Premium financing: A two-edged sword?

Looking back on it, Robert Berman must concede there were signs that the deal his insurance broker and advisor was touting probably wasn’t on the up and up. The broker, Thomas Rapp, allegedly told Berman that he could buy a $10 million indexed universal life insurance policy and pay the $700,000 in annual premiums with proceeds from a loan. The loan would be invested and earn 10% to 12% a year, enough to pay both the interest on the loan and the insurance premiums with maybe even some cash left over. Beautiful.

Rapp repeatedly told Berman that they would borrow money at a low interest rate (2.5%) and use it to earn 10% to 12%, according to court documents. Rapp wrote to Berman “… so if we buy it and get 15%, you get 15% tax free and not give 7% of it to the f---- IRS. …”

When presented with documents detailing the finer points of the transaction, called premium financing, Berman admitted he barely understood a word of it. He claims he asked Rapp to explain it all but never got a complete answer.

Nevertheless, he went ahead with the deal, even after getting cold feet at one point and asking out of the transaction, but he was convinced by Rapp and an associate to continue.

“There are probably only 10 people who know how to do this strategy correctly, and we’re at the top of the list by far,” Rapp allegedly told Berman.

Things went south in a hurry. The total line of credit was exhausted after only the first year of premium payment, leaving no money for future premium payments, according to Berman’s complaint. He claims he suffered a loss of nearly $1.3 million, and he has taken Rapp and his associate to court along with the insurance companies and banks that were involved in the transaction.

Berman’s case may seem unique but actually the courts are becoming clogged with dozens of similar cases accusing brokers and advisors of misrepresentation and even fraud in connection with premium financing plans. While some of the agents and advisors may seem a bit suspect on the surface, the cases are dragging along with them top insurers and banks, including Lincoln National, Pacific Life, Penn Mutual, Mass Mutual and New York Life, all of which have been named as defendants in the burgeoning cases.

The piling up of lawsuits has some people questioning whether premium financing is ever a legitimate investment or buying opportunity and not just some complex scheme to generate huge commissions for agents, brokers and insurers.

“I have debated different experts on this subject,” said Larry Rybka, chairman and CEO of Valmark Financial Group, an independent broker-dealer and financial services company in Akron, Ohio. “I’ve done three big industry debates at the Forum 400, and I have offered $1,000 to people I’m debating to show me one that’s working — not what you say you’re going to do, but show me one that worked. I’ve still got the $1,000 in my pocket.”

Rybka, who is often asked to be an expert witness in premium financing lawsuits, takes an admittedly extreme position on the topic. 

“The only time premium financing works is when the client dies early,” he said. Yet the product remains a strong and presumably profitable one for life insurers. 

Premium financing ‘can be a valuable tool’

“Premium financing can be a valuable tool for high net worth individuals who need life insurance but don’t want to tie up capital,” reads a page on Lincoln Financial’s website.

Comerica says that with premium financing one can borrow up to 95% of premium costs of a life insurance policy, take advantage of “financial arbitrage opportunities” and pay back the loan with flexible options.

“Premium finance is very attractive for healthy insured’s,” [sic] advertises National Life Group. But it also includes this disclaimer: “This business strategy is offered and managed by an independent third party who is not affiliated with the companies of National Life Group. No National Life Group company nor anyone acting on its behalf has evaluated the strategy or is authorized to make any representation regarding the suitability, effectiveness, or legality of this strategy, or the suitability of using life insurance or annuities in connection with this strategy.”

The insurer is bound only by the terms of the life insurance contracts issued by the group insurance companies, not the loans, National Life Group says, which is precisely the point at issue in most, if not all, of the lawsuits.

“That is what the litigation ultimately must prove,” Rybka says. “And there are dozens like this.”

Premium financing obviously has advocates and has become popular among business owners and entrepreneurs who want to maintain financial flexibility and not have to sell off assets to get the insurance coverage they need.

However, some compare the strategy to esoteric and risky techniques such as naked short selling or collateralized debt obligations. It does not have to be that way, say others.

‘It’s been made overcomplicated’

“It’s been made overcomplicated,” said John Reed, president of Premium Finance Life Insurance, which, as his company name suggests, specializes in the strategy. “It is really just as simple as a life insurance policy and a third-party loan to fund it. That’s it.”

 Reed compares it to a commercial real estate investment. 

“If you were a high net worth investor and you were going to buy a commercial strip, you’re going to buy a few buildings, you’re going to hire several people,” he said. “You’re going to hire someone to help you go find the asset you need, and you’re going to hire somebody to go find the money to build it or buy it.”

Indeed, a common scenario in many of the pending lawsuits is that the alleged victim seemed to have relied solely on the agent or advisor selling the strategy and did not seek counsel from attorneys or other financial experts.

“Like any financial tool, it can be misused or misunderstood,” said Paul Carlson, managing partner of Law Firm Velocity, which helps law firms control cash, develop financial road maps and understand financial performance. “In a sense, it is a wealth and liquidity management tool. As a policyholder, you get to scale up your insurance policy value by borrowing a significant portion of the premium. The idea here is that you can secure a hefty policy without having to cough up all that cash up front. Instead, you take out a loan, and the policy itself often acts as collateral. Also, if the policy return is greater than the loan interest, you profit from the difference.”

Some collateral now required

Already though, he notes, the volume of lawsuits has led to a decline of nonrecourse premium financing. Most premium financing now requires some form of collateral beyond just the policy itself, he says. 

So, which is it for premium financing? Smart strategy or scam?

“It’s a mixed bag,” says Nick Schrader, owner of Texas General Insurance. “It allows individuals to borrow funds to cover insurance premiums. But here’s the catch: interest rates can spike, turning a ‘cheap’ loan into a financial drain. If the insurance policy’s returns underperform, you might owe more than the policy’s worth — forcing you to add collateral or default. Some lawsuits stem from advisors overselling benefits while downplaying these risks.”

Schrader compares premium financing to a powerful tool, like a chain saw — beneficial in expert hands, deadly otherwise. 

“Success depends on crystal clear terms, conservative estimates and backup plans — such as selling assets in the event that rates surge,” he says. “For most? Too complicated. But for high-end clients with advisors who are experts in niche strategies — not mere generic agents — it’s a legitimate means of managing coverage and liquidity. Just walk carefully, as those low rate guarantees can cover up sinkholes.”

Michael Ashley Schulman, partner and chief investment officer at Running Point Capital Advisors, in El Segundo, Calif., says in the right hands and for the right client, premium financing can be a powerful and valuable tool. 

“However, it is not like an avocado that can be spread for almost everyone on nearly anything to improve taste and texture,” he says. “Premium financing requires careful consideration of client circumstances, risk tolerance and long-term financial objectives. It can make sense as an alternative method of funding life insurance premiums from a commercial lender as opposed to paying them out of pocket, especially if you or your client has a better use for that capital. In other words, it is an effective cutting-edge tool in specific situations where the benefits clearly outweigh the complexities and potential risks involved.”

Strategy requires thorough analyses

However, he adds, this strategy requires thorough analyses of interest rate projections, collateral requirements and policy performance to ensure sustainable long-term value. 

“The optimal application is typically for high net worth individuals with substantial insurance needs and sophisticated financial planning requirements,” he says.

How liable an insurance provider is in these deals if things go sour and don’t live up to the promises made by the agent or broker is what’s at stake in a key premium financing case soon to go to trial in New York. Most of the cases allege insurers failed to properly monitor or oversee the transactions.

Ester and Baruch Aronson accuse Brave Strategies LLC, along with Penn Mutual Life Insurance Co., MassMutual Life Insurance Co. and New York Life Insurance Co., of misleading them into purchasing high-value life insurance policies with a combined death benefit exceeding $150 million, financed through premium loans. They claim they were assured that out-of-pocket expenses would be minimal and that policy dividends would cover loan interest payments. However, rising interest rates led to increased collateral demands and higher payments, resulting in damages exceeding $1 million. The case also tests New York’s Regulation 187, which mandates that insurance brokers act in the best interest of their clients.

“I think the most damning fact pattern is one where the carrier issues a policy with a premium of almost $1.5 million to a guy who makes $250,000 pretax,” says Rybka. “Also, the company software shows the loan being repaid from the death benefit. I think a jury would find the company liable for cases like this.” 

Doug Bailey is a journalist and freelance writer who lives outside of Boston. He can be reached at [email protected].