The Hidden Costs of Permanent Life Insurance

Rajiv Rebello

Rajiv Rebello

Author

August 29, 2017
The Hidden Costs of Permanent Life Insurance

Why policy owners end up paying tens of thousands more than they need to Are Life Insurance Agents Making Recommendations In Their Client’s Best Interests or Their Own?

For clients considering purchasing permanent life insurance, the options can be daunting. Life insurance policies address many different client desires. Understanding the many choices available—and the total cost associated with each option—is critical to making a selection that best matches the financial plan and individual risk profile of that particular client.

Questions clients will consider prior to investing in a permanent life insurance policy may include:

  • Is permanent life insurance a good fit for my financial profile?
  • Should i buy a permanent life insurance policy or am i better off buying term and investing the difference?
  • Which permanent life insurance policy is right for me?
  • How should i fund the policy?

Unfortunately for the client, the person who understands the most about life insurance is the same person trying to sell it to you. This creates an inherent conflict of interest.

A life insurance agent earns 80 to 100 percent of the first year premium that the policy owner pays into a policy. This means the agent is incentivized to sell as much life insurance as possible—and to encourage the policy owner to pay as much for it as possible. The policy owner, on the other hand, often has very different needs.

Actual Life Insurance Need Decreases with Time

Most people start thinking about purchasing life insurance in order to provide replacement income for their families in the case of death. Generally speaking, people have high life insurance needs when they are younger, but lower life insurance needs as they age.

A young family just starting out typically has high current and future liabilities. An example might be a family facing student loan debt, revolving credit debt and a mortgage payment, all while trying to save for their children’s college expenses and their own retirement. In most cases, the family has limited assets to pay for these liabilities in the case of an untimely death. Hence, they have a need for life insurance.

Agents can easily convince a family to purchase permanent life insurance to cover these needs with the promise of providing a solid investment for the future.

However, as time passes, the family’s financial position and needs change. Their children graduate from college to start their own lives and careers. The mortgage gets paid down along with other debts. Household income typically rises as the parents earn higher wages at their respective jobs.

Overall, the family has fewer financial obligations. The family soon comes to realize that they don’t really need as much life insurance as they did when they were younger. Often times they cancel their policy after just a few years of owning it. This is often done at a significant loss to the client.

Chart 1 - Age of Policyholder

Chart 1:

The chart above shows the modeled death benefit needs over time of a married 35 year old with two small children, a mortgage, and outstanding debt. While he has $1M in life insurance needs as of day one, by age 65 he doesn’t need life insurance as he has managed to self-insure his future liabilities by that time.

The agent will often recommend that the policy owner purchase as much life insurance as possible as of day one whether it matches the policy owner’s needs or not. However, nearly 50% of all permanent life insurance policies are canceled within the first 10 years often leading to significant financial losses for the policy owner.

The life insurance agent will recommend the client purchase an amount of insurance (yellow line) that is significantly higher than what the client actually needs (red line).

Most Life Insurance Investments End Up with Poor Returns

Approximately 50 percent of all policy owners who purchase permanent life insurance end up canceling the policy within 10 years.

Unfortunately, because life insurance carriers pay so much in commission to the life insurance agent in the first year of the policy, the life insurance company has to assess a heavy cancellation fee (known as a surrender charge) to the policy owner in order to recoup their expenses.

As a result, policy owners often spend a lot more in premiums on the policy than the cash they end up getting back when they cancel it. This results in a very significant financial loss, as evidenced by the red bar of losses in the table below

When a policy owner cancels a policy, the life insurance carrier gets the monetary benefit of having collected premiums on a policy without ever having to pay a death benefit in return.

It’s a great position for the life insurance carrier to be in. Unfortunately, it’s the policy owner who ends up paying the price for the carrier’s good fortune in these cases

Chart 2 - Policy Year

Chart 2:

This chart compares the total premiums paid for a $1M policy on a 35 year old from a top life insurance company that holds an AM best A- rating. The table above shows the total premiums paid through a given policy year (gray bar) with the corresponding end of year surrender value (blue bar).

The total loss (difference between paid premiums and surrender value) is shown by the red bar.

For the first five years, the policy owner pays almost $25k in premiums but only receives $1k back if he cancels the policy. Canceling the policy at this point would result in a $24k loss.
For the ten year period this amounts to a $49k premium outlay with only a $31k refund on cancellation of the policy resulting in an $18k loss.

As we’ve stated, nearly 50% of all permanent policies are canceled within 10 years. For reference purposes, a 10 year term policy for $1M would have only cost the policy owner $2k in total premiums.

By buying the permanent policy and canceling it after 10 years the policy owner ends up spending $16k more than if he/she were to just have purchased the 10 year term product instead of the permanent policy.

Proper Life Insurance Planning

Policy owners collectively lose hundreds of millions of dollars in assets due to poor financial planning and sales practices of life insurance agents that are often not in their best interests.

In order to ensure that policy owners don’t fall into the pitfalls described above, financial advisors need to help policy owners better understand their needs for liability protection, estate protection, and desired investment return and most importantly how these can change over time.

Important questions to ask during the search for the right insurance product for your client are:

  1. Does the client have a financial plan? How much life insurance does the client need for this financial plan and how do these needs change over time? Is the life insurance solution being considered a good fit for this changing need?
  2. Does the client have the necessary assets to pay the premiums on the policy for as long as the insured is alive? Have they considered premium financing in order to avoid liquidating assets to do so?
  3. Does the policy provide sufficient liquidity in case the client needs to pull money out of the policy? In other words, how steep are the surrender charges and for how long are they in effect for?
  4. What are the real returns for the investment portion of the life insurance asset? How does this compare to other life insurance products? How does this compare to other assets the client is invested in?
  5. What is the client’s risk profile and should they fund the policy to maximize the value of the asset or to minimize risk of paying too much in premiums if the insured lives longer than expected?
  6. How much commission is the agent earning on the transaction? Is there any other party with insurance expertise providing analysis and advice for the client?
  7. Who will be responsible for reviewing the policy on an ongoing basis and making recommendations to the client?

Life insurance is an important part of any financial plan. But just as it in can save clients from tens to hundreds of thousands in unforeseen losses, it can just as easily be the cause of those losses if not managed, reviewed, and invested in properly.

As an investment adviser/attorney/CPA you have the opportunity to build a mutually beneficial relationship with your clients based on trust and solid information.

For a flat fee, Colva will analyze the life insurance product under consideration (or already in force) to help avoid these pitfalls. At Colva we want to help your client work proactively with their life insurance sales team to find a product that best meets the needs of the client—and not the agent’s commission goals.

Rajiv Rebello

Rajiv Rebello

Author

Rajiv Rebello, FSA, CERA is the Principal and Chief Actuary of Colva Insurance Services. Colva helps family offices, RIAs, and high net worth individuals create better after-tax and risk-adjusted portfolio solutions through the use of life insurance vehicles and low-correlation alternative assets. He can be reached at [email protected].

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Hedge Fund Investments in PPLI: Benefits, Risks, and Due Diligence for PPLI Strategies

Hedge Fund Investments in PPLI: Benefits, Risks, and Due Diligence for PPLI Strategies

Hedge Fund Investments in PPLI: Benefits, Risks, and Due Diligence for Private Placement Life Insurance Strategies

Private placement life insurance (PPLI) has become an increasingly popular vehicle for high-net-worth individuals seeking to combine life insurance benefits with alternative investment strategies. Among the various investment options available within PPLI structures, hedge fund investments offer unique opportunities for portfolio diversification and enhanced returns. Understanding the benefits, risks, and due diligence requirements of hedge fund investments in private placement life insurance is essential for making informed decisions about this wealth management strategy.

## Understanding Hedge Fund Integration in PPLI Structures

Hedge fund investments within PPLI policies operate through carefully structured arrangements that maintain the insurance wrapper’s tax advantages while providing access to alternative investment strategies. These investments typically occur through dedicated funds or separately managed accounts designed specifically for insurance company separate accounts, ensuring compliance with regulatory requirements governing private placement life insurance.

The structure allows policyholders to access hedge fund strategies that might otherwise be unavailable or less tax-efficient in direct investment formats. Insurance companies work with established hedge fund managers to create insurance-dedicated versions of their strategies, often with modified fee structures and enhanced liquidity provisions tailored to the insurance environment.

PPLI hedge fund investments can encompass various strategies including long-short equity, event-driven approaches, relative value strategies, and macro trading. The insurance wrapper provides a tax-deferred growth environment where hedge fund returns can compound without immediate tax consequences, potentially enhancing long-term wealth accumulation compared to direct hedge fund investments.

## Tax Advantages and Wealth Preservation Benefits

The primary benefit of hedge fund investments within PPLI lies in the tax treatment of returns generated by these strategies. Traditional hedge fund investments typically generate significant taxable income through short-term capital gains, dividend income, and interest income, all of which are taxed at ordinary income rates. Within the PPLI structure, these returns accumulate tax-deferred, allowing for more efficient compound growth over time.

Estate planning benefits represent another significant advantage of hedge fund PPLI investments. The death benefit proceeds pass to beneficiaries income tax-free, effectively transferring hedge fund returns without the tax burden that would apply to direct hedge fund investments. This feature proves particularly valuable for families seeking to transfer wealth generated by alternative investment strategies to future generations.

The ability to access policy values through loans without triggering taxable events provides additional flexibility compared to direct hedge fund investments. Policyholders can access liquidity based on their hedge fund investment performance without the immediate tax consequences associated with hedge fund withdrawals or redemptions.

## Enhanced Diversification and Return Potential

Hedge fund strategies within PPLI offer portfolio diversification benefits that extend beyond traditional stock and bond investments. Market-neutral strategies, for example, can provide returns with low correlation to equity markets, helping to reduce overall portfolio volatility while maintaining growth potential.

Alternative risk premia strategies accessible through PPLI hedge fund investments can capture returns from various market inefficiencies and behavioral biases. These strategies often provide steady returns with different risk characteristics than traditional investments, contributing to more balanced portfolio performance across various market conditions.

The ability to combine multiple hedge fund strategies within a single PPLI policy creates opportunities for further diversification. Policyholders can allocate among different hedge fund managers and strategies, creating a fund-of-funds approach within the insurance wrapper while maintaining the tax benefits of the PPLI structure.

## Liquidity Considerations and Management

Hedge fund investments traditionally involve lock-up periods and limited redemption windows that can restrict investor access to capital. PPLI structures often negotiate enhanced liquidity provisions with hedge fund managers, including shorter lock-up periods, more frequent redemption opportunities, or side-pocket arrangements for illiquid investments.

Policy loan features provide additional liquidity options that bypass traditional hedge fund redemption restrictions. Policyholders can borrow against their policy values, including those supported by hedge fund investments, without triggering hedge fund redemptions or violating lock-up provisions.

The insurance company’s role in managing hedge fund redemptions within PPLI policies helps coordinate liquidity needs across multiple policyholders. This pooling effect can sometimes provide better redemption terms than individual investors might achieve in direct hedge fund investments.

## Risk Assessment and Management Strategies

Hedge fund investments within PPLI carry specific risks that require careful evaluation and ongoing monitoring. Manager risk represents a primary concern, as hedge fund strategies often depend heavily on the skill and discipline of individual portfolio managers. Due diligence must focus on manager track records, investment processes, and risk management capabilities.

Operational risk assessment becomes critical when evaluating hedge fund managers for PPLI investments. The insurance wrapper adds additional operational complexity, requiring hedge fund managers to maintain proper reporting, compliance, and administrative capabilities to support insurance company requirements.

Concentration risk can emerge when PPLI policies become heavily weighted toward hedge fund investments or specific hedge fund strategies. Diversification across multiple managers, strategies, and asset classes helps mitigate this risk while maintaining the benefits of alternative investment exposure.

## Due Diligence Framework for Hedge Fund Selection

Effective due diligence for hedge fund investments in PPLI requires analysis of both investment merits and insurance-specific considerations. Investment due diligence should evaluate the hedge fund manager’s investment philosophy, process consistency, and historical performance across different market cycles.

Operational due diligence must assess the hedge fund manager’s ability to operate within the insurance environment, including reporting capabilities, compliance infrastructure, and experience with insurance company separate accounts. The manager’s willingness to modify fee structures or provide enhanced liquidity for insurance applications represents important considerations.

Third-party due diligence resources, including hedge fund research platforms and specialized consultants, can provide valuable insights into manager capabilities and operational strengths. Insurance companies often maintain preferred manager lists based on their own due diligence processes, providing additional filtering for PPLI hedge fund investments.

## Fee Structure Analysis and Cost Management

Hedge fund investments within PPLI typically involve multiple fee layers that require careful analysis to understand total investment costs. Management fees and performance fees charged by hedge fund managers represent the primary investment costs, often following traditional “2 and 20” structures or variations thereof.

Insurance company charges add additional costs to hedge fund PPLI investments, including mortality and expense charges, administrative fees, and surrender charges. Understanding the interaction between hedge fund fees and insurance charges helps evaluate the total cost of accessing hedge fund strategies through PPLI.

Fee negotiations for hedge fund investments in PPLI sometimes result in reduced costs compared to direct hedge fund investments. The pooled nature of insurance company separate accounts and long-term investment horizons can provide leverage for better fee arrangements with hedge fund managers.

## Performance Monitoring and Reporting

Hedge fund investments within PPLI require specialized monitoring and reporting capabilities to track performance and ensure alignment with investment objectives. Monthly performance reporting should include both gross and net returns, attribution analysis, and risk metrics specific to the hedge fund strategy employed.

Benchmark comparisons become important for evaluating hedge fund performance within PPLI, though appropriate benchmarks vary by strategy type. Hedge fund indices, peer group comparisons, and risk-adjusted performance measures help assess whether hedge fund investments are delivering expected value within the insurance wrapper.

Regular portfolio reviews should evaluate the ongoing suitability of hedge fund investments within the broader PPLI policy structure. Changes in market conditions, investment objectives, or hedge fund manager capabilities may necessitate adjustments to hedge fund allocations or manager selections.

## Regulatory Compliance and Reporting Requirements

Hedge fund investments within PPLI must comply with various regulatory requirements governing both insurance products and alternative investments. Investor control restrictions ensure that policyholders maintain appropriate distance from investment decisions to preserve favorable tax treatment under private placement life insurance regulations.

Anti-money laundering and know-your-customer requirements apply to hedge fund investments within PPLI, requiring proper documentation and ongoing monitoring of beneficial ownership and source of funds. These requirements may be more stringent than direct hedge fund investments due to the insurance wrapper.

Tax reporting for hedge fund investments within PPLI occurs at the insurance company level, simplifying tax compliance for policyholders while maintaining transparency regarding underlying investment performance and tax characteristics.

## Integration with Overall Wealth Management Strategy

Hedge fund investments within PPLI should align with broader wealth management and estate planning objectives rather than serving as isolated investment decisions. The insurance death benefit, tax deferral features, and liquidity options must work together to support overall financial goals.

Coordination with other investment accounts helps optimize asset location and tax efficiency across the entire investment portfolio. Hedge fund strategies within PPLI may complement traditional investments held in taxable accounts or retirement plans, providing diversification benefits while maximizing tax efficiency.

Regular strategy reviews ensure that hedge fund investments within PPLI continue to serve their intended purpose as circumstances change. Market conditions, tax law modifications, or personal financial situations may affect the optimal allocation to hedge fund strategies within the insurance wrapper.

## Future Considerations and Market Developments

The hedge fund industry continues to develop new strategies and approaches that may become available within PPLI structures. Emerging areas such as digital assets, ESG-focused strategies, and quantitative approaches may offer additional opportunities for PPLI hedge fund investments.

Regulatory developments affecting either hedge funds or private placement life insurance may impact the attractiveness or structure of these investments. Staying informed about regulatory changes helps ensure continued compliance and optimal strategy implementation.

Technology improvements in hedge fund operations and insurance administration may enhance the efficiency and cost-effectiveness of hedge fund investments within PPLI. These developments could expand access to hedge fund strategies or improve the overall economics of combining hedge funds with insurance wrappers.

Hedge fund investments within private placement life insurance represent a powerful tool for wealth accumulation and estate planning when properly implemented and managed. The combination of tax advantages, diversification benefits, and professional management creates opportunities for enhanced long-term wealth creation. However, success requires careful due diligence, ongoing monitoring, and integration with broader wealth management strategies. By understanding the benefits, risks, and requirements of hedge fund PPLI investments, high-net-worth individuals can make informed decisions about incorporating these strategies into their overall financial plans.

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