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Minimum and Maximum Over-funded Life Insurance Policies

Understanding Life Insurance Policy Designs

If you are interested in learning about how life insurance can be used for private banking strategies and tax-free retirement, you’ve probably been discouraged by all of the confusing and negative content you are finding. The problem is that pop culture gurus have convinced a lot of people that life insurance is not a good investment and that you should “Buy Term and Invest the Difference. 

If you have been led to believe that permanent or whole life insurance has high fees and is a bad investment, then you’ve probably never heard of a maximum over-funded life insurance policy. A minimally-funded life insurance policy is designed for the maximum death benefit. It is what you buy when you want to get as much death benefit as you can for the cheapest price possible. But if you’re interested in private banking and The Double Play, you NEED a policy that is designed for maximum cash value. 

Keep on reading because I am going to explain the difference between a minimum and a maximum funded life insurance policy.

 Life Insurance 101 – What is Cash Value? 

So before I can explain the difference between a minimum-funded life insurance policy and a maximum-funded policy, we need to cover a few basics.  Not everyone understands permanent life insurance and what the cash value of a life insurance policy represents. We need to start with a little life insurance 101.

A permanent life insurance policy is going to pay a death benefit to someone someday. So you have to start by putting yourself in the position of the insurance company. So if you have a 45 year old, for example, and that person wants a policy with a death benefit of $1 Million, then the premium should be enough so that if it were invested, the savings would grow and become the million dollars of death benefit by the time that person reaches their natural life expectancy.

While the savings are accumulating, there is the risk that the insured could step off of a curb, get hit by a bus and die tomorrow. In that case, the life insurance company would be on the hook to cover the gap between the death benefit and the amount of savings at that time. So the premium must also include enough cash to essentially purchase a one-year term policy covering the gap between the cash value savings and the death benefit.[2]

All of your premium dollars are literally going into two separate buckets:

  1. There is the savings component which is the policy owner literally saving up the death benefit over the course of the insured’s natural life expectancy, and
  2. There is the risk component. We are concerned with the savings component.

Minimally-funded Policy

When you call up a life insurance agent and ask for a quote on a policy with a $1,000,000 death benefit, you are going to get a proposal with the lowest possible cost. The insurance company knows that you will probably shop around and get proposals from several other companies. They want to keep the premium to an absolute minimum to win your business. In this case, the life insurance company has designed the policy to collect the absolute least amount of Premium that will, with a very worst-case growth assumption, allow the life insurance company to perform and deliver on its contract guarantees.

The goal of a minimally funded policy is to get the most death benefit for the least cost.

A couple of good examples for a minimally funded life insurance policies are your typical whole life insurance policy and a guaranteed universal life insurance policy. 

Let’s Take a Look at an Example

This graph shows a minimally funded life insurance policy. You can see the death benefit line at the top. It is the orange horizontal line going across the chart at the $1,000,000 mark. The cash value (savings) is the blue line that is starting at age 45 and sloping upward and to the right and eventually crossing the $1,000,000 mark at around 115 years. This line represents the growth of the savings over time.

The bracket at the very left and of the chart shows the gap that the insurance company is responsible for at the time the policy is issued. Only a small portion of the initial premium would have gone to the cash value account of the policy. The second bracket is showing the cash accumulation at the insured’s 79 years of age. At this point, the policy owner’s cash value has accumulated to cover about 50% of the death benefit. The insurance company would be on the hook for the other 50%. 

One thing that is important to point out is that the insurance company has an incentive for the cash value to grow as quickly as possible. The faster that your cash value grows, the quicker it accumulates and removes the risk to the insurance company. In this example, if we shifted the cash accumulation curve upward, then the net amount at risk to the insurance company would be smaller.

Another important thing to keep in mind is that the death benefit never goes away. Even when the cash value accumulates to the point where it would otherwise reach the death benefit, the death benefit gets pushed up. There always has to be a minimum amount of risk in a life insurance contract from a regulatory perspective. Even if you reach age 90 for example, you still have some probability of making it to age 91. So the contract needs to include that mortality cost. 

So as the cash value grows and eventually reaches the death benefit, the death benefit is pushed up by a legally-defined minimum amount of additional death benefit.

As you can see from this graph, this is not the type of policy that you would want to use for Private Banking and real estate investing. It would take forever to accumulate sufficient cash to make it worthwhile. Most of the Real Estate Investors that I know, want as much cash value as possible. They want to be able to leverage the greatest amount possible of cash value right away and put it to work in two places at one time.

Now lets look at a Maximum Over-funded policy design

So this brings us to an over-funded life insurance policy. Since we know that there is some minimum amount of risk that must be in an insurance contract, what if we simply funded the policy with as much premium as possible and kept the minimum amount of risk on top of the cash value right from the start?

This graph shows what a maximum over-funded life insurance policy looks like. In this case, the policy was designed to have only 10 years of annual premiums. This means that after the 10th year, the client is done putting premium into the policy and now the goal then becomes preserving the cash value. The cost of the death benefit is the primary cost driver of a life insurance policy so it is necessary to minimize the death benefit to reduce the mortality cost.

So in this graph you see that the death benefit is maintaining a steady corridor over the amount of the cash value for the first 10 years. The death benefit is getting pushed up by the minimum amount of insurance every year. The true amount of risk to the insurance company remains constant

You can see that after the 10th year, the death benefit drops to the absolute minimum. That reduction in death benefit minimizes the mortality cost of the policy. If the death benefit remained high, the cost of maintaining the high death benefit would consume some amount of the growth of the cash value each year and could eventually get to the point where it starts consuming actual cash value instead.  

 Cost of Insurance in a Max-funded Policy Design 

If you take a look at the cost of insurance after the death benefit has been reduced to the minimum non-MEC[4] threshold, you will find that it typically is under 0.25%. So keeping in mind that the insurance company is investing the cash value “savings”, if they were to achieve a 5% growth on the cash value, the net addition to the cash value, assuming that the policy expenses were 0.25% would be 4.75%. While you can see these actual costs illustrated on a universal life illustration, they are not visible on a whole life illustration. 

The only thing that is shown on a whole life illustration is the amount of premium, the guaranteed cash value and guaranteed death benefit. There are two additional columns for the projected cash value and death benefit based on the assumed growth that the agent uses.

How is the policy constructed?

I wish I could say that there was a common way that life insurance companies design their products. but generally, we must bundle together a basic whole life policy along with a term Rider and paid-up additions in order to create an over-funded whole life policy design. It is the combination of the death benefit from the term rider and the death benefit from the base policy that puts the total death benefit at the line that we saw on this curve.

In a case like this where the premium is approximately $100,000 a year for 10 years, the base policy premium would be a small component of the total death benefit. The term Rider adds a tremendous amount of death benefit for a very low cost. Once the minimum non-MEC death benefit is reached, the rest of the cash from the premium is used to purchase paid-up additions.

The easiest way to imagine a paid-up addition is that it is the present value of the future death benefit. If we imagine a hypothetical example where there was no cost in the policy and the cash value was growing at 7.2%, then the cash value would double every 10 years. This is the rule of 72: if you take the number 72 and divide it by the interest rate that you are earning, the result is the number of years that it takes for your money to double. 

For example, the cash value in a policy for a 57 year old with 30 years of life expectancy remaining, would double three times during that 30 year period. If the policy’s cash value we’re earning 7.2%. in this case, $1 of paid-up insurance would have a death benefit of $8 dollars. So $1 of paid-up additions buys a lot of death benefit when you are young, and very little when you are very old.

So getting back to the original narrative, the $100,000 of Premium would be divided up between the base policy, the paid-up additions, and the term Rider. Each of these contributes to the total death benefit of the policy. But only the base policy cash value and the paid-up additions contribute towards the cash value of the policy.

The death benefit from the base policy should be held to a minimum. This will be a big cost driver of the entire policy. The term rider and paid up additions don’t add a lot of cost. Since the agent’s commission is tied to the base policy, this is where many agents will cheat and trade their interest for yours.

To match the example in the graph, the term Rider would be removed when the 10th year of the policy is reached. Removing the Term Insurance Rider lowers the total death benefit of the policy but the cash value remains. In addition, we would also do a “reduced paid-up”. What this does is reduce the death benefit to the minimum amount of that reflects a “paid-up” policy. 

It is much easier to design a Minimum non-MEC Universal Life policy. The agent simply enters the premium amount that the client wishes to pay and the software solves for the minimum non-MEC death benefit. The software has all of the rules and formulas so that the policy design remains compliant with regulations.

In a universal or indexed universal life insurance policy, the policy owner can change the death benefit by simply filing a change request. The change request would be to reduce the policies death benefit to the minimum non-MEC amount and switch from the increasing to the level death benefit option. 

Whole Life vs Indexed Universal Life

So you will notice that there is no label on this graph as to whether the policy is a whole life or an indexed universal life insurance policy. That is because they will both look the same from a cash value and death benefit perspective. The only thing that is really different is the construction of the policy.

The Spectrum between Minimally-funded and Maximum Over-funded 

So at this point, we have defined the two outer limits of a spectrum between what is the minimum amount of cash necessary to design a policy that will perform on its guarantees and a policy that has the maximum amount of cash and the minimum legal amount of death benefit.

It is important to understand that the entire spectrum between the two polar extremes is available for the life insurance agent to customize a policy design for an individual.

Earlier I had explained that the cost ratio in a maximum funded life insurance policy was about 0.25%. In this example, it is easy to visualize that the death benefit could be left higher than the absolute minimum. In theory, we could double the corridor of insurance and double the costs simultaneously assuming that everything is proportional.

For example, just after the death benefit is reduced, the corridor appears to be about $1 Million. If the cost of that $1 Million reflects just 0.25% of the cash value, then adding on $1 Million more would be about 0.5% of the cash value. The policy would be less-efficient than a Maximum over-funded policy, but would meet the need of that client if they had a need for the additional death benefit protection.

 A properly-designed, max-funded policy should have about 85% Cash Value to Premium 

So any time that the cash value to premium ratio is not 85%, the policy includes more death benefit protection than the absolute minimum required.

You will frequently see a policy design from the “infinite banking” or “Bank on yourself” folks that will have a cash value to premium ratio of about 65%. This is where they typically design their policies. What happens in this case is that the death benefit is much higher, and the policy costs are consuming much more of the premium.

As an aside, it is important to understand that the life insurance agent’s commission is tied to the death benefit. When the death benefit is increased, so are the fees and commissions of the policy. So when the death benefit is held to the minimum non-MEC amount, the policy expenses and commissions are held to an absolute minimum. 

Why you need a Max-Funded Policy for The Double Play

So clearly if you are intending to leverage the cash value of your policy for The Double Play or any kind of private banking strategy, you want as much cash value as you can get for every dollar of premium that you are putting into your policy. 

Understand that if a dollar of Premium turns into $0.85 of cash value, then you have that $0.85 of cash value that is earning interest credits or dividends AND you have a line of credit for $0.85 that you can use for investing in real estate, for example. So notwithstanding the cost of money, you are putting a total of $1.70 to work for every dollar you put into the policy.

In a substandard policy design that has only $0.65 of cash value for every dollar of premium, you are only putting a total of $1.30 to work.

Now when you are using a private banking strategy for investing in real estate, you are starting off at a disadvantage even with the 15% haircut that you are taking in a properly designed policy. So even though you are putting your money to work in two places at one time and earning a superior rate of return, you still need to get back to that original dollar of premium let alone catch up to where you would have been had you just simply taking your money and put it directly to work in whatever you would have invested in any way.

If you have read any of my other articles and videos analyzing the business case for The Double Play, you know that The Double Play will in fact catch up and far surpass where you would have been. 

Now think about how long it would take to catch up when you are starting at a deficit of 35%! It could take many years just to get back to the original premium. Catching up with where you could have been may not occur in your lifetime.

If you are going to use a sub-optimal policy design for The Double Play, or Infinite Banking, then you should only do it if you need the additional death benefit protection. 

Compounding interest is a very powerful force, but when the cash value is starting off at such a deficit to the amount of cash you could have simply invested, it will take many more years before the model breaks even and looks superior to having simply investing in real estate directly.

Conclusion 

Private banking strategies like The Double Play require a maximum over-funded life insurance policy to get the most benefit. Not every “over-funded” policy is funded right up to the legal Maximum (Minimum non-MEC). The best way to know that your policy design is funded right to the minimum non-MEC threshold is to look at the ratio of the cash value to the premium in the first policy year of your Illustration. If it is not 85-90%, then the policy is likely not designed right.[5] Both Whole Life and Indexed Universal Life may be used for The Double Play. 

The fees in an optimally-designed policy are kept to an absolute minimum. When you hear people state that Life Insurance is a bad “investment”, those people are thinking of a traditional, minimally-funded policy. The goal in those policies is death benefit protection, not cash accumulation.


[1]

All insurance is pooling of risk. I’m using the example of a 1-year term to make the explanation easy. Insurance works by pooling premiums from many to pay to pay the claims of a few. My concept of a 1-year term simply puts a price on the mortality cost since it is an explicit amount. This process repeats itself every year. Every policy is stand-alone in the sense that there is the savings component and a mortality cost to cover the gap between the savings and the death benefit each year.[2]

All insurance is pooling of risk. I’m using the example of a 1-year term to make the explanation easy. Insurance works by pooling premiums from many to pay to pay the claims of a few. My concept of a 1-year term simply puts a price on the mortality cost since it is an explicit amount. This process repeats itself every year. Every policy is stand-alone in the sense that there is the savings component and a mortality cost to cover the gap between the savings and the death benefit each year.[3]

“Minimum non-MEC” is the proper way of describing a policy where the death benefit is held to the defined minimum. MEC = Modified Endowment Contract. A policy that is a MEC is still a life insurance contract, but the distributions and loans become taxable. It essentially becomes an annuity with a death benefit. For more on using a MEC for retirement planning, see:http://innovativeretirementstrategies.com/modified-endowment-contracts/

http://innovativeretirementstrategies.com/long-term-care-insurance/ [4]

“Minimum non-MEC” is the proper way of describing a policy where the death benefit is held to the defined minimum. MEC = Modified Endowment Contract. A policy that is a MEC is still a life insurance contract, but the distributions and loans become taxable. It essentially becomes an annuity with a death benefit. For more on using a MEC for retirement planning, see:http://innovativeretirementstrategies.com/modified-endowment-contracts/

http://innovativeretirementstrategies.com/long-term-care-insurance/ [5]

Assuming that you are healthy and do not use tobacco. Other rate classes will have higher costs.

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