Summary of Blog #171 Part (1 of 2)

Interest rate arbitrage occurs with Indexed Universal Life (“IUL”) when:

The loan interest rate is fixed (typically 4% to 5%);
There are outstanding policy loans and the selected index yields more than the loan interest rate;
The cash values securing the loan balances are credited with the yield produced by the selected index as if there were no loans.

Interest rate arbitrage with IUL is a powerful force when coupled with max-funded policies with serious participating loans scheduled for retirement years.

As you will see, there is a way to accelerate the arbitrage further by coupling it with higher premiums and greater policy loans where the policy owner funds the increase in premiums from another source.

Positive arbitrage is created in any year when the yield outperforms the loan interest being charged on the outstanding policy loan.

Negative arbitrage is created in any year when the yield underperforms the loan interest being charged on the outstanding policy loan; however, IUL includes the guarantee that the yield credited to cash values can never go negative regardless of the performance of the selected index. This means that once policy cash values are established, they can never be adjusted downward with a negative yield. The worst case would be a 0.00% yield. (Policy fees such as mortality charges will continue to be debited from policy values.)

Case Study #1 (Arbitrage)

Click here to review the IUL policy for Robert Sterling, age 45, that we illustrated in Blog #171 to demonstrate the effect of arbitrage. It has an annual premium of $50,000 for fifteen years with the minimum possible death benefit. Policy loans of $350,000 for retirement cash flow begin at age 65.

Premiums funded by bank loans are another source of interest rate arbitrage that occurs when the policy being financed is IUL. Accelerated arbitrage is created in any year when, in addition to the arbitrage opportunities created by the IUL’s participating policy loans, the indexed yield outperforms the loan interest being charged on the outstanding premium loans borrowed from the bank.

Case Study #2 (Accelerated Arbitrage)

Click here to review the premium financing arrangement we illustrated in Blog #171 to demonstrate the effect of accelerated arbitrage. In this case, the IUL’s annual premium for fifteen years is increased four times to $200,000 with the minimum possible death benefit. The insured is scheduled to pay $50,000 of the premium (so the out-of-pocket to the insured is the same with either Illustration) with the balance of $150,000 funded by bank loans. Loan interest charged by the bank is accrued. The bank loan and accrued loan interest is repaid at the beginning of year sixteen by way of a policy loan. Policy loans of $350,000 for retirement cash flow begin at age 65. Below is a graphic from our InsMark Compare illustration contrasting the results.

Case Study #1 vs. Case Study #2

As you can see, the effect of accelerated arbitrage is considerable.

Click here to review the illustrations and graphics for this comparison.

Conclusion

Accelerated arbitrage produces an extraordinary increase in benefits for the same personal contribution, but it is not a plan for the faint-hearted. Suitability of the two arbitrage variations examined in Blog #171 (Part 1 of 2) is an important consideration:

A very conservative client may be unwilling to acquire IUL let alone couple it with a premium financing arrangement.
A moderate client may welcome IUL for its arbitrage potential but be unwilling to include it in a premium financing arrangement.
A moderately aggressive or aggressive client may be willing to couple both concepts in search of accelerated arbitrage provided the safety valve discussed below is present.

Safety Valve

With IUL/premium financing coupled as illustrated in this Blog and assuming a policy with high early cash values is used, termination of the plan mid-stream will likely result in the policy having significant residual cash value (“safety valve”) after repayment of the bank loan. This is further enhanced by the guarantee that negative arbitrage cannot occur due the carrier guarantee that the yield credited to cash values can never go negative regardless of the performance of the selected index.

Data Resource

The details of all the data input for both Case Studies is not included in this summary; however, it is extensively covered in Blog #171 (Part 1 of 2). Those interested in utilizing that data for actual illustrations would be well-advised to study Part 1 as it will simplify your research considerably.

Important Note #1: The hypothetical values associated with this Summary assume the nonguaranteed values shown continue in all years. This is not likely, and actual results may be more or less favorable. Life insurance illustrations are not valid unless accompanied by a basic illustration from the issuing life insurance company.

Important Note #2: The information in this Summary is for educational purposes only. In all cases, the approval of a client’s legal and tax advisers must be secured regarding the implementation or modification of any planning technique as well as the applicability and consequences of new cases, rulings, or legislation upon existing or impending plans.

“InsMark” and “Wealthy and Wise” are registered trademarks of InsMark, Inc.

“Accelerated Arbitrage” is a trademark of InsMark, Inc.