Mitigating Tax Hikes, Creating Alpha With Cash Value Life Insurance - Part 1

Andreas Stuermann September 21, 2021


Life insurance death benefit as a contingent asset class
Rice is not alone in his assessment of how life insurance plays a role in an investment portfolio. Focused on obtaining market-beating returns (“alpha”), the investment community’s analysis now goes beyond its traditional positioning of life insurance which tended 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 overtime. Around life expectancy, cash value life insurance generates after-tax IRRs between 4 per cent and 5.5 per cent which is an attractive number in-between returns expected from private equity and government bonds.  

A growing number of investment professionals recognize that the traditional method is incomplete and are taking additional steps for a complete asset class analysis as laid out by economists Harry Markowitz in 1952 and William F Sharpe in 1966. Markowitz’s Modern Portfolio Theory 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. (3)

The second step to complete an asset class analysis relies on the Sharpe Ratio to measure the performance of an investment, such as a real estate investment or security in a portfolio, compared with a risk-free asset, like cash, after adjusting for its risk. The Sharpe Ratio characterizes 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. (4)

The result when analyzing cash value life insurance is that the income tax-free death benefit has a very stable expected return and a low risk of not obtaining that return. This makes it ideal to hedge against riskier asset classes such as private equity and hedge funds which are also highly taxed and lead to a significant amount of capital erosion. In effect, the positioning of death benefit in a balanced portfolio also contributes to tax diversification.

“If you want to take the analysis one step further,” says Rice, “a highly-rated life insurance company is likely to have high-caliber managers for its portfolio. Being able to count on such a level of professional management can further mitigate risk and provide a sense of comfort for a policy-owner.”

Tax and other living benefits of cash value life insurance
Tax treatment of cash value life insurance goes beyond the well-recognized benefits of tax-free growth and access. During someone’s lifetime, a cash value life insurance policy can be a preferred source of liquidity on par with cash in a checking, saving or money market account. When structured as a non-modified endowment (“non-MEC”), through as little as two annual premium payments, a policy’s cash value can be accessed in the form of extremely low interest and tax-free loans which remain tax-free as long as the policy remains in force. (5)

The tax-free nature of policy loans means that the rate of return to the policyholder can be expected to be similar to after-tax returns of other assets bearing greater investment risk, providing tax diversification. Perhaps best of all, when there is a need for cash, instead of being at the mercy of banks and other lenders with predatory rates and conditions, policyholders can leverage their own life insurance asset to provide cash for personal and business needs. 

Bruce Hyde is a partner in the wealth management firm Round Table Wealth where he serves as the chief compliance officer and a wealth advisor. “Perhaps the greatest benefit cash value life insurance offers is certainty. At the death of the insured, beneficiaries can be assured of receiving cash - cash that can be used to replace lost income or to provide liquidity for estate planning.”  

Hyde explains to his clients that their money can go to one of three places when they die. “It can go to your family, to charity or to the government. Life insurance provides certainty that money going to taxes can be replaced to the family or charity.”

Depending in which state the policyholder resides, there are varying degrees of asset protection for cash value life insurance. (6,7).  These protections extend to both the cash value and the death benefit with the death benefit generally protected from claims of creditors. Life insurance proceeds pass by contract and not through probate where claims against an estate are adjudicated, ensuring that beneficiaries receive the death benefit in full and income tax-free.

Affluent individuals considering incorporating cash value life insurance into a wealth management strategy should decide on which benefits are most important before purchasing and structuring a policy. Along with the multitude of benefits offered, there are detractors that need to be considered. Weighing the pros and cons will help with the question of suitability.

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