Justin Smith’s recent series on the real real returns available from life insurance contracts was eye opening.
The use of life insurance as a vehicle for short-term cash, while extremely effective, is simply not intuitive for most. The optimized designs Smith uses to maximize the long-term, real real returns are atypical to say the least.
Another aspect of Smith’s material that can be a bit challenging is how to go about actually integrating life insurance into a larger investment strategy.
The Challenge of Implementation
Most portfolio modeling software does not include life insurance as an asset class. Further, the impact that the inclusion of life insurance has on the balance of the portfolio is extremely important to understand.
Left to their own devices, wealth managers are unlikely to invest the time and energy required to answer all of these question on their own.
Fortunately, research on this topic already exists.
The critical point to understand is that life insurance death benefits are non-correlated. There’s no market risk involved with the return represented by the death benefit.
Inserting this type of asset has a direct and very distinct impact on the portfolio in total: It reduces the overall risk given an equivalent potential return.
De-risking a Portfolio
This can play out in one of two ways.
1. Increased potential returns. If a wealth manager includes a life insurance death benefit in a portfolio, the overall risk, as measured by the standard deviation, drops. This affords the wealth manager the opportunity to be more aggressive in other positions, bringing the level of risk back to “pre-insurance” levels. As a result of these changes, the potential return is increased.
2. Decreased risk. Of course, that same wealth manager may elect to “de-risk” the portfolio rather than adjust the balance of the assets. The impact of life insurance in that scenario is to allow the wealth manager to deliver the same potential returns with lower levels of risk, again measured by the standard deviation.
The benefit to the wealth manager is clear: They have a previously unknown – or perhaps misunderstood – extremely effective risk management tool at their disposal.
The crux for the wealth manager is finding that life insurance subject-matter expert to rely on when executing on this type of strategy, or conversely, the life producer finding the wealth manager who will be open to the discussion of not only why they should consider greater use of life insurance with their clients, but also of how to actually implement said strategies.
Integration of a Life Insurance Contract
With all of that as background, consider the following example of how the integration of a life insurance contract into a portfolio could play out:
All of this discussion has one very important element in common with Smith’s research and one of his key points: The view of some wealth managers that life insurance is a threat or competitor is really no longer valid.
The truth of the matter is that the time could not be better for these two disciplines to work together more closely.
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