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Author: Dwdonhoff Big gold star, 5000 posts Top Favorite Fools Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 17921  
Subject: Re: Hybrid Life Insurance Date: 2/1/2014 8:35 PM
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Hi Metalsource,

Has anyone looked into some of these Hybrid insurance policies that offer upside potential and downside protection with tax free payouts in the later years of your life.
It sounds like you are referring to the products known as Indexed Universal Life (IUL.) It's a principal guaranteed account (insured against any annual market losses, with gains captured and re-gauranteed annually,) with a linked annually-renewable term life policy (which gives it the tax-free distribution IRS treatment.)

Many also include riders for long term care and such as well.
Generally speaking, any additional death benefit or any other feature riders added to the bare-bones renewable life chassis will add internal costs, resulting in less favorable asset growth.

There may be exceptions, but generally speaking you are usually better off separately shopping out specific 'pure insurance' benefits you may want... and/or comparing the costs of such pure insurance against the reduction of performance if you have them 'baked in' with an IUL.

Could this be part of a diversified portfolio.
IULs are good for the funds you don't want to (or can't afford to) lose to market drawdowns during surprise needs for liquidity. You can access 90% of your principal and growth at any time without tax consequence or reduction of tax protective capacity. When designed for financial performance (as opposed to a product focus on death benefit itself,) the best of them outperform virtually any alternative of equal safety.

Some people argue that you can't afford to avoid risking losses, because somehow the aggregate of all risk-gained wins among all investors are more than the aggregate of all risk-caused losses among all investors, but this is tantamount to an argument in favor of gambling, and flies in the face of basic economics. In addition to the drag on the zero sum nature of unhedged security holdings, minus trade spreads and fees, the problem of surprise liquidity demands when the unhedged markets are in a drawdown force the locking-in of losses that dramatically reduce net unhedged returns over time.

When it's understood that (prior to reaching the threshold point where principal can be afforded to be lost) all loss expectations must be offset with reserves, the overall returns of unhedged investments drop by the loss of returns on the safe reserves themselves.

The CAGR of the S&P500 including dividends is 10.40%

The maximum drawdown in the S&P500 that is reasonably likely to occur during an average investor accumulation lifetime of 40-50 years, is around 45%-55%;
1. http://practicalquant.blogspot.com/2010/02/quantifying-losse...
2. http://michaelcovel.com/pdfs/sp_stats%201.pdf

The IUL (if hedged to the S&P 500 options) captures a portion of the annual S&P upside, with zero annual S&P downside, and an annual reset so that the IUL never has to wait for recovery of prior drawdown losses before accumulating new net gains. This strategy is easily built on a DIY basis, but the costs to do it outside of the insurance company portfolios virtually guarantees there are no competitive alternatives.

In order to compare an account that is principal guaranteed with 90% liquidity, to an account with 100% drawdown exposure and 100% liquidity, the formula would go like this;

Unhedged historical CAGR * inverse of realistic lifetime worst-case drawdown
(for the S&P500, 10.40*.45 = 4.68% approximately... minus any tax exposure annually, and/or at distribution,)
Net IUL Internal Rate of Return (CAGR - all costs) over realistic investor lifetime periods (mid 7%s, accumulating & distributing tax free.)

There are some passionate arguments pro and con... and a few keywords or concepts to look out for to alert to an ignorant or bogus position;

1. 'Dividends' = Some anti-IUL people try to argue that IULs (and any principa-guaranteed indexed strategies) forfeit the index dividends from their returns. This is an instant argument discreditor, as dividends and bond interest rates are the calculated cause of the option price changes that determine the annual upper limits to the index gains in the hedged strategies. When dividends rise, the limits of the maximum gains rise, and vice versa.

2. Costs and expenses = Another instant discreditor, as building a hedged position to capture the same amount of S&P index upside, with an annual cap of zero or less to the downside, would cost roughly 4% per year for the duration of a typical investor's account lifetime (40 years,) while the IUL products cost an annual average well under 1% over the same timeframe.

3. Commissions as a distorting incentive = Aside from the fact that commissions are already included in the #2 consideration, above, the reality is that financial institutions (and their salespeople) earn far more in commissions from managed/rebalanced/diversified accounts over an investor's typical account lifespan than are paid out on IULs. On a risk-equaled comparison, it is much more lucrative to the securities industry to sell unhedged positions than it is to the insurance industry to sell principal-guaranteed hedged positions. The commission-bias argument actually leans heavily against the full-risk argument.

With a typical account life expectancy of 40 years, comparatively safe securities positions (with sufficient reserves for drawdowns) will cost commissions paid out somewhere in the range of 75 bips to 150 bips annually, where the IUL commissions paid out over the same period will be closer to a range of 15-35 bips.

1. Somebody has to be insurable. These accounts aren't available (at these levels of performance) without a shell of annually renewable life included around them. The actual rating of the insured is not so relevant, as a lower rating (higher cost per dollar of death benefit) simply results in less death benefit being required by the IRS code to capture the tax-free distribution benefits... and vice versa. The total gross expense determined by the IRS code to tax-shelter a given amount of money is roughly the same regardless of the insured. In other words, if 2 people wanted to put $100,000 into an IUL... one being a super-healthy 25 year old, the other a 75 year old chain smoker... the IRS-calculation determines minimum death benefit by the costs of the benefits, so the 25 year old would have cheaper coverage yet be required to buy more of it, and the 75 year old would have more expensive coverage and be required to buy less of it... so their comparative outlays (internal to the account performance itself) would be roughly the same.

2. The best performance requires detailed design knowledge up front. The internal costs for the duration of the account are determined by the 'dialing in' of the account's effective design at issue, so taking an uncustomized or poorly customized account could result in lower performance over time than otherwise.

3. The maximum contributions (both up front, and over time) are determined at the time of initial design, and if additional unexpected funds are later desired to be included, another health exam would be required to expand the minimum life coverage required for the tax-free benefits.

Hope that's helpful.

Dave Donhoff
Leverage Planner
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