Many potential clients reach out to me wanting to set up a Single Premium Life Insurance policy. It would seem to make sense. If you want to use life insurance to invest in real estate, you would want to get your savings into a policy as soon as possible, right? This post will address Single Premium Life Insurance. More specifically, I’m going to talk about why you SHOULDN’T use Single Premium Life Insurance for real estate investing.
To explain why you DO NOT want to use a single premium life insurance policy for investing in real estate i.e. The Double Play.
Don’t use Single Premium Life Insurance for Real Estate
It’s important to realize that a Single Premium Life Insurance policy is intended for people who want to buy a fully paid-up policy. The primary goal is Death Benefit protection, not Cash Value accumulation.
You need to realize that most Single Premium Life Insurance policies are Modified Endowment Contracts (MEC).
What’s a Modified Endowment Contract ?
It’s important to know that Life insurance policies “Endow” at age 120. That is when you have essentially saved up your own death benefit. A MEC means that you are over-funding it to such an extent that you have modified the endowment to occur much earlier. These are great when the goal is death benefit protection, but they are not useful when you need to take loans. The reason for this is that a MEC receives poor tax treatment. Any loan against the policy will be taxed as ordinary income! You do not want this if your goal is either tax-free retirement income or real estate investing.
Definition of Life Insurance
Life insurance is for the Death Benefit. In order to “Qualify” as life insurance, there must be some specified amount of risk in the policy. A MEC is still life insurance, it just receives poor tax treatment. There are two rules to define Life Insurance:
Guideline Premium Test
The Guideline Premium Test defines the maximum premium that you can pay for any given death benefit. So in a Maximum over-funded policy with a $25,000 annual premium, we would work backward to find the death benefit where $25,000 is the Guideline Premium.
There is also a Guideline Single Premium. This defines the maximum single premium that you can pay for any given death benefit. A premium of this amount would create a MEC and it would just barely meet the definition of life insurance.
Cash Value Accumulation Test
This is another test for life insurance that is based on maintaining a minimum “Corridor” of death benefit protection above the cash value. This test is better suited to single premium life insurance and MEC policies.
Single Premium Life Insurance and The Double Play
Don’t do it. As you will see below, the fee structure of these policies is not good for cash value accumulation.
Also, one of the main things to understand going into this section is that the Death Benefit is a function of the first year premium. We are solving for the lowest possible Death Benefit given the initial premium.
Charges in a Properly-designed Single Premium Policy
The Table below shows the premium, the expenses and the cash value in a Properly-designed policy. I want to start here and then compare this to an improperly-designed policy so that you can see how the fees impact your cash value.
What I want you to take away from this table is the relationship of the fees to the premium and the death benefit. It will soon be obvious why you do not want to fund a policy with a single premium.
Let’s go through the expenses one by one so you understand them.
The Premium Charge is a cost recovery mechanism for expenses that are related to the amount of premium. Most of this is paid to the State in the form of Premium Taxes. This example has a premium charge of 5.5%. If you don’t pay a premium, there is no premium charge.
Cost of Insurance
This is quite simply the amount of money that the insurance company must pool to pay expected claims. In year one, $83 is the amount of money that must be pooled to pay the claims on all the 45 year olds who are not going to live to see 46. This process repeats each year. You will notice that the COI increases each year as the insured gets older.
Policy Issue Charge
This is where the insurance company makes money. The previous two categories are for cost recovery. This charge is related to the death benefit. Since this is a maximum over-funded policy, both the Death Benefit and this charge are minimized. A minimally-funded policy with the same death benefit would have the same charge. It’s also important to realize that these charges are scalable. That means that if you double the Death Benefit, you will double the charge. That will be important in the next section when we look at the policy funded with a large lump sum premium.
This is just $5 per month on this policy. It is an administrative charge on every single policy regardless of the death benefit and premium.
Charges in a Single Premium Policy
Notice that this illustration is showing a $36,000 premium in year one only. Otherwise it is the same as the previous illustration. While this table is showing a large lump sum premium followed by smaller annual premiums, understand that the concept relates to a Single Premium Policy as well. This makes it easier to make a comparison because only one variable changed.
Let’s go through the policy expenses one more time to show the differences in this version:
Notice that since the premium is 3X as large in Year 1, the premium charge is also 3X as large. The premium charge is simply 5.5% of the premium. No problem.
Cost of Insurance
It’s important to understand that the Death Benefit is a function of the first year premium. If we are increasing the premium 3X, the Death Benefit is also going to go up 3X. Because the Death Benefit is 3X, the Cost of Insurance is now 3X as high. Notice that this does not decrease after the premium is lowered.
Policy Issue Charge
Since the Policy Issue Charge is related to the Death Benefit, you can see that this charge has increased 3X too. Notice how the charge does not decrease in years 2 through 10 even though the premium is much lower. If you look at the ratio of the total charges divided by the $12K premium, you can see it is almost 38% in Year 10! The fees were less than half of that in the properly-designed illustration above.
What did we learn?
It should be readily apparent that a single premium policy will have a very high expense load for the first 10 years. You will be giving much of your single premium back to the insurance company in the form of charges.
The lump sum policy started off with $24,000 more. By the end of 10 years, there was only $13,310 more. There are better ways to use your money!
How to optimize the policy design
If you have a large amount of savings that you would like to get into a policy, the best way to do that is with a 5-pay design. Simply spread your savings out over 5 years. This design will still have the policy issue charge in years 6 through 10, but I have found that 5 years optimizes the trade-off between the high fees and getting the money into the policy and working.
The policy should always be designed for a minimum Non-MEC Death Benefit. This will be dependent on the first year premium. Realize that the Death Benefit in a 5-pay will be about one-fifth of the Death Benefit of a Single Premium Life Insurance policy.
Because the Death Benefit is a function of the first year premium, make sure you fund each subsequent premium at the same level as the first premium. This will keep the expense ratio minimized.
Early Cash Value Rider
And finally, a well-designed policy should have an Early Cash Value rider that waives the surrender charges. This allows the policy owner to leverage all of the cash value.
Any agent who knowingly designs a policy intended for real estate investing with a single large premium is either…
- Blissfully ignorant of the impact of what they are doing, or
- Knowing doing it for their own benefit i.e. much higher commissions.