How to Determine the Right Policy
HOW TO SELECT THE TYPE OF INSURANCE PRODUCT OR PRODUCT MIX APPROPRIATE FOR THE CLIENT
Above all, the planner must always “MATCH THE PRODUCT TO THE PROBLEM.” The particular type of life insurance coverage appropriate for a given client is a function of four factors:
1. the client’s personal preferences, prejudices, and priorities;
2. the amount of insurance needed;
3. the client’s ability and willingness to pay a given level of premiums (cash flow considerations); and
4. holding period probabilities (duration of need considerations).
Preferences, Prejudices, and Priorities
The selection of a particular type of life insurance policy or policy mix is to a great extent a very personal decision. Just as some individuals prefer, by psychological nature, to lease an automobile or rent an apartment, others prefer to make their purchases with a minimum down payment and stretch out the length of payments as long as possible, while others prefer to make a relatively large down payment and to pay off the loan or mortgage as quickly as possible. To many clients there is emotional comfort in “owning,” while others feel that owning ties them down and restricts their freedom of choice and flexibility. Similar comparisons can be made to life insurance policies. Some clients do not want to “pay, pay, pay…and have nothing to show for it at the end of the term,” while others have been told all their lives to “buy term and invest the difference.” In the real world, both positions are correct, and not correct. Even the advice of knowledgeable planners has been tainted by their own prejudices. For most clients, the right course of action usually lies where they are most comfortable—since peace of mind is really the impetus for the purchase of life insurance in the first place.
Another useful analogy is the purchase of technology tools by professionals. Some tend to purchase the highest quality, most expensive tools that they can afford to so that the tools will serve them well over a lifetime (or at least the reasonably expected lifetime of the tools). They do not tend to purchase lower priced, lower quality tools that will have to be replaced by other tools because they wear out, were inadequate to begin with, or break. But others cannot afford to (or will choose not to) purchase top quality tools. They may have other priorities. They may prefer to have the money to invest or to spend on current consumption. They may end up spending more over the length of their careers on tools and may be inconvenienced in the process of continually replacing the original tools.
Although this “preference/priority”-based decision making is not necessarily the most logical, it is a strong and important process that requires the planner to take into consideration the client’s psychological makeup. The rules of thumb here are as follows:
1. Buy term if the client has a high risk-taking propensity.
2. Buy term if the client has a “lease rather than own” preference.
3. Buy some type of whole life insurance if the client has an “own rather than loan” type personality.
4. Buy some type of whole life insurance if the client wants something to show for his money at any given point. The more important it is for the client to have cash values and dividends at any given point, the more whole life type coverage is indicated.
5. Buy a mix of term and whole life if the client is—like most clients—not solidly on one end of the spectrum or the other.
Amount of Insurance Needed
When the amount of insurance needed is so great (as it often is for families with young children or for couples with high living standards relative to their incomes) that only term insurance or a term/whole life combination is feasible, the need for death protection should be given first priority. This results in simple rules of thumb:
1. Buy term insurance when there is no way to satisfy the death need without it. The term insurance can be converted to another form of protection at a later date, if and when appropriate.
2. Buy a combination of term and permanent insurance when the client can cover the entire death need and is able and willing to allocate additional dollars to appropriate permanent coverage.
Keep in mind, however, that buying term insurance means paying ever-increasing premiums for a constant amount of coverage. People with little prospect of increasing their income sufficiently to pay ever-increasing term premiums face a difficult trade-off. They can buy term insurance for the amount of coverage they think they currently need, and face the prospect of being unable to afford that coverage in the future. Or they can purchase as much permanent insurance (e.g., level-premium whole life) as they can afford and be relatively assured that they can maintain the coverage for the long term, but have less coverage than they think they need.
Cash Flow Considerations
There are a large number of premium payment configurations that provide considerable flexibility for policyowners. Some clients will prefer to fully prepay for their coverage and take advantage of the tax-deferred internal buildup of investment return. This limits the total amount of premium that will be paid, even if the insured lives well beyond life expectancy. Other clients will be more comfortable with the payment of premiums at regular intervals for a fixed period or for the life of the insured (or for the working life of the insured). This “installment” purchase of life insurance benefits the policyowner who dies shortly after the policy is purchased, since a much lower total premium would be paid before death.
Conceptually, the insurance company itself is indifferent to the premium payment method selected; all of these patterns of payment, if applied to the same level of death benefit and continued for the same duration of time, will have the same actuarial value. So client abilities to pay and preferences are the major factors in the decision. The rules of thumb are as follows:
1. Prepay coverage (buy vanishing premium or limited payment whole life permanent insurance) if the client expects to live longer than average.
2. Pay on the installment basis (purchase term or low outlay whole life coverage) if the client thinks he or she faces a greater than average mortality risk.
3. Purchase yearly renewable term (YRT) if the client wants or needs to pay absolutely minimal initial premiums, but is willing to pay increasingly larger premiums each consecutive year to keep the same level of coverage in force.
Duration of Need Considerations
In many cases, the planner’s decision must be dictated at least in part by how long the need is expected to last. Some rules of thumb here are:
1. Buy term insurance if the need will probably last for 10 years or less.
2. Buy term and/or whole life if the need will probably last for 10 to 15 years.
3. Buy some type of whole life coverage if the need will probably last for 15 years or longer.
4. Buy some type of whole life coverage if the policy will probably be continued up to or beyond the insured’s age 55.
5. Buy some type of whole life coverage if the policy is purchased to solve a buy-sell need.
6. Buy some type of whole life coverage if the policy is designed to pay death taxes, or to transfer capital efficiently from one generation to another, or to replace capital given to charity or otherwise diverted from the client’s intended beneficiaries.
HOW TO DECIPHER POLICY ILLUSTRATIONS OR LEDGER STATEMENTS
The policy illustration or ledger statement is the principal source of financial information regarding a new-issue policy. The separate chapters on the various types of policies provide ledger statement illustrations and describe in considerable detail what to look for in these statements. Here, we present a general overview. Understanding these ledger statements is important, because the information they provide serves as the basis for the various policy comparison measures that are discussed below.
The first step in understanding a policy illustration is to identify the columns that state the following:
§ yearly premium payments;
§ year-end policy cash values;
§ projected policy dividends;
§ cumulative cash value at given policy durations;
§ the death benefit from the basic policy; and
§ the death benefit provided by any dividends.
The critical questions are:
1. What does the client pay, year by year—compared to what he gets if he lives and what his family receives if he dies?
2. What portion of those amounts is guaranteed—and what portion of those amounts is projected?
3. What interest or other assumptions are built into these figures?
Financial services professionals should examine a policy illustration with particular emphasis on the following:
§ surrender charges;
§ cash value projections;
§ policy loans; and
§ dividends.
Surrender Charges
Determine what the company charges if the client surrenders the policy in a given year by looking at the cash value columns. Where there are two columns for cash values—one that reflects the net surrender value of the contract and the other the year-end cash value for the policy—the difference between these two amounts is the surrender charge for the given year.
Cash Value Projections
Ascertain the “premium level safety” by looking at the cash value projections on universal life and interest-sensitive life products. It is common under these two types of policies to show future cash values based on: (1) the guaranteed interest rate; and, also, (2) one or more higher interest rates related to either: (a) current portfolio earnings, or (b) whatever earnings level the agent has selected for the illustration.
Question the long term reasonableness of the assumptions. Are they unrealistic? Does the cash value associated with the guaranteed interest rate drop to zero after some years of duration? This indicates that the premium being charged for the contract will at that point become inadequate to support the coverage in force if the insurer is only able to credit cash values with the guaranteed interest rate. The client will be forced to pay higher premiums unless the contract earns interest higher than the guaranteed rate. If the illustration shows positive cash values at all policy durations, the premium will be adequate to carry the policy indefinitely.
Policy Loans
The notes to the ledger statement should explain what interest rate is being charged on the policy loans and if the rate is fixed or variable. If the rate is variable, is the rate being used for illustration reasonable over the period shown?
Check the illustration to see if loans are part of a systematic plan of borrowing to pay premiums. This is called a “minimum deposit” plan. Although no longer a popular approach to financing insurance premium payments, this is evidenced by a regular pattern of increasing outstanding loan balances where the increases are tied closely to the interest rate applicable to the previous outstanding balance and the premium payment due under the contract.
Dividends
Remember that dividends are not guaranteed. Many insurance companies have recently, and significantly, reduced dividends below their original projections. If the ledger statement shows policy loans, the notes to the ledger statement should explain whether dividends are reduced when loans are outstanding. Check to see whether the projected dividends reflect reductions attributable to any projected policy loans. Also, determine what interest rate the company assumes it must earn to pay the projected dividends. If the assumed interest rate seems too high or too optimistic over the long run, run another ledger with projected dividends based on a more supportable long-run interest assumption. Also, check the interest rate that the insurer will pay on any dividend left with it to earn interest. (The interest is currently taxable, even though the dividend itself will not be taxable to the policyowner.)
For more Information:
Risk Management & Insurance
Personal Lines Insurance, Commercial Property Program, Commercial Auto Program, PPLI Solution,
HOW TO SELECT THE TYPE OF INSURANCE PRODUCT OR PRODUCT MIX APPROPRIATE FOR THE CLIENT
Above all, the planner must always “MATCH THE PRODUCT TO THE PROBLEM.” The particular type of life insurance coverage appropriate for a given client is a function of four factors:
1. the client’s personal preferences, prejudices, and priorities;
2. the amount of insurance needed;
3. the client’s ability and willingness to pay a given level of premiums (cash flow considerations); and
4. holding period probabilities (duration of need considerations).
Preferences, Prejudices, and Priorities
The selection of a particular type of life insurance policy or policy mix is to a great extent a very personal decision. Just as some individuals prefer, by psychological nature, to lease an automobile or rent an apartment, others prefer to make their purchases with a minimum down payment and stretch out the length of payments as long as possible, while others prefer to make a relatively large down payment and to pay off the loan or mortgage as quickly as possible. To many clients there is emotional comfort in “owning,” while others feel that owning ties them down and restricts their freedom of choice and flexibility. Similar comparisons can be made to life insurance policies. Some clients do not want to “pay, pay, pay…and have nothing to show for it at the end of the term,” while others have been told all their lives to “buy term and invest the difference.” In the real world, both positions are correct, and not correct. Even the advice of knowledgeable planners has been tainted by their own prejudices. For most clients, the right course of action usually lies where they are most comfortable—since peace of mind is really the impetus for the purchase of life insurance in the first place.
Another useful analogy is the purchase of technology tools by professionals. Some tend to purchase the highest quality, most expensive tools that they can afford to so that the tools will serve them well over a lifetime (or at least the reasonably expected lifetime of the tools). They do not tend to purchase lower priced, lower quality tools that will have to be replaced by other tools because they wear out, were inadequate to begin with, or break. But others cannot afford to (or will choose not to) purchase top quality tools. They may have other priorities. They may prefer to have the money to invest or to spend on current consumption. They may end up spending more over the length of their careers on tools and may be inconvenienced in the process of continually replacing the original tools.
Although this “preference/priority”-based decision making is not necessarily the most logical, it is a strong and important process that requires the planner to take into consideration the client’s psychological makeup. The rules of thumb here are as follows:
1. Buy term if the client has a high risk-taking propensity.
2. Buy term if the client has a “lease rather than own” preference.
3. Buy some type of whole life insurance if the client has an “own rather than loan” type personality.
4. Buy some type of whole life insurance if the client wants something to show for his money at any given point. The more important it is for the client to have cash values and dividends at any given point, the more whole life type coverage is indicated.
5. Buy a mix of term and whole life if the client is—like most clients—not solidly on one end of the spectrum or the other.
Amount of Insurance Needed
When the amount of insurance needed is so great (as it often is for families with young children or for couples with high living standards relative to their incomes) that only term insurance or a term/whole life combination is feasible, the need for death protection should be given first priority. This results in simple rules of thumb:
1. Buy term insurance when there is no way to satisfy the death need without it. The term insurance can be converted to another form of protection at a later date, if and when appropriate.
2. Buy a combination of term and permanent insurance when the client can cover the entire death need and is able and willing to allocate additional dollars to appropriate permanent coverage.
Keep in mind, however, that buying term insurance means paying ever-increasing premiums for a constant amount of coverage. People with little prospect of increasing their income sufficiently to pay ever-increasing term premiums face a difficult trade-off. They can buy term insurance for the amount of coverage they think they currently need, and face the prospect of being unable to afford that coverage in the future. Or they can purchase as much permanent insurance (e.g., level-premium whole life) as they can afford and be relatively assured that they can maintain the coverage for the long term, but have less coverage than they think they need.
Cash Flow Considerations
There are a large number of premium payment configurations that provide considerable flexibility for policyowners. Some clients will prefer to fully prepay for their coverage and take advantage of the tax-deferred internal buildup of investment return. This limits the total amount of premium that will be paid, even if the insured lives well beyond life expectancy. Other clients will be more comfortable with the payment of premiums at regular intervals for a fixed period or for the life of the insured (or for the working life of the insured). This “installment” purchase of life insurance benefits the policyowner who dies shortly after the policy is purchased, since a much lower total premium would be paid before death.
Conceptually, the insurance company itself is indifferent to the premium payment method selected; all of these patterns of payment, if applied to the same level of death benefit and continued for the same duration of time, will have the same actuarial value. So client abilities to pay and preferences are the major factors in the decision. The rules of thumb are as follows:
1. Prepay coverage (buy vanishing premium or limited payment whole life permanent insurance) if the client expects to live longer than average.
2. Pay on the installment basis (purchase term or low outlay whole life coverage) if the client thinks he or she faces a greater than average mortality risk.
3. Purchase yearly renewable term (YRT) if the client wants or needs to pay absolutely minimal initial premiums, but is willing to pay increasingly larger premiums each consecutive year to keep the same level of coverage in force.
Duration of Need Considerations
In many cases, the planner’s decision must be dictated at least in part by how long the need is expected to last. Some rules of thumb here are:
1. Buy term insurance if the need will probably last for 10 years or less.
2. Buy term and/or whole life if the need will probably last for 10 to 15 years.
3. Buy some type of whole life coverage if the need will probably last for 15 years or longer.
4. Buy some type of whole life coverage if the policy will probably be continued up to or beyond the insured’s age 55.
5. Buy some type of whole life coverage if the policy is purchased to solve a buy-sell need.
6. Buy some type of whole life coverage if the policy is designed to pay death taxes, or to transfer capital efficiently from one generation to another, or to replace capital given to charity or otherwise diverted from the client’s intended beneficiaries.
HOW TO DECIPHER POLICY ILLUSTRATIONS OR LEDGER STATEMENTS
The policy illustration or ledger statement is the principal source of financial information regarding a new-issue policy. The separate chapters on the various types of policies provide ledger statement illustrations and describe in considerable detail what to look for in these statements. Here, we present a general overview. Understanding these ledger statements is important, because the information they provide serves as the basis for the various policy comparison measures that are discussed below.
The first step in understanding a policy illustration is to identify the columns that state the following:
§ yearly premium payments;
§ year-end policy cash values;
§ projected policy dividends;
§ cumulative cash value at given policy durations;
§ the death benefit from the basic policy; and
§ the death benefit provided by any dividends.
The critical questions are:
1. What does the client pay, year by year—compared to what he gets if he lives and what his family receives if he dies?
2. What portion of those amounts is guaranteed—and what portion of those amounts is projected?
3. What interest or other assumptions are built into these figures?
Financial services professionals should examine a policy illustration with particular emphasis on the following:
§ surrender charges;
§ cash value projections;
§ policy loans; and
§ dividends.
Surrender Charges
Determine what the company charges if the client surrenders the policy in a given year by looking at the cash value columns. Where there are two columns for cash values—one that reflects the net surrender value of the contract and the other the year-end cash value for the policy—the difference between these two amounts is the surrender charge for the given year.
Cash Value Projections
Ascertain the “premium level safety” by looking at the cash value projections on universal life and interest-sensitive life products. It is common under these two types of policies to show future cash values based on: (1) the guaranteed interest rate; and, also, (2) one or more higher interest rates related to either: (a) current portfolio earnings, or (b) whatever earnings level the agent has selected for the illustration.
Question the long term reasonableness of the assumptions. Are they unrealistic? Does the cash value associated with the guaranteed interest rate drop to zero after some years of duration? This indicates that the premium being charged for the contract will at that point become inadequate to support the coverage in force if the insurer is only able to credit cash values with the guaranteed interest rate. The client will be forced to pay higher premiums unless the contract earns interest higher than the guaranteed rate. If the illustration shows positive cash values at all policy durations, the premium will be adequate to carry the policy indefinitely.
Policy Loans
The notes to the ledger statement should explain what interest rate is being charged on the policy loans and if the rate is fixed or variable. If the rate is variable, is the rate being used for illustration reasonable over the period shown?
Check the illustration to see if loans are part of a systematic plan of borrowing to pay premiums. This is called a “minimum deposit” plan. Although no longer a popular approach to financing insurance premium payments, this is evidenced by a regular pattern of increasing outstanding loan balances where the increases are tied closely to the interest rate applicable to the previous outstanding balance and the premium payment due under the contract.
Dividends
Remember that dividends are not guaranteed. Many insurance companies have recently, and significantly, reduced dividends below their original projections. If the ledger statement shows policy loans, the notes to the ledger statement should explain whether dividends are reduced when loans are outstanding. Check to see whether the projected dividends reflect reductions attributable to any projected policy loans. Also, determine what interest rate the company assumes it must earn to pay the projected dividends. If the assumed interest rate seems too high or too optimistic over the long run, run another ledger with projected dividends based on a more supportable long-run interest assumption. Also, check the interest rate that the insurer will pay on any dividend left with it to earn interest. (The interest is currently taxable, even though the dividend itself will not be taxable to the policyowner.)
For more Information:
Risk Management & Insurance
Personal Lines Insurance, Commercial Property Program, Commercial Auto Program, PPLI Solution,
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