More Lessons from Wall Street: A Duty to Diversify?

The recent near failure of AIG begs the question about the need for and adequacy of diversification in life insurance portfolios.  While diversification is a generally-accepted prudent practice in investment portfolios, diversification of life insurance portfolios among multiple insurers and/or multiple policy types is considerably less common.  So even though the number of life/health insurance company failures has been low in recent years (averaging less than 1% of the industry per year since 2000), and even though the life insurance industry is generally considered well-capitalized (see last week’s e-news issue Volume 08 Issue 24 - September 18, 2008 - Life Insurance Lessons to Take from this Week), recent events serve as a reminder that insurance companies can and do fail, and as such, that diversification should at least be considered in life insurance portfolios. 

Of course, the benefit of diversification is reduced risk of loss, but diversification comes with a cost.  In the context of an investment portfolio, diversifying across inversely-correlated asset classes produces more stable returns but at the “cost” of a lower overall return.  For instance, an investment portfolio with a very aggressive asset allocation comprised of only equities would have produced a return of almost 9% over the past 15 years, but with wide swings in the year-to-year return expected to range from a gain of almost 40% to a loss of more than 20%.  Alternatively, a more balanced investment portfolio with a moderate asset allocation comprised of 65% equities and 35% fixed-income holdings would have produced an 8% rate of return over the past 15 years and with less volatility in the year-to-year returns ranging from a gain of roughly 25% to a loss of a little more than 10%.  In other words, the benefit of diversification is an almost 50% reduction the risk of loss, but comes at a “cost” of 100 bps in lower returns.[i] 

Similarly, diversifying a life insurance portfolio among different insurers can reduce the risk of loss (e.g., loss of coverage or loss of access to policy values during a period of rehabilitation) and/or the risk of cost increases (e.g., see last week’s e-news issue Volume 08 Issue 24 - September 18, 2008 - Life Insurance Lessons to Take from this Week).  Diversification of life insurance policy holdings may also reduce the risk of loss of coverage/policy values through greater protection under a State Guarantee Association fund/program (e.g., in the same way that spreading deposits among several banks provides greater FDIC protection) depending upon the applicable State(s).  In fact, the Uniform Prudent Investor Act (UPIA) presumes diversification is inherently prudent, unless a concentration among fewer portfolio holdings can be demonstrated to be more prudent.  However, as with an investment portfolio, diversification of life insurance policy holdings comes at a cost. 

By definition, the lowest-cost life insurance portfolio is comprised of the single product from the single insurer offering best-available rates and terms (BART).  Diversifying among multiple insurers, therefore, increases the overall costs by inclusion of the 2^nd, 3^rd, 4^th, etc. best-available rates and terms, which by definition are more costly than the 1^st best-available rates and terms.  For instance, the costs in a life insurance portfolio insuring a 70 year-old male who qualifies for preferred-health rates and comprised of a single new policy holding issued by a single insurer offering best-available rates and terms would average about $25,000 per $1,000,000 of death benefit.  Alternatively, the costs of a life insurance portfolio diversified among 4 insurers offering the 1^st, 2^nd, 3^rd, and 4^th best-available rates and terms would average about $26,500 per $1,000,000 of death benefit, or roughly 6% more than a portfolio comprised of only 1^st best-available rates and terms. 

Of course, diversifying a life insurance portfolio without knowing which insurers offer the 1^st, 2^nd, 3^rd and 4^th best-available rates and terms could cost considerably more.  For instance, the costs of a life insurance portfolio diversified among 4 randomly chosen insurers offering the 2^nd, 9^th, 13^th and 15^th best-available rates and terms would average more than $28,000 per $1,000,000 of death benefit, or more than double the incremental cost of diversifying among the insurers offering the 1^st, 2^nd, 3^rd, and 4^th "BART" insurers.  As such, access to independent research that can identify/verify those insurers and products offering best-available rates and terms is essential to any conversation about diversification.  Click here to learn more about THEInsuranceAdvisor.COM research and how to use Confidential Policy Evaluator (CPE) Research Reports to investigate those products and providers offering best-available rates and terms