Make Money by Borrowing Against Cash Value Life Insurance? Don't Count On It!

I am a big fan of cash value life insurance (obviously). There are some amazing things that can only be done using life insurance.

However, there is a notion out there (that may be true at times!) that you can make money through loans on your life insurance policy.

It's a concept called arbitrage.

In short, the idea is that if you can borrow against your policy for LESS than the policy is EARNING, you are in a positive arbitrage situation.

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If your $100,000 policy is earning 5%, you'll be credited $5,000.

If your $100,000 loan (as an example) is costing you 4%, you'll pay $4,000 in loan interest - either out of pocket or out of your policy earnings.

Your $5,000 interest earnings is greater than your $4,000 loan interest cost, so you have a 1% or $1,000 positive arbitrage.

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Don't count on it, especially long-term from the insurance company directly! And no, I don't care what the policy's illustration says either!

It doesn't make sense!

I'm going to directly quote a true authoritative book called Tools and Techniques of Life Insurance Planning, 9th Edition on how policy loans work and you'll see why a long-term positive arbitration doesn't make sense with the insurance company:

POLICY LOANS

The ability to use the contract as a source of emergency or opportunity cash is one of the most valuable attributes of permanent life insurance. Virtually all cash-value policies include a policy loan provision. As property, the policy can also serve as collateral for a loan from a bank or other lender but more often the insurer will provide the cash under the more favorable terms of the policy’s loan provisions.

When a policyowner borrows money directly from the insurer what is actually occurring is something other than a loan in common parlance. The difference is this: In a true loan the borrower must agree to repay the money. A policy loan does not require repayment. It is more like an advance of the money the insurer will eventually pay out under the contract. The policyholder is receiving an advance – of his own money.

Even though federal tax law treats a policy loan as a classic loan, it is not. A debt, per se, never exists and the policyowner and insurer do not have a traditional debtor-creditor relationship. During the insured’s lifetime, the insurer is always 100 percent secured against loss because the amount that the policyowner can borrow can never exceed the amount the insurer would have to pay the policyholder if he chose to surrender the policy. In fact, during lifetime, the loan can never exceed that amount (less the interest payable on it). Furthermore, the insurer can (and will) deduct the loan value, plus interest from the proceeds otherwise payable if policyowner has not repaid the loan before the death of the insured.

Once the insurer advances money to the policyowner, that person or entity can use the money for any purpose. Policyowners who wish to take policy loans generally do not require the permission of a revocable beneficiary because that party has a mere expectancy in the net (face amount less indebtedness) proceeds. Even an irrevocable beneficiary has no right to demand consent to a policy loan – if the policy states clearly that such consent is not required. However, once policyowners make an absolute assignment (i.e., a total and irrevocable transfer of all interests in their policy) to third party beneficiaries, even if the former policyowners are the insureds, they may take no further loans from the policy.

The amount of the loan is limited essentially to the policy’s cash value (less a holdback for interest). Technically, the policy might state something to the effect of:

The loan value is the amount which, with interest at a daily loan interest rate of ___ percent, will equal the policy’s cash value. Interest on the loan will be payable on each policy anniversary but if not paid when due it will be added to the loan.

Every year the amount that the insurer can advance to the policyowner increases as the cash value grows. But once the total of principal and accumulated unpaid interest equals or exceeds the policy’s cash surrender value, the policy will (after a one month’s notice) terminate and the insurer will cancel all benefits.

Why does the insurer charge interest on an advance of money that will someday be paid to the policyowner? Because the insurer’s statement of what policy values will be year after year is based on the assumption that the insurer will have a reserve (i.e., an amount in excess of that needed to pay for the current year’s costs) to invest and earn interest so that the insurer can keep its future contractual promises.

If premiums unused for costs in early years are not on hand, the insurer cannot invest that money and pay the amounts promised in the future. The charge made to policyowners who accept these advances puts the insurer back where it would have been had it been able to invest the money. 

(In fact the interest rate may be somewhat higher than the amount assumed by the insurer in calculating policy loan values because the insurer needs to pay for administrative costs in making, keeping track of, and repaying these loans and, to some extent, to create a disincentive to borrowing.)

Policyowners may repay a policy loan at any time while the insured is alive (subject to a minimum payment for administrative aggravation and cost purposes). Once the insured has died (or the policy has been placed on extended term status), typically the insurer will not accept repayment of a loan. If the policyowner does not repay the advance, the insurer will reduce either the cash value of the policy available to the policyowner or the death proceeds paid to beneficiaries.  (Steve Leimberg, 2023)

Because of the statement of values, particularly guaranteed values, it doesn't make sense for the insurer to charge LESS interest than they promise to credit back to the policy.

That's a long way of saying that the insurance company has to be made whole in order to fulfill its contractual promises.

Can you have arbitrage outside of the policy? Absolutely!

If you can deploy that capital to take advantage of opportunities where you have exceptional knowledge, you can do very well! It's also the same principle regarding premium finance strategies. It's not about arbitrage between the interest rate of the financed premiums and the performance of the policy. It's about what the business can do with the premium difference to put back into their company.

If you're being shown a policy with indefinite arbitrage, look for any language in that illustration that can guarantee that situation for the life of the policy. (You won't find it.) This is why I won't promote such arbitrage. It's nice when it happens, but with that authoritative reasoning, it just doesn't make sense to 'bank' on it for an extended period.