#53 | The Law of Large Numbers

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Risk is typically defined by the frequency and magnitude of loss. Equities are theoretically riskier than bonds because equity holders are hit first with losses, so both the frequency and magnitude of losses are higher in equities than bonds. Cash is less risky than bonds because the probability of a money market fund breaking the buck is low and the losses would be small. But looking only at the risk of a particular asset class ignores the fact that diversification allows for a basket of high risk assets to operate as a single low risk asset. Financial risk diminishes as it’s spread out over a larger basket of assets assuming that the correlation of the assets is low. Therefore, fundamental investment theory prescribes a diversified portfolio as the best way to get the most return with the least amount of risk. If you can diversify, then you can mitigate individual risks. In other words, diversification essentially allows for self-insurance of financial risk. A million dollars in stocks is one big risk – a million dollars spread across 20 asset classes is 20 risks. The performance of the overall pool of assets becomes more predictable as the money is spread over more assets and more risks. That’s the power of self-insurance through diversification.

But financial risk is different than almost any other type of risk we experience because the risk is denominated in dollars. Dollars are infinitely divisible and scalable. One person can have a billion dollars. But other risks we experience are denominated in things that aren’t divisible or scalable and yet still carry financial consequences. One person only has one life. Diversification across many different smaller lives is not possible. One can’t spread the risk out by playing a particular scenario many different ways simultaneously. If you go skydiving, you will either live or die. As a skydiving survivor, I can vouch that I didn’t die but I can’t vouch that skydiving a million times won’t result in a death. Most events we face are simply not self-insurable. The way we manage risk for most of those scenarios is by being cautious. Most people don’t go skydiving. They simply don’t take the risk because they can’t self-insure. But what if a risk is unavoidable? And what if that risk happens to carry a massive financial consequence?

This is precisely what we find with death. It’s an unpleasant but essential conversation. The certainty of death is 100%. The most cautious person in the world still meets their Maker. The only question is the financial consequence when it occurs. For some folks, the financial consequence is lost income for the survivors. For other folks, it’s the need to hire help to manage the house in the aftermath. And still for other folks, there’s a real, tangible cost in the form of the Estate Tax. People with an estate tax liability are faced with the 100% probability of a high magnitude event at an uncertain date. Self-insurance through diversification is not an option. There’s only one you.

But that doesn’t mean you don’t have options. Anyone with an estate tax liability should hire a creative estate planning attorney who can start moving assets out of the estate. Assuming all goes swimmingly, you’ll live until you’re 95 and your assets will gradually disappear from your taxable estate (and your control). You’ll die a pauper and your kids will be crying into Hermès handkerchiefs. Virtually every estate planning technique requires two things to work – returns higher than what the IRS expects most assets to earn and many years over which to transfer the assets. The latter is usually the problem. An early death results in truncated asset transfer and a large estate tax liability. Mortality is a risk that can’t be self-insured. Ignoring it doesn’t mean that you’ve covered. Ignoring the problem leaves a gaping hole in even the best estate and financial plans. The estate tax liability triggered by an early death represents more loss than the excess gains that even the best investment managers could deliver over the same period of time.

There are two viable options to manage this liability – self insurance and third party insurance. The only way to fully self-insure against this risk is to allocate capital away from productive investments and to liquid cash. In other words, you have to assume that you’re going to die tomorrow every day. The price for doing so is the compounding loss of benefits from putting capital to productive use. Third party insurance allows for complete coverage of the liability for the price of the premium. As I wrote in Life Insurance as the Anti-Asset Class, the compounding price of converting 12% assets into 1% assets in order to hedge the estate tax is astronomical compared to the price of purchasing third party insurance and keeping the 12% assets at work. Furthermore, simply moving assets out of 12% money and into 1% money puts a damper on the client’s ability to transfer assets out of the estate. Assets earning 12% are easy to move because the IRS expects them to earn 3% and the residual is transferred tax free. But if the assets are earning 1%, then it’s virtually impossible to move them without incurring gift tax. Self-insurance essentially locks in the estate tax liability that it’s trying to hedge.

Unfortunately, many people try a third option – no insurance. They keep the 12% capital at work and refuse to spend the money to buy an insurance policy. They incorrectly view insurance as an expense and believe that other options have no cost. The reality is that every method for dealing with the estate tax has a cost. The cost of self insurance is the opportunity cost of capital on holding full cash reserves against the estate tax liability. The cost of third party insurance is the premium. The cost of no insurance is a 45% reduction of the estate over $10 million and the earnings on those assets in perpetuity. Let’s look at all three options for a $100M estate tax with an assumed $45M estate tax liability.

  1. Self Insurance – $4.95M annually and growing. $90M at 12% = $10.8M. $45M at 12% and $45M at 1% = $5.85M.
  2. Life Insurance – $1.2M annually for a $100M policy held in the estate
  3. No Insurance –$5.4M ($45M at 12%) annually in perpetuity to account for lost earnings.

In all three cases, the client keeps the same residual but the cost is dramatically different. The client would have to earn something like 3.5% in order for self-insurance and no insurance to be more optimal than an insurance policy. But cost is inescapable. The estate tax liability transforms the personal risk of death into a financial risk. The only economical way to manage the risk is to diversify, and the only way to diversify personal risk is to purchase an insurance policy. It’s not a question of expense. It’s a question of risk management. The same principle that has guided the decisions of the best money managers in the world leads to the conclusion of purchasing third party insurance to manage personal risks.

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