#340 | The Infinite Banking Concept

person putting coin in a piggy bank

Quick Take

The Infinite Banking Concept (IBC) has attracted something of a cult following for its quasi-libertarian branding and purported financial benefits. The core idea behind IBC is sound – using policy loans from a Whole Life policy is a reasonable and responsible way to pay for large capital expenditures. But from there, the story gets murkier. Some IBC-type sales rely on the assumption of perpetual arbitrage, pointing out that the Whole Life values continue to compound uninterrupted but conveniently forgetting that outstanding loan balances do as well. Some IBC-type plans also advocate for paying premiums with policy loans, creating further leverage in the policy. And now, some IBC proponents have turned to Indexed UL as illustrated arbitrage in Whole Life has waned. Fortunately, there’s a simple tool for agents and carriers alike to determine the quality of an IBC-type plan – if it relies on illustrated loan arbitrage, then it’s problematic. And, fortunately, you don’t need illustrated loan arbitrage to make the case for using policy loans as a liquidity and planning tool for clients. That’s IBC at its best and, in my view, where it should stay.

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Over the past few years, I’ve been increasingly asked about the Infinite Banking Concept (IBC), a trademarked term coined by Nelson Nash in his book Becoming Your Own Banker, published in 2008. The book and the concept have inspired something of a cult following. Practitioners of IBC talk about Nash in reverential terms. His book is regularly studied, quoted, analyzed and used to spread the good news of Infinite Banking. Dig a bit into IBC and you’ll see that it’s more than just a financial planning concept. It’s an appeal to individualism, self-determinism and freedom from the “evil” forces of global finance. Here’s how Nash frames it in a video on the Nelson Nash Institute website:

“In essence, the Infinite Banking Concept is ridiculously simple, but it’s complicated by the mindset that the general public has. They think it can’t be true because it’s so simple. The forces out there that cause all this sort of stuff [shows images of the Fed, the NYSE, Hank Paulsen and Ben Bernanke] deliberately make it that way. They intimidate – that’s what it amounts to. Well, you’ve got to realize what evil looks like. And that is evil that’s going on out there. Don’t participate. That’s all. You’ve got to learn to secede from the way that the world thinks…and when you do, you create a microcosm that’s all yours.”

Listening to IBC practitioners – and when I refer to IBC in this article, I’m usually talking about it in general terms –it’s sometimes hard to separate the philosophy from the strategy. The more I’ve dug into it, though, the more I agree with Nash’s statement that the essence of IBC is ridiculously simple. What is it? IBC is the idea of using overfunded Whole Life policy as your own personal piggy bank – but unlike the piggy bank you had as a kid, this one earns dividends and allows for near-immediate, no-questions-asked policy loans at defined and pre-determined rates.

The Infinite Banking Concept revolves around the idea that most people are investing and making capital expenditures. Think about a farmer buying seed every year, a family paying for college tuition, a person buying a car, you name it. The typical strategy for those large expenditures is that the family or business either liquidates investments or borrows money to pay for them. Liquidating investments means missing out on future returns and borrowing money requires being underwritten by a bank, posting collateral and being subject to a loan spread. IBC practitioners are generally keen to highlight risk of traditional investments and the cost, uncertainty and lack of control inherent in taking bank loans.

The theory of IBC is that no such tradeoffs between investing and borrowing exist in a Whole Life policy with non-direct recognition policy loans. Taking a loan from the policy to pay for a capital expenditure does not (directly) affect the dividend earned by the policy. In IBC parlance, the benefits of compounding growth continue to accrete to the policyholder uninterrupted regardless of whether the values are loaned out or not. The policy cash value remains intact, steadily growing on a guaranteed basis and earning non-guaranteed dividends.

On the lending side, IBC practitioners correctly point out that a policy loan is much easier to get and keep than a bank loan. Life insurers don’t ask questions about how you’re going to use the money. They don’t slap fees and spreads onto the rate that they charge because the rate is defined in the contract equally for all policyholders. They don’t ask for collateral because they already have it. You don’t have to apply for a loan – you just tell the life insurer you want it and they send it to you almost immediately. And you can keep it for as long as you want, without prepayment penalties or defined loan terms.

The fact that life insurers allow access to policy cash values on an immediate, no-questions-asked, non-taxable basis seems downright magical. Policy loans are an incredibly powerful tool that can and should be used more often than they actually are for exactly the sort of capital expenditures that IBC-ers have identified. Pure and simple. The fact that IBC wraps this universal policy feature in the language of libertarianism and self-determination is something of a marketing gimmick and client buy-in mechanism that is extremely effective, at least for a certain subset of the population. But don’t confuse the rhetoric with the strategy. There is merit to the core idea of IBC.

However, dig a bit deeper in to IBC and things start to get a bit murkier. The reason why IBC practitioners almost always use Whole Life policies with non-direct recognition loans is because they are operating under the assumption that the performance of the policy will always exceed the cost of the policy loan. This is not, however, a core tenant of IBC, at least as far as I can tell. IBC “works” regardless of the relationship between the performance of the policy and the cost of the loan.

But from a marketing standpoint, the positive arbitrage illustrated and generally realized over the past 30+ years by non-direct recognition loans is a key piece of the puzzle. You’ll often see charts like the one below from IBC practitioners to promote the “always compounding” aspect of IBC:

The example on the left shows a person investing every year and then incurring a capital outlay that depletes their savings every 6th year. The example on the right shows the same amount being paid into premium on a Whole Life policy and a policy loan being taken every 6th year. IBC practitioners seem to conveniently seem to ignore the fact that although the Whole Life policy values compound, so do the policy loan values. And if the compounding rates are the same, then there is no financial difference between a withdrawal and policy loan. The only way that the left side looks different than the right is if the cost of the loan is less than the performance of the policy. That positive “arbitrage” is what creates illustrated equity and drives up the ultimate long-term value of the IBC strategy. Without positive arbitrage, then the left and right side would look identical.

Simply put, the mechanical strategy of IBC doesn’t require illustrated arbitrage on non-direct recognition loans, but the marketing appeal of IBC broadly relies on it. This is a real problem with IBC. As I’ve written in other articles, there is no structural basis for the idea that there will be long-term arbitrage on non-direct recognition loans*. Policy loans are booked as an asset at the life insurer – and to be clear, life insurers love this asset class. When someone takes a policy loan, the life insurer essentially swaps a corporate bond asset that has default risk and requires risk-based capital for a policy loan asset that is fully collateralized, has no default risk and requires no risk-based capital.

But it’s just an invested asset that supports the dividend of the Whole Life policy. Direct recognition loans tie the dividend earned on the loaned value to the yield on the supporting asset which, in this case, is the interest rate charged on the policy loan. Non-direct recognition loans, by contrast, blend loaned and unloaned assets together to support an overall policy dividend. The rate on a direct recognition loan can be floating or fixed because the dividend itself is linked to the loan, but the rate on a non-direct recognition loan needs to float so that it can reflect market interest rates. Otherwise, the loaned assets would pollute and dilute the overall dividend pool.

But the long-term effect is the same regardless of the structure of the loan – the carrier books an asset, deducts an investment spread and then uses the asset to fuel the interest component of the dividend. Structurally, policy loans should and almost always do have a cost. That cost is obvious on a direct recognition loan but not obvious on a non-direct recognition loan.

In a falling rate environment, there can be a pronounced and sustained gap between the performance of a Whole Life policy and the cost of a non-direct recognition loan that not only masks the inherent cost of policy loans but presents the chimera of perpetual long-term arbitrage. In a rising rate environment, the sword cuts the other direction, as is happening right now. Moody’s Aaa bonds, which serve as the basis for the interest rate on most Whole Life non-direct recognition policy loans, currently sits at 5.25%. Most actual credited rates on Whole Life – which is the Dividend Interest Rate minus the spread – are around that same rate, if not lower. Positive arbitrage has vanished. We’re in a new era that doesn’t undermine the mechanics of IBC, but it does challenge its marketability and some of its appeal.

The issue is even more acute for IBC because it creates something of an extreme version of normal policy loan behavior. I’ve heard from folks at carriers who have agents selling policies in IBC-type plans that it’s not uncommon for a premium to be paid and then for 90% of the value to be loaned out within two weeks of being paid. It’s also not uncommon for a policy to have numerous inflow and outflow transactions in a year with the total volume exceeding the total cash value by a wide margin. I’ve heard of policies sold by IBC practitioners that have had nearly 100 transactions in a year. IBC practitioners push the limits of liquidity in life insurance policies, fully taking advantage of life insurers’ willingness to provide immediate policy loans.

Life insurers typically reserve for liquid cash values in life insurance policies with investments of around 10 years, on average. That’s a solid match for a basket of normal life insurance policies that offer full liquidity but few policyholders actually use it. But if you think about the proper investment strategy to support a portfolio of exclusively policies sold in IBC-type structures, the investment maturity might be closer to one year because of all of the cash constantly flowing back and forth. Anything longer might result in unpredictable capital gains and losses from constantly buying and selling the asset. It wouldn’t work – or, at least, wouldn’t be advisable.

The effect is further compounded (pun intended) by the fact that some agents take IBC beyond anything I’ve seen in the core cannon of IBC – they advise clients to borrow money from their Whole Life policy in order to pay more premium. In a world of perpetual illustrated arbitrage between the cash values and the policy loan rate, this sort of thing “works.” The more you borrow, the more you pay in premiums, the more net equity magically appears in the policy. “Magic” being the operative word. But the problem is that this creates even more churn in the portfolio, constantly funneling loaned money into long-duration investments that need to be liquidated for more policy loans.

If the life insurer actually invested in one-year bonds to match the liquidity required by Infinite Banking, then the dividend interest rate would be virtually non-existent, at least for the past decade or so, on unloaned assets. The entire strategy essentially wouldn’t work. The liquidity demanded by IBC would have a real cost in terms of lower performance in the policy. The idea behind using Whole Life as a piggy bank with continuous compounding is that it offers a both/and solution – both the ability to earn dividends based on long-duration investment yields and take virtually unlimited immediate policy loans. That works as long as the majority of the Whole Life block doesn’t actually use the IBC strategy.

If an entire block is IBC and constantly churning policy loans, then it turns into an either/or situation – either you get long-duration investment yields in the dividend or you get unlimited immediate policy loans which, in turn, fuel a dividend interest rate that is below the policy loan rate. To put it simply, marketing IBC as a way to borrow money at no cost or with positive arbitrage is something that might work if a few people do it, but structurally can’t work if everyone does it – a fact that is becoming more obvious as policy loan interest rates have started to eclipse Whole Life performance.

The response from the IBC crowd has been interesting to see. Most IBC practitioners have (rightly) stuck to their guns about the value proposition primarily being the flexibility of the Whole Life policy and (also rightly) pointing out that dividends will eventually increase as interest rates increase. But there also seems to be a bit of a pivot towards another product category, one that isn’t as stable as Whole Life and doesn’t have the same level of guarantees but does offer the prospect of continuous illustrated arbitrage between the policy loan rate and the performance of the policy. What product might that be? You guessed it – Indexed UL.

Formal Infinite Banking has historically been tied exclusively to Whole Life, but informal infinite banking has been going on in Indexed UL for as long as I can remember. I remember back in 2007 seeing illustrations for Indexed UL where the client paid 2 premiums and then borrowed money from the policy to pay all premiums afterwards, a concept referred to as “hyperfunding” and generally banned by life insurers because it is so incredibly dangerous and prone to lapse.

With Indexed UL, the margin for error on a fully loaned contract is much smaller than in Whole Life because the interest credits are variable. Just a single year where the credit is 0% can blow up an Indexed UL contract. That can’t happen in a Whole Life policy because there is always some level of guaranteed growth. Fully loaned contracts always need to be managed very carefully, but problems arise much faster in Indexed UL than in Whole Life. That’s why, in my view, Indexed UL is fundamentally incompatible with the core tenants of Infinite Banking, which rely on the safety and security of the underlying Whole Life chassis.

So what’s the verdict on Infinite Banking? Here’s the way I’ve come to see it. The base level concept is sound and not particularly unique to IBC – policyholders have the ability to borrow from their contracts and they should consider using policy loans for some purchases instead of external bank loans, primarily for the flexibility and control of the policy loan itself. That’s how you become your own banker, to put it in IBC terms. Anyone with any type of permanent policy has this ability, even a Variable UL.

One step down is the idea that taking out a policy loan allows the policy to compound growth at a rate higher than the cost of the loan, which – in IBC parlance – means that the client gets the power of uninterrupted compound interest while still being able to access their money. This is a situational benefit, not a structural one. And, right now, it’s arguably not even true. This argument, in my view, is where infinite banking takes its first little wrong turn.

One step down from there is the idea that if you can earn net interest on your loans, then you should use policy loans for everything. Hence, policies that have a hundred transactions a year and even use those loans to pay premiums on the policy so that you can then take out more loans and repeat the process. This is extremely problematic. It creates systemic risk in the policy because it’s constantly loaned to the max and, at the same time, could force the life insurer to cut the dividend because it has to invest shorter to account for all of the liquidity being accessed in the policy. Life insurers would do well to avoid this risk.

The final step down is to swap out Whole Life for Indexed UL under the presumption that Indexed UL can generate the arbitrage that is no longer illustratable or found in Whole Life. I’ve long made the argument that Indexed UL isn’t very risky and I stand by that – but the exception is if the policy is fully loaned, as it very well would be in an IBC-type sale. These sorts of sales are so far removed from the core IBC that they’re almost unrecognizable.

In my view, life insurers should welcome traditional IBC sales. They are exactly what carriers should want – relatively large, generally heavily funded, usually persistent policies. But when you climb down the latter into the other sales practices, the appeal becomes less certain. Do life insurers really want that much money flowing in and out of policies? Do they really want policyholders borrowing money to pay premiums? How many of these policies can they take before it actually starts to cause problems for their administration system and investment strategy? The answer will vary by carrier, but the carrier should at least be aware of the business they’re getting and cognizant of how its being sold.

And that’s precisely the problem. There is no check box for IBC sales – and even if there was, it’s hard to know which type of IBC a carrier is getting. The way a life insurer finds out if they have a bunch of IBC plans is that they start seeing an uptick in the number of transactions being processed and an overall expansion of policy loan balances in a block. That’s very much a lagging indicator and an inexact one at that.

A better preventative mechanism is also, fortunately, the easiest to implement and most broadly effective – get rid of situations that purport to show positive arbitrage from positive loans. Use direct recognition loans. Zero-out illustrated loan arbitrage on Indexed UL loans. In short, don’t give people the idea that they can borrow from their policy and still earn net interest perpetually as some sort of riskless, magical money machine. That’s true for IBC but it’s also true in general. Nothing good will come of that, in my view, even if it does actually come to pass. Better to underpromise and overdeliver than the other way around.

*If there’s arbitrage to be had, then it’s because of outside business earnings – and those would show up to benefit the policyholder regardless of whether the loan is structured as direct or non-direct recognition, as happens in MassMutual policies that have both options.