Time to take out a little insurance

Time to take out a little insurance
Are you up to speed on securities protection?
Jonathan Chevreau, Financial PostPublished: Monday, June 04, 2007
With stock markets logging new record highs each passing day, advisors may be getting anxious queries from clients concerned about protecting their gains from a nasty stock-market correction.
A timely topic is investment insurance. Consider house insurance, where one pays small annual premiums to protect homes against fire or other disasters. Odds are that nothing will happen to the house but the homeowner doesn't begrudge the premiums that provided peace of mind.
Investment insurance works the same way: You have an equity portfolio for the upside and purchase put options on those securities to ensure the portfolio's value can't fall below a certain level.
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If the market keeps rising, you're happy and don't fret about the premiums spent to achieve peace of mind. If the market tanks, you're protected and relieved your advisor had the foresight to insure your portfolio.
Sadly, not all advisors are knowledgeable enough to do this for clients, or licensed to sell what's required to insure a portfolio. They would do well to read a new book on the topic published by securities lawyer and consultant Robert Goldin.
The first part of Insure Your Investments Against Losses (Bastian Books, Toronto, 2007) looks at techniques for insuring individual securities. It covers the gamut from call options and put options to collars, strangles and straddles. He also looks at strip bonds, futures, principal protected notes, index-linked GICs and other "guaranteed" investments.
Most of the techniques covered require a securities licence -- this book may well motivate those licensed only to sell mutual funds to broaden their focus. Goldin suggests clients looking for such protection dump advisors not qualified to sell options and find ones who are.
The meat of the book is the second half, which looks at how to insure whole portfolios. First it recaps Modern Portfolio Theory, which most advisors view as the foundation of their clients' portfolios. MPT covers such familiar ground as the efficient market, asset allocation, positively and negatively correlated asset classes and alternative investments such as hedge funds, income trusts and precious metals.
However, Goldin does not advocate holding a portfolio of different non-correlated asset classes, or the traditional MPT approach.
Rather than diversifying, he believes in "insurifying."
His term for this is Efficient Portfolio Theory or EPT. With EPT, portfolios consist almost entirely of equity indices, preferably through low-cost exchange-traded funds (ETFs).
By nearly, he means about 96% of the portfolio. The other 3% or 4% is used to buy put options on the indices most reflected in the chosen ETFs.
After assembling such portfolios, you simply insure your investments against losses and sleep soundly at night. "It's that simple," he writes.
For advisors already familiar with options, EPT is a surprisingly simple alternative to other less easily understood alternatives designed to hedge losses. In the book, Goldin says some investment insurance strategies can be performed by do-it-yourself investors while others may require financial advisors "until you feel comfortable implementing them yourself."
Variants of this strategy have been promoted elsewhere. Goldin started to explore the topic when he asked himself why major financial institutions always make money despite the vagaries of the market.
Indeed, finance professor Moshe Milevsky raised similar issues when Manulife Financial unveiled Income Plus. Milevsky said it was possible for investors to "bake their own solution" by combining puts and calls in a retirement collar.
Certified financial planner Fred Kirby, president of B.C.- based Dimensional Investment Planning Inc., is a believer in well-diversified low-cost portfolios of index funds or ETFs. But in a series of client reports on Protecting Your Portfolio, Kirby acknowledged the limitations of Modern Portfolio Theory once a bear market hits.
He found actively managed Canadian equity funds and dividend funds offered better protection than index funds in bear markets.
He also found international equity diversification "fell far short of providing complete safety." It "works when we don't want it to and doesn't when we do."
For clients convinced a market correction is at hand - perhaps because it's the consensus among market timers -- Kirby suggested several steps or half steps investors can take to reduce risks.
They could hedge their bets by selling half their equity positions in tax-deferred accounts and moving the proceeds to cash. Alternatively, they could sell half their registered equities to buy U.S. and Canadian dividend ETFs or mutual funds.
They could also hedge half their equity exposure using a similar approach to Goldin's, although Kirby's suggestions were issued before Goldin published his book.
Thus, for taxable accounts in bear markets, Kirby suggests hedging half a client's equity exposure with a long-term bearishly split strike option index strategy. This locks in a portfolio's value while deferring previously accumulated capital gains otherwise payable in a taxable account.
Kirby cites as an example the SPX mini index [XSP/CBOE], currently trading at 150. For every $30,000 of a U.S.-based S&P500 type of portfolio, investors wishing to hedge half its value simultaneously buy one put contract of XSP December 145 2008 and sell one call contract of XSP December 155 2008 for a net credit of $300 (3 times $100). With the index at 150, the value of each contract is $15,000, effectively protecting half the $30,000 portfolio.
Investors might also consider the new Horizon BetaPro S&P60 Bull and Bear Plus ETFs. The bull version moves in the same direction as the XIUs on the TSX but at double the rate.
Similarly, the bear version is the equivalent of selling the XIUs short, Kirby says, but again at double the rate. American equities can be covered by U.S versions of these funds trading on the Amex: ProShares Ultra S&P500 and UltraShort S&P500.
Kirby hedges only half the equity portion of portfolios because he assumes the first 10% of each move up or down is missed. "Sometimes, the timing of the hedge will be right and will be profitable; other times it will be wrong and there will be an opportunity cost.
But in the long run, it should break even. Its purpose is to decrease portfolio volatility and help keep its value."
jchevreau@nationalpost.com

Using life insurance to your (tax) advantage

It provides some benefits that may be attractive to people in the affluent income group.
Apr 29, 2007 04:30 AM Ellen Roseman

In last week's column, we talked about the way mortgage lenders push you to buy life insurance to cover your loan.
The lender's insurance, while convenient, offers less protection than what you would get with a life insurance policy sold separately.
Here are the main disadvantages of buying mortgage life insurance from a bank, trust company or credit union:
The lender owns the policy and is the beneficiary. With a policy you own personally, you own the policy and choose the beneficiary.
The lender's insurance is not portable. If you switch lenders, you may not be able to get insurance if you have a health problem. But if you own a guaranteed renewable policy, you will never have to provide medical evidence again.
The lender's insurance doesn't decrease in cost, but the coverage shrinks as your mortgage balance declines. With a policy you own personally, the coverage doesn't go down unless you reduce it.
Another problem (not mentioned last week) is post-claim underwriting. This means the insurance is sold to those who may be ineligible for benefits.
Only when someone dies is an assessment done. And the claim may be denied if the death is related to a prediagnosed medical condition.
When you own your life insurance policy, the coverage is underwritten at the time of application. It's almost impossible for the insurance company to get out of paying a death claim after the first couple of years.
So, what kind of life insurance should you buy?
Term insurance is the way to go when you're young. You can protect your spouse and children at a low cost because you're buying only insurance – with no savings or cash value.
It's a no-frills way to insure yourself for a specific period of time. And if you survive to the end of the period, the policy is worthless.
However, a term policy gets more expensive as you get older. You may find the cost prohibitive in your 70s or 80s, if you can get coverage at all.
"The probability of dying increases, so the insurance company must charge more to cover this risk," say financial professors Moshe Milevsky and Aron Gottesman in Insurance Logic: Risk Management Strategies for Canadians.
But why will you need life insurance once your mortgage is paid off and your kids are grown up? What's the point of having it if you have no dependents?
The answer is taxes. Life insurance provides some benefits that may be attractive to people in the higher income groups.
With a permanent (or non-term) policy, part of the premium goes toward pure insurance coverage. Another portion goes toward a savings component to fund future premiums.
This type of coverage also goes under the name of whole life, universal life or level life insurance. The premiums are higher than term premiums for the first part of your life, while term premiums exceed level premiums later on.
"Level, or permanent, insurance is a system whereby you overpay in the early years in order to subsidize the later years," the authors say.
"Since you're overpaying in the early years, the excess over the pure premiums is being invested in a side fund. In some cases, you can actually control where those excess premiums are invested.
"As you age, some of the savings will be depleted to make up for the fact that your annual level premiums are lower than what they should be."
Some people buy life insurance for estate planning. While Canada has no death taxes, your estate will be taxed on the appreciated value of everything you own at the time of death – such as securities and real estate (aside from a principal residence).
Faced with a large tax bill, your survivors may have to liquidate assets.
"In other words," say the authors, "the tax code can force you to sell the very asset that you are paying taxes to inherit. Ugh!"
Besides helping to pay the final tax bill, life insurance can provide tax benefits along the way.
The savings that build up inside a cash-value policy are sheltered from tax. You won't get a tax bill every year for interest, capital gains or dividends earned inside the policy, as you will when you invest in a bank deposit or mutual fund.
Suppose you can defer tax for 30 years. How much would that saving be worth? The authors give an example.
Imagine that you invest $10,000 at 5 per cent interest. If you pay tax each year on the gains at a 50 per cent marginal tax rate, you will have $20,975 at the end of 30 years.
But if the inside build-up is tax-free, you have $43,220 at the end of 30 years – a gain of $33,220. Once you pay a 50 per cent tax on the gain – since you can't escape tax forever – you're left with $26,610.
"Compare the numbers," they write. "You have $5,635 ($26,610 minus $20,975) more from the tax-free inside build-up than from the alternative product.
"This is about 50 per cent of your initial $10,000 investment. Now scale this up to $100,000, or even $500,000, and you get a sense of the magnitude of this benefit.
"You have paid taxes in both cases, so we are not comparing apples to oranges. In the first case, you paid tax continuously; in the second case, you paid it at the end."
You can use this strategy with a large variety of investment funds within a life insurance policy. That's why it's called universal life.
Sometimes, financial advisers urge clients to buy life insurance policies for their newborn children.
Why buy life insurance for children who have no dependents to protect?
Adult children may not contribute to a registered retirement savings plan until they're 30 years old, says Asher Tward, vice-president of estate planning at TriDelta Financial Partners in Toronto.
But they can have investments growing tax-free from birth if their parents buy them a universal life insurance policy.
The policy costs very little at an early age, he says. You'll be doing your kids a favour since they will never have to buy life insurance again – and they won't have to worry about being uninsurable if they develop a medical problem later in their lives.
Next week, we'll provide tips on buying a universal life policy.