Do You Need to Diversify Your Whole Life Insurance Holdings?

Diversification is a term so deeply intertwined with traditional financial/investment advice that we often think of it as infallible.  If you want to sound intelligent, or at least appear reasonably knowledgeable, make the recommendation that one carefully work to diversify his/her portfolio and there's a good chance your advice is impervious to criticism.  For the most part, this is correct.  At least insofar as we are talking about traditional securities that pose a real threat of losses.  We often think of diversification as a mechanism through which we shield ourselves against catastrophic times–though the magnitude of such an event poses various dangers that most traditional diversification recommendations are incapable of stopping…that's a story for another day.

So if we accept diversification as an incontrovertible element of our portfolio building, do we need to apply the same notion if we choose to buy cash value life insurance as part of our portfolio?  I mean, buying a whole life insurance policy from one company with the intention to use its cash build-up as one of my many sources of retirement income seems imprudent if I bet it all on just one insurance company…right?

When put that way, this sounds reasonable.  Perhaps I need to also choose the second-best performing company and also buy a policy from them.  That way I'm “shielded” from the potential losses I face if something goes wrong at one of these two companies.

What Sort of Risk do I Face When Owning Life Insurance?

The reason savvy investment advisors recommend diversification of securities like stocks and bonds has to do with the somewhat arbitrary way these securities can gain and lose value.  While I don't wish to suggest that it's all just “legalized gambling” (that term never made any sense to me, regular gambling is legal in lots of places) there are unforeseen circumstances that can quickly alter the value of these securities.  Diversification is a strategy that seeks to blunt the jerking-like movement in asset prices that can lead to catastrophic losses.

This same strategy also blunts the break-away run-up in asset prices that could produce dramatic increases in wealth.  That trade-off is well known, but the assessment is simply the risk of serious loss outweighs the potential for such gain.

Life insurance operates under different circumstances.  The risks you face when buying a whole life or indexed universal life insurance for wealth accumulation, retirement income planning, self banking strategies, etc. are not the same risks you face when buying stocks or even bonds.  The chief risk you face when owning a life insurance policy is counter-party risk–i.e. will the other party, the insurance company, be able to produce the results you think it will.

While this risk is real, there's little evidence I'm aware of that supports any claim that insurance companies are untrustworthy as a rule.  Yes, we know dividend payments declined as market interest rates declined, but that event did not take place in a vacuum.  All other fixed-income style assets also experienced declining returns and yields due to lower interest rates.  I'd also point out that life insurance policies were the slowest to decline and still maintain a reasonably good advantage with respect to rate of return expectations over these similar assets.

What's more, these insurance products do not operate under the same volatility that stocks and bonds can when it comes to asset pricing.  These products have very specific rules for how values work and they cannot decline in value over time.  This removes the key reason investment advisors recommend diversification.  For this reason, trying to diversify your life insurance risk exposure becomes less important, but also a bit tricky.

Diversifying Introduces More Risk

While it's mathematically true that buying two whole life policies from two different insurance companies does reduce the risk of your facing complete loss through company failure.  It's also true that buying two products from two different companies increases the risk that you experience loss because at least one of the companies you buy from fails or faces an undesirable reality.

The dilution of results mentioned above with stocks and bonds is also a reality when diversifying life insurance companies.  The key difference, however, is that the risk of loss when it comes to life insurance products is substantially lower than the risk of loss faced when buying a single security traded on a public stock market.  It's this difference in risk/reward that makes me dubious on attempting to diversify life insurance companies.

Remember How Whole Life Insurance Works

Whole life insurance and indexed universal life insurance do not decline in value due to bad economic events are even bad circumstances unfolding at an insurance company.  So if bad news does develop, policyholders almost always have time to come up with an exit/alternative strategy.  Compare this to owning stocks where bad news results in immediate loss of value leaving the owner with no time to sell and move the money somewhere else.

So if you selected a life insurance product from a company that ends up declining in its ability to produce the results you were expecting, you have the ability to move on to a different strategy elsewhere and keep all of the money that you made thus far.

But let's not overlook the inherent safety that life insurers represent.  Life insurance companies are, by their operational nature, safe places to manage assets.  It's one of, if not the, key attribute they bring to the table when it comes to asset management.  These products don't need additional diversification because they are diversification in and of themselves.

Diversify Life Insurance Types

None of what I've said so far should apply to diversifying exposure to different life insurance product types.  In other words, I don't want you to read this article and walk away assuming that you should never spread exposure across something like whole life insurance and indexed universal life insurance.  That I would encourage as it permits you to take some advantage of both product types.


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