I recently went through the process of applying for term life assurance, and it occurred to me that life assurance has several similarities to investing in value stocks. When you buy term life assurance, you decide the term, and pay a fixed amount each month; buying stocks, via dollar-cost averaging for example, is much the same – you decide the holding term and pay a generally fixed amount each month. There the similarity ends. At least until you turn it around a bit. The life insurance company is really the party investing – they are investing in you. They assume all the risk associated with the contract, and obviously will want to minimize it; as a result they conduct extensive research into your medical history and habits. After all, they could end up losing several hundred thousand dollars or more.
Many of us, when buying stocks, could benefit from such a methodical and thorough approach to research into minimizing risk and providing life assurance for our investments. We can ensure our returns – in the form of capital gains or dividends (insurance premium) compensate us adequately for the capital (insured amount) we have at risk in the stock (the insured).
As investors, we need to think like life assurance companies, and do our research into what our capital is really going into. A thorough and full “healthcheck” of the company so to speak.
Does the subject company have any terminal “diseases”? These could include: too much debt, consistently poor return on invested capital, return on assets, low profit margins, a narrow moat and too much competition. Perhaps it is burning cash. Cash flow is like blood flow: you want it to be uninterrupted by constrictions such as debt and high liabilities. A good way to check whether a company is terminal and likely to go bankrupt and die is the Altman Z-Score.
On the other hand, look for positive factors. Is the company “shedding weight”, “exercising”, and eating the “right foods”? In other words, does it have little or no debt, a positive cash flow, and are the executive management doing a good job – i.e. is the company taking on board good management? Look for high RoA, RoE, and RoIC. A good way to check a company’s positive health is via the Piotroski Score.
A combination of high scores in these measures and a high margin of safety is not enough on its own, but it probably helps minimize a lot of the risk factors. Life assurance gives peace of mind, both for the policyholder who is covered, and the underwriter who knows he has minimized his risk. As an investor, if you consider the above factors prior to investing, you will also have peace of mind.
Note: I look for both scores to be high, preferably Altman >= 4 and Piotroski >= 7. A high Altman and low Piotroski is not so good. Avoid low Altman scores though, especially with bargain stocks in the NCAV screen.
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Cash value life insurance is a life insurance policy that builds cash value in a tax-sheltered (tax-deferred) way as you the premiums. This cash value can be used by you whenever you want.
The original form of cash value life insurance was whole life. Whole life’s concept is to reward a long-time policy holder by giving them a return on their premiums, as opposed to what up til then was the only type of life insurance, term, which was–and is–pretty much like renting life insurance coverage for a while.
If you rent a home, you have a place to live while you pay the rent, but when you move that’s it–you own none of that property and you are out all the money you paid to the landlord. If you own your own home, however, you may very well have to pay more for your mortgage than you would as a renter (the number one reason people rent and don’t own in the first place), but in the long run your money is going much further for you. You have more and more equity in that home for yourself every year, and as the years go by more and more of your mortgage payment goes toward the principle so that you equity holdings start to increase parabolically.
With term life insurance, you have life insurance coverage for as long as you pay the premium. The premium is very cheap compared to that for whole life or other cash value policies, but as soon as you stop paying the premiums or the term is up, that’s it–no more coverage and no cash back. And you had nothing to draw on while you had the coverage (you had no equity to borrow against).
Since whole life came into being, some other types of cash value life insurance products have been devised. These are universal life, variable universal life, and no-load life policies. These types of policies were devised to provide solutions to the shortcomings of whole life, which are basically two: the premiums are quite high and the cash value returns build too slowly. No-load policies have lower premiums and faster cash value buildups in exchange for a one-time set-up fee and basically no customer service. The UL policies allow greater flexibility in choosing the investment account portion to allow one to go for higher returns; they are bundled versions of “buy term and invest the difference”.
And that is the great flaw of cash value life insurance policies: people really can do better if they “buy term and invest the difference”. This philosophy goes like this: find out from a given insurance company (one that you are probably going to do business with) what your premiums would be for a term policy of a given face value (death benefit). Then, find out what that same policy would cost you if you bought it as a whole life policy. Then, buy the term policy, but take the difference between that premium and the whole life premium and invest it in the stock market every month. So, if you could buy the same death benefit as a term policy for $100 less per month than you could get it as a whole life policy, you will take $100 every month and put it into investments. As long as you invest long-term, you will beat the returns from any whole life policy PLUS save money on premiums.
Critics counter that that is correct EXCEPT–people aren’t disciplined or investment savvy enough to do that. Whole life, they say, is a “forced” savings and investment.