This article was originally published on Forbes.com.
As the Fed continues its pattern of reducing interest rates, it’s becoming a favorable time to borrow money. As of this writing, the 10-year Treasury is at 1.781%, according to data from The Wall Street Journal. To put that into perspective, in November 2018, it ranged from 2.993% to 3.238%, and 10 years ago — during one of the worst financial crises the world has seen — it reached over 3.8%, according to WSJ data. And in 1981, it reached a whopping 15.0%. These historically low rates present an attractive environment for investors to borrow money. Given this opportunity, the importance of building rate protections into premium financing strategies is of great concern.
First let’s cover why wealthy individuals are financing their large life insurance contracts. My firm sees two primary reasons clients want to borrow to pay life insurance premiums:
1. To fund a large amount of life insurance for death benefit purposes. Borrowing allows an individual to obtain a large amount of insurance at a low out-of-pocket cost — which usually just consists of interest payments on the loan. The death benefit and/or cash value is enough to support the loan over the long run, if the policy performs as expected.
2. To accumulate cash in the policy so it can be accessed in the future as income if they wish to do so via tax-free policy loans. If the benefit is not used during their lifetime, the death benefit is passed down to the respective beneficiary.
Building in controls can hedge against potential rises in interest rates.
If interest rates rise, borrowing premiums every year could become expensive and be detrimental to policy performance. One answer is to buy a fixed rate in the marketplace, which tends to be pricey compared to floating rates today.
So how can we obtain a low floating rate and minimize interest rate increases? The answer some have found is interest rate caps, collars and swaps. Each of these financial instruments is constructed using a combination of buying and/or selling interest rate derivatives. While there is more complexity to these products than can be explained here, there are ways to potentially reduce risk significantly by utilizing these strategies.
Caps can help control interest rates.
An interest rate cap, when properly employed, allows an investor to cap (or control) the amount of interest they are willing to pay in any given year. It allows an investor to still capture any value if floating interest rates decrease, while adding a ceiling on what the maximum amount they can pay in any given year. The investor will pay a premium to have this protection and can usually roll the cost into the loan.
Collars control the upside and downside of interest rates.
If investors want to give up some of the value in the event interest rates continue to decrease, an investor can purchase an interest rate collar on a floating rate. It allows a person to still experience a floating rate, but between two barriers (collar) — a floor and a cap. Anything between those two rates will be paid by the client accordingly. The individual won’t pay anything lower than the floor rate and nothing more than the capped rate. An additional amount of collateral will still be required from the bank; however, the collar can be structured with no cash outlay and would just require the additional posting of collateral.
Swaps allow a borrower to move from floating to fixed rate.
The last instrument is an interest rate swap. This allows a client to swap their floating rate for a fixed rate determined by the bank. The client will always pay an all-in rate of whatever the swap rate is every year, no matter what, while the bank will take the risk of the floating rate. The fixed rate the banks are willing to “swap” at depends on what kind of risk they want to take on and varies by bank. There is no premium that an investor must pay for this feature; the bank prices it into their deal on whatever fixed rate it is willing to offer in a swap arrangement.
Complex strategies require annual review.
Another important aspect of these strategies is the ongoing annual review of the loan, insurance strategy and derivatives put into place. Although each of these is a long-term strategy, it is certainly not a “set it and forget it” one. As borrowing rates fluctuate and policy performance varies, it is imperative to have a good handle on the constantly changing banking and insurance marketplace. One must understand how to manage all three components of the program — the loan, the derivative and the underlying insurance policy — and how a change in one variable could have a material impact on the other. Many loans have certain covenants and collateral requirements that need to be understood and negotiated.
While this article only scratches the surface of how these interest rate hedging strategies work, investors have been using them for years to hedge against interest rate risks. It just so happens that in today’s environment, we can lock in incredibly low rates for a long length of time (usually 7 to 10 years) and take some risk off the table on increasing rates in the future. The question to the investor becomes how much risk are they willing to keep on the table, or take off, to ensure these premium finance programs have a better chance of success?