Life Insurance and Derivatives Term Paper

Excerpt from Term Paper :

conventional wisdom has always stated that hedging strategies and life insurance are ill-matched partners. The belief has always been that the philosophical motivation behind employing one is diametrically opposed to that of the other. Insurance companies have traditionally shunned the use of derivatives as a hedging strategy because the insurance industry is all about risk management and hedging instruments required too much specialized knowledge and too many risks to be utilized as suitable strategies, especially when there were conventional investments that could guarantee a significant long-term return one's capital investment. During prosperous -- or at least non-volatile times -- very few investors or managers questioned this way of thinking. However, ultimately, whether one is talking about life insurance, pensions or playing the market, it's all about winning, and over the last few years as the market made a mockery of mutual funds and other traditional investment tools, the only ones who have come out winners are those willing to looking beyond convention.

While mutual funds were cruising and making money with virtually no effort, the motivation for creative thinking and investment was irrelevant; the bottom line was being served -- sometimes spectacularly -- and people were happily looking towards futures free of financial worry. Now, with a radically altered landscape, winning isn't the only option and the world of financial investment has returned once again to a place where only the best and the brightest are going to flourish. The days of double digit returns on mutual funds is long gone and not likely to return as the bear market has seemingly become something of a permanent fixture. In fact, the only guarantee at this point is that those who are basing their retirement strategy on mutual funds may very well end up bagging groceries to make ends meet in their golden years. Larger investors who make bundles going the path of traditional markets now find themselves in a holding pattern stuck with devalued shares hoping, with their only hope being that Mr. Greenspan will suddenly lose his marbles and add a half dozen points to the prime. We all know what the odds of that happening are.

Another factor working against consideration of hedging strategies, beside that of conventional wisdom, was the public's heightened sense of risk fueled by the publicity surrounding the ineptness of some managers with high profile clients. These investment managers not only failed to deliver on wild promises, but also crossed the line when they began engaging in bookkeeping practices that were far more creative than their management strategies.

The reality that hedge funds are not covered under the United States Investment Advisors Act of 1940, are essentially not allowed to market their products, and require investors who must be income qualified has created the impression that only those who are very market savvy, and can afford to lose more than most people ever dream of making, are the only one who dare tread into these markets.

However, when one separates the sensationalism from the truth, what emerges is a clear picture that the winners in today's market are those involved with hedging strategies.

On the whole, while those holding mutual funds have followed the market into the tank, those with hedging strategies have seen profits soar --not necessarily in direct contrast -- but certainly without correlation to market performance.

Consider some of the numbers. In twelve of the last fourteen years, Hedge funds have out-performed mutual funds with 95 and 98 proving the exception. This past year, while Standard & Poor's 500- stock index declined 9.1% and the NASDAQ dropped a frightful 39%, the average hedge fund showed an eight percent increase. Last year's success has been attributed to the performance of the market which analysts have called the most volatile since 1930. That's only half the truth, because while the market did provide the opportunity, the successes that hedge fund investors reaped was due to the evolving strategies of creative managers who knew how to ride the rapids.

Those who shorted, especially with regard to declining technology stocks, returned an average of 30%. Those taking advantage of merger-fever with risk-arbitrage funds realized a return of 14.3%. Playing on the ups and downs of biotechs, HMO's and large pharmaceuticals, those involved with Sector funds really brought home the bacon with returns of 62%. If risk implies the chance of failure, than for the coming years, which appears more risky now -- mutuals or hedge funds?

There is nothing magical about hedge funds. They merely provide what's needed in a declining market and that's diversification. By investing in niche areas such as private equity, commodities, and risk arbitrage or, by shorting stocks -- something that typical mutual funds, by law, are restricted from doing -- they have in actuality reduced risk for investors.

Indeed, even more typically conservative investors such as endowments, foundations, and large pension funds are beginning to see the wisdom in hedge fund investment. In 1993 institutional investors contributed approximately five percent of hedge fund invest. Today, it's up to over 25% and continues to climb. The only fear now is that as institutions up their ante in hedge funds, they will demand more oversight and accountability, possibly putting a damper on the maverick approach of managers that has proven so successful. While, it is difficult to track just how much is being invested in hedge funds, overall estimates put the figure at 500 billion dollars being managed by approximately 6000 hedge funds world wide. This seems like a huge figure -- and it is significant -- however, it still represents just one percent of what the United Nations estimates in 50 trillion dollars in global investment assets. What this means is that the market is hardly saturated or being over-run as some traditional analysts are claiming. At present tax-exempt pension funds represent about eight percent of the money invested, while Endowments & foundations represent just six percent of the investor base. This number is growing, as investors are demanding diversification -- alternatives to the traditional holdings of mainstream portfolios. Employing as many as twenty different strategies, the brokerage communities are continually seeking new methods and products to satisfy those firms seeking to maximize their customers' holdings.

Insurance companies seeing the wisdom of diversification through hedging have recently begun to enter the picture and are searching out the most efficient ways to hook up their policyholders with the hedge fund products that are now being requested.

What makes life insurance an especially attractive investment vehicle is of course the tax advantages that it offers. If insurance companies can come up with the right products they stand to capture an even more significant portion of the investment market than they currently hold. One can even say that with the right products handled in the right fashion they will become the avenue of choice for those looking to make profits that would be decimated by taxes.

It's important to recognize it is the level of flexibility available with different insurance products that make them either viable or not for hedge fund investment. While the simplest products restrict such investments, the most sophisticated ones offer significant potential for customization.

Term Life Insurance products generally do not build cash value, so they are not candidates for hedge fund investment. Cash Value Insurance which require higher premiums provide some investment opportunities, but that money needs to remain liquid to provide policyholders with loans. Typically, they are managed internally and investors have no say in the underlying investment, which eliminated their use for hedge fund investment.

Policyholders with Variable Life or Universal policies may choose the vehicle for their cash value investment, but because they these policies are not limited to accredited investors they cannot be legally invested in hedge funds. The returns on the above-mentioned policies compound tax-free; however, the value of the policy can end up decreasing if the investments do not perform well, a risk that has become all too evident in recent years.

The new alternative now being offered is Private Placement Life Insurance (PPLI). This product can be customized to meet individual needs. Whereas it is only available to a limited number of accredited investors, it may utilize alternative investments such as hedge funds at the discretion of the investor. Two ways are available to invest in private placement products: offshore and domestic onshore. Because many states were unwilling to lift restrictions on those insurance firms investing in hedge funds, offshore products were created and originally dominated the field.

The motivation for investors in Private Placement Life Insurance has little to do with insurance; the attraction is that it serves as a way for large investors to turn profits with their existing hedge funds while maintaining the insurance tax wrapper. As this idea began to catch on, several states loosened up their restrictions and more domestic opportunities started to appear.

As defined by Regulation D. Of the Securities act of 1933, and accredited investor is an individual "whose individual net worth,…

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