URNING THE ‘MIDNIGHT’ OIL: Protecting Against Rising Interest Rates
We have been in the ideal environment over the last five years when it comes to Premium Finance transactions, especially with IUL. Loan rates have stayed low and the market has been experiencing positive returns.
To illustrate: If your policy date was in January and using 1 year Libor + 1.75%, you would have experienced something close to the following rates and credits assuming your IUL had a 0% floor and 11% cap:
But, when will this trend end? And how do you help protect against rates going up and IUL performance hitting the floor? It’s important to remember that these transactions are not timed and are designed to perform over the long term, say 10 or 15 years.
We are going to focus on what can you do to help protect your clients on the banking side. We will leave the policy design and management tricks for another time. Below are a few considerations in no particular order:
Commitments – focus on longer term committed facilities where you can offer a loan spread that is now locked in for three to five years versus doing annually renewable loans. If a bank decided to increase a spread by 0.25% next year, your client’s rate is already up 0.25% regardless of what Libor does.
Rate Caps – purchase a cap at inception that will ensure the cost of the loan will never exceed a certain rate (5% for example) for a certain period of time (five years, for example). The lower the rate and the longer the protected period, the more expensive it becomes. This requires a payment (paid or accrued) but does not affect collateral.
Rate Collar – use a collar to have the loan rate float within a range, similar to an IUL with a cap and a floor. If the initial variable pricing was 3.50% a collar may keep the rate in the range of 4–5% over 5 years. Meaning you start higher, but have the protection it won’t go above 5% for that period of time. This requires additional collateral, not a fee.
Fixed Rates – your client can lock in a fixed rate for a certain period. We have great flexibility to design various options that would start today at inception or even allow you to float for two years and then lock in starting in year three. These are most commonly done through SWAPS. Also, keep in mind that the loan commitment and the SWAP duration do not need to match. So for example, you can have a three-year commitment and a nine-year fixed rate. The assumption is that the committee will renew three times to match the fixed rate chosen. Even though you will pay above the market rate initially, it provides you the certainty of your cash flows. These do not require a payment but need to be collateralized. The collateral is a percentage of the total loan amount.
So, what does all of this mean:
It is important to find balance. Unrealistic loan projections and AG 49 rates will always look good, but will it hold up? If you can show conservative illustrations and offer options to protect against rising interest rates, you are removing some uncertainty from a complex transaction.
The key is to keep the potential and expected cash flows of these now more “conservative” designs at a level that still makes them attractive, relative to just paying the premium. There must still be a significant upside to taking on a life insurance loan. You cannot take all of the risks out of it, and if you could, the cost would be prohibitive.
Experience has shown us that we talk about it more than we deliver. However, it is a necessary part of the plan design and an essential step if you want your client to have all the information so that they can make a well-informed decision. They need to know the options, so they can decide what is best for them, both at inception and throughout the entirety of the plan.
Cheers to a brighter tomorrow.
*The above article is for educational purposes only, and should not be used as professional advice