I am not an insurance salesman.  Nonetheless, I have a keen appreciation for the unique role that life insurance can play in addressing the business planning and estate planning needs of the business owner.  In contrast, most of my clients have an almost visceral negative reaction to the idea of purchasing life insurance because business owners typically view life insurance as a poor investment of capital.  Generally speaking, I agree that life insurance is a poor investment for the insured, but it is often an excellent investment for the insured's company, estate, and heirs.  The value of life insurance must be assessed from the perspective of the company and the beneficiaries.

Is Life Insurance a Good "Investment"?

Typically, a business owner purchases life insurance for one or more of the following four purposes:

• "Key person" insurance, to compensate the business for the loss of its most important employee, the owner. 
  
  
• Income replacement, to provide the business owner's family with cash to offset the loss of earnings by reason of the owner's death.
  
  
• The creation of liquidity, to allow the owner's business or the business owner's estate to pay off debts or to satisfy estate taxes.
  
  
• Wealth transfer, to create additional capital for the owner's business or descendents.

The first two purposes typically are served by purchasing term life insurance, which provides coverage for only a specific period of time or term, because the need for that coverage will disappear at a reasonably definable point in time – the business owner's retirement.  Term insurance, of course, has no investment component because there is no payout if the business owner's death doesn't happen within the applicable term.  Term insurance is purely a hedge against the risk of an untimely death. 

However, barring a planned sale of the company during the business owner's lifetime, the third and fourth purposes are served by purchasing a "permanent" life insurance product – either a whole life policy or some form of universal life policy.  The business owner likely will always need life insurance coverage to produce liquidity and to transfer wealth to the next generation, so term insurance is inappropriate for these purposes.

Any permanent insurance product has an investment component and, therefore, should be evaluated on the same basis as any other investment:  by analyzing the expected rate of return and the amount of risk.  With an insurance policy, the anticipated return is known as the "internal rate of return" and can be calculated and illustrated easily by any competent insurance advisor.  The illustration will show the rate of return to the policy beneficiaries from the investment of the insurance premiums over the insured's lifetime which, based on different projections as to the insured's age at the date of death, will vary.  The investment value of the policy then can be compared to other alternative investments.

However, in comparing an insurance policy to alternative investments, a business owner needs to consider two unique properties of an insurance policy.  First, in the event of an untimely death, the insurance policy produces an unparalleled return on investment, and this hedge against mortality cannot be obtained with any other investment.  Second, life insurance proceeds typically are not taxable income, so the projected rate of return from the insurance policy is a tax-free rate of return.  Accordingly, in order to compare the internal rate of return against alternative investments, the internal rate of return must be adjusted upwards to account for the impact of income taxes on alternative investments. 

Assessing the Investment Performance of Existing Life Insurance Policies

While people periodically review the status and the appropriateness of their securities portfolio, they rarely examine the performance of their life insurance policies.  In part, this is probably a result of the fact that many people fail to recognize that every permanent life insurance policy has an investment component.  In addition, life insurance historically has been part of a "buy and hold" strategy for providing liquidity at the time of death, with many people viewing insurance as a stable, unchanging product.  In fact, however, the insurance marketplace and product offerings by insurance companies have undergone massive changes within the past two decades.

Another reason that many people do not revisit the performance of their life insurance policies is that many policies are held in an Irrevocable Life Insurance Trust, or "ILIT," in order to avoid estate tax on the insurance proceeds, and, therefore, the policies do not show up on the client's balance sheet.  In a sense, this is a case of "out of sight, out of mind."  Theoretically, the trustee of the ILIT should review the policy performance on a regular basis, but such a review rarely occurs.

If a business owner has held a life insurance policy for several years, an assessment of that policy's performance is of critical importance.  In this regard, the following issues should be considered:

• Is the policy performing as illustrated?  If the policy was purchased at a time when interest rates were high, it is likely that the initial illustration assumed a relatively high interest rate for the life of the policy.  In recent years, interest crediting rates or participating life dividends on many universal life and whole life policies have been lower.  Similarly, recent market downturns have affected the performance of "variable" policies.  Even a small variation from the initial policy illustration can cause a significant difference over time. 
  
  
• Is the policy sufficient for current needs?  The life insurance policy should be monitored to keep pace with changing personal and financial circumstances.  The insured's life expectancy, projected estate tax liability, and need for liquidity will change over time, and a different amount of death benefit may be needed.
  
  
• Is there a more competitive policy available?  Like any other business, life insurance carriers are continually using market innovations to offer more competitive products.  Improved life expectancies, lower mortality costs, better underwriting, and improved expense controls continue to cause changes in the pricing of life insurance.
  
  
• Do newer products offer better features?  Newer products can offer an array of features that may better meet your needs.  For example, many new products offer guarantees of coverage to specified ages.  New riders are also available, such as riders for return of premium, accelerated death benefits, and long-term care.
  
  
• Is the insurance carrier financially strong and stable?  In this market, the financial strength of the insurance carrier is perhaps the most important aspect of any policy which is to be held long-term, but the financial strength of an insurance company may change over time.  Thus, it is important to evaluate the continuing financial stability of the company that issued the policy.

Conclusion

The unique properties of life insurance (instant liquidity and a tax free payout) make it an invaluable tool for a business owner. However, like any other investment, it should be evaluated and readjusted regularly to ensure it meets the business owner's needs and expectations.

For further information regarding the issues described above, please contact Stuart B. Dorsett.

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This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.