The COVID 19 pandemic has served up a number of lessons for us all, with some of these lessons coming at great cost.
This is a remarkable time for businesses. Many will suffer, and some will fail. Most recently, American retail stalwart J.C. Penney declared bankruptcy and will close almost a third of its stores. Scores of businesses will suffer simply because of the type of service they offer. For example, consider hair and nail salons, spas and other businesses that offer personal services. There is simply no way these types of businesses can adapt to this environment.
The Paycheck Protection Program has been of enormous help to some businesses, but others have been excluded for one reason or another. There’s only one course of action that ensures a business can weather hard times, and that’s maintaining a cash reserve. It is those with reserves that will come through the pandemic intact. Every well-run company should build a cash reserve that’s liquid and accessible.
When companies do have plenty of cash and equivalents on the balance sheet, they tend to invest it in low risk vehicles like money market funds, CDs, or liquid, riskless government bonds. These are certainly sensible places to stash cash away, but it comes with a downside. Any investment that protects against loss is highly unlikely to offer any opportunity for gain. Wouldn’t it be grand if there’s a way to have your cake and eat it too?
Let’s take banks as an example. Many banks use bank-owned life insurance (BOLI) as a way to offset benefit costs, post tax-advantaged earnings, maximize investment yields and improve their bottom line. In the simplest terms, the way it works is that banks insure key senior executives. The bank, not the executive, owns the policy. It pays the premiums, owns the cash value, and is the beneficiary of the policy. The insurance generates non-taxable earnings in the amount of the growth in cash surrender value.
What is significant is that this insurance is part of the bank’s Tier 1 capital. From a regulatory point of view, Tier 1 capital is the most important measure a bank’s financial strength because it is composed of core, non-risk capital.
So what conclusion can we draw? If a whole or universal life policy is considered non-risk capital by a bank, which is subject to stringent regulatory constraints, it could certainly be a safe and effective investment for companies who want to manage their cash reserves.
Companies can pursue the same type of strategy that banks do. For example, a firm might purchase life insurance on senior executives such as the CEO, COO, and CFO. By purchasing a whole life or universal life policy, they can protect their principle while enjoying upside potential. Cash value accumulates at a minimum guaranteed rate, and that rate will exceed rates on money market funds, CDs and other non-risk investments used as cash equivalents. Cash reserves are deployed much more effectively in this way and grow with the cash value of the policy.
Insurance companies, like banks, are financial intermediaries, but are regulated differently and subject to different types of risks. While insurance companies are subject to interest rate risk, their liabilities tend to be long term. Banks, however, given their integral role in the financial system and the fact that their liabilities are largely in the form of deposits, always face the risk of runs by depositors in times of financial uncertainty. Insurance companies are not subject to this type of risk. Moreover, insurance companies often match their liabilities to fixed income investments and are therefore not so vulnerable to extreme volatility in the financial markets.
Companies that choose to invest reserves in life insurance can enjoy returns on their investment over time as well as the liquidity that comes with the ability to takes loans against cash value, make withdrawals or even surrender their policies for cash value. There are few better ways to ensure the safety of company reserves while continuing to build value.