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Life Insurance Is an Asset Class

There are words and phrases that we hear and read so often, we sometimes forget their original definitions. For the sake of clarity, here is a glossary of terms—with their appropriate definitions—relevant to this conversation.

An asset is something that can be used, either now or in the future, to generate income. By this definition, assets are more than financial instruments such as stocks and bonds; a business is an asset, and so is one’s ability to earn income. (And while real properties can be assets, a personal residence is not an asset for many households. If their home is sold, the proceeds won’t generate income, but will be used to acquire new living accommodations.)

An asset class is a group of assets with common financial characteristics, including the tendency to perform similarly in changing market conditions. There are many ways to classify assets, but some commonly used categories are Equities, Fixed-income, Cash Equivalents, Real Estate, Guaranteed Accounts and Commodities.

Correlation is an assessment of how different asset classes respond to changing economic circumstances. Asset classes that respond to a change in similar ways are said to have a positive correlation, while asset classes that move in opposite directions from the same change have a negative correlation. If one asset class is not affected by an event, relative to other asset classes, it is considered to have a zero correlation, and is sometimes referred to as an uncorrelated asset class.

Diversification is a financial strategy of combining asset classes with different correlations to reduce the overall risk of loss. Instead of trying to select “winning” asset classes in an ever-changing world, diversification attempts to moderate loss; when some asset classes are down, the hope is that others will be up.

Some experts argue that diversification also reduces overall returns, but a financial model known as Modern Portfolio Theory (MPT) has shown that a prudently blended mix of asset classes not only reduces risk but delivers maximum returns. MPT was first articulated in the 1950s, and in 1990 the originators of the concept received a Nobel Prize in Economics for its importance in financial planning.

The Un-Correlations in Life Insurance

One of the key elements for successful application of the MPT strategy is identifying uncorrelated asset classes, i.e., those whose performance doesn’t zig or zag in relation to others, but remains stable. In this paradigm, a number of economists have begun to reconsider the place of life insurance, particularly whole life insurance, in a diversified portfolio.

In 2008, insurance expert Richard Weber and actuary Chris Hause produced a lengthy (109 pages) white paper titled “Life Insurance as an Asset Class: A Value-Added Component of an Asset Allocation.” In it, the authors explained, in detail, why life insurance could be a valuable uncorrelated asset class in an individual’s portfolio when there is an underlying lifetime need for life insurance.

Two aspects of a whole life insurance policy can be considered uncorrelated assets: The insurance benefit and the cash values. A May 2011 article from Reuters (“Insurance: The New Asset Class?”) characterized the insurance benefit as an “options contract,” because there is an agreement between the policy owner and the insurance company that a guaranteed asset—the proceeds paid to beneficiaries—will be delivered if and when the insured dies. Because the value of this asset is not contingent on market conditions or timing, it can be a significant uncorrelated asset.

In addition, Weber and Hause find the “living benefits” of the cash values have “the dominant characteristic of a fixed account with a minimum guaranteed return.” These guaranteed values, along with potential dividends*, accrue systematically and are minimally impacted by the volatility of other asset classes. While an insurance company’s investment returns are a component in declared dividends, other internal factors, such as administrative expenses and mortality costs, also factor in these distributions. A life insurance company doesn’t need a rising market to deliver a healthy dividend.

True to the MPT model, including life insurance as a distinct uncorrelated asset class can not only reduce risk, but also produce better returns. Weber and Hause provide a detailed mathematical analysis in which a combination of life insurance and bonds delivers superior long-term accumulation results compared to a bond-only account while decreasing investment risk. Weber and Hause conclude:

“Permanent life insurance intended for a lifetime can produce at least as favorable a long-term return with less risk within a portfolio of equity and fixed components than a portfolio without life insurance.”

For a variety of reasons, from financial globalization to central bank interventions in national economies, it’s become harder to find truly uncorrelated assets, ones whose performance is minimally impacted by external events. This realization has coincided with recognition of the unique asset class features in life insurance. While it cannot tout the opportunity for high returns, within the context of Modern Portfolio Theory, life insurance can be a foundational uncorrelated asset that reduces risk and enhances financial health.

* Dividends are not guaranteed, and are declared annually by the company’s board of directors.

By Elozor M. Preil

Elozor Preil, RICP®, CLTC is Managing Director at Wealth Advisory Group and Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS). He can be reached at [email protected]. See www.wagroupllc.com/epreil for full disclosures and disclaimers. Guardian, its subsidiaries, agents or employees do not give tax or legal advice. You should consult your tax or legal advisor regarding your individual situation.

 

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