Imagine this situation. You invest $100,000 in a rental home with a friend to be used as a passive income generator. Ten years later, the principal mortgage is paid off and the investment is worth $150,000.
Now, let’s say you were looking to free up some cash for another purchase. You’re considering selling, but want to be as tax efficient as possible. Your options are to:
- Sell your share of the house
- Never sell
- Refinance the investment, borrowing against the real estate as collateral
Option A will get you cash quickly, but will leave you with a high capital gains tax bill upfront. Option B is tax efficient (as the house can be passed down to your estate tax-free) but it doesn’t solve your need for cash today.
In this scenario, option C is the way to go. Because borrowing is not a taxable event, it allows you to get cash now without paying any taxes on your investment.
This is a common strategy used by real estate investors, but what many people don’t realize is it’s also applicable to other alternative assets—particularly life insurance.
Life Insurance As An Alternative Investment
Life insurance has long been a staple of high-net-worth portfolios, according to Marc Schechter, Senior Managing Director of Schechter Wealth.
“If you are at the big wirehouses—the Merrill Lynch’s, UBS Group’s (NYSE: UBS), JP Morgan Chase & Co.'s (NYSE: JPM)—if you have assets there, it’s likely that you have approximately a 10% allocation to alternatives.”
But it’s not an asset class that gets a lot of attention. Schechter noted that less than 1% of assets invested with independent advisors are in life insurance. Part of that is because it’s a misunderstood asset.
“I think that life insurance gets a bad rap, and some of it rightfully so, but in the same way that there’s horrible real estate to own and there’s great real estate to own,” he said. “You can’t lump an asset class, a profession, anything, into one description. The life insurance products we use are so complicated that we can design them to be horrible and we can design them to be great. It all depends who the architect is.”
Schechter Wealth, a boutique financial advisory firm specializing in high-net-worth clients, focuses on life insurance because of its ability to provide diversification and achieve tax-efficient returns, such as in the example above.
“You can do the same thing with life insurance, banks will lend against that,” said Schechter, referring to borrowing against a life insurance policy. “When they lend to you, it’s like refinancing with no tax.”
Conventional And Unconventional Uses
There are two elements to every life insurance policy: the death benefit and the cash value component.
Most of the world uses life insurance for income replacement (death benefit) or estate planning purposes, for example, to pay an estate tax if they have an illiquid net worth (cash value).
But there are other unconventional uses that are not commonly used and which Schechter says can provide huge benefits.
One of the ways Schechter said they use life insurance differently is by wrapping a hedge fund inside of a policy—known as Private Placement Life Insurance. They’ve also arbitraged insurance policies against each other, profiting from the difference.
“A lot of people might say ‘I can structure a life insurance policy for investment purposes’ but they don’t lower the death benefit, so the mortality charges stay high and the policy doesn’t perform well,” he said. “When we design policies for life insurance, we buy the lowest amount of life insurance that the IRS allows us to, and it lowers mortality charges in the contract and it increases the cash yield during your lifetime.”
According to Schechter, the reason life insurance is so underutilized as an alternative asset by most independent advisors is “simply because independent advisors don't have the knowledge, understanding, and access to them.”
In an effort to change that, Schechter Wealth recently partnered with CAIS, the fintech platform that connects advisors with alternative investments such as structured notes, to launch CAIS Insurance Solutions. The partnership will involve Schechter Wealth providing education and resources to RIAs on the CAIS platform so that they can feel comfortable adding them to their client portfolios.
“CAIS saw our unique positioning in the life insurance space, and wanted to bring our capabilities to RIAs,” said Schechter. “Ask 99% of professionals in the life insurance space about private placement, and they’re not going to know about it. That all plays into why there’s been a lot of bad policies designed. But if you work with great people, they do things differently.”