FINANCIAL PLANNING
Using life insurance and annuities for planning during time of great uncertainty for other forms of investments has most recently revived a rather dormant industry in many respects. The days of the “dot-com” millionaires seems to have peaked, and in many cases, have crashed. Many, if not most, of the experienced life insurance agents and general agents have become “financial planners” with considerable success in many instances. Those who have not forgotten the basics of life insurance and annuities find the present atmosphere as that of encouragement and opportunities.
Suddenly, to many producers, the guarantees of the life and annuity policies, are appealing, but at the same time, the past experiences of those planners and the concerns of their patrons does not allow them the luxury of totally ignoring the non-insurance investment vehicles. But there still remains the variable and interest-sensitive products that can grow when the financial and investment climate grows, and still furnish a guarantee, or a “floor,” if these markets decrease.
This text addresses the newer type of life and annuity policies with emphasis on those that depend upon the ups-and-downs of the traditional investments – stocks, bonds, mutual funds, REITs, etc. – and the indexing of such investments in some cases, to determine the amount that is available or would be available for the financial or estate planning purposes.
Obviously, this is an area that requires the highest degree of training and experience in order to fulfill the expectations of the clientele. In-depth knowledge on how various types of products actually “operate” and the provisions thereof, plus knowledge of how results of these products are taxed, are most important before a proper, professional and meaningful program can be presented to the client. While many of the students of this text may already have reached their pinnacle of professionalism, many have not. Therefore, a brief review of courses, many of which lead to professional designations that can provide the foundation for success, is in order here.
There are many types of planners, obviously, that use life insurance or annuities very little, and many of these non-insurance planners have their “own horse to ride” as they may principally represent mutual funds, stockbrokers, etc. This can lead to the situation where certain advisors are driven by the products that they represent which can lead to the situation that (1) the customer may lose confidence in the individual if it appears that this is the situation, and (2) even worse, there is a tendency for the “advisor” to work independently of any other expert in financial planning, e.g. an insurance agent may emphasize only insurance products, where a mutual fund may be much more appropriate, but will not be introduced because of lack of securities license. An insurance agent recently complained in an industry magazine article, that because a tax savings for the customer was discovered by the agent, the customer’s accountant convinced the customer that the work done by the agent was useless, obviously because the accountant was felt that his professional expertise was being questioned by the insurance agent. This does not indicate that the agent should become an accountant or an attorney, but a professional agent with expert knowledge of the various products that he offers, can obtain the respect of non-insurance professionals – indeed, there are many insurance agents who are very successful and that work closely with attorneys and accountant on planning matters, particularly if the customer has considerable assets.
Financial Planners, in particular, are usually loosely divided into two categories:
(1) Those whose compensation is based upon the commissions they receive from the sale of their particular product. This applies to insurance agents and securities dealers generally. They provide advice in financial planning, and then to accomplish their recommendations, they offer their products. This can be considered as an advantage as it can all be “rolled into one single package.” Conversely, they can be accused of not being objective because of this arrangement. There is a distinct possibility that a competitor would point out this perceived conflict of interest to further their interests.
(2) The other side of the coin is the fee-based financial planners, who do not “sell” a product used in the process, but for a fee paid by the consumer, they make recommendations. Many individuals appreciate their independence and their objectivity since they have no financial interest in which product is sold to accomplish their financial planning objectives. The disadvantage of this type of planning provider is that the fee must be paid whether the customer accepts they’re planning recommendations or not. Any purchase of securities or insurance would contain commission costs on top of the consulting fee. The fee-based financial planners are usually accountants.
There obviously is considerable confusion among those who feel the need for financial planners, to determine who, besides their brother-in-law, is qualified to advise them on financial matters. As indicated earlier, there are many titles of financial planners, but only some have professional designations. To add to the confusion, there are several types of professional designations and consumers may easily become totally confused by the plethora of initials following the advisor's name. Some (not all) of the “titles” or designation are as follows”
CFP’s receive their designation from the Certified Financial Planner Board of Standards after completing a (normally) three-year course. The CFP Board designed the home-study courses, but one may obtain the designation by completing certain college courses and pass a comprehensive examination. The courses include Financial Planning & Insurance, Investment Planning, Income Tax Planning, Retirement Planning, Employee Benefits and Estate Planning. They have recently introduced an “Associate” CFP designation after certain experience requirements and passing an examination. Both designations require 30 hours of Continuing Education each year.
The ChFC designation is considered by many as the most prestigious designation and it is awarded by the American College of Life Underwriters, Bryn Mawr. PA, the same institution that awards the Chartered Life Underwriter (CLU) designation. Obviously, the majority of the ChFC’s come from the insurance industry, and nearly all are CLU’s also.
The 10 home-study courses are:
Insurance and Financial Planning
Income Taxation
Individual Life Insurance
Planning for Retirement Needs
Investments
Fundamentals of Estate Planning
Financial Planning Applications
Wealth Accumulation Planning
Financial Decision-Making at Retirement
- Plus any one of the following:
The Financial System in Our Economy
Planning for Business Owners and Professionals
Estate Planning Applications
Life Insurance Regulation, Compliance and the Political Process.
These examinations are offered twice a year, but may be completed via the Internet at any time.
This designation is also awarded by the American College of Life Underwriters, and is awarded after a 40 hour, 2-week residency course. The student may specialize in either financial planning or financial services. Courses consist of Financial Planning, Advanced Pension & Retirement Planning, Advanced Estate Planning (2 courses), Personal Tax Planning and Executive Compensation. They also have courses in Business Valuation and Professional Self-Management. For Financial Services, the courses offered are Professional & Organizational Behavior, Human Resource Management, Marketing Management of Services, Decision Making in Financial Services, and Professional Self-Management.
The PFS designation is awarded only to Certified Public Accountants (CPA’s) after completing a comprehensive financial planning examination administered by the American Institute of Certified Public Accountants, have a minimum of 3 years of financial planning experience, and have at least 500 hours of financial planning every year.
Several colleges, such as Georgia State University, San Diego State University, Purdue and Brigham Young University, offer courses in financial planning, in undergraduate, masters or doctoral programs.
The discussion of insurance for planning purposes and the success of the producers, have a similarity to a discussion of about any other successful business, whether professional football teams, huge conglomerations, or any other area of business – basics. For the football fan, it may be recalled that very recently one team paid a huge sum of money and several high-draft picks for eternity (almost) in order to get a new coach that has a particularly successful record. Then what did this high-priced coach do – return to basics. Therefore, in this text, there will be a certain amount of “basics.”
Investments that are designated as vehicles for future retirement or estate planning must be protected against various risks that may or may not arise. Insurance is unique as it provides a service that the purchaser hopes that they will never have to use. While the “old” Whole Life Insurance policies have fallen into disfavor by many during the recent past, it certainly is not a product that a responsible financial planner would hesitate to recommend.
Universal Life and Variable Life will be discussed in this text. These are the “new generation” of life insurance plans that combine the security of insurance with the flexibility of other investments and indexes. It will become apparent that there are multitudes of solutions to planning problems that can be alleviated by using these complex products. However complex these products may be, a basic axiom of the function of insurance is that of risk management. According to Barron’s Dictionary of Insurance Terms, Risk Management is a “procedure to minimize the adverse effect of a financial loss by (1) identifying potential sources of loss, (2) measuring the financial consequences of a loss occurring; and (3) using controls to minimize actual losses or their financial consequences.” Ernst & Young’s Personal Financial Planning Guide states: “Risk Management: the discipline of determining how likely certain events will be, then deciding what steps will limit or transfer the consequences.”
Many of the “risks” that are encountered in everyday life are “managed” by individual choice, such as exercising regularly, not smoking, eating proper foods, getting physical checkups, etc. However, there are more deleterious risks that are beyond the ability of an individual to control. These risks can be transferred to another, and the “transferee” is insurance – indeed, that is the purpose of insurance. For those and other risks, the personal decision of the client must be first and foremost in the determination of transferring risk. The client must consider how much risk they are willing to tolerate, and then determine how much of that risk can be transferred. The likelihood of that risk affecting the client is important, but the insurance industry, if anything, is a gatherer of statistics and can help determine this. The last, but certainly not the least, factor is the cost to the client of transferring that risk. It is important to understand that one should never underinsure a risk that they could cover for little cost. A good example of this is liability insurance on an automobile policy – it is quite inexpensive, but a million-dollar lawsuit as the result of an auto accident is not unreasonable in today’s society.
A working definition of life insurance begins with understanding why the concept of insurance originally developed. In all lives, uncertainty exists about what will happen tomorrow, next month, next year. The future holds unknown events, some that will be positive, others, negative. Negative events include the possibility of loss. Insurance is specifically concerned with financial loss. For example, because most people own and rely upon the availability of cars, they can envision the financial loss that will occur if the car is damaged in an accident. As a result, people buy auto insurance to protect themselves against the uncertainty - the risk they take by driving - that they will suffer a financial loss if an accident occurs.
Fewer people readily envision the financial loss that will occur as the result of death. One might argue that there is no uncertainty here because everyone will die sooner or later. While death is certain, however, the uncertainty is this: When will it occur? And more importantly, what will be the consequences?
If one wants to know exactly how much life insurance premium they should pay, all they have to know is two items: (1) Date of Birth. (2) Date of Death!
In addition to the emotional consequences of death, the financial consequences can be devastating, especially if the deceased has financial obligations that extend to others. The death of a person who provides the primary income for a family can result in the loss of everything ‑ the home through lack of funds to continue making mortgage payments; the source of ongoing income for food, clothing, utilities and more; the children's education; the survivor's retirement.
Insurance is obviously the answer to this uncertainty because it produces a substantial sum of money that becomes available precisely when it is needed - when the financial loss occurs. If all people could personally generate and accumulate enough wealth to cover financial losses, there would be no need for insurance. Since most people are not wealthy, insurance was devised as a way of having a large number of people share in the loss.
Instead of pooling money with private parties, people who purchase life insurance make small payments to an insurance company in return for the guarantee of a substantial sum of money if death occurs. The financial loss is still spread among many others who also purchase insurance from the same company, but it is the insurer who accumulates the funds and is responsible for paying for losses. In this way, the financial risk is transferred from one person to a group through an insurance company.
The best understood and most obvious purpose of life insurance is to pay a certain amount of money to survivors when the insured person dies. Paying death benefits was the original purpose of life insurance policies and continues to be the major reason people buy life insurance. Life insurance paid at the time of death can be used for many purposes, including:
While life insurance has traditionally been used for purposes such as these, contemporary policies can provide additional benefits, whether the insured person lives or dies.
As life insurance policies evolved, more emphasis was placed on the cash values that accumulated in policies as premiums were paid. Certain policies have features allowing cash accumulation that may be used by the insured person who does not die. For example, a policy might accumulate cash values that would be payable to the policyowner when she or he reaches a certain age or after the policy has been in force for a specified number of years. With the recent wild fluctuations of the stock market, cash accumulation has taken on a life of its own and will be discussed in great detail later in this text.
A basic (very basic!) distinction to be made about life insurance policies is whether the insurance is permanent or term. Permanent insurance, which is also called cash value life insurance, is permanent only insofar as the policy language is concerned. Originally, "permanent" meant that the policy was in force until the insured person died or lived to age 100, whichever came first. If the insured were still alive at age 100, the policy would pay its full amount of insurance to the insured instead of continuing until the insured person died. More recent policies often have earlier payoff dates.
In addition, permanent policies typically build some type of cash value that is available while the insured person is living. For example, the cash value may be borrowed or used to help pay premiums. In more contemporary policies, cash values can grow significantly to provide retirement income. While the more appropriate terminology for these policies is ”cash value life insurance," they are still often called permanent insurance.
Term Insurance, conversely, does not build cash values and does not continue "permanently." Instead, a term policy is written to pay a specified amount of insurance only if the insured dies within a specified "term" or period of time. When the term ends, so does the insurance coverage. In the past, if the insured wanted to continue coverage, a new term policy usually was required. In recent years, however, most term policies are written with an automatic renewal feature.
Permanent life insurance ("Whole life") also refers to the premium‑paying period. Premiums are paid for the entire period the insurance is in force, again either until the insured dies or reaches age 100 (or other age the insurer selects). The advantage of making premium payments for a long period is that each payment will be relatively small for the benefit provided. At the time the policy is purchased, each payment is determined and "fixed" so it never changes during the policy lifetime.
Term Insurance is basic insurance and it must be assumed that any licensed insurance agent fully understands Term Insurance. However, since it is used for a wide variety of purposes, including financial and estate planning, therefore a brief discussion of this product is in order.
Term Insurance is defined as coverage that:
Level Term: When the amount of coverage in a term policy remains the same throughout the policy period, the policy is called level term. This is the typical way to purchase Term Insurance. So, for example, if the term is for five years and the amount of insurance is $150,000 when the policy is purchased, the coverage remains at $150,000 through the end of the five years or when the insured dies, whichever comes first.
Decreasing term Insurance has a death benefit that gradually becomes smaller over the policy period. A popular use of decreasing term is to provide having a lump sum of money, which is available to pay off a mortgage if the insured should die before doing so. Decreasing term policies used for this purpose are informally called mortgage insurance or mortgage redemption insurance and many are structured so that every year the death benefit exactly equals the remaining mortgage amount.
For example, the term might be the same number of years as the mortgage. If a 30-year mortgage were $100,000, the decreasing term policy would be written originally for $100,000, reducing as the amount of the mortgage reduces.
Some insurers also offer the option of Increasing Term Insurance, which is typically written as a rider or endorsement to a cash value life policy. The increasing term provision operates much as a Rider, as it “rides" along with the cash value policy. This will be discussed in more detail later.
With such a rider, the policyowner pays an additional premium; the death benefit amount gradually increases during the term the rider is in effect.
Term Insurance policies are written for various periods of time, depending upon the particular insurer. While most term policies have periods of one, five or 10 years, terms of 15, 20 or 25 years may be available. Other policies might be written for a term associated with the insured's age, such as until the insured reaches age 55 or 65.
From the options offered by a particular insurer, the policyowner may choose the term most appropriate for his or her needs.
A feature that often attracts insurance buyers to Term Insurance is the lower premiums - lower at least initially as compared to permanent types of coverage. Premiums can initially be lower because
Term policy premiums typically remain level during the entire policy period. So, for example, an insured that purchases a 10‑year term policy pays the same premium for the 10‑year period. Then, if the term policy is renewed, as discussed in the next section, the new premium is calculated and likewise remains the same for the subsequent 10‑year period.
Most insurers offer their term policies on an automatically renewable basis. Under this arrangement, when the original policy period expires, the insurer automatically renews the insurance for a "like term" - a 10‑year term policy for an additional 10 years, a 15‑year policy for 15 more years, etc. - unless the insured specifically refuses the renewal. All policies specify a maximum age, however, after which the policy will no longer be renewed. The precise age differs among insurers, but age 60, 65 and 70 are typical.
The primary benefit to the insured is the ability to renew the policy for many years without proving insurability - which he or she is still in good health. Without the renewability feature, an individual must have another medical examination to prove insurability.
At renewal, the new premium is determined according to the attained age - the age the insured is on the renewal date. The premium, therefore, is higher because of the increased age of the insured - not because of a change in health. These premiums are sometimes called step rate premiums because they "step up" to a higher level as the insured ages. Some policies guarantee what the attained age premiums will be, others do not.
When a policy does not guarantee the premium amount, the premium is indeterminate. Like the indeterminate premiums discussed previously, such premiums might be higher or lower than the last premium the policyowner paid. A maximum premium must be established, however, and typically, few companies ever charge the maximum.
The original premium for a renewable term policy is somewhat higher than for a term policy that is not renewable since the insurer takes a greater risk by offering renewability in the future when the insured's health may have deteriorated.
While automatically renewable term policies do not require a medical exam, an insured might choose to have a medical examination because of the re‑entry feature included in some term policies. This feature offers two possible levels of premium increases - a higher level for choosing not to take a medical exam and a lower level for having the exam to prove that the insured is still in good health.
While most contemporary Term Insurance is automatically renewable, a few term policies still follow the older historical pattern of offering renewability, but not automatically. In such policies, a very short time window typically exists during which the policyowner may exercise the renewal option after a term policy expires - 30 days is common. Under this type of policy, failure to renew within the time limit means the individual once again must prove insurability and meet any other insurer requirements in order to purchase a new term policy.
Convertible term policies permit the policyowner to convert from term to cash value life insurance. A term policy that includes this right often has the word "convertible" in its name.
Insurers vary significantly on the period of time but will state the maximum age that the insured may convert in the policy.
One may also encounter older policies that require much earlier conversion, such as:
The rate will be determined based upon either the insured person's attained age or original age.
Attained age refers to the person's age at the time conversion occurs. Conversion at attained age means the premiums will be higher since the person is older once the policy is converted, a new policy is issued and the policyowner starts paying the higher premiums. The new cash value policy is then no different from any other cash value policy.
Original age is the insured's age when the policy was originally written. Since the insured was younger, the rates are lower than for attained age policies. However, there is an additional lump-sum cost for original age conversion.
The amount of this additional charge is the difference between the premiums actually paid to date and the higher premiums that would have been paid had the insured purchased cash value insurance originally. Added to that amount is a small percentage to cover the insurer's expenses.
An increasing term rider could be added to cash value life insurance, making the policy a combination of' permanent and Term Insurance and thereby satisfying specific needs.
Some cash value policies permit the permanent insurance on one individual ‑ usually the family breadwinner – to be supplemented by Term Insurance on other family members. Such a combination policy permits family coverage‑insurance on all members of the family under a single policy at rates lower than for individual policies. For example, a married man who is the sole wage‑earner might purchase cash value insurance on his own life and add Term Insurance to cover just his wife or both his wife and their children.
Varying amounts of Term Insurance are permitted for family members in these combination policies, usually based upon some mathematical portion of the permanent coverage and sold in "units." For example, the permanent coverage on the primary breadwinner might be one unit of $10,000, and based upon that unit, the other spouse will be covered for $2,500 of Term Insurance and any children will have $1,000 of insurance each. If the breadwinner purchases two units instead of one, the coverages would be $20,000 permanent insurance, $5,000 of term on the spouse and $2,000 of Term Insurance on each child. The exact dollar amounts are stipulated by the particular insurance company.
Any children born or adopted after a family policy goes into effect are automatically covered at no additional premium. Insurance on children expires when each child reaches an age stated in the policy, usually 18 or 21. Some policies allow coverage to continue longer if the child is a dependent, full-time student. Children's coverage sometimes may be converted to permanent insurance.
There are many different ways to write family coverages, some permitting a small amount of permanent coverage on the breadwinner's spouse. Other policies might provide that the cash value coverage would be equal to four times the Term Insurance on a spouse. Still others might limit the Term Insurance on family members to very small amounts designed to cover the cost of burial and little more.
Family plans, while historically providing an economical insurance solution for lower income families, may not be appropriate for many contemporary families in which both adults provide a significant part of the family's income.
Another use for combination policies is to provide family income when the breadwinner dies. Under these policies, the cash value insurance death benefit is paid in a lump sum and the Term Insurance is paid in installments over a certain period. Options of 10,15, or 20‑year periods are commonly offered.
When decreasing Term Insurance is used for this purpose, the period begins on the date the policy is issued and the amount of insurance begins decreasing gradually. The longer the insured person lives, then, the smaller the amount of Term Insurance available. This assumes that if the insured lives longer, less money from insurance will be required for the survivors because the insured continues to earn the money for ongoing living expenses. If the insured dies before the decreasing term period expires, income payments from the Term Insurance begin to be paid to the family.
The lump‑sum death benefit portion of family income policies is typically paid at the time the insured dies.
Some family income policies include level Term Insurance instead of decreasing term. In this case, the "term" begins when the insured dies and continues for the stipulated period, with income payments to the family made during the entire term. This arrangement may also be called a family maintenance policy.
Because Whole Life policies are permanent insurance, cash values build during the policy period. In the early years of a Whole Life policy, typically while the insured person is young, more premium money is paid in than is actually required based upon the mortality tables for a younger person. The insurer accumulates, as cash values, the difference between the premium actually required to cover mortality costs and the premium the policyowner pays.
Cash values grow not only from the excess premium payments, but also from interest paid on the cash value. At some point, as the insured ages, the level premium that is still being paid no longer covers the mortality risk, but the larger premiums paid in the earlier years balance the cost.
Whole life policies guarantee that specific amounts will accumulate each year the policy is in force and will be available to the policyowner as cash values. A table included in the policy itself shows the guaranteed cash values. The rate of interest is typically low simply because it is guaranteed rather than tied to anything going on in the financial world that might otherwise affect interest rates. While relatively low, these guaranteed rates help the cash values grow over the years of a Whole Life policy.
While fixed, level premium payments represent the most common method for purchasing insurance, single premium Whole Life policies are also available. In this case, the insured buys the policy with just one large lump-sum premium and the policy is paid‑up for life, providing both the insurance protection and an immediate cash value. Because a large cash value is available from the onset of the policy, the interest earnings over the years are likely to be greater. And, while a single premium policy requires a greater cash outlay initially, it actually costs less in the long run since it is not subject to the ongoing administrative charges the insurance company incurs each time a premium payment is made.
Not all insurance purchasers want a policy that requires them to make premium payments for a lifetime. This criticism led to the development of limited payment or limited pay policies. As the name implies, these policies require the insured to pay premiums for only a limited period of time.
Like Whole Life policies, limited pay policies require a certain premium amount that never changes during the policy period. Because the number of years during which premiums are paid is shorter, limited pay premiums are higher than Whole Life premiums.
Insurance companies offer various types of limited payment policies such as 10‑pay life, 20‑pay life, 25‑pay life, 30‑pay life, Life paid up at 65, Life paid up at 80, etc.
These types describe how long the policyowner pays premiums. For example "10‑pay" means premiums are paid for 10 years and the insured then has coverage for life. "Life paid up at 65" means the insured pays until his or her age 65 and then is covered for life.
Like Whole Life insurance, limited pay policies also pay the face amount if the insured lives to age 100, or other age the insurance company specifies.
Paying the higher premiums for limited pay policies can additionally benefit the policyowner. Cash values accumulate at a faster rate simply because more money is available earlier to earn interest. Since these cash values are guaranteed, more value is available sooner than with a Whole Life policy. And, of course, there is the advantage of knowing exactly how long premiums must be paid.
CHAPTER 1 – STUDY QUESTIONS
1. A customer may not feel comfortable with a financial planner if
A. the planner receives commissions from an insurance company that he/she represents.
B. the planner is licensed to sell mutual funds.
C. the planner is a registered stockbroker.
2. What should you do if the clients wish to bring in their own attorney and tax consultant?
A. The agent/planner should refuse to allow them to become involved.
B. The agent/planner should then bring in another attorney and accountant.
C. The agent/planner should welcome their expertise and work closely with them.
3. The original purpose of life insurance was
A. to provide funds from construction of homes and buildings.
B. to pay to estate taxes.
C. to pay death benefits.
4. Term life insurance that decreases in death benefits over a specified period of time may also be known as
A. mortgage insurance or mortgage redemption insurance.
B. increasing term.
C. Universal Life.
5. Because the number of years, during which premiums are paid, is shorter, limited pay premiums are
A. lower than Whole Life premiums.
B. higher then Whole Life premiums.
C. variable.
6. In Term insurance, when the original term of issue expires, the policy will be
A. automatically renewed.
B. automatically cancelled.
C. automatically converted to Whole Life Insurance.
7. A life insurance policy that guarantees a specific amount of cash value at a specific time, guarantees fixed payments and guarantees a specific death benefit is called
A. Universal Life.
B. Variable Life.
C. Whole Life.
8. When the face amount of a Term life insurance policy remains the same throughout the policy period, the policy is called
A. Decreasing Term.
B. Increased Term.
C. Level Term.
9. The type of family policy that combines Decreasing Term with Whole Life is called
A. Family Maintenance Policy.
B. Family Income Policy.
C. Family Policy.
10. One of the following is the best reason to buy Whole Life insurance.
A. Buying out a surviving partner’s interest in a business.
B. Accumulation of cash assets.
C. Protect the mortgage on a home.
ANSWERS TO CHAPTER ONE REVIEW QUESTIONS
1A 2C 3C 4A 5B 6A 7C 8C 9B 10A