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.