Life insurance is unique among types of insurance in that it insures against an event (death) that will occur as opposed to an event that may occur. But, although death is a certainty, individuals buy life insurance to hedge against the time when death will occur. It's this focus on timing that makes the death benefit provided by life insurance different from other asset classes. That is, the timing
Life insurance is unique among types of insurance in that it insures against an event (death) that will occur as opposed to an event that may occur. But, although death is a certainty, individuals buy life insurance to hedge against the time when death will occur. It's this focus on timing that makes the death benefit provided by life insurance different from other asset classes. That is, the timing of death is unrelated to the ups and downs of the economic market and helps to stabilize an individual's portfolio of assets. Given the economic uncertainty we saw in 2010, more and more people are incorporating life insurance into their investment portfolio. But careful management of these policies is required to maximize their return.
Individuals use various strategies as a hedge against uncertain future events. For example, farmers or ranchers may buy or sell commodity futures as a hedge to protect their potential profit in the face of price fluctuations for their crops or livestock. Investors may buy puts to lock in a profit on securities. And, although the event of death is a certainty, many individuals buy life insurance to hedge against the uncertainty as to when death will occur. As estate planners, we must help our clients plan for a death at the “wrong” time.
Here are some ways life insurance acts as a hedge against an untimely death.
- Protecting against loss of income
The insurance can make up for the loss of income if a breadwinner dies and her income ceases.
- Avoiding the need to sell assets at the wrong time
Over the last few years, asset values have greatly declined. The survivors may believe that with time, the asset values will increase, yet they have a need for cash now.
- Avoiding a forced sale
Life insurance can obviate the need for a forced sale to pay estate taxes if the estate is illiquid. The tax collector only takes cash, and if there isn't liquidity in the estate, assets will have to be sold or mortgaged.
- Paying taxes without depleting the estate
Many people don't want their assets depleted to pay estate taxes; life insurance is a way to provide the money to pay those taxes.
- Providing money to buy out business co-owners
For privately held businesses with multiple owners, the death of one owner can bring in new, undesirable owners (for example, the owner's heirs) or create a demand for cash to buy out the deceased owners interest. Most business owners have an agreement so that the remaining co-owners can buy out the heirs. But if the business or other owners don't have enough cash for the buyout, the deal can't go through. This creates tremendous stress and difficulties.
Death Benefit as an Asset Class
The recent economic downturn has taught people that assets can lose value. Almost all assets carry that risk with them. To reduce such risk, financial planners have presented the concept of asset allocation to their clients. It's based on the theory that assets have a correlation with one another and looks at how one asset will react relative to other assets under the same economic circumstances. The objective of asset allocation is to include different assets that won't perform in exactly the same way. Theoretically, by putting together different assets that have low correlations to each other, an entire portfolio of assets is less subject to market fluctuation. Unfortunately, that theory for the most part has been unsuccessful over the last several years. Foreign and domestic stocks, bonds and real estate all had large reductions in value. So how does life insurance fit in with the mix?
The life settlement business gives us a clue. Investors have been purchasing existing life insurance policies from owners (the insureds) who bought the policies to hedge some of the risks previously described. For whatever the reason, if policy owners are paid enough, they're willing to part with their policies. The buyers (funders) look for older insureds whose health has changed since the time they purchased their insurance and are now willing to sell their policies. The settlement companies that broker these transactions (that is, work with the funders who become the eventual owners of the policies) receive life expectancy reports based on the current medical conditions of the insureds. They then put the policies out for bids by the funders they already have relationships with. Those funders believe they can make a substantial return on their investments if they buy enough policies at the right price with the right premiums payable going forward; thus, the actuarial probabilities work in their favor. In today's marketplace, life settlement companies are purchasing policies based on the expectation of annual returns of 15 percent or higher. Because of the transfer-for-value rules,1 the investors will pay income tax, but still get a high taxable rate of return. Moreover, the event is a certainty; it's the timing that's not.
Value to Keep Policy
The life settlement transaction leads to this question: If someone is willing to buy a policy, pay more than its cash surrender value and then pay premiums going forward, what's the value to the owner to keep the policy? To understand that value, one needs to know what the term “life expectancy” means to an actuary. It's the age at which 50 percent of insureds at a certain present age will have died. That also means that by that age, 50 percent of insureds will still be alive. Funders are acquiring a large number of policies so that while no single death may occur at life expectancy in any individual policy, all the policies in total will produce a result based on the insureds' deaths being close to the life expectancy age. In contrast, an individual with only one policy won't be able to determine how close to life expectancy his death will occur. Even so, because the death proceeds won't be subject to income tax, the returns are still enticing. Let's look at an example:
A 79-year-old woman has a $1 million policy she took out seven years ago. The current cash value is $75,000 and the annual premiums are $25,000. At the time she was issued the policy, she was a preferred risk. Based on her health today, the insurance company will consider her a “Table 4,” which means that the company believes she will die sooner than a healthy person her age. Her life expectancy today if she still had a preferred rating would be to age 93. However, based on her current health, she's expected to live another nine years to age 88. If she had given up the policy, she would have gotten the $75,000 cash surrender value. But let's assume she keeps the policy and continues to pay the premium. If she dies at age 88, the rate of return is 19.8 percent. But if she lives to her original life expectancy of age 93, the rate of return is 9.4 percent. If she lives to 100, the rate of return is 4.5 percent. Isn't that a good investment, especially considering that's a tax-free rate of return?
Let's go back to the idea of correlation that I brought up earlier. Does the timing of the woman's death have anything to do with any other financial asset? NO! The woman's health is unrelated to how the market, businesses, real estate or commodities are doing, at any given time.
Let's look at what this scenario might be for someone considering new, second-to-die insurance. Assume we have a husband and wife — Jim, age 63, a standard non-smoker, and Joan, age 60, a preferred non-smoker. Based on the 2008 Valuation Basic Tables released by the Society of Actuaries, their joint life expectancy is 33 years. Using a hypothetical policy with a price based on their ages and health, the internal rate of return at life expectancy is 7.1 percent tax-free or a taxable yield of over 10.9 percent assuming a 35 percent tax rate. If either spouse survives for another 40 years (to age 103 for Jim and age 100 for Joan), the internal rate of return is 4.3 percent tax-free.
However the cash surrender value at any time will be less than the premiums paid, and often substantially less. Who would be interested in buying life insurance as a part of his investment portfolio? The obvious candidates are those who need life insurance — those who need a hedge against an untimely death. But suppose, based upon an individual's own goals, he doesn't need life insurance as a hedge — what then?
Although many people glibly say they want to spend their last dollar as they take their last breath, in reality people don't manage their assets that way. They don't know when they will die, so to maintain their lifestyle, it's best not to invade principal or not invade it substantially (unless they purchase an immediate annuity guaranteed for life). Everyone has seen the loss of values in the last few years. Does anyone want to bet that values will remain steady or go up in the future?
A Portfolio for Inheritance
Life insurance makes sense as an investment and diversifier for individuals with assets that they're otherwise not consuming; in effect, a portfolio that will become an inheritance for their heirs. Even those who bought insurance for a reason that no longer exists may want to keep it. I met with a client recently who had a substantial amount of life insurance that was purchased to pay estate taxes. Based on the value of his assets now, he could reduce the amount of insurance by 50 percent. When I told him this, he said: “I bought it to protect my estate. Now, it is my estate.” He didn't reduce the amount of insurance.
Managing Life Insurance
What do people do with the assets they have such as securities, business interests and real estate? They either manage those assets themselves or have someone else do it. If we consider life insurance as an asset, shouldn't it be managed as well? Think of it this way:
Your client has a life expectancy of 10 years and owns a life insurance policy for which he's paying premiums. According to an in-force illustration the insurance company provides, based on current projections, if the client stops paying premiums, the policy will stay in force for 20 years. Should the client continue to pay premiums? The client may need more information to assess his options. Remember that your client's life expectancy is determined to be when 50 percent of the people your client's age are expected to die. According to the same 2008 Valuation Basic Tables, the probability that your client will die in the next 20 years is 90 percent. Are you comfortable advising your client to take the odds and not pay premiums going forward? What if your client pays something less than what he was paying now? How long will the policy last and what's the probability of your client's death during that period? What if your client takes the bet at 90 percent and dies before the end of 20 years? Isn't the rate of return higher than that if your client continued to pay premiums?
How many trustees of life insurance trusts go through this exercise? How many insureds have agents who can do this for them, never mind how many have agents actually do it?
With the proper tools used by professionals, your client can know his options for managing his life insurance policies and can make informed decisions about how to their pay premiums. This policy management is a fee-for-service and not a commission-based (nor should it be) business. It's done by professionals that have access to the most current mortality figures broken down further by risk category (that is, preferred, standard, smoker, rated). It can be client-specific by getting life expectancy reports. With that information, an appropriate course of action can be taken.
- Internal Revenue Code Section 101(a)(2).
Richard L. Harris is the managing member of Richard L. Harris LLC in Clifton, N.J.