Howard On Life Insurance

Mixed Messages

Many financial advisors will tell someone with dependants that life insurance is the first step in responsible financial planning. Some pundits argue that life insurance is the worst thing you can buy. Aggressive promoters will tell you to put all your money in their particular financial instrument – be it life insurance, gold, or a hedge-fund. As you probably suspect, no single financial instrument fits every need and it is rarely appropriate to put all your eggs in any one financial basket. It shouldn't surprise you that it takes more than a 30 second sound bite to understand a multi-faceted financial instrument.

What is Life Insurance?

Life insurance is a financial tool founded on the centuries old concept of risk pooling. By risk pooling, I mean that a community of people each put annual premiums in a pot which goes to those who suffer an insured loss. In the case of life insurance, those who die first get a better return than those who die later. Thus, it can be misleading to compare the expense charges of a life insurance policy with those of a mutual fund. Unlike a life insurance policy, a mutual fund does not collect risk premiums, manage mortality risk, or pay death benefits. Furthermore, life insurance is governed by state laws stipulating reserve requirements, actuarial standards, contract terms, and performance guarantees which do not apply to investment funds.

Historically insurance was little more than a pot of money held for the benefit of a community group – such as a fraternal lodge, church, or trade union. Modern insurance is mostly private or government. Private life insurance has evolved from simple risk pooling to multifaceted products which can be tailored to meet specific needs including: income replacement, estate liquidity, liability defeasement, and wealth accumulation.

Insurance is commonly categorized as either "term" insurance or "cash value" insurance. Term insurance is a pure risk pool which means that you have to die to win. Cash value insurance accumulates excess reserves on a tax favored basis. You can access cash values by surrendering the policy or borrowing them. If you don't access the cash values, their accumulation inside the policy effectively reduces your insurance charges or increases your coverage depending on the policy and options you select.

The most complex and perhaps most flexible cash value products are indexed and variable life policies. State regulations require that non-indexed polices be supported mostly by high quality bonds. In contrast, indexed and variable polices allow you to opt out of traditional bonds and tie your policy's performance to other investment vehicles – including stock funds, bond funds, and hedge funds. Indexed funds are closer to traditional polices in terms of structure and state regulation rather than federal regulation. Variable products are regulated by both the state and the federal government so agents selling them are double licensed and double supervised. Variable products segregate cash values in separate accounts that are legally and physically separated from the insurance company's money. Variable products are not permitted to offer mutual funds but commonly offer "clones" of popular mutual funds as separate accounts. A common source of confusion regarding variable products is that federal regulations require that expense charges be disclosed in a peculiar way that is somewhat disconnected from reality.

Like most financial products, indexed and variable life insurance products are good tools in appropriate situations. I have helped sophisticated parties use them very effectively. I have seen them inappropriately sold to individuals looking for low premium family protection. (Counter intuitively, higher premiums generally outperform lower premiums to the extent that the tax code limits premiums to prevent abuse.) If you have sufficient resources, you can negotiate the terms, conditions, investment options in what is called a private placement arrangement.

Income Replacement

When the death of a breadwinner would be a financial disaster for the survivors, life insurance can replace that income with an income-tax free lump sum exactly when it is needed. The appropriate amount and form of insurance depends on your values and financial situation.

Estate Liquidity

Estate taxes are due nine months after death. Non-involved family members need to be bought out of business interests. Life insurance can provide the needed cash. Properly structured life insurance trusts can leverage annual gift exemptions and avoid estate taxes.

Other Uses

Life insurance can be used in sophisticated ways to fulfill financial and personal objectives. As we explore your situation and objectives, insurance funded options such as private placements, defeasement, or reinsurance arrangements may arise. These options are best discussed privately.

Advisor Roles

You have a vision of the future. Legal documents provide the structure for realizing your vision. Insurance can provide funding and liquidity to support your vision. Thus, you will normally employ both legal and insurance advisors. My normal role is to present structural alternatives and draft your legal documents. In most situations, your insurance agent will develop and present coverage options without my direct involvement. When appropriate in complex cases, I may become more involved than most attorneys because I am a Chartered Life Underwriter, former variable life product manager and financial consultant. In any event, I am not licensed to sell insurance and I do not share in any insurance commissions.

Implementing Your Vision

Life insurance and estate planning in general is very personal. Your values, resources, and family are unique. Before you make any estate planning or insurance decision, I invite you to share your situation and vision with me. Your options will arise from those personal discussions.