Deconstructing IFA Lender and Credit Risk

This article is Part 4 of our IFA Risk Management Deep Dive Series.

Part 1: A Foundational Guide to IFA Risk Management for Accountants

Part 2: Flawed IFA Structuring: An Accountant’s Guide to Foundational Risks

Part 3: Stress-Testing IFAs: Modeling Correlated Market Risks for Your Clients

While market risks are external, counterparty risks stem directly from the actions and policies of the third-party lender. The relationship with the lender is not a partnership; the client is a borrower subject to the bank’s credit and risk management policies. These policies can and do change over the multi-decade life of an IFA. These risks are often underestimated, buried in the fine print of a loan agreement.

As the accountant, your role is to look beyond the attractive interest rate and help your client understand the structural power the lender holds.

1. The Demand Loan Reality: “Callable on Demand”

A critical and easy-to-overlook feature of IFA credit facilities is that they are legally structured as demand loans or demand lines of credit.

• The Pitfall: The Lender’s Right to Repayment. This legal structure gives the lender the right to demand partial or full repayment at any time, for any reason, even if the client has been diligent in making all required interest payments. This clause is not a mere formality; it is a fundamental tool for the bank to manage its own institutional risk. A change in the bank’s internal risk appetite, a strategic decision to exit the IFA lending market, a regulatory directive, or a severe systemic economic crisis could all prompt a lender to reduce its exposure by calling these loans. Such an event might force the client into a fire sale of their leveraged investments, likely at the most inopportune time, to generate the cash needed to repay the debt.

2. Shifting Sands: The Risk of Changing Lender Policies

The terms agreed upon at the inception of an IFA are not immutable. Lenders typically review their IFA facilities on an annual basis and reserve the right to unilaterally change their lending policies and terms.

• The Pitfall: Unilateral Changes to Terms. A client could be several years into an IFA when the lender decides to alter its policies. For example, the bank could:
  • Increase Collateral Requirements: A lender might reduce the maximum loan-to-value (LTV) ratio on the policy’s cash surrender value from 100% to 90%. This would immediately create a collateral shortfall for any client leveraged at the previous maximum.
  • Increase the Interest Rate Spread: The lender could increase the spread it charges over their prime rate, increasing your client’s cost of borrowing.
  • Introduce New Fees or Reporting: New annual administration or review fees could be introduced, or the lender could require additional, more onerous financial reporting.

Your client, having already committed significant capital to the insurance policy, has very little negotiating power and is often forced to either accept the new, less favourable terms or undertake the difficult and time-consuming process of finding a new lender willing to take over the facility.

3. The Collateral Call: The Point of Collapse

A potential failure point of an IFA during a client’s lifetime is the collateral call. This occurs when the outstanding loan balance exceeds the value of the collateral as permitted by the lender’s LTV policy. It is the culmination of the market and counterparty risks discussed previously.

• The Pitfall: The Forced Rectification. A collateral call can be triggered by a confluence of negative events. When a collateral call occurs, the lender will demand that the client rectify the shortfall immediately. The client is then faced with a series of options:
  1. Post Additional Collateral: The client may have to pledge more of their personal or corporate assets to the bank, further encumbering their balance sheet and creating an opportunity cost as those funds cannot be used elsewhere.
  2. Partially Repay the Loan: The client may have to liquidate other assets—potentially triggering capital gains taxes—to generate cash to pay down a portion of the loan.
  3. Surrender the Policy: The client can be forced to collapse the entire strategy. This involves the lender seizing the policy’s cash value to apply against the loan, which is a taxable disposition of the policy.

Conclusion: Advising on the Lender Relationship

The loan agreement is one of the most important documents in an IFA strategy. It’s essential that you, your client, and your client’s lawyer review it carefully to understand the lender’s rights and the client’s obligations. While the risk of a well-behaved loan being called by a major financial institution is low, it is never zero. The client must maintain a strong financial position and a good relationship with the lender throughout the life of the strategy to mitigate these significant counterparty risks.

If you are reviewing a client’s IFA loan agreement and have questions about the terms or potential risks, we can share our experience with the various lenders in this specialized market. We invite you to contact us.

Next in This Series: A CPA’s Review of IFA Tax Compliance (Coming Soon)