Report regarding Premium Financing on an AIG Global Plus Index Insurance Policy
This is a formal report that included numerous illustrations and other attachments. If you have never seen a life illustration, well………. you are going to get hurt somewhere along the line with one that does not address the risks involved. Illustrations are primarily marketing tools since agents tend to use whatever figures they want to justify the sale. The risks are rarely ever identified. Frankly, you are not going to have but perhaps 1% of agents who knows what to do anyway. One risk, not identified in the report per se is the fact that the IRS has a tendency to audit all the contracts to see if they properly prepared. (Looking for gift tax and whether a policy will be brought back into an estate for estate tax purposes) They are also changing and tightening laws as we speak.
In any case, the basic analysis below should be adequate for most review.
September 26, 2008
RE: AIG and Premium Financing
Dear Dr xxxxx
I have reviewed extensive material from AIG, talked to their customer service reps, Director of Advanced Planning and one of the two attorneys that deal with estate issues. I have reviewed countless illustrations as well as ordered my own.
Additionally, as is obvious, I have had extensive conversations with Marc yyyyy regarding same as well as having conversations with brokers. In short, not only do I not believe that the product will produce as projected, you could never have been presented this product in the beginning.
The brochure clearly states that you have to have a minimum of $15 million in order to use this product. Per Marc, you are around $10 million. Now, I am aware of the real world of this industry and if you were $14+ million, then perhaps not a problem. But this is too much of a discrepancy. Further, an agent has a duty to the company to submit only clients who fit the profile required by the company. Any deviation to this is considered a breach of the agent’s fiduciary duty. Unless there is some documentation provided by you attesting to the $15 million requirement, they have committed a fraud.
But for the purposes of this report, and assuming some legitimate excuse for the processing of the application at the higher net income, I offer the following.
First, insurance illustrations are notorious for presenting numbers that are either fictitious, too great or some combination thereof.
The illustrations I received to have some acceptable numbers, but they are categorically deceptive and there is not a legitimate advisor who would allow them to be used. Please see the attached 5 year rolling summary of the S&P 500, the Hang Seng and the Stoxx. It is not necessary that you go through the numbers to do any calculations. Here is the point. Look at the returns in the 90s. I doubt that anyone would suggest that the overexuberance of that decade made sense nor that it would be repeated again. They are using an effective 17.53% return internationally. That will not be repeated. In any case, you multiply that by 60% participation rate for the 10.52% figure used in the illustration. Admittedly the subsequent 8 years are reflective of two recessions and the returns would be lower but the reliance on the previous decade distorts returns. They are simply unsustainable going forward. Some advisors indicate that one can only look at the past for any numbers at all. But the world has changed radically starting around the mid to late 90s. From my article, Investment Malfeasance and Breach of Fiduciary Duty, Due to the proliferation of the computer and the launch of the Internet came the "ability" to view millions of pieces of information (not necessarily knowledge)”. The industry and marketplace has been forever changed by the instantaneous ability to gather up all types of information and statistically validate computations by simply selecting a unique time frame, a special formula, a unique quote from some advisor in a sophomoric ‘money’ magazine (which have grown almost exponentially), whatever. It is possible to support almost any contention you want by enough selected marketing. But a wholesale reliance on past history cannot match astute analysis of current economics as a guide to the future. The analysis is this: after the decade of the illogical dotcom- Warren Buffet, along with other advisors- indicated that there might be a reversion to the mean- essentially that stocks must have lower returns to return to the average of the 9.4%. average of stocks for the past 50 years as of 1984. Many state that market returns will be in single digits for some time to come.
I also offer this additional commentary from one of the preeminent advisors, Peter Bernstein:
“For institutional investors, the policy portfolio [a rigid allocation like 60% stocks, 40% bonds] had become a way of passing the buck and avoiding decisions. The problem was that institutions had settled on a [mostly stock] asset allocation because in the long run, they concluded, that's the only place to be. And I think the long run ain't what it used to be. Stocks don't have to do well in the future because they did well in the past. In fact, the opposite may be more likely.
As you know, I have my doubts about the certainty so many investors feel about the long-run attractions of investing in stocks. We do not know what is going to happen over the long run, never have, never will, and when [in 1999] the institutional funds were relaxed about [holding] equities, it was a moment when equities were far away from anything resembling real value. Ben Graham said to invest with a margin of error, so you don't get killed when you are wrong. They invested with a margin so small or nonexistent that meant they had to be right or they would get killed -- and they were.
As such, I took the 10 years from 1998 to 2007. That is 8.00% return- but one must recognize that the number represents a 60% participation rate (you take the returns of two indexes at a 75/25 split and then multiply that number by 60%).
By dividing the 8% by 0.6, that is really an expected 13.33% overall return.
No. That is unacceptable. Still too high.
Considering that the last 8 years have been tumultuous (at best) has merely reinforced the general consensus for even lower returns going forward. Further, with the impact of oil on every day prices, the resurgence of inflation, and a potential bailout up to $1 trillion, it would appear difficult to use returns even at 13% overall- still considering the use of international stocks. They too will bear the brunt of increasing oil prices; second tier countries are experiencing increasing inflation and the credit mess caused by the United States will impact them even longer than the U.S. I believe that a 10% return is adequate. If you therefore use the 60% participation rate, that leaves an overall 6% return for the index.
Nonetheless, I did request and review the 8% illustration. In this case, the value is $134,000,000 by age 100. But with a 13.33% true return internationally. However, as noted above, I don’t think you will get it. And they ‘want’ $640,000 for ten years to do it (the implications of that number is addressed under estate planning below).
Marc also requested a 6% return. They provided a 6.35% mid term return and that was acceptable. The illustration shows it will last for 50 years- age 100- and should cover 99% of a real life lifetime. But while the death benefit would be $28,000,000, your loan would be about $25,000,000, so you have gained essentially nothing for coverage.
It also still costs $6,400,000. Admittedly you did not have to pay it yourself- but you didn’t get anything in return anyway. And if you wanted/needed insurance within a trust, no company is going to give you more than the $11,500,000 already in your name.
Probably a participation rate of around 6.75% would allow you to have your full $11,500,000 insurance and still be able to pay off the loan. That is an overall 11.1% return. That might be possible but still beyond what professional advisors expect.
In order to have a better idea of premium financing, one first looks at what a basic policy would cost. I asked for two AIG illustrations directly. One was for a 6.75% return for a 7 pay. It showed that if you paid $140,000 annually yourself for 7 years, the policy would last till age 82. That was not acceptable. So I asked for another—and another. The illustrations received were not what I requested and at this point I am not sure if I can get what I want. But by extrapolating the various illustrations, it appears that a payment by you of $175,000 for 7 years would provide coverage to age 100. Admittedly you are paying for it directly- there is no loan. The comparison to premium financing and the risk is detailed below.
Can you use bonds in the AIG portfolio? Yes- but the returns- as with stocks- are not guaranteed and, generally, are less than equities. Therefore, you will not have enough return at any point in order to pay off the loan
It has been presented to Marc that this is a guaranteed loan for your lifetime. It is not. These are annual callable loans- it is at the whim of Concord if they wish to continue. The rational for a ‘lifetime’ loan is that they would call the loan due and payable ‘only’ if the returns in the policy are insufficient to cover the loan. The problem is the contract does not state that. Therefore the loan can be called at any point and if the cash value of the policy is insufficient to pay the loan (almost a certainty) then you will have to use any collateral you put up for security. Once again the rationale is that it is ‘obvious’ that they would never do such a thing. By the same token, it was obvious that the mortgage mess could never occur, that WaMu and many other banks would not default, Merrill Lynch would never be sold and that a bailout of close to $1 trillion by the U.S. was impossible.
Creditors are calling whatever loans possible because they are uncomfortable about foreclosures, bankruptcies and more. Could it happen to Concord? Why not? As such you need to recognize a difficult financial scenario- the loan is called and you have to use other collateral.
Of course the situation with Concord may be more like this. They will review your policy each and every year to determine if the underlying returns cover their position. If they were to find that the returns were not sufficient, they will call the loan only then. You will have to cancel the policy and use whatever cash there is to offset the loan demand plus pother collateral as necessary.
The problem is that many years could pass before this happened (if at all, obviously). But if your health conditions had changed (and they assuredly will), then you may not be able to get another policy. Certainly it will cost more due to your age. You would have therefore accomplished nothing in terms of coverage and then actually diminished any chances of reducing any estate taxes.
The loan interest is based on a very familiar LIBOR (London Interbank Offering Rate) plus 95 basis points (0.95%). They use a 6.14% charge based upon, one again, past history. I do not like this method and feel that one must allocate some risk element to looking out that far. I did use 6.25% in my loan calculations- though I still am uncomfortable being that low.(My past work has required estimations for inflation and I used 3.25% and 5% for years. You now note that inflation is 5.25% and growing. Even viable alternatives can have difficulties). Here is the point. The LIBOR short term rates was under 3% two days ago- then it shot up to 6,9% because of this credit mess. I admit the annual rate did not increase substantially, but it hopefully is clear that you have to add in some adjustments for what can go wrong. I am not sure that 7% is the ‘magic number’, but one MUST address risk and that past history is not necessarily any reflection to the future. If the economy straightens out and overall market volatility subsides, maybe you can make a lot of money in the trust. That is essentially how it has been explained to you. However, I think risk has gone up, volatility has gone up, and the world is not the same place as before. The Dotcom craze will not happen again for decades and real estate will suffer the same consequences. Future returns will be lower. So, why not the LIBOR rate being higher than shown on the illustration.
Here is another conundrum that has not been addressed. This policy is to go into an ILIT (Irrevocable Life Insurance Trust). You will be gifting monies to the trust since it is a loan. However you will only need to treat the loan fee as a gift and file a gift tax return. That, by itself, is not a big deal. But the whole premium package is a big deal in terms of the odds of working over the next 50 years.
I believe that you have about a 15% chance of getting an effective 17%+ return as identified for the 10.52% (60% participation) as shown in all your illustrations.
About another 15% probability of perhaps having about $11,500,000 in net life insurance in 50 years due to the lower returns and the requirement to pay off the loan.
So there is a 70% chance that it will not work as intended because returns will be less than 10.52% and interest rates will be higher. Therefore if the loan is called due to underperformance, what are the financial implications to you.
Assume 15 years from now and the loan is $15,000,000. Your cash value is $10,000,000 (all hypothetical). They call the loan. You will have to come up with the extra $5,000,000 from your collateral. But, according to AIG’s attorney, the entire $15,000,000 will be treated as a gift. Here is what will occur. About 10,000,000 of that (estimated) will be subject to gift tax at 50%. So you will have to pay another $5,000,000 in tax to the IRS. That is not an issue with the high returns since they can conceal any of the negative possibilities that might occur. But it is not real life.
Premium financing can work. Yours might.
But as I told Marc initially, whenever you have so many moving parts, if one goes wrong, the whole scenario can collapse. I think that their projected returns are far overstated for the future and the interest on the loan should be higher to account for a level of economic risk which has escalated substantially since 1999.
If I am right, the financial repercussions will be dire.
But this is also assuming that you can buy the product at all.