On Topic

Managing Risk

Insurance is part of risk management

Risk management includes investments that explicitly reduce risk. Virtually all forms of insurance do this at the cost of premiums one pays for shifting risks to the insurer. In this sense, insurance is the mirror image of investments that generate returns for accepting risk from a corporation or from a market. Insurance is not usually included in discussions of investments, but it is very much a part of risk management. Thus a person who has purchased substantial permanent life insurance that may fund a comfortable retirement can take more risks with an investment account than someone who has no insurance and who must avoid losses lest he be forced to retire in poverty.

Insurance policies tend to rise in price along with the potential uses of payouts and the flexibility of policies. The simplest form of life insurance, term insurance, is a straight bet that in the period insured, typically a year, a person will not die. If the insured lives, the policyholder, usually the same person, has lost a small sum on a premium but has had the benefit of life. The insurance company has gained in this case. If the insured dies, he has won in the peculiar sense that a small premium produced a large gain. The insurance company loses.

Whole or permanent life policies are term policies with a savings feature that accumulates cash value - usually slowly - and eventually turn into sums that can help fund retirement, typically via an annuity. An annuity is life insurance running backward, that is, a sum of money that generates the equivalent of premiums that are now paid to the insured, designated as the annuitants. In the simplest life annuity, the benefits are paid until the annuitant dies. This is risky way to conserve a fortune, so it is very common to choose annuities that pay the greater of life or a defined number of years with funds going to other beneficiaries after the death of the annuitant.

There are more complex insurance policies that wrap permanent insurance into a package that also contains an investment section, which may contain assets that range from safe but low-yield government bonds to relatively risky stocks. Called Universal Life, it is a long-term device that can even be used to provide tax-free cash flows in retirement when the value of the policy is used as collateral for low interest loans to the policyholder. The loans are carried until death when the insurance pays out. The payouts are considered to be tax-free since the insurance was bought with after-tax money.