The thing that encourages me the most about being a fee-only advisor, without the ability to sell commission-based insurance or investment products, is that we can focus on providing the most knowledgable advice for the client. Too often I see people buying insurance in a way that, in my opinion, is not a process designed for Risk Management. Unfortunately, most insurance is sold without client and advisor having conducted a true, unbiased risk management assessment.
Risk management is analyzing risk and considering,
- first, how to mitigate the risk;
- second, what assets and income are available to minimize the financial impact;
- third, whether to insure (risk-transfer) or self-insure (risk acceptance); and
- fourth, how to cost-effectively insure against the risk.
Yet many buy insurance without assessing risk. On the other hand, frequently we have clients that view insurance as a waste of money, but as any business will tell you, it is a necessary expenditure, and only through proper risk management can you limit the waste, while protecting against the risk. Consider these situations:
Story of Widow # 1
A few years ago I was asked to meet with a new client who was recently widowed. It did not take long to figure out that she was under-funded, based on her income potential, assets and liabilities. As we talked, I quickly realized what had happened. A few years before, the couple had obtained a life insurance policy to help the wife and children if something happened to the main income producer, the husband. The husband was building a small service business and wanted assurance for his family, so the 45 year old husband bought a $1,000,000 universal life policy with a premium of about $400/month. After a couple of years the husband’s business was still struggling some so the couple wanted to lessen the burden of the insurance premium. They decided to reduce the premium by 50%, thereby also reducing the face amount of the policy by the same 50%. . A year later, the husband unexpectedly passed away, and the widow collected $500,000 of proceeds, but she truly needed $1,000,000 or more of insurance. If the couple had conducted risk assessment and had purchased a 20 year term life insurance instead, their premium would have been a very manageable $100/month. Instead, the widow was left without the resources she needed for her family.
And this is the part of the story most people do not understand. The commission on the $1,000,000 Universal Life Policy is $2,500 or more in year one, but only about $500 on the 20 year term, therefore the risk management decision may have been influenced by the economic bias of an advisor. Some would try to argue the Universal Life Policy is the best long term solution because at the end of 20 years the term policy would end, but Universal Life can retain value for life. However, in making a decision about risk protection, the first question a client needs to address is, “do I need life insurance for life?” In the instance of Widow # 1, I would have advised No. One may also argue that the universal life policy will provide some extra retirement cash if the client lives to 65.. And yes, this is true, but keep in mind that with less expensive term insurance, $3,000/year of premiums can be saved and allocated as the client desires, while still properly insuring the real risk.
Story of Widow # 2
In the second case, the father and breadwinner passed away, but prior to his death, the family had completed a risk assessment. The couple had already identified their long term desires for the wife and children, should this scenario occur. They had determined they wanted the children to be able to attend college and had planned for the cost. They factored necessary debt servicing into their budget and discussed whether the wife should re-enter the workforce. And, after they had reviewed the ins and outs of the risk, they had decided to insure for $2,000,000. The premium of $200/month fit well within their budget for a 20 year term insurance premium, and the insurance covered their needs well past both their youngest child’s expected graduation date and the date they expected to retire. With their plan, when ready to retire they could do so on their assets, pensions and social security, leaving the surviving spouse financially secure without life insurance proceeds. As a result of their preparations, when the unexpected did happen, the widow was in a very favorable economic situation.
If the veil of tranquility is broken, the last thing a family needs is to worry about family finance. Therefore, insurance should be the expenditure of money to protect against the financial devastation of a risk, like the death of the family income producer, in the most cost- effective way possible. Businesses do not waste their monies on policies that make them feel like they are getting something in return for their premium. The primary concern for a business is guaranteeing adequate coverage for the risk they have chosen to insure. Businesses expect risk coverage to be an out- of- pocket expense. Yet, individuals often think of insurance very differently, seeking a return rather than risk coverage, without recognizing their “return” is peace of mind. Achieving peace of mind for the least amount of out- of- pocket cash should be the only concern. At the end of the day, we all need to know how to protect against risk, and so we would encourage you to do your risk management planning without economic bias.