#15 | Life Insurance as the Anti-Asset Class

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If you’ve been to any industry meeting since about 2005, you’ve undoubtedly sat through a presentation entitled “Life Insurance as an Asset Class (LIAC).” But I think there’s an argument to be made for talking about life insurance as the anti-asset class. Assets are here-and-now capital. Insurance is capital contingent on a particular event. Insurance becomes a full-fledged asset only when the event happens. Life insurance is an asset because its trigger event is certain, but we’d be missing a major part of the story if we ignored its power as contingent capital.

There are profound benefits of using contingent capital to offset specific liabilities. Imagine that you have two options for savings – a general cash fund or a basket of insurance policies covering every conceivable risk. Which would you rather have? In a world of small risks, you’d rather have the cash fund because small risks aren’t worth the overhead costs of insurance policies. But in a world of large risks, you’d much rather have the insurance because the only viable alternative is to fully reserve for every risk no matter how remote its possibility. Reserving for every risk would require massive cash reserves – a highly inefficient solution if capital can be deployed for higher yields elsewhere.

The power of insurance is that it enables capital to remain at work instead of stuck in liquid reserves. Accessing contingent capital through premium payments is much more efficient because premiums represent the statistical likelihood of the event. No such luxury is available if hard assets are used instead of contingent capital. Reserving cash for the likelihood of the event is statistically accurate but ignores the binary nature of risk. The event either happens or it doesn’t. Holding pennies on the dollar for an unlikely risk doesn’t negate the fact that the risk takes the whole dollar. The only way to transform pennies on the dollar into whole dollars in the event of a liability is to use contingent capital. Partial cash reserves, then, are not an option. The tradeoff for managing liabilities is contingent capital or full reserves. And, as it turns out, the cost for the latter can be crippling.

Let’s say you have 70 year old client with a $100M net worth, most of which is tied up in a successful business growing in excess of 12% annually. The estate tax liability is $35.8M and the client has pulled money out of the business to park it in cash (earning 2%) to hedge the liability. So what’s the cost of the reserve? Roughly $3.58M in the first year alone (12%-2%) in terms of the opportunity cost of capital. Up to age 100, the self insurance strategy would lower the overall return on assets to 8.19% despite the fact that the business continued to grow at 12%.

Life insurance, by contrast, allows the vast majority of the capital to remain in the business while peeling off a trivial amount annually to pay premiums for contingent capital to hedge the estate tax liability. A $38.5M policy on two Preferred 70 year olds would cost $575k annually, essentially saving the client $3M in the first year. Over time, the average return for the entire estate increases to 9.42% with the life insurance policy. I did not include the death benefit payout in the calculation. The increase in the rate of return is the sole result of the client’s newfound ability to transfer capital out of reserve and into the business. The policy IRR had nothing to do with it. So is $38.5M the right number? If the client is right about 12% growth in the business, then $38.5 is way too low. A $100M policy boosts the overall average return to 10.21% and fully hedges the estate tax liability until age 81.

There are a couple of really nice conclusions from this. First, policy price doesn’t matter. I doubled the price of the policy and at $100M of coverage the overall return was still 9.66%, well in excess of the return without insurance. Insurance at basically any cost is better than no insurance if the opportunity cost of capital really is 10%+. Second, more insurance is better than less insurance. Theoretically, this client could buy up to $200M of coverage before it started to have a diminishing effect. It’s virtually impossible for the client to buy so much insurance that the business earnings wouldn’t be able to cover it under the 12% growth assumption.

But what if the 12% assumption is wrong? My story is all about getting money back into the client’s hands so that he can deploy it to earn high returns. Those high returns have to exist to justify the transaction. If the client was earning 6% instead of 12%, for example, then the effect would be less dramatic. Without insurance, the mean return for the overall estate would be 4.67% and only 5.06% with a $38.5M policy. A $100M policy would generate a 5% mean return. In either case, the client would be better off buying insurance but it wouldn’t be the same sort of slam dunk and certainly wouldn’t require as big of a policy as under a 12% growth assumption. And if the client actually realizes something less than the policy IRR, then the life insurance returns will increasing the average return for the estate. In other words, heads you win, tails you win.

My simplified story doesn’t take into account complex estate planning techniques.Clearly a business growing at 12% annually is a ripe candidate for freeze-and-squeeze transfers to trusts. Any client with savvy lawyers would be doing sales, FLPs, GRATs and the rest to make sure that the assets get out of the estate as quickly as possible. However, many clients aren’t doing proper estate planning techniques for a variety of reasons that have nothing to do with sheer economics. Even if they are, most estate planning strategies still create a tax liability for the grantor because the strategies require time and returns to move assets. Life insurance can still play a role in enabling the client to put more cash back into the business without having to worry about an estate tax risk, even if the role is smaller and for a shorter period of time than in my example.

At its core, though, my anti-asset class idea is all about empowering clients to go full-bore into whatever they do without having to sweat the estate tax. Life insurance guys sometimes shy away from a client who claims to be earning 10%+ on assets because returns in life insurance look paltry by comparison. No matter. Unless that client has zero estate tax liability or complete liquidity in the portfolio, life insurance only becomes more powerful as the assumed rate of return increases by enabling more cash to be allocated to higher returns. That’s the power of contingent capital – for managing large liabilities, it provides all of the benefits of liquid capital with minimal opportunity cost.

Final note. If the logic is so sound, then why don’t more people buy life insurance? I think there are two primary reasons. First, inadequately funded self insurance appears to be the most efficient solution until the risk comes to fruition. Creating some cash savings is less painful than paying premiums because the cash doesn’t go anywhere (yet). Second, life insurance itself entails risk. Our products are complicated, opaque and require long-term commitment. People might like the idea of a contingent capital tool that enables them to keep more money in play, but they don’t like life insurance. It’s up to us to explain the products and position them in a way that minimizes policy risk to the client. That does not mean selling Guaranteed UL. That means selling a diversified basket of policies from a set of very strong life insurers with impeccable track records.

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