Bill Black, CLU, ChFC, with W. H. Black & Co. in Winter Park, Fla., began paying more attention to the internal rate of return (IRR) values he was seeing on the life insurance illustrations he was giving clients a few years ago.
The numbers showed the after-tax rate an insured would have to earn on his or her premium payments to outperform the life insurance contract. Under reasonable assumptions about life expectancies and no policy loans, the insurance contracts were projected to provide very competitive returns to insureds who kept the policies until they died.
Black cites several examples. In one case of a tax-free Section 1035 policy exchange, a 76-year-old client considered transferring $127,590 of cash value to a new policy that provided a $231,830 death benefit.
The client initially considered taking the funds and investing them, so Black ran several illustrations that showed the IRR for different life expectancies.
“If he lives to age 85, he would have to earn 6.15% annually after taxes on that money to have it grow to an amount equal to the life insurance,” says Black, in an interview with AdvisorOne. “But let’s push him out five years beyond life expectancy. He would have to earn 4.06% per year after taxes to have that $127,000 grow to the $231,830 in life insurance.”
The numbers also work for multi-premium cases, Black maintains. He has an 84-year-old client whose wife is 81; they are buying an $855,000 policy for an annual premium of $37,000. The numbers still favor the life insurance, says Black.
“If they live 10 years until he’s 94 and she’s 91, which is beyond life expectancy, they’d have to earn 14.42% per year after taxes to beat that deal. If they lived 15 years until he’s 99 years of age and she’s 96, they would have had to earn 4.96% per year after taxes to beat that.”
The catch is that it’s the client’s heirs who will reap the benefits of the higher IRR—the client won’t receive any lifetime cash flow or realization of the policy’s values. But as yields available to conservative investors continued to fall, Black began considering life insurance as an asset class and not just a risk management product.
The idea of positioning life insurance as a separate asset class sounds might sound like the latest way to sell a stodgy product. But the argument does have merit, according to Stephen Horan (left), Ph.D., CFA, head of private wealth management at the CFA Institute in Charlottesville, Va. Horan, who has no business ties to the life insurance industry, notes that defining an asset class is as much art as science.
“There is no standard setting body for asset classes,” he said, in an interview. “Everybody has a different view but it is primarily a collection of assets that have a common set of risk profiles. So, for example, we often talk about equities as an asset class because they’re the residual claimants in a corporate finance setting and that’s kind of the common denominator.”
Horan believes it makes sense to consider life insurance an asset class. “From a deconstructionist standpoint, an asset is something that generates an expected future cash flow either in the form of income or capital gain and that can be financial, (or) it can be physical,” he says. “Life insurance fits that profile.”
This is because it will generate cash flow under certain conditions. “What makes it unique and different from, say, a bond, is that the cash flow is triggered by a particular event, not on the part of the issuer but on the part of the owner of the asset; in this case it’s death,” notes Horam. “(That) makes it a unique asset and as such, in my view, distinct enough to represent a different kind of an asset class.”
From that perspective, term life insurance is essentially a put option on the insured’s life. The underlying asset is the insured’s human capital or lifetime-earnings potential, and the option’s strike price is the policy’s face value.
Whole life insurance combines guaranteed cash values with the put option. Viewing the coverage this way gives clients additional insight into their portfolio allocations and insurance-buying decisions, Horan claims.
From a financial planning/risk management perspective, however, Black argues against the use of term insurance even if it does constitute a separate asset class. “Term insurance stops at a certain point in time,” he points out. “I can’t tell you if you’re going to be alive or dead then. You can guarantee a permanent policy until the person is 125 years of age and that’s way beyond any reasonable expectation of longevity.”