Premium financing means borrowing from a lender to pay most of the premium on a large life insurance policy. It's usually done with an IUL, which means indexed universal life, and it's usually sold to people with high incomes or a lot of money tied up in things they can't easily sell. A client brought me a plan where they'd put in $50,000 a year for ten years. A premium finance company would add $200,000 a year, so $2.5 million would go into a policy with a $3.85 million death benefit. I took that plan apart, and redesigned it, in a video on cutting the expenses out of a premium financing plan.
On paper, the policy would pay off the lender's loan in year 13. By then the loan would be about $3.2 million. A few years later, the client would start drawing about $190,000 a year in retirement income. The whole plan depends on arbitrage, which means the policy earning more than the loan costs. The lender charged 6.5% in the first year, and the rate floats. A few years earlier, these loans ran 2.5% to 3%. When rates went up, a lot of borrowers got hit with higher interest and calls for more collateral. Those calls often came in the same years the market fell and the policies credited very little.
The lender wants to be covered if the policy is ever surrendered. So you pledge collateral for the gap between what the lender has put in and the policy's cash surrender value, which is the amount you'd walk away with. In this design, that meant about $125,000 of extra collateral in year one, on top of the $50,000 premium. Year two needed about $40,000, mostly because of $120,000 in surrender charges. The illustration also assumed the highest rate the illustration rules allowed for that product, 6.72%. I'd rather see 6%.
The surrender charges came from the design. The target premium was about $72,000. Target premium sets the agent's first-year commission and how much the carrier takes back in charges, and what target premium measures goes deeper on it. Over 15 years, the carrier was set to take back about $199,000 for it. Total charges reached about $414,000 by year 15, about 17% of what went in.
I redesigned it with the same $3.85 million death benefit, the same crediting rate, and the same lender. I changed one thing. I blended in supplemental term insurance, which pays no commission, up to ten times the base amount. The target premium dropped from about $72,000 to $8,490. The first-year surrender charge fell from about $125,000 to about $15,000, so the policy covered the lender on its own, with no outside collateral. Illustrated retirement income rose from about $190,000 to about $243,000 a year. Total charges over 15 years came in about $175,000 lower. The agent's first-year commission dropped from about $72,000 to about $8,000. The lower target premium is where the savings came from, because it sets both the commission and the charges the carrier uses to recover it.
Some risks don't change with a better design. While the lender's loan is open, you can't touch the cash value, because all of it is pledged. The loan rate can rise, the index can credit zero, and collateral calls tend to come in bad years. When someone can fund a policy themselves, I'd rather they max-fund it and borrow from the policy at the carrier's fixed loan rate, which was 5% on that product. The leverage is smaller, but you keep access to your money. A policy loan reduces the cash value and death benefit until it's repaid, and every illustration is a projection.
If you're looking at a premium financing proposal, ask for three things: the target premium, a year-by-year collateral schedule at the lender's rate plus two points, and the same illustration run at 6% instead of the maximum rate.