If you are a real estate investor who wants to use a life insurance policy for real estate investing, you need to have a maximum over-funded life insurance policy. When you get an illustration from your life insurance agent, how do you know that the policy has been designed properly? and is a maximum over-funded life insurance policy? Understanding life insurance illustrations isn’t easy.
In this article I am going to show you how to read a life insurance illustration. I am also going to give you a short list of things to look for to make sure that your policy is designed right and is a maximum over-funded design. Not only that, I am going to give you a few extra tidbits to ensure that all of the assumptions that the agent is using are reasonable. There are a lot of tricks that the agent can use to make the illustration look better.
#1 Make Sure You’re Looking at the Full Illustration
First off, make sure you are looking at a full illustration and not a summary. Most life insurance illustrations are anywhere from 30 to 60 pages long. The full illustration should explain how the policy works, how the interest crediting or dividends are calculated, and how policy loans work, as well as other features of the policy.
#2 Cash Value to Premium
The absolute best way to know that your policy is designed right is to look at the Cash Value to Premium Ratio in the very first year. That percentage should be right around 85% if you are healthy, under 60, and do not use tobacco. This is true whether the policy is a whole life or an indexed universal life. It is also true whether the client is doing a short pay of only 5 or 10 years or paying all the way out through age 65.
This table shows a 5-pay design for a 32 year-old converting a lump sum of $500,000 into premium by spreading it across 5 years. This is the optimal way to convert a lump sum into premium. 5 years gets the money working as quickly as possible while minimizing the policy expenses. Note that the cash value to premium ratio is over 92%. This policy is perfectly designed for maximum cash accumulation.
#3 Look for MEC Limit & GLP
Another thing that you can do is look for the MEC Limit or Guideline Level Premium. Most illustrations will show the “MEC Limit” or “7-pay” limit somewhere on the illustration. “GLP” is the test for life insurance in a universal life insurance policy. The premium should be equal to the lesser of the two numbers. Getting into the MEC or Definition of Life Insurance would be a serious Rabbit Hole to go down. Send me a message if this is something that you would like to see me cover in a future article.
This screen capture shows the Guideline Level Premium and the Maximum non-MEC annual premium from an actual illustration. Note that the maximum non-mac annual premium is $57,386 per year. While the Guideline Level Premium is $50,000. The premium must be less than the lower of these two calculations.
A “MEC” still meets the definition of life insurance whereas a premium in excess of the Guideline Level Premium violates the definition of Life Insurance. The Guideline Single Premium is the maximum premium that still meets the definition of life insurance for some amount of death benefit protection. It still meets the definition of life insurance, but it is a MEC.
The paid-up additions should be maxed out if a whole life design is funded right up to the maximum limit. It would be impossible to meet the 85% guideline otherwise. When I am referring to a maximum over-funded whole life, I am including the total premium for the base policy, any term Rider and all of the paid-up additions. The “interest” you are paying to your bank should never be used to purchase paid up additions.
Real Estate Investors need to put their money to work in two places at one time. Moreover, it is important that you have as much money to put to work in two places at one time as possible. Therefore, you want to maximize the premium up front so that it can be leveraged right away, not added to the policy later in the form of paid-up additions. That is very inefficient from a cash accumulation perspective
Many practitioners of private banking systems, like Infinite Banking and Bank on Yourself, typically design their policies with room to add additional premium later in the form of paid up additions. These illustrations will show much less than 85% cash value to premium. If you are working with one of these agents, you may just need to be a little firm in asking for what you want: A minimum non-MEC policy design. You are not going to create a MEC because you are not going to be adding any Paid-up Additions later. You are going to stuff it full of Paid-up additions from the beginning.
#4 Level Premiums
The next thing that you want to look for is that all of the premiums are level. You should never put a lump sum of Premium into a policy. A large lump sum premium in the very first year drives up the death benefits and all of the costs in the policy. These costs are then absorbed by the lower premium that follows and the subsequent years. This is covered in much more detail in the video that I did on the costs in a maximum over-funded life insurance policy.
When a universal life insurance policy is designed to be funded right up to the Guideline Level Premium, you cannot put any more money into the policy without violating the definition of Life Insurance. However, you do have the flexibility to reduce your premium without changing the death benefit or anything else in the policy. The only downside would be that the cost would represent a higher proportion of each premium going into the policy.
#5 Early Cash Value Rider
This only applies to Universal and Indexed Universal Life Insurance policies. Normally, the surrender value of a policy is not equal to the cash value in the first 10 years during the surrender charge period. An Early Cash Value Rider waives the surrender charges in exchange for a small fee. Without this rider on the policy, a real estate investor would not be able to borrow against 100% of the cash value in a policy. Not every insurance company offers an early cash value Rider. It is important to make sure that the company offers this rider before committing to a policy. It must be on the policy before it is issued.
This does not apply to maximum over-funded Whole Life policies because these are designed differently. The bulk of the cash value in a whole life is made up of the paid-up additions. Paid up additions are liquid from day one.
You can see the effect of the early cash value Rider by comparing the non-guaranteed accumulation value to the non-guaranteed surrender value. They are both equal. This policy design shows a 32 year old insured with a $100,000 per year premium for only 5 years.
#6 “Increasing” Death Benefit Option
A universal or indexed universal life insurance policy must use the increasing death benefit option during the years that the policy owner will be paying premiums. If the death benefit is set to level, the policy owner will be essentially saving up the death benefit for the insured over the insured’s expected lifetime. This will not result in the maximum funding of the policy’s cash value.
Whenever the policy owner is finished putting premium into the policy, the death benefit must be reduced to the minimum non MEC death benefit. In addition, the death benefit option should be switched to level. These changes insure that the policy has no more death benefit than is absolutely necessary to remain compliant with the definition of Life Insurance.
This graph shows the relationship between the death benefit and the cash value in a maximum over-funded life insurance policy. This policy design shows a 45 year old client paying a $100,000 per year premium for only 10 years. You can see that the death benefit is “increasing” at a constant level over the cash value. This continues through the 10th policy year when the death benefit is reduced to the minimum non-MEC amount. The corridor of risk steadily declines over time keeping the policy’s cost to an absolute minimum
This illustration shows a design where the policy owner is paying $100,000 per year for only 5 years. If you look at the Orange shaded cells in the non-guaranteed death benefit column, you will note the steep reduction in the death benefit between years six and seven. If you compare the accumulation value to the death benefit, you can see that during policy year six, the Net Amount at Risk is more than $4 Million over the cash value. The following year, after the death benefit reduction, the Net Amount at Risk is less than $1.5 Million over the cash value. This means that the cost of insurance in the policy is reduced by over two-thirds.
If I showed more rows of the illustration, you would see that the death benefit eventually starts to be pushed up in order to maintain the minimum corridor of risk.
#7 10-Pay Whole Life
It is common to see Whole Life policies that can be paid up in 10 years. Insurance companies offer other options, such as 20-Pay or Paid-up at Age 65. These are not maximum over-funded life insurance policies. These are policies are over-funded, but they are not maximum over-funded. A 10-pay is simply a policy that will be completely paid up in 10 years. What “paid-up” means is that the policy will have the maximum cash value and the minimum death benefit corridor at the 10-year mark. It is guaranteed not to need any additional premiums beyond that point.
#8 Growth Rate Assumptions
The dividend rates of whole life policies are not typically shown on illustrations. If you do not see it, ask the agent to verify it in some manner.
A universal life insurance policy should clearly state the growth rates that the agent used in making their projections. The growth rates are completely adjustable within a reasonable range. Regulatory bodies usually set a maximum on the rate that can be utilized.
What is a reasonable rate to use?
As of this writing in early 2020, there are a few insurance companies offering dividends over 6%. While I would love to assume that they are investing geniuses, I would personally like to know where they are investing their money so that they can safely earn over 6% return in this market. The problem is that the Moody’s corporate bond index average is 2.73% for Aaa Corporate bonds. So if the insurance companies are investing their reserves in assets growing at less than 3%, how are they paying 6%. Is that level sustainable?
Indexed Universal Life:
It is important to understand that the goal of an indexed universal life is not to capture the equity market rate of return. The goal of an indexed universal life is simply to beat the debt market rate of return. I covered this in more detail in Life Insurance 101. Companies that offer indexed universal life invest their money in the bond markets just like companies that offer whole life. The difference in an indexed universal life is that the insurance company takes the interest that they would have otherwise paid to the policy’s cash value in the form of a dividend and they go to the index options markets with the goal of hedging to get as much movement in market indices as they can get with the money that they have.
When interest rates are very low like they are right now, insurance companies have much less budget with which to work. The result is that the insurance companies lower the caps on the indexing strategies. The lower cap is because that is all the movement in the market that they can capture with the money they have to spend on options.
While historical returns are no guarantee of future returns, it is straightforward to take the current cap rate and apply it to historical year-to-year changes in the underlying index and calculate your own annualized rate of return based on past performance.
In recent years, insurance companies have been innovative in developing new hedging strategies tied to different market indices. I think it is great that the policy owner can get exposure to multiple indices to reduce the risk of the cash value earning 0% in any given year. However, sometimes these new strategies offer the agent the ability to make projections using a higher interest rate.
I think that the safe bet is to simply use a reasonable crediting rate rather than expecting one hedging strategy to do better than another just because the historical returns were better based on a look-back where they apply the cap and floor to historical returns to see what it would have done. This can lead to custom indexing strategies simply designed to look good based on history. There is no guarantee that they will do just as well under future market conditions.
I do a look back based on the current cap rate for the basic 1 year point-to-point on the S&P500. I look at 5, 10, 15, 20, and 30 year periods to see what the return would have been with the current cap rate. I base all of my projections for all indexing strategies on the lower end of the results. Even in today’s markets with the Moody’s Aaa Corporate Bond index below 3%, the 1-year point to point “look back” is still showing an annualized rate of growth between 6 and 7%. Those results will change as interest rates change in the future.
If you do not know how to calculate an annualized rate of return, check out this blog post. This is the only accurate calculation of historical averages.
The bottom line is this: be conservative and ensure that if you are running multiple illustrations on different company’s products, ensure that the growth rates are identical so that you can see which policies show the best cash accumulation.
If you are using the exact same premium, and the exact same growth projections, then any differences in the cash values are due to the underlying costs of the policy.
Lower costs = Greater cash accumulation. The only way you are going to see this is to rule out all of the other variables.
#9 Saving Age
If you are within 6 months of your next birthday, the illustration will automatically price out at your next age. This can be overruled and the policy can be backdated. backdating the policy actually works in your best interest when you are designing a maximum over-funded life insurance policy. The initial premium will be due at the time that the policy is issued. However, the policy anniversary will be the date to which the policy was backdated. This means that you can get your second annual premium into the policy in less than 12 months.
#10 Variable Loans
As I stated in the Introduction to The Double Play, the best way to leverage the cash value of a permanent life insurance policy is to get a line of credit from a third-party Bank. However, sometimes there is an advantage to taking a loan directly from the insurance company. One example would be when you want to make a down payment on a property and you do not want your lender to see that you are making the down payment with a line of credit.
For this reason it is important that you choose an insurance company that offers a variable, non-direct recognition policy loan right away. Most companies have a minimum waiting period to take a variable loan.
Here’s the problem. A fixed loan may sound good. But a fixed policy loan is not like a fixed interest rate on a mortgage. When you take a fixed interest loan from the insurance company, the collateral for your loan (your cash value) is also moved into their fixed interest crediting strategy. If your collateral is in the fixed interest crediting strategy, then it is not taking part in any of the indexing strategies that have an opportunity to earn a premium over the debt market rate of return. Any chance of positive interest rate Arbitrage is gone.
The list of insurance companies that offer both and early cash value Rider and a variable loan option in the first year is very small.
#11 Things to Consider
If your goal is to leverage the cash value of your life insurance policy, you do not want the additional cost of any supplemental Riders eating into that cash value. If the Riders are important to you, you should consider a separate term or permanent life insurance policy that is a minimally-funded design. You will get much more bang for your buck.
Many policies come with accelerated living benefit riders that pay out some portion of the death benefit in advance if you suffer a critical or chronic illness. You must consider the impact of exercising one of these riders on a policy that is being leveraged. The cash value is part of the death benefit. If the cash value is fully leveraged, then any benefit accruing from one of these riders would be impacted.
In addition, once the death benefit is reduced after premiums cease, there is little additional benefit over the cash accumulation value of the policy. The most benefit would be in the early years of the policy while the owner is making the premium payments. That is when the death benefit significantly exceeds the cash value.
- Make sure that the growth rates are reasonable and conservative.
- Make sure that all of the assumptions are the same between your illustrations. You need an apples-to-apples comparison to see the true differences in the policy costs.
- If the policy is showing a retirement income, ensure that the income is projected out to Age 120. This is the most conservative assumption and makes sure that you will never run out of money. Some agents like to show income for only 20 years. I don’t know about you, but I hope to live beyond age 85!
- “Leveraged” indexing strategies. I liked these when they first came out. They are a great tool for the policy owner who understands how they work. as I stated earlier, the insurance company takes the interest that they earn on the cash value and they use it to hedge in the options markets to capture as much movement in the market index as they can get. One way for the insurance company to get more money to use for hedging his to charge a fee. So in exchange for a fee, you can buy a higher cap and capture more market movement. The problem is that these strategies should only be used when you expect the market to exceed the cap. In years where the market goes down or remains under the cap, the cash value will take a hit because of the fee, but there will be no performance enhancement.
Some agents will use these strategies without the knowledge of the prospective client because they can run illustrations with a higher projected interest rate assumption. In makes the policy illustration look better when compared to another policy illustration. But it’s not an apples-to-apples comparison because of the fees and the growth assumption.
So that is my list of what to look for in a policy illustration. Without knowing what to look for, its not easy to know if your policy is designed right up to the maximum level of funding. The goal of this website is to demystify life insurance and to give you the tools you need to know — without talking to an agent — to get the most efficiently-designed policy so that you can maximize your wealth accumulation through your utilization of The Double Play.
Be sure to get a copy of my eBook: This Policy Design Mistake Could Cost You Thousands
If you’d like to get a better understanding of the costs in a life insurance policy, please be sure to check out this recorded Webinar. Thanks for reading!
Surrender charge periods generally run from 10 to 20 years. This is the period over which insurance companies collect their policy issue charges.