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.)

While the Sharpe ratio illustrates that life insurance can in fact significantly reduce the risk profile of a portfolio, therefore increasing its risk-adjusted returns, how does this translate into opportunity? A simple Monte Carlo analysis shows that a family incorporating life insurance into its overall wealth management plan increases both the average and median expected returns while substantially reducing downside risk. Conversely, the life insurance allocation has a nominal impact on potential upside performance. The risk of having an estate residue of under $200 million is reduced by 7% while the median expected portfolio is increased by 5.4%, or $19.3 million. From an enterprise risk management strategy, putting life insurance into this couple's portfolio has reduced downside risk and increased expected returns for the estate beneficiaries.

While utilizing Monte Carlo simulation is a useful tool in quantifying the statistically likely outcomes of investment decisions, it does have significant limitations. The most important from a general investor context is what happens when statistically unlikely events occur, commonly referred to as "tail risk." An alternative analysis incorporating historical returns under extreme conditions (the "boot strap" method) helps put tail risk in a historical context. Past performance is, of course, no indication of future results and is not a guarantee of performance. However, from January 1929 through December 1938, the S&P 500 index had negative annualized returns six times. It would have taken an investor with $100 million at the beginning of January 1929 over 15 years to have his portfolio consistently exceed the original investment and over 20 years to have doubled his initial portfolio based on the historical returns. By contrast, a non-variable life insurance allocation could have immediately hedged the initial investment and could have been 133% greater than the unhedged portfolio at the maximum historical differential point. The portfolio with life insurance maintains a higher pretax balance to the estate beneficiaries through age 89 based on historical returns.

Tax Considerations
In analyzing the benefits of a life insurance hedge, we did not incorporate tax friction, asset management expenses or estate tax considerations into the analysis. This was purposely done so as not to skew the results by aggressive assumptions and not to bias the outcomes. However, life insurance enjoys tax preferences and is not taxed during the accumulation phase, and death benefit proceeds are received free of income tax and capital gains tax. Additionally, life insurance may be structured to be both free of estate taxes and generation-skipping transfer taxes. Coordinating with trust planning and premium gifting techniques can further increase the comparative advantage of a life insurance hedge on a liquid portfolio in terms of benefits to non-charitable estate beneficiaries.

Additional Benefits
Current investment research and recent experience indicate that asset class correlations increase during periods of heightened market volatility; this phenomenon limits the benefits of traditional asset allocation at precisely the moment in time when the benefits of proper asset allocation are desired most. At the same time, the cost of options and futures contracts increases in conjunction with increased volatility, thus increasing the cost of portfolio hedging when it is most desired. Life insurance remains uncorrelated to these market factors and holds a constant "cost" regardless of market volatility.

Further, some investors in uncertain times may overweight their investment allocations to lower-yielding securities, providing portfolio stability while potentially sacrificing long-term returns. Balancing growth objectives and capital preservation objectives presents complexity and conflict to families, advisors, and charitable foundations. Life insurance provides a guaranteed capital preservation floor at death for charitable and non-charitable estate beneficiaries, enabling advisors to maintain or increase allocations into public and non-public securities similar to endowment-style portfolios.

Beyond immediate principal guarantee, life insurance has other unique features including:

Attractive risk relative to returns over long time horizons with a diversified pool of insurance carriers;

Potential high-yield bond or equity-like returns beyond normal life expectancy with a decreased risk profile;

Non-correlation to most public and non-public securities; and

The quality of being complementary to other sophisticated estate planning techniques that take time to complete.

Conclusions
Considering life insurance in a context beyond traditional estate tax applications can provide a valuable investment risk-mitigation tool for high-net-worth individuals. Although other investment risk mitigation should not be eschewed in favor of life insurance, life insurance can provide a complementary component of the overall investment philosophy. Incorporating the unique attributes of each individual's investment portfolio, wealth management objectives and tax planning into a comprehensive model evaluating the potential benefits of utilizing life insurance can provide individuals and their advisors with relevant data points to make an informed decision.   

Kenneth J. Masters, CLU, ChFC, AEP is director of life insurance design and development at Pinnacle Financial Group, an independent advisory firm based in Southborough, Mass.