Leverage and Limits
by Chris W. KiteMr. Kite is a life policy design analyst with FIG Marketing. Visit www.figmarketing.com.
Do you know how life insurance loans can give you over a 100% net return in a year?
And how these loans could also have a net loss of more than -95% in a year?
That’s a dynamic of using loan leverage in Index Universal Life (IUL). This wide range of results is not shown in illustrations and may not be understood by most insurance professionals. The results occur with leveraged loans where the credit rates on account values securing the loans can be much higher or lower than the loan charge rate.
These leveraged loans come in various forms with names such as index loans, variable loans, par loans, or alternate loans. They are a very good option for policy owners who can manage the risk that goes with potential higher returns. The purpose of this article is to suggest guidelines for how to manage these risks and benefit from the leverage.
Key Is In The Loan Value
The key is to look at the loan to value (LTV) percent and resultant leverage factor. Here’s an example to show how the leverage works for the questions at the start of this article.
Let’s look at an IUL policy where the insured is now in her 80s or 90s:
- Account Value $1,000,000
- Loan Balance $950,000 for 95% LTV
- Net Cash Value $50,000
- Loan Charge Rate 5% results in $47,500 loan interest charges.
- If no index credit, the charge reduces $50,000 net cash value to $2,500.
- That’s a -95% loss of net cash value!
There are also insurance costs to be deducted, but typically the policy account value is in the corridor where there is the minimum difference between the death benefit and account value allowed by tax law. Those costs may equate to about 20 to 60 basis points. That would be 0.20% to 0.60% of the account value.
In the example above, a 0.25% insurance cost would equal $2,500. That would bring the net cash value to zero and require loan repayments rather than taking loan income.
What About Upside Potential?
What if the index credits are at a 10% cap?
- Index credits of $100,000 would be 10% of the account value.
- The credits increase the net cash value from $50,000 to $150,000.
- Then $47,500 loan interest charges decrease the net value to $102,500.
- That’s a 105% gain in net cash value!
However, timing is critical with IUL. If the credits would all be posted by the end of the policy year, then the policy should be fine unless there is some monthly shortfall. On the other hand, if the credits would all be posted a few days or weeks after end of the policy year, then loan repayments may be needed prior to the credits being posted. This timing of credits also often makes it hard to compare an annual statement to a sales illustration.
How do leverage factors relate to ranges of loss and gain? What range is appropriate?
- 95% loan to value equates to a leverage factor of 19 as 95%/5% = 19.
- Factor 19 leverages a 5% loan charge into a -95% loss.
- The factor adds 1 to be 20 on the credit side. 20 times 10% = 200%.
- Net out the -95% loss and you have the 105% net gain.
IUL illustrations solving for loan income often go over 95% loan to value. I even see 99%. In policy administration, these high LTVs would likely only work with exact monthly timing of premiums, credits, and charges; and monthly adjustments to loan income. I do not know if any current administration system handles these adjustments.
Leverage With Lower Loan To Values
Let’s look at the leverage with lower loan to values. These use a 5% loan charge, net loss with no credits, and net gain with 10% credits.
Loan to Value Leverage Net Loss Net Gain
90% 9 -45% 55%
80% 4 -20% 30%
50% 1 -5% 15%
My suggested rule of thumb for a limit on using leveraged loans would be where zero credit equates to a loss of -20%. That is at 80% LTV for a 5% loan charge. It would be about 83% LTV for a 4% loan charge and about 77% LTV for a 6% loan charge. At that point, loans could be switched to fixed to reduce risk and also allow easier policy management at older ages.
A more liberal limit would be to limit loans when zero credit for two consecutive years would require loan limits to avoid repayments. See my article Imagine the Future of Illustrations for this idea and others to improve illustrations and policy service.
As a related topic, I plan to look at how switching to fixed loans at a leverage limit seems to be a better plan in most cases than using overloan protection riders with their costs, timing, qualifications, and tax law uncertainty. I am also looking at how sequences of credit rates are misunderstood in these IUL dynamics.
Hope to hear your questions and comments.