Following a formal process

Regardless of the approach you use to arrive at a dollar amount for insurance purposes (for example, the needs-based or human life approach presented later in this section), follow these five steps to assess a client’s risk profile, identify the client’s insurance needs, and present your plan to your client:

Step 2: Educate the client on mitigating risks

Although you can’t put a price tag on risk, I like to use a formula to demonstrate the wisdom of allocating some portion of the client’s assets to protect against potential losses. Here’s the formula I use:

Present value (PV) of financial loss ≥ PV sum of all premiums + Opportunity cost – PV of cash value accumulations (if applicable)

Where,

• PV economic loss is the present value of some future, possible, and/or probable liability in dollars.
• PV sum of all premiums paid is the amount of money paid over time into an insurance policy or contract or other strategy to protect against that specific future liability.
• Opportunity cost (if premiums were invested elsewhere) is the money that could have been made if those insurance premiums were invested somewhere else. (Figure a five to six percent compounding return.)
• PV of cash value accumulations is the accessible cash value that has accumulated in the insurance policy contract at some point in the future, if that feature is applicable.

The equation shows that a possible loss would cost your client more than the total cost of having insurance to protect against that loss. If you wanted to get even more fancy, you could try to research the probability of your client experiencing a particular event, like death or disability. There’s just one small problem — no one believes it could happen to him, which makes the whole probability exercise futile with clients.

To calculate present value (PV), use the following equation:

where FV is future value, i is the discount rate, and n is the number of years.

Here’s a simple example: A 40-year-old household breadwinner earning $200,000 per year and receiving an annual raise of 6 percent adjusted for inflation stands to earn $10,972,902.40, over the next 25 years leading up to retirement at age 65. You can use a lifetime earnings calculator or a spreadsheet to figure that out or do some really long math:

• First year: $200,000
• Second year: $200,000 x 1.06 = $212,000
• Third year: $212,000 x 1.06 = $224,720
• Fourth year: $224,720 x 1.06 = $238,203.20
• and so on to the 25th year, and then total all annual salaries to arrive at a total lifetime earnings of $10,972,902.40.

Assuming a discount rate of 3 percent for inflation, the present value of $10,972,902.40 is

The breadwinner could protect against that loss with a renewable term life insurance policy, paying annual premiums of $5,000 that increase 3 percent annually, which comes to $182,296.30 over the 25-year term. Assuming a discount rate of 3 percent for inflation, the present value of that policy is

The opportunity cost of not investing that $182,296.30, assuming an annualized return of 6 percent is $274,322.56. Assuming a discount rate of 3 percent for inflation, the present value of that policy is

Based on these three numbers, you can show the client that the potential loss to the family if he dies without insurance is $5,240,719.30, but he could protect the family from that loss by paying $218,083.72 for a term life policy. Here’s the math:

• PV of financial loss ≥ PV sum of all premiums + Opportunity cost – PV of cash value accumulations (not applicable, because this is a term policy)
• $5,240,719.30 ≥ $87,065.74 + $131,017.98
• $5,240,719.30 ≥ $218,083.72

Note that PV of cash accumulations isn’t applicable, because this is a term life insurance policy. Using cash value life policies can be a good way to build contract value, which reduces opportunity cost on the capital allocated to such a policy, as well as, the cumulative premiums paid.

Step 5: Present the options, reach agreement, and implement the plan

Create a table to illustrate your liability management plan, as shown in Figure 9-1. For each solution you recommend, state your reasons for including that solution as an option and present its pros and cons or its cost, benefits, and features. Let your clients know that you have chosen only the best of the best insurance providers, and explain the importance of choosing products from companies that are in a financial position to back those products.

Don’t use emotional coercion to manipulate a client into a product or strategy. Most clients sense when their arms are being twisted, and they’re more likely to reject your recommendation than embrace it. You can get your point across in ways that aren’t coercive. I prefer presenting the facts objectively to appeal to the sentient beings I want to serve and allow their rational thinking to drive the best choices.

Several insurance-sales coaching programs are available to train advisors in techniques designed to connect clients with the gravity and emotion of potential life disasters, so clients are more receptive to insurance solutions. These approaches are effective because they increase clients’ awareness and understanding without being pushy.

Using the income replacement approach

One approach to estimating how much life or disability insurance a client needs is to calculate the income the person would earn over the course of his life.

A general rule in calculating coverage for losing a breadwinner’s income is to multiply the person’s annual salary by 20 years. If the person earns $150,000 per year, then $150,000 x 20 years = $3 million in today’s dollars paid as a lump sum. However, you should adjust for the ages of the surviving spouse and children, if any. With younger survivors, you may want to multiply the annual salary by 40. If the survivors are older, you may go as low as 10 times the salary.

For example, suppose your client is a family of five. Mom’s a 32-year-old attorney earning $250,000/year married to a 28-year-old dad who stays at home and raises the kids. In the event of mom’s death or physical disability, the family would probably need $250,000 x 40 = $10 million to maintain their lifestyle and achieve their future financial goals.

The family could decide that the premiums on a $10 million insurance policy are too expensive. They figure that in the event of mom’s death or disability, dad could get a job to offset the loss of income, they could scale down, and the kids would be able to take care of themselves in 15 years. They figure that they could probably get by on $100,000 per year, so they decide that $100,000 x 20 = $2 million of coverage would be sufficient.

Taking the needs-based approach

With a needs-based approach to estimating insurance coverage, you link the benefit payout to a future liability. For example, suppose your client wants to make sure his eight-year-old daughter’s college expenses are paid for in the event of his death.

You could use an online calculator or the future value (FV) function in Excel to crunch the numbers and determine that the total cost of a four year college education starting 10 years from now would be about $432,000:

A simple $500,000 life insurance policy specifically timed to provide that coverage throughout the daughter’s college career would suffice here. To be precise, a $500,000 death benefit, 15-year term life policy would do the trick.

Life insurance

Life insurance provides financial benefits to heirs in the event of the insured’s death. The three biggies are:

• Term life provides a tax-free death benefit (tax-free) to the named beneficiaries, if the insured dies within the specified time period. The policy has no cash value, so if the client lives past the term, he can’t recoup any of the premiums. The good news is that term life policies are relatively inexpensive.
• Permanent life policies provide protection for the insured’s entire life, assuming the premiums are paid. These policies also have a cash value — a portion of each premium is held by the company and allowed to grow tax-deferred. Unfortunately, permanent life policies, such as universal life or variable life, may not live up to their name. Stock and bond market returns, company management, and product pricing can all impact the staying power of a particular policy with a constant premium. If you’re advising a client to purchase a permanent life policy, read the fine print and make sure the provider is financially strong and well established and that your policy performance assumptions are sound.
• Whole life policies are a type of permanent life policy that locks the premium for the entire life of the policy regardless of changes to the insured’s age and health. A whole life policy has a cash value that can grow tax-deferred, and be accessible through policy loans. Most whole life policy providers even pay dividends to policy holders. If you’re offering whole life policies, be especially careful to work with a stable carrier, and ones that pay dividends based on nondirect recognition (no adjustment is made to policy dividends when there’s an outstanding loan balance)

Life insurance policies often include features that make them stand out, such as the following:

• Waiver of premium if the policyholder becomes seriously ill or disabled
• Accelerated death benefit, which pays cash advances if the policyholder is diagnosed with a terminal illness
• Guaranteed purchase option, which enables the policyholder to purchase additional coverage without having to prove he’s in good health
• Mortgage protection to pay off a mortgage upon the death of the policyholder

Disability insurance

Encourage your working clients to consider disability insurance in the event that an injury or illness prevents them from working. Social security disability pays only $700 to $1,700 per month, and the payments start six months or longer after the date the disability began. Unless your client has a good chunk of change squirreled away, even a short-term disability can be financially devastating.

Your clients who need disability insurance should consider both short-term and long-term disability insurance (see Table 9-1).

Disability insurance policies differ in several ways, including the following:

• The definition of disabled: Whether you’re unable to work, period, or are able to do a job that’s outside your field of expertise. For example, if you’re a disabled attorney but can work as a secretary, the policy may not pay.
• Partial disability coverage: Some policies pay a portion of the salary if the insured can work only part time, whereas others pay only if the insured is unable to work at all.

Health insurance

Unexpected medical bills are one of the biggest contributors to personal bankruptcy in the United States, so your clients should have health insurance and the means to cover the deductible. For example, a family with a policy that has a household deductible of $10,000 per year should have at least that much saved in basic FDIC insured bank savings before allocating funds elsewhere.

Even if you decide not to provide health insurance plans, develop a clear understanding of your client’s health insurance policy terms and conditions, including deductible amounts and limits. With this understanding you’re in a better position to help clients plan their savings and investments, so they have resources to draw on if necessary.

Homeowner’s insurance

Although you’ll rarely, if ever, encounter a client who owns a home and doesn’t have homeowner’s insurance, you should review the policy to ensure that the coverage is sufficient. Coverage should include the replacement cost of the home and personal property inside the home, including expensive artwork, jewelry, and collectibles.

For many clients, the home they own is their most valuable asset. Without sufficient insurance coverage, a single tragic event could rapidly deplete the homeowners’ net worth.

Auto insurance

Because drivers are required to have auto insurance, most drivers have it, but you should review the policies to ensure that your clients aren’t underinsured or paying too much for their policies.

Encourage your clients to get one or two auto insurance quotes from reputable companies. Comparing policies from two or more insurance companies may reveal ways your clients can save money to allocate elsewhere.

Liability insurance

The possibility of a client being sued (especially if he has millions) is a real risk to a family’s accumulated assets. Various types of personal or professional liability policies, such as umbrella policies and malpractice insurance, fund the possible settlement and/or judgment from an unlucky personal or professional lawsuit.

Many businesses and professions (including financial advisor) are required to carry error and omissions policies. Policy premiums are typically range from $700 to $1,500 annually for $1 million in protection against unintentional damage to a client.

Annuities

An annuity can be a combination of insurance and investment that pays the holder a certain amount of money starting on a certain date and every month for the rest of the holder’s life. The idea is to provide a guaranteed income stream, so annuity holders don’t outlive their money. The other benefit is that investors in annuities don’t have to concern themselves with managing their investments; that job is handled by the annuity manager, although the investor may have some choices.

As much as guaranteed income for life sounds great, annuities have several drawbacks, including the following:

• When you buy an annuity, you’re pretty much stuck with it, or you have to pay a stiff surrender fee to get your money out.
• Some annuities (like, variable or indexed) are commonly sold by brokers who are paid a commission, sometimes as high as 10 percent or more.
• Often certain annuities typically charge annual fees of 2 to 3 percent compared to 1 to 1.5 percent for managed mutual funds.
• When you die, your money stays in the annuity; it’s not passed to your heirs. This is the case for life income–only annuities.

Here are the two main versions of annuity contracts:

• Single premium immediate income annuity: This old-fashioned annuity is a simple promise to pay the annuity holder a certain amount based on a lump sum deposit. The payment isn’t subject to market volatility and is widely regarded as a favorable tool in retirement income planning.
• Flexible or multiple premium deferred accumulation annuity: This newfangled annuity adds interest to the deposits, and this interest may be guaranteed for a certain number of years. The promise here is that the annuity will “capture stock market upside without downside capital loss risk.” This type of variable or indexed annuity is typically expensive and somewhat complex. Use extra due diligence to figure out how a product really works before recommending it to a client.

Do your homework and be prepared to explain the pros and cons to your clients. I’ve witnessed too many so-called financial advisors who fail to comprehend the finer details in these kinds of annuity contracts. By demonstrating your thorough understanding of the product’s pros and cons, your client will have gained tremendous confidence in their plan.

Collecting a one-time, up-front commission

A vast majority of insurance product manufacturers incentivize and compensate their salespeople by paying up-front commissions of anywhere from 50 to 120 percent of the first year’s total premiums. Commissions like that can add up to big bucks and make your clients wonder whom you’re really working for.

If you choose this compensation model, here are a few ways to ensure that your interests align with those of your clients:

• Present products from more than one product manufacturer.
• Present high-cost, mid-range, and low-cost options, and let your clients choose what’s best for them.
• Broaden your service offerings, so you don’t come across as just an “insurance salesperson.” While I believe that being a risk-management-first advisor is a noble profession, adding asset management and guidance on other financial matters to your service offerings takes some of the focus off insurance sales.

Getting paid in installments

Getting paid in installments (officially known as annual recurring trail revenue) involves small payments over a number of years instead of one large, up-front commission. You can still earn the same amount of money, but it’s spread over several years. I recommend this arrangement for two reasons:

• Getting paid over several years projects to your clients that you’re committed to their long-term success.
• Spreading out commission payments typically improves short-term policy cash value accumulation (specifically in the case of whole life cash value policies) because most of the first-year premium payment is being applied to the policy instead of being paid out in commissions.

Lean toward the smaller, ongoing revenue, whenever possible. Most insurance product manufacturers provide a variety of compensation models.

Embracing transparency

Whichever compensation model you choose, be transparent with your clients. Get ahead of any future regulatory pressure by incorporating commission transparency on all sales today.

I’ve begun the difficult practice of being consistently transparent, which has been refreshing to my clients. To follow in my footsteps, here’s what you need to do:

1. Reveal the percentage commission that you’ll earn when the contract or policy is in force.

   For example, whether you’re receiving 100 percent of the first year premium in the first year or over the course of five years, quote that total.

   Be general. If you’re getting a 55 percent up front plus another 20 percent financing bonus and another 25 bonus, you don’t need to break it down. Just tell your client that you’ll be getting 100 percent of the total first year premiums.

2. Educate your client on the competitive marketplace and the industry’s predominantly commission-based compensation model.

Revealing commission compensation to the client has expanded the types of insurance products and structures I offer clients. I can often find insurance products that are better aligned with my client’s interests when I expand my search to include products that pay, for example, 10 percent up front and 10 percent over the next nine years.