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A Balanced Portfolio Includes Life Insurance as a Contingent Asset Class

A Balanced Portfolio Includes Life Insurance as a Contingent Asset Class

February 02, 2022

At Cedar Point Financial Services LLC, we encourage clients to view their life insurance policies as a part of their overall investment portfolio.  Life insurance is often viewed as a product of necessity to provide liquidity to meet estate, personal and business obligations.  Typically, little to no thought is given to life insurance as a contingent asset class whose often sizeable death benefit impacts an investment portfolio and affects other asset classes.  Demonstrating a formal relationship between life insurance and other assets can shape investment behavior. 

When investment managers and estate planners analyze life insurance similarly to how they view other investments such as bonds, stocks and private equity, the influential role life insurance plays in a well-designed investment strategy is evident.

Don’t Just Look to a Policy’s Expected Return at Death

The traditional positioning of life insurance by the investment community tends to only consider the expected return realized on the income tax-free death benefit when it is paid.  This is computed by measuring the return of the death benefit against the premiums paid over time.  Generally, at life expectancy, most clients will realize a return from a permanent type of life insurance, such as whole life or universal life, of between 5% and 7%--tax-free.  This is an attractive return falling in the middle of the returns expected from government bonds and private equity. 

An investment manager utilizing life insurance as a contingent asset class will find this traditional method incomplete and will want to take two additional steps for a complete asset class analysis as laid out by economists Harry Markowitz and William F. Sharpe.  First, in a 1952 essay, Markowitz unveiled his Modern Portfolio Theory where he, theorized that, in addition to determining an expected return, individual portfolio assets should also be analyzed for their expected risk, which is the risk of not achieving the expected return. 

Then, in 1966, Sharpe developed what is now known as the Sharpe Ratio.  The final step to complete an asset class analysis relies upon the Sharpe Ratio to measure the performance of an investment, such as a real estate investment or security in a portfolio, compared to a risk-free asset, after adjusting for its risk.  The Sharpe Ratio describes how well the return of an asset compensates the investor for the risk taken and is used to compare one asset against another in order to achieve the optimal portfolio based upon a client’s tolerance.

The Expected Risk of Obtaining an Expected Return on Life Insurance is Key

Computing the expected risk associated with obtaining the expected return from life insurance is measured by standard deviation, which is the average amount by which returns over a specific time vary from the mean.  Specifically, death benefit deviation is the average amount by which the projected return on investments (“ROIs”), adjusted for their probability of occurring, vary assuming death occurred in any year.

As they are contingent upon mortality and not the markets, each projected ROI is adjusted for and multiplied by the corresponding probability of surviving to and dying at each age.  A standard deviation is calculated on these probability weighted ROIs.  The lower the standard deviation, the less risk there is of not obtaining the expected return.  Standard deviations for life insurance among various ages, sex and health risks are commonly quite low, ranging from .15% to around 1.00%.  Conversely, the standard deviation for other assets classes is significantly higher – over 4% for bonds and over 17% for stocks.  Investment managers are able to visualize this risk-return for various asset classes by plotting them on a chart where the vertical axis is the expected return and the horizontal axis is the expected risk.  This ‘efficient frontier’ demonstrates the maximum return for a given risk or a minimum risk for a given return.

Efficient Frontier Including Life Insurance

© 2020 Lion Street, Inc.  Used with permission.

Sharpe Ratio Allows Life Insurance to be Measured as a Contingent Asset Class

The final step in an asset class analysis is calculating the Sharpe Ratio, the average return earned in excess of the risk-free rate per unit of volatility or total risk.  Usually, any Sharpe Ratio greater than 1.0 is considered acceptable to good by investors.  A ratio higher than 2.0 is rated as very good.  A ratio of 3.0 or higher is considered excellent.

The formula for the Sharpe Ratio subtracts the risk-free rate from the expected return of the portfolio and then divides the result by the standard deviation of the portfolio’s expected risk.  The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time, such as cash or U.S. government bonds. 

For example, cash is expected to grow at roughly 2.1% annually over the next twenty-five years.  If the expected return from life insurance is 6% and the standard deviation is .40%, then the Sharpe Ratio is 9.75, an excellent rating.  In comparison, Sharpe Ratios for most other asset classes are commonly found to be under .50 and, on their own, not considered good risks.

Asset Class Sharpe Ratios

Assumes a 2.1 risk-free interest rate for cash

© 2020 Lion Street, Inc.  Used with permission. 

Balancing a Portfolio with Life Insurance

Armed with Sharpe Ratios for various asset classes, investment managers are able to mix a number of asset classes to achieve a blended Sharpe Ratio which matches the expectations for return and risk.  When an investor is expecting a significant sum of death benefit and life insurance has a high Sharpe Ratio, life insurance is the ideal contingent asset class to use as a foundation for mixing in other investments. 

An investment manager may use the low risk of life insurance’s expected return to hedge against riskier asset classes such as REITs or foreign equities.  In practice, life insurance is used to reduce risk and increase risk-adjusted return in a portfolio, which is especially desired for portfolios held for wealth transfer.

Expected Risk & Expected Return positing of Life Insurance in a Portfolio

© 2020 Lion Street, Inc.  Used with permission.


Speaking the Same Language

Cedar Point Financial Services LLC recognizes that a life insurance policy’s death benefit has a meaningful impact on a client’s wealth and should be positioned as such—collaborating with investment managers.  An investment manager is able to apply the criteria and methodology of Modern Portfolio Theory and the Sharpe Ratio to life insurance and position life insurance in the same manner as other asset classes.  Our team will also incorporate policy ownership and premium funding considerations in respect of any estate or gift tax planning concerns.