Most advisors are familiar with the concept of investment diversification, but how well does the average advisor understand the need for diversifying life insurance coverage? Investment diversification is the strategy of reducing exposure to various market risks and promotes more consistent performance in an investment portfolio. Diversifying a client’s life insurance coverage is similar in concept, but with different criteria. The strategy looks less to managing potential market conditions, and more to the client’s family relationships and future financial trajectory. The advisor must identify and help manage the risks presented along the way. Advisors often focus on life’s common liabilities to create a client’s risk profile: income replacement, mortgage repayment, and children’s college funding. Each of these is easily quantified in dollars, and the financial risk tends to fall mostly on a single life. As a consequence, the advisor and client may settle on the simplest solution, a single high-denomination contract. In this approach, the only serious analysis involves whether to use permanent or term insurance. This article covers only some of the major considerations in a portfolio approach to managing life insurance coverage. Among other considerations, advisors should at least consider the following reasons why a client may need more than one contract and type of coverage:
- To insure the family caregiver
- To spread risk
- To avoid over-paying for coverage
- To protect a legacy
I. Insuring the family caregiver During the risk analysis, the economic value of a “stay-at-home” mom or dad may be overlooked. It’s important to recognize that a person maintaining a home and caring for a family has financial value. If an individual takes care of children or another person in the home, such as an elderly parent, their death could create unexpected – and significant – caregiver expenses. Will the client’s family suddenly be faced with childcare or adult daycare costs – or even assisted living expenses? Will they need a housekeeper to get chores done and run errands? These costs can be very significant. Stay-at-home parents represent an important financial consideration, and should have life insurance coverage to minimize any potential hardships. II. Spreading Risk Though life insurance is a risk management tool, it is important to look at risks to the insurance itself. Structuring a fallback or hedge may be prudent against poor policy performance. Consider a scenario where the client elects permanent coverage, but future benefits depend heavily on favorable but uncertain outcomes. If the policy provides a death benefit guarantee, how likely is it to materialize under all circumstances? Where a baseline level of coverage is non-negotiable to the client – as it most always is – a 30-year level premium term contract or universal life contract with guaranteed death benefit would complement the variable contract. Consider also the client’s understanding of how their permanent contract works. It is often founded on the assumption that the carrier will enjoy favorable results, and therefore be able to charge modest amounts for generous benefits. Carriers are required during the sales process to illustrate the effect on performance of the contract’s guaranteed costs and minimum benefits, and the costs and benefits themselves are shown in the contract. Still, if the carrier falls back on the contract’s charge structure to ensure payment of future claims, many clients may be unprepared to pay those costs in return for minimum benefits. They may surrender the contract, or exercise a settlement option. Either way, they will have a coverage gap. Since carriers do not often resort to charging maximums, simply splitting coverage between one or more carriers effectively mitigates the risk to the client of losing most or all of their coverage in this way.
III. Layering Coverage
Group term coverage offered through an employer is often the client’s first defense against loss. A realistic plan needs to consider additional individual coverage. Generally speaking, for temporary risk exposures, clients may be better off going with term life insurance policies. The client maintains the coverage only as long as it’s needed, and will not pay more per $1,000 of death benefit to support a cash reserve the client doesn’t want.
For different risk exposures, instead of buying one 30-year term policy, the client can consider multiple plans with different level premium periods. For instance, if the client has a current need for $1,000,000 of coverage, which includes a $200,000 loan that will be repaid in the next 10 years, is it worth it to purchase a $1,000,000 contract for 30 years that factors in the loan amount? A less-expensive course of action could be to layer the coverage by breaking it into two smaller contracts: a $200,000 10-year contract, and $800,000 of 30-year coverage.
Why not simply purchase the $1,000,000 contract and reduce the face amount after 10 years? This provides some flexibility for the client; if the total need remains unexpectedly high, the client won’t have to choose between new underwriting and paying costly renewal premiums after the level premium paying period on the smaller policy has ended.
The answer may come down to cost, or the intangible value of flexibility, or both. Certainly, using two policies may be less expensive, but the opposite may also be true. Since costs per $1,000 of coverage can vary among carriers and even within a carrier’s own term portfolio, a quick comparison between the shorter and longer contracts could show an effective discount for carrying a single contract at the higher amount. Of course, the advisor should verify that the high-coverage contract permits reductions in face amount, and the administrative charge, if any, associated with a reduction.
Layering term also works in a portfolio where much of the overall premium budget is servicing a permanent policy. A classic example is where the client owns a permanent policy, but is using it primarily to build cash value. To maximize the effectiveness of this strategy, the client keeps the policy’s cost of pure insurance at a minimum by keeping the face amount as low as he or she feasibly can. Naturally, this may create a gap between the client’s life insurance need and the death benefit payable. Adding a new “layer” of coverage via a separate term contract can be an inexpensive way to fill the gap.
In all cases, any strategy should be evaluated in light of the client’s needs and the applicable contractual provisions to determine what is possible and whether a course of action should actually be undertaken.
IV. Protecting a Legacy
A married couple’s legacy strategy of passing down assets such as real estate, businesses, investments or artwork could go awry if the children have to sell some of the assets to raise liquidity to pay federal estate taxes. Income taxes may be due at death on certain retirement plans also.
Survivorship insurance, or second-to-die insurance, covers the lives of both spouses and pays benefits only when the survivor dies. Since the unlimited marital deduction allows assets to pass estate tax-free to a widow or widower, and retirement plan rules permit the spouse to roll over plan balances income tax-free, these taxes can be delayed until the death of the survivor. A survivorship policy delays the life insurance benefit payout until that time, when the infusion of cash is needed to help with taxes.
Though estate taxes and income tax on retirement plans are two of the more common reasons to own survivorship life insurance, there are other scenarios where it may be useful or even vital.
State death taxes – At the federal tax level, the estate, gift, and generation-skipping transfer tax rate is 40%, and the per-person tax exemption for all three taxes is indexed for inflation ($5,430,000 in 2015). Decedent spouses can also pass their unused tax exclusion to their surviving spouse.
However, for couples with estates below this threshold, state estate or inheritance taxes may still be a factor. Ownership of survivorship insurance may offset economic loss sustained due to state inheritance and estate taxes.
Late start survivorship plan – In some cases, people procrastinate and resist making any irrevocable decisions until it’s too late. A stop-gap solution to protect clients against estate tax exposure can be for the less healthy or older spouse to purchase a second-to-die life insurance policy on the lives of both spouses. The policy is owned by a revocable living trust; when the owner spouse dies the policy becomes an asset of his or her credit shelter trust (“B” Trust). When the second spouse dies and estate taxes are due, the proceeds are outside the taxable estate. The benefit of this strategy is that the couple retains control over the policy and its cash value. If the non-owner spouse dies first, the survivor can gift the policy to an irrevocable trust, or surrender it for its cash value.
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V. Review
Lastly, let’s review the scenarios discussed, and what combination of life insurance policies might be appropriate for each.
Basic protection model:
- Ages 25-40
- Employer group term (typically $50,000)
- Income replacement: Term policy #1, coverage to retirement
- Debt repayment and college funding: Term policy #2, coverage to later of remaining term of debt or youngest child’s age 25
- Caregiver costs: Term policy #3, coverage to youngest child’s age 18
Cash value accumulation model:
- Ages 40-55
- Employer group term ($50,000 or more)
- Income replacement: Term policy #1 or guaranteed universal life
- Caregiver costs: Term policy #2, coverage to youngest child’s age 18
- Debt repayment and college funding: Permanent policy, minimum death benefit to enhance cash value accumulation
Legacy planning:
- Ages 55-70+
- Employer group term ($50,000 or more)
- Income replacement: Permanent policy #1 with chronic illness rider
- Retirement of debt and college funding: Term policy or permanent Policy #2, cash value accumulation
- Death taxes/estate costs, recoup/replace lost asset value: Permanent policy #3, survivorship life
Not surprisingly, as shown by these examples, managing a life insurance portfolio is similar to managing an investment portfolio in that it requires periodic review. Another thing to remember is that being insured is its own best sales pitch, so starting clients early with less-expensive coverage can help create the motivation to obtain additional coverage as needs arise.
The main point is that a single life insurance policy does not always fulfill the needs of a client – and doesn’t have to. By identifying and prioritizing temporary and permanent needs, layering coverage, and using different types of products to complement each other, you will be more than a product provider – you will be your client’s partner in strategic risk management.
• Care to comment on this article or share your experiences and challenges you’ve faced in layering coverage for clients? Please visit this new thread now.
Brett W. Berg, LLM, CLU, ChFC, is Vice President of Advanced Markets at The Prudential Insurance Company of America, Newark N.J.
Created Exclusively for Financial Professionals. Not for use with Consumers.
0275644-00001-00 Ed. 04/2015 Exp. 10/10/2016
