A famous quote of Warren Buffet's is, "Only when the tide goes out do you discover who's been swimming naked."
With the stock market and real estate market meltdown, there has been some opportunity to see who might have been without cover. One area that may have taken many people by surprise is the impact on variable life insurance, which brings to mind the issue of leverage.
We know leverage is when you get an enhanced return, usually by using borrowed money to help buy investments. However, there are many ways to produce leverage. The key here is that the
result of leverage is that in an up market, you get more than your normal investment would have produced, and in a down market, your losses are larger than they would have been.
So now let's look at variable life. As we know, the cost of insurance in a variable life policy is dependent upon the amount at risk. If the fund value is high, the amount at risk is low. In a healthy stock market, fund values increase, causing less and less money to go toward the cost of insurance. This allows more and more money to go to fund values which then grow and allow you to have lower and lower costs of insurance.
But now consider where we've been in the stock market. The same leverage that enhanced the performance of variable life in the strong market years can have a devastating impact on policies in down markets. As the fund values decline, the amount at risk in the policy increases, which causes the cost of insurance to go up.
As you pull more money out to pay for the cost of insurance, you pull those funds out of declining and already severely compromised fund values. It is an ever-accelerating cycle: Fund values go down, cost of insurance goes up, withdrawals to cover cost of insurance increase which causes fund values to go down even more.
Of course there is a cure for it: Pay more premiums or transfer more money into the policy. Unfortunately, tough times are not usually the ideal time to increase premiums. The same economic problems that cause the stock market to fall can increase the possibility of losing a job or freeze up liquidity, making it even more difficult to find funds to replenish the insurance.
My point is, did you think of variable life insurance as being insurance which is leveraged? I'm not sure that I did. So when I decide what type of insurance is the best suggestion for someone, what factors would lead me to recommend variable life?
My first thought is who has the risk capacity to do leveraged investments? I am not talking about risk tolerance. Risk tolerance is important too, but here I am addressing whether the individual or trust has the financial backing to use a leveraged solution. Is there plenty of extra money backing this insurance? Is there the legal ability to increase funding (which may be relevant in a trust or qualified plan situation)?
Another consideration is to look at how the insured's cash flow is impacted by adverse economic conditions. Some careers do very well under adverse economic conditions, while many don't.
We use insurance to protect families and businesses against devastating consequences when bad things happen. Our focus is usually on the risk of death and who bears that impact. But our protection doesn't work very well if the cover we provide leaves us naked when the financial tide goes out.
Micki Hoesly, CLU, ChFC, entered the financial services business 32 years ago. In 1983, she began her own company, Capital Resources, specializing in pensions. Ms. Hoesly is also the owner of Resource 1, Inc. a Registered Investment Advisory firm. She is a 30-year Qualifying and Life member of the Million Dollar Round Table and is Chairman of the Top of the Table. She is an internationally recognized speaker on retirement planning, financial planning, insurance and investments.
