In the 17 years I’ve been covering personal finance, no one ever suggested that I look at insurance as an asset class. So when Stephen Horan, the head of private wealth management at the CFA Institute, mentioned that I consider this financial vehicle an asset class, I took note. Here are the excerpts from our conversation.
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Let’s start with your definition of an asset and an asset class.
An asset is something you might pay for today and hope for some cash flow in the future. Insurance is like this. The cash flow is contingent on some event — it is clearly an asset. An asset class is a group of assets that have common characteristics. Investors traditionally view asset classes to include things like stock, bonds and real estate.
Like other asset classes, insurance provides the contract holder with cash flow under some specific circumstances. The timing and size of the cash flow are quite different from traditional asset classes, like stock and bonds. So, insurance deserves its own category and is more similar to options than stocks or bonds. Insurance is unique in a return and risk sense. Distribution of return is highly non-normal. Insurance doesn’t conform to traditional asset classes.
What asset class is insurance most like?
They are most like option contracts. Options are in their own asset class — derivatives — insurance can be viewed in a similar way. If you take a whole life policy for example it has a cash value. We can dissect the whole life policy into two components — the cash value is one – it may look like a bond. The second is the insurance part, the contingent claim that will pay off. That’s the derivative part.
Investors should never view insurance as a stand-alone product. In any and all cases it should be associated with some other asset class, whether it’s your house, or outliving your assets.
What is the advantage of recognizing insurance as an asset class?
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It allows investors to better understand financial products. For example, whole life insurance is actually two asset classes in one. The first asset class is the cash value, which typically behaves like a portfolio of cash with modest returns. The second asset class is insurance, specifically term insurance in this case.
Given this information, what can an investor do with it?
For one, they can more accurately measure their asset allocation. Suppose an investor has a whole life policy with a $100,000 cash value. And let’s say the investor also owns $200,000 of fixed-income mutual funds and $300,000 stock mutual funds. Most of us would conclude that their asset allocation is 40% bonds and 60% equity.
Understanding insurance as an asset class allows us to see that the investor really has $300,000 of fixed income exposure ($200,000 fixed income mutual funds and $100,000 cash value in the whole life policy). Their true asset allocation is 50-50.
Are there other benefits of thinking about insurance as an asset class?
Yes, understanding that a whole life policy is partly cash and partly insurance allows investors shop around for a better deal.
Suppose a whole life policy with $100,000 of insurance coverage and $50,000 of cash value would cost an investor $70,000 if purchased with a single premium today. Let’s say the investor could alternatively buy $100,000 of term insurance for the rest of their life for the equivalent of $15,000 today. He or she would be better off purchasing the term insurance and investing $50,000 in a bond fund (spending a total of only $65,000) than purchasing whole life insurance for $70,000. Both alternatives produce the same result, but one is less expensive.
But in reality, term and whole insurance are paid for with a series of premiums over time rather than a single up-front premium.
Yes, that is true, but the concept is the same. Whole life premiums are higher than term life premiums because they include a cash value. Investors will often accumulate more “cash value” on their own by purchasing term insurance and investing the extra money they would have been used to buy whole life in a bond fund.
Can investors apply the same logic to other insurance-like products, including variable annuities and equity linked insurance contracts?
Yes. By breaking these products down into their principle component parts, investors will get a better understanding of their true asset allocation and may find ways to achieve the same result at a better price by purchasing the parts separately.