Traditionally, life insurance planning discussions with high-net-worth individuals focus on estate tax mitigation, estate liquidity and estate equalization. What about high-net-worth individuals and families who have sufficient liquidity to pay the estate taxes? Can life insurance serve as an invaluable tool in their wealth management strategy? In our opinion, the answer is a resounding "yes"-it can be used as a unique portfolio hedging technique.

The benefit of this hedge can be quantified and measured like any other financial asset, and a reasoned decision can be made about whether to incorporate life insurance as a component of an overall wealth management strategy or just as an investment portfolio risk mitigation strategy. When the family's wealth is considered a business enterprise, life insurance becomes part of the family's enterprise risk management strategy.

In addition to its traditional estate planning uses, life insurance has additional benefits as a portfolio hedge:

It can reduce or hedge investment tail risk by paying guaranteed death benefits.

It can ensure the funding of charitable bequests.

It can protect family foundations from poor investment performance, thus maintaining the family's planned charitable giving.

It can replenish wealth for later generations as an exponentially larger number of family members draw down from a single source of family funds.

Life insurance offers a unique hedging opportunity since the fundamental question with an insurance policy is "when" will the death benefit proceeds be realized. This is empirically different from a traditional investment hedge technique like an S&P 500 LEAP (Long-term Equity Anticipation Securities) contract in which the question is instead "if" the contract will be "in the money" and hence exercised. With traditional hedging techniques, an expiring "out-of-the money" option is a true expense with no residual benefit and must be renewed at an unknown future cost at available contract durations. Conversely, a guaranteed non-variable life insurance policy remains uncorrelated to the market and can either offset investment portfolio losses or can be additive of favorable portfolio investment experience. The "cost" of a life insurance hedge is typically less than 50 to 100 basis points annually of the total portfolio and can be funded directly with the reallocation of current estate income or financed through traditional banks like other collateral supported assets.

Quantifying The Benefits
The impact of life insurance as a portfolio risk mitigation tool can be quantified by applying commonly used financial metrics. The first such metric is the Sharpe ratio, which is used to compare investment options with different risk profiles. The Sharpe ratio seeks to quantify for comparative purposes the incremental return differential above an assumed risk-free rate given the incremental increase (or decrease) in risk as measured by portfolio standard deviation. Using a healthy 65-year-old couple with a $100 million diversified investment portfolio, we have estimated the portfolio weighted average return to be 6.95% and the standard deviation to be 11.43% based on historical performance. (We have used a portfolio comprised of 75% equity and 25% bonds and Bernstein's 50-year Wealth Forecasting Model as of December 31, 2006.)

Using an assumed risk-free rate of 3.00%, this translates into a Sharpe ratio of 0.35. By incorporating a $50 million guaranteed non-variable survivorship life insurance policy with an annual premium of $516,000 per year, a family can increase its overall portfolio Sharpe ratio to 0.46 primarily by decreasing the standard deviation by about 2.00%. This is a risk-adjusted return increase of 31%. Assuming a standard normal distribution, i.e., a typical bell curve, the expected range of returns between -4.48% and 18.38% is 67% of the time. By decreasing the portfolio standard deviation, we would expect that 67% of the time the portfolio returns would be between -2.48% and 16.38%, inclusive of a life insurance death benefit payment. (The insurance policy average return was calculated using the expected internal rate of return at life expectancy based on the 2008 VBT table. Standard deviation was calculated using the mortality weighted rates of return as compared to the expected IRR at joint life expectancy.)