Should Life Insurance Be Considered in Your Clients’ Asset Allocation?

Life insurance is typically viewed as a risk management tool. Consequently, life insurance and asset allocation decisions have historically been divorced from one another. Increasingly, academics and advisors are tearing down this divide as new thinking develops around the role of life insurance.

What is Life Insurance, Really?

Life insurance seeks to replace what may be an individual’s most important asset—his or her future earning power. It can be viewed as an “options contract” since it represents an agreement between a policy owner and an insurance company that a certain amount will be paid to beneficiaries when the insured dies. As a practical matter, this is a guaranteed asset, not contingent on market conditions or timing.

Life Insurance and Modern Portfolio Theory

Asset allocation is the exercise of blending low-, non- and negatively-correlated assets together to achieve an optimal balance of return and risk in line with an investor’s risk tolerance, objective and time horizon. One of the lessons of the 2008 credit disaster was that when crisis occurs, correlations among assets may converge in an instant, reducing the value of traditional diversification.

Unlike most variable assets, a life insurance’s death benefit is cash when it is needed most, and is paid at the full value of the policy, without regard to market conditions. The cash value of a universal or whole life policy takes on the characteristics of a fixed account, with a guaranteed return. The failure to include the cash value in an individual’s overall asset allocation may result in misrepresenting the true risk and return characteristics of a client’s investment holdings.

For instance, let’s assume the appropriate allocation for a couple is 50 percent equity and 50 percent fixed income. Currently, they have $450,000 in a total stock index fund and $450,000 in a bond index fund. However, they also have a $100,000 cash value in a whole life policy, which is not included. When accounting for the cash value, the couple’s portfolio is actually 45 percent equity and 55 percent bonds. Based on their investment profile, they might be more appropriately allocated if they had $500,000 in the stock index fund and $400,000 in the bond index fund, with the $100,000 cash value bringing them in line with appropriate 50/50 allocation.

When viewed in this way, counting the cash value may allow an individual to have a greater stock exposure, raising the potential for higher long-term returns, while remaining within their parameters of an appropriate allocation.

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