Investing for Life, Investing in Life Mortality Risk

2020 has been a topsy-turvy year so far. Stock markets have crashed and rebounded sharply, bonds have held firm and gained, diversifying virtually all the risks of stocks, commodities and real estate have diverged sharply within their subclasses, and alternative investments have soared. Yet, despite all the hype about alternative investments in digital technologies such as blockchain, artificial intelligence, data analytics, 2020 has shown that the traditional asset classes of stocks, bonds, and real estate are still the best ways to invest, even for High Net Worth Individuals (HNWIs).

Although investors reaching a higher level of net worth or wealth usually have a slew of alternative investments offered to these HNWIs by banks and advisors eager to profit from their business, nothing has made fortunes faster than investments in listed stocks, and nothing has been safer in times of a crisis than bonds and physical real estate. There truly isn’t a real need to invest outside of these asset classes for the vast majority of us. But there is one risk type which most of us do invest in, even if we don’t usually look at it in this light. And that is investing in life mortality risk, our own life to be exact.

Investing in Life Mortality Risk

We all invest in our own life, or in mortality risk at some point or other in our lives through insurance, although we do not usually think of it in this way. That is because, when we are younger, life insurance does mainly serve as protection, to protect our loved ones from financial distress in the event of our early demise. But when we are older, we buy annuities both as a protection against outliving our financial resources, and as a informed bet on how much longer we will live compared to the median person, based on our own assessment of our health and longevity. An example of this is CPF Life.

Additionally, we may wish to leave a bequest upon our passing, as a goal for our retirement. The selfish lifecycle model predicts that retirees will put all their wealth into annuities, and leave nothing for the next generation. However, actual behaviour shows that many people do have a bequest motive, whether it is motivated by altruism, precaution, or even as a way of making sure their children/heirs visit them in retirement.

So how do we go about setting up a bequest? While there are many ways of achieving this, for example, investing in a portfolio of stocks and bonds, term life insurance to 99 years of age can be a far better way to do so. Why is this so? The problem with the standard investment portfolio is that not only are the returns uncertain, the timing of the bequest is uncertain as well. As a result, the retiree may need to put aside a far larger amount of his wealth towards the bequest, rather than using it for his own retirement expenses.

Investing in life mortality risk to set up a bequest

Setting up a bequest by investing in life insurance

For example, looking at the quotes on comparefirst.sg, the cheapest term-to-99 insurance for a male aged 50 is $5,605 per year for $500,000 of coverage. Suppose long term interest rates are at 3%. The present value of $5,605 a year until age 99 is $147,225. So what this means is that by putting aside just $147,225 now to cover future premiums, this person can leave $500,000 to his heirs when he dies. In fact, there may even be change left over! Adjusting this for the likelihood of death (which goes up really high after the age of 80), the expected value of this is about $114,052.

No big deal, you may say, as you can generate the same $500,000 through investments. For example, putting $75,000 into a stock and bond investment portfolio earning 6% in compounded returns will result in about $500,000 by the age of 84, or 34 years time. But there is volatility and risk in this portfolio, which means that there is a good chance that there will be less than $500,000 at the age of 84. Or the person could pass away earlier, when there is also less in the investment portfolio as there is not enough time for compounding to work.

Nor would putting the the $147,225 into long term bonds be any better. At a 3% rate of return, you will need to compound it for 42 years to get to $500,000. And there is still the risk of an early demise, which will reduce the amount going to the heirs. In both the stock/bond and the pure bond investment portfolio cases, to hedge against the risk of an earlier passing and volatility, you have to put a larger amount into the portfolio. But this will mean less to spend in retirement.

Using insurance covers all the unexpected situations for bequests

So what this means is that by using term life insurance to 99 years, the retiree with $1 million in retirement funds can squirrel aside less than $150,000 for the bequest and go on to use the $850,000 for annuities and health insurance and other retirement spending. On the other hand, the DIY investor has to make do with less than $850,000 in retirement, simply because he cannot hedge against the timing of death. While in theory putting aside $75,000 in a stock/bond investment portfolio might be enough to leave a bequest of $500,000 at the age of 84, in practice, the only way to effectively guarantee a bequest of $500,000 is to put aside $500,000 today, which leaves only half of the $1 million in retirement funds for retirement expenses!

Net, it is far more efficient to use term life insurance to 99 years to generate the bequest. The bequest amount is always the same, regardless of when you may pass on.

What are the returns on Term Life Insurance?

As we have shown previously here, it is surprising, but term-to-99 life insurance is quite cheap in Singapore, relative to the likelihood of death. And it will continue getting cheaper as our life expectancy keeps going up. That is why it has become an instrument of choice for leaving a bequest. The contract illustrated above to leave a bequest of $500,000 works out to have a present value of around $70,000 for a discount rate of 3%! This is a rare case where commercial insurance actually has both a positive net present value, and has protection value as well.

What about the rate of return on such a transaction? If the term insurance starts at the age of 50, and is claimed at the age of 84, which is the life expectancy for men in Singapore, it gives an internal rate of return (IRR) of 5.24%. This is quite good for an almost risk-free bond-like instrument. Of course, we do not all expect to pass on at the same age. Hence the IRR could vary. For example, we show the IRR across a range of ages below:

Rate of Return by Age at which Claim is made

Age at which claim is made	Internal Rate of Return
75	9.35%
80	6.68%
85	4.24%
90	3.73%
95	2.85%

In fact, even if you lived till the age of 99, at which this particular policy will pay out the full sum assured of $500,000, your minimum return will be 2.4%.

If we account for the expected likelihood of death at every age (based on this), the expected IRR goes up to 7.95%! Of course, this also assumes that there is a small chance that the policy owner can pass away before the age of 60, which is what the insurance underwriting process seeks to minimise. So, if we further assume that there is no chance of death for the first 10 years of the policy, the more conservative expected internal rate of return to this policy is still a good 6.30%.

Why are the Rates of Return so Good on Investing in Life Mortality Risk?

Well, this is a puzzle which perhaps someone in the life insurance industry can help shed light upon. One thing is for sure though, the non-participating life funds (which is the fund which the premiums for pure life insurance goes into) are usually the most profitable among the funds that the life insurers in Singapore run. Yes, term life insurance is far more profitable as a business than Whole Life or Investment Linked Policies (ILPs)!

Why is this so? Partly because the price of term life for younger people is more expensively relative to the likelihood of a claim, as we show here. Also, for long term contracts, insurers profit when policyholders no longer need the insurance coverage and lapse on their policies. But getting the profits out from the life fund is not so straightforward. From an accounting perspective, the insurer earns a profit when they collect more in premiums than pay out in claims or put into reserves for future claims. So the only way to do so is to underwrite more and more policies. This puts downward pressure on the pricing, especially in a competitive market, and where the life funds already have a big buffer of capital from prior year gains.

Regardless, the main message is that term-to-99 life insurance is useful for leaving a bequest, and is priced relatively cheaply. Hence as consumers, it is something we should give serious thought to using.

How does this fit with Retirement Planning?

Mainstream retirement planning doesn’t deal much with life insurance, because life insurance usually protects a younger family from the financial distress of the death of the breadwinner. But life insurance can and should play a bigger role in retirement planning,

1. Leaving a bequest

Using term insurance to leave a bequest is probably the most common use of life insurance in retirement planning. While it is often fashionable to talk of leaving nothing to your children, or giving them what they need while you are still alive, let’s just say that when we get older, our perspective on this often changes.

One common bequest that is usually left by a parent is the family residence. But such a lumpy bequest tends to create a host of other issues. For example, if there is one residence to be shared among several children, who gets to stay in it? And how will they make decisions about selling or renting or renovating it, which may incur costs? A far simpler option may be to bequest the family residence to the child who will continue to stay in it, and use the life insurance payouts for the other children.

Bequests are also used to enforce good behaviour from family members who stand to benefit from it. These include keeping the family together, and making sure the children and grandchildren visit from time to time. Sure, filial piety will ensure this as well, but we do live in a modern world where even marriage vows may not be so sacrosanct anymore, what more filial piety!

And of course we do read about cases where members of the family fight over their inheritance. But, looking at it from another angle, such family fights usually happen after the patriarch/matriarch passes on, which means that the bequest promised did a fantastic job in keeping their family together, and in enforced harmony until then. After that, they would be in no mind or condition to care anymore!

2. As a hedge against an early death

One of the main gripes about the CPF Life annuity in Singapore and the preference of people to take up the Basic Plan or the Retirement Sum Scheme is the worry that should they die too early, the money put into the annuity is lost. And they end up opting for schemes which are clearly inferior to the Standard or Escalating Plan under CPF Life. Inferior, because they both have lower payouts, and end up with a lower amount of residual bequests.

Well, one easy solution to this is to both enroll in the CPF Life Standard or Escalating Plan, and to use the higher level of monthly payouts to pay the premiums on a term-to-99 years life insurance. If you live longer than the median person, the CPF Life annuity would pay off handsomely. If instead you have a shorter life, the life insurance would pay off. Either way would hedge against the vagaries of mortality risk. This approach also takes out the stress of seeing the bequest from the RSS/CPF Basic plan dwindle year after year as time passes.

3. Investing in life mortality risk

Morbid as it may sound, mortality risk is a very well understood risk class, and is completely uncorrelated with every other asset class. After all, we have yearly updates of the life tables for both men and women in Singapore which actuaries use to determine the pricing and profitability of various life insurance products. As we discuss earlier, due to the anomalies in pricing, customer underwriting and, perhaps, legacy profits in the life funds, term life insurance is surprisingly cheap relative to the chance of death for older people, and hence benefits term-to-99 years insurance policyholders.

No different from any other asset class with risk and return characteristics, mortality risk rewards those who simply hold it (for example, giving an expected 6.3% return for term-to-99 years insurance policyholders). Those who live longer than average will benefit more from annuities, while those who live shorter than average will benefit more from term life insurance. And knowledge of one’s own genetics, family history and health must surely count as material information for making such investments.

Conclusions

While we tend to think of insurance as purely for protection, life insurance companies are muscling into the wealth management space. And investors are also relooking at insurance products as investments for many reasons, among them: