Robert Mur­phy, co-author of How Pri­va­tized Bank­ing Really Works is inter­viewed on Free­dom Watch.

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Why IBC Works

Writ­ten by Robert P. Mur­phy Wednes­day, 08 June 2011 15:25

When peo­ple first hear about the advan­tages of the Infi­nite Bank­ing Con­cept (IBC), a typ­i­cal reac­tion is to say, “That’s too good to be true.” For exam­ple, the IBC agent might tell his or her client that in order to take out a loan against the cash val­ues in a whole life pol­icy, the pol­i­cy­holder sim­ply needs to call the insur­ance com­pany up and tell them the amount and the address. The per­son on the phone won’t ask what the loan will be used for, what the income of the bor­rower (i.e. pol­i­cy­holder) is, what other assets the per­son might have to serve as col­lat­eral, and what time­frame the per­son intends to take in pay­ing back the loan. Nope, the insur­ance com­pany employee will sim­ply take down the infor­ma­tion and the check might lit­er­ally go out in the next day’s mail.

In con­trast, try pulling the same stunt with a com­mer­cial bank or credit union. Even when apply­ing for a secured loan, with (say) a house with lots of equity serv­ing as col­lat­eral, a bor­rower will need to jump through all sorts of hoops and fill out a few forms before get­ting approval. The process could be quite time con­sum­ing, even for some­one with impec­ca­ble credit and siz­able assets.

So are the IBC agents sim­ply lying? And if not, what gives? Are the insur­ance com­pa­nies staffed by magic elves while the banks are staffed by grumpy trolls?

No, the IBC agents are not lying. I per­son­ally have taken out sev­eral pol­icy loans, and have seen first­hand just how easy the process is. At the same time, I have also tried at sev­eral points to obtain lines of credit from dif­fer­ent com­mer­cial banks, and the process is a seri­ous has­sle. I can thus ver­ify the amaz­ing descrip­tions of IBC painted by its enthu­si­as­tic fans.

As an econ­o­mist, I can also explain what’s going on. The dif­fer­ence in the treat­ment given clients by insur­ers ver­sus con­ven­tional lend­ing insti­tu­tions is the nature of the under­ly­ing col­lat­eral on the loans. Once we under­stand how a whole life pol­icy works, and what a pol­icy loan really is, then it becomes obvi­ous why the insurer doesn’t have the pol­i­cy­holder fill out paper­work to take out a loan.

In the present arti­cle I’ll sketch the argu­ment. For a fuller treat­ment, I encour­age inter­ested read­ers to come to Nashville on July 22 – 23 for the “Night of Clar­ity.” (Full details at http://www.usatrustonline.com.) In my talk for the Sat­ur­day work­shop, I’ll elab­o­rate on the con­tents of this arti­cle, as well as mak­ing other points about the mechan­ics of whole life poli­cies and why IBC works so well.

TERM VERSUS WHOLE LIFE INSURANCE

Term life insur­ance is “pure” insur­ance. The pol­i­cy­holder pays a cer­tain amount of money as a pre­mium, so that if he hap­pens to die dur­ing the period in ques­tion (say, six months or a year), then and only then will the insurer cut a check to his estate. If the term of the pol­icy runs out and the pol­i­cy­holder is still alive, then he gets noth­ing from the insurer. It’s anal­o­gous to buy­ing fire insur­ance on one’s house. If there’s no fire, then noth­ing hap­pens, and the money spent on pre­mi­ums is totally gone.

In con­trast, a whole life pol­icy (as the name sug­gests) is designed to last for a person’s entire life. As long as the per­son keeps pay­ing pre­mi­ums, the pol­icy stays in force; there is no pre­de­ter­mined expi­ra­tion, as is the case with a term pol­icy, which might be designed for (say) a 20-year term.

As the crit­ics of whole life are quick to point out, the pre­mi­ums needed to keep a whole life pol­icy in force are much higher than those for a term pol­icy with a com­pa­ra­ble death ben­e­fit. Part of the dif­fer­ence is due to the con­tin­u­a­tion option described above. In other words, since the insurer is agree­ing to a level pre­mium for as long as the pol­i­cy­holder wants to keep a whole life pol­icy in force, the insurer has to set the pre­mium high enough to cover the addi­tional expec­ta­tion that the pol­i­cy­holder will die while the pol­icy is in force.

In con­trast, the vast major­ity of term life poli­cies expire with­out the per­son dying. In fact, things are even bleaker for the insur­ance com­pany. At a cer­tain point, the owner of a whole life pol­icy gets a huge check from the insurer even if he is still alive. Nowa­days the cut­off age might be 121 years.

For exam­ple, a per­son might sign up for a $1 mil­lion death ben­e­fit whole life pol­icy when he’s 25. So long as that per­son con­tin­ues to make his pre­mium pay­ments, he can go on pay­ing the same pre­mium, even as he ages and becomes a much higher risk. Ulti­mately, if and when the per­son reaches 121 years, the insurer com­pany sends him a check for at least $1 mil­lion. (In prac­tice it may be more, since the per­son will have pur­chased more “death ben­e­fit” along the way.) Now we see why whole life poli­cies are so much more expen­sive than term poli­cies with the same ini­tial death benefit.

A use­ful anal­ogy is to real estate: The pol­i­cy­holder of a term pol­icy is like some­one rent­ing an apart­ment. He pays the rent month after month, and receives shel­ter in exchange. But after the term of the lease expires, and the land­lord raises the rent, the per­son moves out of the apart­ment. He has noth­ing to show for the money he spent over the years, except the memories.

In con­trast, some­one might buy an apart­ment unit with a mort­gage from a bank. This person’s monthly mort­gage pay­ments will be higher than what the renter had to pay each month, assum­ing they live in com­pa­ra­ble apart­ments. How­ever, with each month’s pay­ment, the buyer acquires more and more equity in the prop­erty. After keep­ing up with his pay­ments for (say) 30 years, the mort­gage is paid off and the per­son owns the apart­ment outright.

The anal­ogy with life insur­ance should be clear. The term pol­icy in effect is just rented insur­ance. In con­trast, the per­son who starts a whole life pol­icy gains equity in the pol­icy with each suc­ces­sive pay­ment. Specif­i­cally, the cash sur­ren­der value grows over time. This is anal­o­gous to a home­owner cal­cu­lat­ing how much equity he has in his prop­erty, i.e. ask­ing how much it’s worth minus how much he still owes on it. For whole life, the cash sur­ren­der value is defined as the (present dis­counted value) of the expected death ben­e­fit pay­out minus the flow of future pre­mium payments.

As time passes, the loom­ing death ben­e­fit becomes more and more cer­tain, because the per­son will either die or attain age 121. On the other hand, with each suc­ces­sive pre­mium pay­ment, the remain­ing num­ber of such pay­ments dwin­dles, mean­ing that the pol­i­cy­holder has a freer and freer claim on the death ben­e­fit. This is why the cash value of a pol­icy grows over time. When crit­ics declare that whole life is “obvi­ously” a ter­ri­ble finan­cial prod­uct, because one can get “the same” insur­ance from a term pol­icy at a much cheaper rate, this is akin to some­one say­ing that buy­ing a house is “obvi­ously” a dumb move because one can rent the same liv­ing space for much lower monthly payments.

The famous “buy term and invest the dif­fer­ence” strat­egy ignores other dif­fer­ences too, but in the present arti­cle I want to focus on pol­icy loans.

POLICY LOANS

In order to ful­fill its con­trac­tual oblig­a­tions to a whole life pol­i­cy­holder, the insurer must take a por­tion of each pre­mium pay­ment and invest it con­ser­v­a­tively. As a whole life pol­icy ages, the insurer had bet­ter have a grow­ing stock­pile of finan­cial assets ear­marked for the pol­i­cy­holder, so that if and when he reaches age 121, the insurer can hand over the assets now worth (say) $1 million.

From the insurer’s per­spec­tive, then, there are numer­ous streams of income every month flow­ing from the var­i­ous pol­i­cy­hold­ers. Some of them actu­ally die, and thus pay­ments must be made in accor­dance with the con­trac­tual death ben­e­fits. Beyond that, there are salaries and other over­head expenses to be paid. After these expenses, what’s left can be plowed into invest­ments so that the total assets of the insurer grow over time, just as the pol­i­cy­hold­ers all think that their cash val­ues are growing.

When a whole life pol­i­cy­holder applies for a loan, the insurer does not “take it out” of the pol­icy. Rather, the insur­ance com­pany takes some of the money that it oth­er­wise would have invested in out­side assets, and instead loans it to the pol­i­cy­holder. Strictly speak­ing, in terms of the cash flow a pol­icy loan doesn’t “touch” the whole life pol­icy at all. Rather, the insurer makes a loan on the side to the pol­i­cy­holder. The insur­ance com­pany is quite happy to make such a loan, because the pol­i­cy­holder pledges the cash value of his own whole life pol­icy as col­lat­eral. To repeat, strictly speak­ing the pol­icy loan doesn’t “suck out” the cash value of a pol­icy, but rather the out­stand­ing loan (depend­ing on its size) off­sets some of the cash value. In the same way, if a home­owner applies for a home equity loan, he doesn’t lit­er­ally sell off the guest bed­room to the bank. Rather, he takes out a loan from the bank and pledges the equity in his house as collateral.

A MATTER OF LIQUIDITY

Now we see why insur­ers are so free-wheeling when it comes to pol­icy loans, whereas com­mer­cial banks and credit unions are much more uptight: the col­lat­eral on pol­icy loans is much more liq­uid than on con­ven­tional secured loans. Con­sider what hap­pens if a whole life pol­i­cy­holder has taken out a $10,000 loan at 5% inter­est. Sup­pose he never makes any pay­ments on it, so that the out­stand­ing loan bal­ance has grown to $10,500 a year later. Then the pol­i­cy­holder is hit by a bus and dies. Does the insur­ance com­pany care? Not at all (unless the employ­ees knew the pol­i­cy­holder per­son­ally!). Because the man owned a whole life pol­icy, the com­pany now owes his estate a check for the death benefit.

Sup­pose the death ben­e­fit orig­i­nally would have been $500,000. Now, because of the out­stand­ing pol­icy loan, the insurer sub­tracts the bal­ance and only sends the man’s widow a check for $489,500. In con­trast, sup­pose the man had gone to a com­mer­cial bank, ask­ing for a secured loan of $10,000 with his new boat serv­ing as col­lat­eral. If the man missed his pay­ment on the loan, the bank would start to worry. As the loan rolled over at inter­est, it might even­tu­ally grow to be more than the under­ly­ing col­lat­eral was worth. (This isn’t likely to hap­pen with a well– struc­tured whole life pol­icy loan, because the under­ly­ing cash value grows pre­dictably over time too.)

Another prob­lem for the com­mer­cial bank is that if the man defaults and the bank seizes his boat, the bank might dis­cover that the man didn’t take good care of the asset, espe­cially when he saw the default com­ing. (Again in con­trast, there’s noth­ing that the pol­i­cy­holder can do to ruin the cash value in his pol­icy. The insurer doesn’t allow him to bor­row more against it, than the cash value at any given time. There is no need for the pol­i­cy­holder to do any­thing “respon­si­ble” to keep the col­lat­eral in good shape.)

Finally, even if the boat has been kept in good con­di­tion, such that its mar­ket value is more than the bal­ance on the loan, the bank still has to go through the has­sle of sell­ing it. This can be a major prob­lem, espe­cially in our cur­rent sit­u­a­tion where banks are the reluc­tant own­ers of mil­lions of fore­closed homes. (Again in con­trast, the insurer doesn’t have to do any­thing to “seize” the col­lat­eral of the pol­i­cy­holder who defaults on a pol­icy loan. It sim­ply sub­tracts the rel­e­vant amount from the check it oth­er­wise would have sent.)

CONCLUSION

Once we under­stand the nature of a whole life pol­icy and how pol­icy loans actu­ally work, it becomes clear why insur­ers offer loans at such attrac­tive inter­est rates and almost unbe­liev­able terms. The expla­na­tion is that the under­ly­ing col­lat­eral — the cash value of the pol­icy itself — makes such loans the safest invest­ments imag­in­able for the insurer. No mat­ter what, they are going to be repaid, because they are already con­trac­tu­ally oblig­ated to pay a death ben­e­fit to the pol­i­cy­holder. The out­stand­ing loan bal­ance, if any, can just be sub­tracted before the check is sent out. Many of the crit­i­cisms of whole life poli­cies like­wise fall away once we explore the nature of these policies.

Car­los Lara, Nel­son Nash, Paul Cleve­land, and I will explore these ideas more fully in the Sat­ur­day work­shop at this year’s Night of Clarity.

(Full details at http://www.usatrustonline.com.)

We will pro­vide an intro­duc­tion to IBC appro­pri­ate for the begin­ner, but along the way we’ll also explain many nuances that even a sea­soned agent may never have fully under­stood. The end result will be to demys­tify IBC, and show that its amaz­ing results and flex­i­bil­ity don’t depend on any gim­micks, but are the result of the nature of the arrangement.