UNCOMMON KNOWLEDGE

By Michael Bronstine

It is all about diversification

Modern Portfolio Theory has an amazingly simple premise when it comes to diversification: Look at your investable assets in their most basic asset class components of cash, equities, and fixed income – while being mindful of your risk tolerance. Then create a customized asset allocation that combines these components in such a way as to maximize growth and minimize risk. Modern Portfolio Theory is nothing more than Modern Diversification. Of course, there are some additional asset classes money managers may expand into: real estate, certain commodities (precious metals and petroleum, for example), and life insurance.

Life insurance? Certainly! Consider the two fundamental components of life insurance purchased for a lifetime: the underlying cash values (asset class = fixed income) support the death benefit, and the death benefit itself (asset class = cash). This is not to suggest life insurance as an investment. When acquired for the classic purposes of replacing an individual’s Human Life Value, or when used to provide liquidity to an estate, business, or charity, life insurance properly acquired can be an important part of an overall approach to asset accumulation over one’s lifetime. Life insurance is most typically allocated into the fixed-income category for its underlying cash value, which is in turn invested in high-grade bonds to support whole life policies. At the other extreme, life insurance can earn Index Credits if policy reserves are deployed, for example, into an S&P500® Index account. Regardless of asset class attribution, cash values should be viewed as a long-term asset. Life insurance is not a savings account (there is no immediate access to your cash values in the first few years), and yet the return on its long-term accumulation value is remarkably like the real returns of high-grade bonds when considering the tax advantage of tax-deferred accumulation on cash values. When the insured dies, the accumulations become part of the death benefit, for which there is no income tax – essentially, “forgiving” the tax-deferred accumulations during life.

It is also about risk tolerance Considerations of risk tolerance are the key to success when pursuing asset allocation’s approach to diversification. Risk tolerance is typically described by four distinct categories: Conservative, Balanced, Aggressive, and Very Aggressive. A “conservative” investor’s risk tolerance is so averse to the loss of principal that it results in less than 40% – sometimes only 20% – of invested assets being deployed in equities. The balance is in cash and fixed-income securities, such as taxable and non-taxed bonds. While this better assures preservation of value, it is often at the expense of returns, since there is a historic relationship between the amount of risk you are willing to take and the reward you may achieve for that risk. Also, when preservation of principal is the objective, purchasing power is often sacrificed and the real after-inflation value of the investment could be negative. At the other extreme are the “very aggressive” investors, who will ordinarily have their entire portfolio invested in equities. While there is a possibility that such risk tolerance, properly deployed, could overcome the “drag” of inflation, there is no guarantee of a return of anything – including principal. There are numerous subjective qualities that result in an investor’s style ranging the spectrum from conservative to extremely aggressive, and you should consult a qualified financial professional to help you determine your unique considerations around risk tolerance.

In real estate, it is about location. In asset growth, it is about management. The basic protection offered by participating whole life should be the cornerstone of a portfolio of policies – or at a minimum, term insurance with the intention of converting to whole life as resources permit. Simply put, the critical benefit that life insurance provides should not be subject to the uncertainty of market volatility. Regardless of risk tolerance and the resulting asset allocation, the individual components of a portfolio must be managed. That is true of mutual funds, bonds, real estate – even cash. And it is true of life insurance. Not only should life insurance be properly acquired–consistent with the policy owner’s unique issues of purpose, resources, time frame, taxes, and other considerations – but life insurance policies need to be managed. While especially true for all variations of universal life, all life insurance policies today depend on some element of uncertainty. Whole life policy premiums, cash value, and death benefits are fully guaranteed, but the uncertainty lies with the future return on the insurance company’s safely invested reserves for future liabilities – which manifest in annual dividends – which do not become guaranteed until paid. With universal life policies, virtually all variations incorporate cash value accumulations that depend on company-declared crediting rates, sub-account returns, or indexed returns – and all styles will portray current expenses and anticipated gains in their illustrated projections, but only the guarantees are… well, guaranteed!

At the end of the day, life insurance is a unique asset class for its ability to bring cash into the financial equation of a family, business, or charity at the time it is likely to be most needed – with the loss of income or resources that death usually brings.

• Life insurance buys time to sell businesses, land, and other hard-to-market assets on a favorable basis. • Life insurance preserves equity value without a forced sale.
• Life insurance helps pay expenses and costs that accompany the transition from couple to single; business owner to successor; key person to manager replacement, etc.

Life insurance as an asset class was a novel and even controversial idea 10 years ago. Today, it is an established truism that for those with lifetime needs for life insurance, the properly acquired policies can only be optimized when they are considered part of the overall financial structure of an individual, business, or charity – and managed along with a