In the realm of finance, portfolio diversification refers to spreading portfolio risk among different companies, asset classes, and even economies. The objective of any diversification strategy is to reduce the level of risk associated with a portfolio. This concept can also be applied to life insurance. In previous decades, the main thrust was to have a large policy with one trusted and financially stable insurer. However, the economic downturn of 2008 left highlighted the problems with this singular-portfolio approach.
Even before the downturn, some financial advisors advocated having multiple life insurance policies with different insurers. This strategy might seem inconvenient and costly (since premium rates for larger coverage amounts are lower). However, the principle involves spreading the risk among different insurers and increasing the flexibility of your life insurance portfolio. Purchasing multiple life insurance plans is necessary for diversification, but it must be done in two basic ways:
1. Using different insurers to meet your insurance needs
2. Purchasing different types of life insurance
• The importance of estimating coverage
Before using different insurers or types of plan, one must determine how much coverage is needed. Given that life coverage needs change over time, it might be difficult to establish it objectively. This influences the size of the portfolio and the manner in which the portfolio should be allocated.
• Using different insurers
Although insurance companies are required to keep reserve funds to meet liabilities, the best guarantee is only as good as the insurer and the economic circumstances as well. Insurers spread significant risks through reinsurance. As a client, you should also insure against the financial collapse of an insurer. For instance, the global economic crisis of 2008 precipitated the financial crises of AIG in America, and CLICO in the Caribbean. Few would have predicted that those two major players in their respective markets would have financial problems that affected their ability to meet their financial liabilities on demand.
Using different insurers reduces this risk significantly. One should not choose just any insurer, but those that have a good rating from rating agencies. The A.M. Best rating is the benchmark for insurance companies. However, even a good A.M. Best rating does not indicate that an insurer is immune from financial difficulty. Both CLICO (B+) and AIG (A) had good ratings, although these grades represented downgrades – accompanied by a warning of the risk exposure that both companies faced because of their investment portfolio. The first step to diversifying your life insurance portfolio is to identify no more than two or three strong insurance companies from whom you would purchase insurance.
• Purchasing different types of life insurance
Life insurance has become very intricate. Decades ago, there was only a choice between term insurance and whole life plans. Now there are various types of term insurance and several versions of permanent insurance as well. Major plans include convertible term insurance, universal life insurance and whole life insurance.
Captive life insurance agents try to convince potential clients that it’s best to have a large cash-value policy. However, you should estimate your coverage need first and then determine how you would split the coverage among plans after properly analyzing coverage needs.
The “portfolio diversification” concept could (and should) be applied to life insurance as well. While there are benefits to being loyal to one insurer (like lower premium rates and discounts), the reduced risk of diversifying is a major benefit of diversification. This would not seem very important until you are holding a life insurance plan that your insurer is unable to honour.