Bank on Yourself: Using Life Insurance as a Source of Liquidity

Treating life insurance as an 'infinite bank' can be effective in some cases, but this strategy has downsides.
By NerdWallet 
Using Life Insurance as a Source of Liquidity

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First, there was LEAP. Then there was Infinite Banking, also known as Be Your Own Banker. Now it’s Bank on Yourself, by Pamela Yellen. All of these books, however, are basically marketing projects by and for people who sell life insurance for a living, and are designed to appeal to more affluent investors with some free cash flow and who have long-term liquidity needs, over and above a desire for a permanent death benefit.

Here’s the pitch, in a nutshell:

Over the course of their lives, most people pay oodles of interest to creditors on all manner of loans, from mortgages to cars to credit cards to college loans. This lost interest — and the interest on that interest — represents a tremendous drain on individual wealth.

If, instead, you aggressively saved money within a certain type of life insurance policy, you could fund these purchases from that policy — and pay the policy back, rather than the bank. While there are some technical issues with the phrasing, this is the functional equivalent of paying yourself for the loan, with interest. Thus, you are retaining the interest within the cash value of your own life insurance policy, rather than paying off the bank. The claim is that rather than enriching the bank, your payments go back to enriching yourself or your heirs, when the policy pays off at your death.

Meanwhile, the pitch goes, you also get all the other benefits of whole life insurance:

  • A guaranteed tax-free death benefit for your beneficiaries (important!)

  • Cash value that grows at a guaranteed minimum crediting rate, with no risk of market loss.

  • Tax-free growth

  • Tax-free withdrawals

  • Tax-free loans

  • Annual dividend payments, provided your carrier is a mutual insurance company, owned by policyholders.

Is it a scam?

No. It’s certainly not for everybody. There are a number of factors that have to be in place for the concept to work well. But it is not a rip-off or scam by a long shot, when properly set up.

Historical precedent

The first large-scale attempt to market this concept in the age of modern media came about in 1980, with Robert Castiglione’s founding of LEAP, Inc., and the publication of his book, LEAP — The Lifetime Economic Acceleration Process: The Key to Financial Success. Castiglione’s book, like Be Your Own Banker and Bank On Yourself, attempts to make the case for using life insurance in this way in laymen’s terms, free of technical language — and, alas, sometimes free of detailed analysis of the math involved.

But the concept was nothing remotely new, even in 1980. In fact, the roots of this strategy go back generations — at least prior to the Civil War. Here’s how it worked, in practice:

Farmers have always struggled with extreme seasonality of cash flows. It is the nature of the business. Farmers would generally have to borrow money to buy farmland. Then they would have to borrow more money to plant, and to have money to live on while they paid their mortgage, paid their laborers, if any, and waited for the harvest. At harvest time, if crops were good, they took their crops to market, and used the money to pay off the debt on their seeds and labor expenses. Meanwhile, a portion of their mortgage was paid down.

Remember, the term ‘mortgage’ comes from the same root as morte, or death. We are spoiled now, and are used to paying off a mortgage well before we embark on a lengthy retirement. In those days, people frequently did not live beyond their mortgages. Instead, rather than risk losing the family farm, the family would buy life insurance. If the farmer died before the mortgage was paid off, the life insurance company would pay the death benefit, and the farmer finally ‘bought the farm’ from the bank — which is where the term comes from.

Keep in mind that this was in the days before we had index funds, and before we even had mutual funds as we know them.

The system worked well for farmers, shippers, storekeepers who sold to farmers on credit pending the harvest, and other people with uneven cash flows: If they saved aggressively within a life insurance policy, the got a death benefit, and a ready source of liquidity from loans from the life insurance policy. And since the policy was ultimately secured by the death benefit, it was a safe loan from the point of view of the insurance company: It also meant that if there were a poor harvest, the farmer didn’t risk bankruptcy or foreclosure if he couldn’t pay back the loan right away. He could wait a year or two, in a pinch.

He still had a mortgage with the bank, but there were usually no car payments and very little consumer credit to worry about. Ultimately, however, the concept was the same: Using the cash value in a permanent life insurance policy as a short- and medium-term source of liquidity and financing.

Once the farm was paid off, the next generation didn’t have a mortgage anymore. So the policy could be tapped to buy more land, or to buy a new tractor or combine, build a new house, or anything else they wanted to do.

While little understood in popular media, the concept has been passed down from farmers to a wide variety of other businesses who use COLI, or company-owned life insurance, as a source of capital to fund operations, pay bonuses, or any number of other uses.

Why it works

There are two concepts at the heart of the Bank on Yourself concept, the LEAP concept, Be Your Own Banker, Infinite Banking, or any of the other systems. The first is the concept of the mutually-owned life insurance company. This means that it’s policyholders who own the company, rather than corporate shareholders. The ‘co-op’ ownership structure means that profits go to policyholders — boosting the returns in cash value policies — and subsidizing the cost of term life insurance policies.

Under current tax law, dividends paid to life insurance policyholders are tax-free, which means the after-tax returns on policies participating in the profits of the insurance company.

The second engine driving the concept, again, is a concept little understood outside of insurance circles. The concept is direct recognition — or more precisely, the lack of it. Here’s how it works:

When a life insurance company practices direct recognition, they only pay dividends on the cash value left in a policy after any loans are taken out. If you have $100,000 in the cash value, and you borrow $50,000 against the policy to buy a car, the insurance company will only pay the guaranteed crediting rate and dividends on the $50,000 left over.

But that’s not the only way to skin a cat. Some insurers do not practice direct recognition. They charge interest on the loan, yes — but they do not stop paying the crediting rate and dividends on the money you borrowed against.

That difference is key: When you borrow money against a life insurance policy, you are not really borrowing your own money. You are borrowing from the general fund of the life insurance company — and using the cash value in your policy to secure the loan. This is the logic behind the policy of not practicing direct recognition.

Arbitrage opportunity

A policy that does not practice direct recognition allows you to arbitrage the difference between the minimum crediting rate on cash values, plus dividends on one hand, and the interest rate the insurance company charges on loans, on the other, to create a source of very cheap credit. It’s probably not free money — unless dividends that year are unusually high. But it does mean that if the dividend rate is 5 percent and the interest rate is 6 percent, your cost of capital is now 1 percent. This doesn’t happen with companies that practice direct recognition. But with non-direct recognition companies, it does. It just takes a while to get to that point.

And there’s the heart of the infinite banking concept, right there: A cheap source of liquidity or finance, available without a credit application and no paperwork. You don’t have to pledge your home, and you never have to pay back the loan. The insurance company pays itself out of the death benefit, if need be, plus interest.

However, it works better if you do pay off the loan, so you can take advantage of the cheap financing again and again. Eventually, you can draw down your cash values to supplement your other sources of retirement income. The whole kit-and-kaboodle is treated by the IRS similarly to a Roth IRA: Funded with after tax dollars, but growth and income taken from the policy is tax free (provided you didn’t blow it by contributing more than the maximum allowable premium for the death benefit — turning the policy into a modified endowment contract.

The downsides

The concept works very well for some people, but it’s not a magic wand. Even with dividends, which aren’t guaranteed, the internal rate of returns available on these policies is very modest — especially in a low-interest rate environment.

  • It’s not for people who don’t need or want a permanent death benefit.

  • It’s not for people who can’t afford a term premium to protect their families.

  • Expenses are front-loaded. The agent and insurance company can eat up half of the first year’s premium

  • It’s not for people with an unstable source of income.

When such a strategy might be appropriate

Banking on yourself could be the select strategy for people in a variety of circumstances, such as:

  • People who believe income tax rates will be higher in the future than they are now.

  • People who are concerned they may be the target of lawsuits: Life insurance cash value often receives substantial protection from creditors, depending on your state.

  • People who want to save money for college while preserving their child’s or children’s eligibility for financial aid under the federal method of calculating a family’s expected contribution.

  • People who want a portion of their portfolio allocated to modest but guaranteed growth.

  • People who like the features of a Roth IRA and who would contribute large amounts of money to one if they could.

  • You don’t want to have to wait until you’re 59 ½ to be able to access the money.

  • You want assets to bypass probate at death.

  • You expect to have an estate tax liability at death, or at the death of your spouse, if he or she survives you.

Two dirty little secrets

Any decision on the part of a mutual insurance company not to practice direct recognition of loan balances creates a kind of prisoner’s dilemma: Policyholders that don’t borrow against their policies are in effect subsidizing the activities of those that do. Which means that not everybody can take advantage of this strategy and tap their policies to finance large purchases at the same time! The more well-marketed this strategy is, the less effective it will become.

The second dirty little secret is that not every life insurance agent carries or wants to carry a securities license. Which means the only solutions in their arsenal they can present to someone who wants to put a lot of money aside for the future involves overfunding whole life, universal life, variable universal life or equity-index universal life policies. When all they have is a hammer, the danger is that everything might start looking like a nail.

There is nothing wrong with the strategy in its place, for the right individual. The concept is sometimes sold to people who have trouble keeping up the premiums for whatever reason, causing the policy to lapse — a disaster for the consumer unless there is already substantial cash value in the policies – a process that could take years.

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