage of the program. That should help us design the program at the outset to mitigate those risks and the economic and tax costs of any remedial steps that may be necessary. Talk about metaphysical. Or maybe we’re now at existential.
A Penny Saved
The lower the “all in” carrying costs of a program like this, the better. I’m referring to the cost of each of the principal plan components, including the loan, the policy and the servicing arrangement. The lower the embedded costs in the program, the less the client will have to depend on policy performance or other factors to make the program successful. Of course, that’ll involve some comparison shopping and, no doubt, some negotiation. You really need to be thorough here. You can’t just accept responses that start with, “As a practical matter…” or “On a present value basis…”
Tax Implications and Planning
You need to explore with them how to coordinate product selection, design and funding with ancillary planning for the trust to reduce both the economic and tax cost of supporting the program and staging the exit right. For example, maybe stair-stepping the premiums in the early years while Sally funds the trust with income-producing property could help reduce the overall debt service to support the program.
