Life Insurance Solutions: Risk Reducing Strategies in the Aftermath of the 2008-2009 ‘Crisis’.

Changing perception of risk

Peter L Bernstein, in his excellent book Against the Gods: The Remarkable Story of Risk tells the story of a famous professor of statistics at a Moscow university who, during the air-raids of WWII declined to use the air-raid shelters on the grounds that “there are seven million people in Moscow and the odds of being hit by a bomb are remote”. One night a friend of the professor was in the air-raid shelter as usual and with great surprise saw his friend walk in. He asked the professor what had caused him to reconsider and received the following reply: “There are indeed seven million people in Moscow, but only one elephant. Last night, they got the elephant!”

In one stroke, the professor’s view on risk had changed. Though it was no more statistically probable that he would be next in line to the elephant, his view on the probability of him suffering harm had changed and he now felt that it was a better risk management strategy to seek shelter than to rely on the probabilities of not being hit by a bomb.

In 2008, to coin a metaphor, they got the elephant. The MSCI index dropped close to 60 per cent as the world’s financial markets teetered on the brink of collapse, fortunes were wiped out and some of our most venerable financial institutions stared into the abyss, recognising the real possibility that this year may be the year where not only bonuses were uncertain, but the survival of the entire financial system was at risk.

A whole generation of investors had been brought up on the premise that stock market returns always outperform ‘safer’ alternatives and that when corrections do occur, they are brief and a recovery is sure to follow immediately. This has proven correct time after time and in the past 20 years, the MSCI has recorded negative returns in only five years[1]. However, somehow the ‘collapse’ of 2008 seemed so much greater and caused much more damage than almost any market correction since the Great Depression.

Diversifying market risk

This article is the story of the individual investor. At the institutional level things were not better, only the extent to which the risks were either mispriced or undercapitalised differed and so the effect seemed so much greater. For the individual investor, his advisers, fiduciaries and investment managers, these were grim times and during the course of 2009 and 2010 we have seen a steady flow of professors heading for the air-raid shelters of cash and other ‘safe’ assets.

This paper suggests that the use of specialised insurance solutions combined with a portfolio consisting of equities (MSCI[2] is used as a proxy for a broadly diversified portfolio of stocks) has the ability to lower the standard deviation of a portfolio at a very reasonable cost and to also ensure that a portfolio is protected against depletion from market declines should the estate pass during a time of crisis.

As professional estate planners, we are more concerned with preserving assets than enhancing returns through investments. Advising UHNW clients is often different as they may be focused on their businesses and their investment portfolio can be seen as a diversification away from their main assets (and hence, risks). When advising a client on asset allocation it is worth bearing in mind that their cumulative annual returns (CAR) from their businesses are very often greater than that represented by any reasonably well-structured investment portfolio. A family business with a five-year CAR of 20 per cent is not an unusual creature – Asia-based family businesses regularly see growth in excess of 20 per cent on a year on year basis and in order to put together an investment portfolio to compete with this, great risks are often necessary. Hence, our advice to our clients is to consider a significant portion of investable assets as a diversification away from business-cycle risks and to apply a more conservative asset allocation than is often found in the traditional investment markets.

UHNW Investors discover new ways of transferring risk

Although our practice has grown significantly in the past five to six years, we saw a dramatic increase in approaches from UHNW clients and their advisers in the second half of 2009; at a point when the investment markets had already turned positive and it was suggested that the bear market had ended.

As estate planners we deal with innumerable complexities in the cases upon which we advise, ranging from estate equalisation to business succession solutions for large, wealthy families and we wanted to understand how the increase in ‘diversification conversations’ had come about – particularly in the wealth structuring context.

It would seem that as markets tumble conservative asset protection solutions trade at a premium and during bull markets asset protection is a less active topic. However, during the latter half of 2009 and into the beginning of 2010, the conversations we had on advising on asset protection and diversification increased noticeably and we felt it would be useful if we tried understanding the dynamics between the investment-only model and the investment and protection combination we had so successfully put in place for UHNW clients for the past 40 years.

An exercise we did together with one of our insurers compared the average annual standard deviation of a portfolio consisting of 100 per cent equities (using MSCI World Index as a proxy) and a portfolio consisting of 70 per cent equities (again, MSCI WI) and 30 per cent in a guaranteed ‘Universal Life’ insurance policy with a face amount of US$10MM.

The results were exceedingly positive and indicated several forces at work that resulted in significantly reduced portfolio volatility at a very marginal reduction in average annual returns.

Figure 1, attached, shows the annual returns of a portfolio consisting of 100 per cent invested in a well-diversified equity portfolio compared to the 70/30 portfolio we wanted to examine. In the past 20 years the equity-only portfolio would naturally expect 100 per cent of the volatility and returns of the index chosen. The 70/30 portfolio returned a much improved volatility picture with a reduction in average annual standard deviation of more than 25 per cent. A more interesting observation was that the average annual return fell by only 17bps, or less than five per cent.

Figure 1

The reduction in the volatility is to be expected as the investment component of the Universal Life policy is largely made up of high-grade corporate bonds, and a portfolio made up of 70 per cent equities and 30 per cent fixed income should produce this result. What is perhaps more surprising is that the reduction in volatility comes at a very low cost; the average annual returns showed a moderate decline as mentioned above.

An even more interesting result can be seen in Figure 2 where we have reverted to estate planning mode and considered how the hypothetical client’s portfolio would have looked if he had passed away in any of the 20 years examined.

What we find is that due to the insurance element added the client’s portfolio has outperformed the equity-only portfolio in all of the past 20 years and in none of those years did the net value of the portfolio drop below US$10MM (the initial amount invested in this hypothetical example). The result is not probability-dependent – irrespective of what the investment return had been over the 20 years, the insured amount of US$10MM would be paid to the beneficiaries (trusts, PICs, etc) along with the value of the investment portfolio (whether positive or negative).

Figure 2

It would seem then, that the increased approaches we have seen during the past 18 months is driven by a change in perception of risk – a corollary to the opening story. Clients who regularly would accept relatively wide swings in performance of their invested assets appear to have turned less positive to risk but, unwilling to turn away from it entirely, are examining portfolio make-ups that can address concerns both for the value of investments as well as an Estate in general.

It is important to note in this context that the insurance solution chosen was picked as it provides no-lapse guarantees on the insured amount, that is to say the insurance benefit could not lapse even if the invested premium failed to grow at the rates projected by the insurer. A traditional Universal Life policy has no investor control and so it can be structured to meet any number of jurisdictional requirements in this respect (compliance with the US IRC sec. 7702 in particular) both with regards to invested assets as well as cash value accumulation.

Traditional estate planning using ‘new’ tools

After a number of conversations with our clients we have concluded that the traditional ‘art’ of estate planning has not been forgotten – today more than ever clients are in need of professional, unbiased advice when it comes to structure their estates in a manner that offers a meaningful improvement in both investment- as well tax and legal risk. More often than not, our clients are looking for holistic advice that ranges across disciplines and that accepts that the clients often take significant risks in their businesses and that the advice they seek from professional estate planning firms has to address the security of the external investments as well as the Estate overall.

For a fiduciary with investment responsibility, the above example may be worthy of further study – combining investments with the safety of a well-structured life policy can go a long way towards mitigating the results of a down market cycle on an estate, which should be of interest to the beneficiaries served.

[1] 1992, 2000, 2001, 2002, 2008

[2] http://www.bloomberg.com/apps/cbuilder?ticker1=MXWO%3AIND

Odd Haavik
Odd Haavik is the Chief Executive Officer, Asia & Europe for Willis Global Wealth Solutions (GWS), a division of the Willis Group. A global risk management consultancy, GWS serves individual HNWI, their families and businesses from offices in Singapore, Hong Kong, Zurich and Miami. He can be contacted at odd.haavik@willis.com. Willis Global Wealth Solutions home page is www.willis.com/gws