Is Insurance an Asset Class?

Whole life insurance can provide several diversification benefits to wealthy Canadian investors. Particularly for investors with holding companies. By offering a mix of tax-efficient growth, risk management, and estate planning advantages. But, there are some significant drawbacks such as costs and transparency. So, is insurance an asset class? This post will explain.

Tax-Deferred Growth Within the Policy

Before we dive into whether insurance is an asset class, let’s understand why wealthy investors use life insurance.

Whole life insurance offers some unique features that other investments do not: the cash value of an insurance policy grows tax deferred. For investors with holding companies, this can be a valuable addition to an overall portfolio. So, by allocating a portion of capital to whole life insurance, wealthy investors can diversify into an asset that grows outside of traditional investment vehicles such as stocks or bonds, without the drag of annual taxation.

Now, stocks and other appreciating assets also grow on a tax deferred basis. So long as investors don’t realized the capital gains associated with that growth. What makes insurance a bit different is the growth from a whole life policy is often a much smoother ride.

Tax deferral benefits can be especially beneficial for holding companies that may already face passive income tax exposure on investment earnings. Because with whole life insurance, part of the policy’s growth in cash value is shielded from annual taxation until funds are withdrawn or accessed, providing a significant long-term compounding advantage.

Access to Capital While Maintaining Growth

Another benefit of whole life insurance as an asset class is liquidity. Whole life insurance policies often allow policyholders to borrow against the cash value or withdraw funds, providing liquidity when needed without having to sell off other assets and trigger capital gains. For holding companies, this offers a low-risk source of capital that can be used for other investments or estate planning, all while maintaining the tax deferred growth of the underlying policy’s value.

This flexibility adds another layer of risk management to a portfolio, allowing wealthy investors to avoid the liquidation of investments that may be hard to sell, have embedded capital gains, or are exposed to market volatility.

Estate Planning and Tax Benefits

Wealthy Canadian investors often face substantial tax liabilities at death, particularly related to capital gains and the value of private company shares held in their holding companies. Whole life insurance can be used as a tool for estate planning by providing a tax-free death benefit that can cover these liabilities, preserving the wealth and supporting liquidity for an estate.

By integrating whole life insurance into their overall portfolio, investors diversify not only across asset classes but also across their tax strategy. The death benefit from a whole life policy can be a tax-efficient way to transfer wealth and can prevent forced liquidation of other assets to meet tax obligations at death.

Stable, Diversified Returns

Whole life insurance policies typically offer stable, guaranteed returns, which can be an attractive complement to the volatility of other asset classes like equities, real estate, or private company investments. For holding companies looking to diversify their portfolio risk, the guaranteed returns of whole life insurance provide a low-risk component that balances out exposure to other non-correlated investments.

This makes whole life insurance particularly valuable in an overall asset allocation strategy, adding stability and reducing portfolio volatility.

Comparison to a Pension Plan

In many ways, the investment component of a whole life policy resembles the structure of a pension plan:

• Guaranteed Growth: Just as many defined benefit pension plans guarantee a certain payout based on a formula, the cash value in a whole life policy grows predictably, often based on actuarial assumptions. Pension plans often provide a predictable source of income in retirement, and similarly, the cash value in a whole life policy provides stable, long-term growth.
• Risk Mitigation: Both whole life policies and pension plans mitigate risk for the policyholder or pensioner. In a pension plan, the sponsoring company (or government) takes on the investment risk to deliver the promised benefits, just as the insurance company takes on the risk of ensuring the guaranteed growth in a whole life policy. This contrasts sharply with stocks, where the investor bears all market risks.
• Long-Term Focus: Both pension plans and whole life insurance are designed with a long-term perspective. Whole life insurance policies accumulate cash value over time, just like pension plans accumulate benefits over an employee’s working life. This long-term focus aligns with the goals of wealth preservation, income generation, and risk management, particularly for wealthy investors looking for stability across economic cycles.
• Tax Efficiency: Pension plans offer tax deferral on contributions and growth until retirement. And, so do RSPs and other registered plans. Whole life policies allow for tax-deferred growth on the cash value component. But, so do stocks when investors avoid selling. So, its important not to exaggerate the tax benefits of life insurance as other investments and account types can also provide similar advantages.

High Costs and Fees

One of the biggest drawbacks of whole life insurance is the high costs associated with them. There is no free lunch in finance (or life) and insurance is no different. For an insurance company to accept the risk of guarantees, and to provide a stable rate of return, they charge high fees. Some of these fees are explicitly listed and clear to investors. But others, are hidden within the returns that policies achieve.

Before considering using life insurance to diversify your investment portfolio, consider whether the diversification benefits and tax advantages can be achieved in other ways.

Low Liquidity and Early Surrender Penalties

Whole life insurance policies are designed to be held for the long term. If a policyholder needs access to the cash value in the early years, and they are unwilling to borrow against the cash value of their policy, there are typically surrender charges or penalties. These charges can significantly reduce the amount available for withdrawal or borrowing in the first several years of the policy.

• Early Surrender Penalties: If you surrender or cancel the policy early, the cash value may be reduced by surrender charges, and you may lose a significant portion of the value that’s built up in the policy.
• Limited Liquidity: While policyholders can borrow against the cash value, doing so reduces the death benefit and accrues interest on the loan. Access to the full cash value is typically limited for several years due to the front-loaded nature of the policy’s costs.

Slow Cash Value Accumulation

The cash value in a whole life policy typically builds slowly, particularly in the early years. This is because much of the premium goes toward covering the cost of insurance and various fees. As a result, the policyholder may not see significant growth in the cash value for several years, which can make it a less attractive investment option for those seeking higher returns or faster liquidity.

Complexity and Lack of Transparency

Whole life insurance policies are complex financial products. Their cost structure, policy features (e.g., dividend payments, loan provisions), and the way the cash value grows can be difficult to understand, especially when compared to more straightforward investments like stocks, bonds, or ETFs.

Opportunity Cost

By committing significant funds to whole life insurance premiums, policyholders may miss out on the opportunity to invest in higher-returning assets. For example, if an investor uses $50,000 per year to fund a whole life policy, that money cannot be invested in stocks, bonds, or real estate, which may offer higher returns over the long term.

Is Insurance an Asset Class?

Whole life insurance offers wealthy Canadian investors, particularly those with holding companies, diversification benefits through tax-efficient growth, liquidity, estate planning, and stable, guaranteed returns. The cash value grows tax-deferred, allowing long-term compounding without the drag of annual taxation, and policies provide liquidity through loans, preserving other investments from market volatility.

Whole life insurance also offers estate planning benefits, covering tax liabilities upon death with a tax-free death benefit. It provides predictable returns like a pension plan, offering guaranteed growth and risk mitigation. And, unlike stocks and bonds, whole life insurance returns are stable, and policyholders may receive dividends without market risks. Borrowing against the policy for income-producing investments can make the loan’s interest tax-deductible if CRA requirements are met.

However, there are some downsides including high fees, slow cash value accumulation, limited liquidity, early surrender penalties, and complexity. These factors can reduce its appeal compared to traditional investments.

Our Family Office

Before diving headfirst into any investment. Whether it’s insurance, stocks, or any other investment fund, our family office recommends using a clear Investment Policy that defines objectives and other important factors first. This way, clients can determine what they need before they go shopping (for investments). Working from a plan instead of “shooting from the hip” makes investors less susceptible to salespeople and more likely to choose investments they need compared to what others may recommend.

Our family office takes time to protect our clients from making rash decisions. We also don’t get paid commissions for offering investment advice. Instead, we help our clients organize and simplify their financial life. Our process ensures we’re on the same side of the table with our clients. Acting in their best interests alone. Whether insurance or any other investment is suitable depends on your individual goals and situation. These factors can be determined and codified before considering which investment is best.