The Advantage of Using a Multi-company Insurance Brokerage Firm; of Backdating; of Paying Premiums Annually. Case Study # 13

I just finished a case that illustrates the advantage of an insurance brokerage firm representing many companies versus a single company, even a good one such as Northwestern Mutual, State Farm, or USAA.

The best offer my normal go-to company would provide this client was Preferred rather than Preferred Best, because she uses anti-anxiety medication. However the insurance brokerage firm which I suggest for many clients (but from which I receive no commissions, in case you’re wondering) uses a generic application, so without her having to sign additional paperwork automatically switched her to Metropolitan who issued her Preferred Elite. Met had no problem with her mild medication and the premium difference was 21% less for 15 years. This brokerage firm routinely uses over 30 companies and shuffles risks around based on health conditions, medications, avocations, and occupational hazards, for optimum offers. Insurance underwriting departments have personalities too, and some are more tolerant of certain risks.

We also backdated the policy to be issued at a younger age for a lower premium. Backdating is a common practice allowing the policy to be issued up to six months earlier to gain a younger issue age, for lower lifetime premiums. The downside is you pay premiums for a period when you had no coverage, so you have to weigh the savings against the waste. After careful calculations, even if this insured backdated the maximum allowable time of six months the future savings represented a 16% after-tax return on the “wasted” premium. However she only needed to backdate for three months meaning the future savings represented a 36% tax-free return. It makes me wonder why it’s not automatically done, however agent commissions are a percentage of premium and an older issue age means higher premium, so there is a disincentive to do so.

The final piece of advice which I’ve devoted an entire blog to in the past is the advantage of paying annually versus quarterly or monthly. Sometimes this is a budget issue (can’t afford to pay annually) but the financing charge inherent in a monthly payment is typically 10%. If you take the money out a savings to pay annually, you save a lot more interest than you would earn leaving your savings account intact.

All of these improvements are small nuances compared to the big picture (right-sizing the policy, a competitive company, the right type, etc.) but collectively they are weighty. Once a policy is launched it’s usually carried for decades if not a lifetime, so trimming the premium down upfront is certainly worth the effort

Which Insurer Will Treat You Best?

I finished two cases in December that each took over half a year to wrap up. Very unusual. They had other similarities too: minor health issues, over insured by major insurers, with young children yet oblivious to Social Security survivorship benefits, and best of all, their improvements were outstanding. These type of improvements motivate me.

The first client was a pharmacist with a State Farm $750,000 20 year term, issued nine years ago, costing 140/month, and rated table 2. His health condition had improved so we asked State Farm if they might reduce the rating, but they would not. I have my auto and homeowners insurance with State Farm, but they are no leader in life insurance. We first right sized his policy since he had young children with substantial Social Security survivorship benefits he did not know about. His assets had increased and debt reduced since he purchased the policy and he and his wife felt comfortable reducing it to $500,000. The new 15 year level premium policy (four years longer than the current one) was issued at Standard Plus for $505/year. He’ll save nearly $1200/year.

The second client was a young engineer whose pharmacist wife had a Northwestern whole life policy with a large loan. A Lincoln life agent was encouraging her to roll this into an annuity. The agent had sold each of them a $1.5 million term policy, and after carefully evaluating their survivorship goals and how they were already self-insured through current assets we reduced her coverage to $500,000 and his to $750,000. We also reduced the Northwestern to shrink the policy loan. Its cash value was earning an attractive dividend interest rate, and putting it through the commission ringer for the annuity unnecessarily whittled down its value.

Lincoln would not permit her to reduce her current policy which was excessive as per their goals. The engineer’s weight was a tad above the guidelines for the best risk category, so over several months he dieted to get below the threshold and ended up getting Preferred Best rates. I directed him to an insurance brokerage company representing many companies. The best risk category with a super competitive term specialist, along with rightsizing the policy, saves them $1440/year on term premiums, while reducing loan interest to Northwestern, and avoiding annuity commissions.

Periodically ask yourself– how did you came up with the amount of your policy? do you understand Social Security survivorship benefit? and have things changed? One last similarity: they will each save my fee back 1.4 times per year for many years, likely totaling 18K for one and 30K for the other. That’s a 140% annual after-tax return on their fee.

Neither the “Good Neighbor” company nor the one named after America’s favorite president served these clients as well as a specialist whose name you wouldn’t recognize. Knowing which insurer will treat your risk factors best and how to put your best foot forward is why there’s no such thing as a “good” company for all insureds. The risk category you are assigned can make a “good” company not so good after all.

Should I Drop My Whole Life Policy? Case Study #11

This is a common question from clients unsure about what they have and a common recommendation from agents seeking to earn a new commission. Yesterday I talked to a Virginia client considering dropping a Lafayette whole life policy which he had purchased eight years ago when an agent recommended he replace a 20 year old Northwestern policy. Earlier this month a local client’s Edward Jones advisor recommended he replace a 30 year old Northwestern whole life policy with a new John Hancock policy. All of these were bad ideas.

At least three things drive these costly mistakes:

  1. it’s difficult for the consumer to understand the value of a cash value policy, since it’s a mixture of insurance and investment.
  2. the entire industry moves on agents pursuing commissions which only happens when new policies are sold.
  3. some respected financial advisors, e.g. Dave Ramsey, make generalizations disparaging whole life insurance.

I am not a fan of whole life insurance and rarely recommend a new purchase. (Though some companies and specific policies are much better than others and there’s a small niche for these.) However there’s a dramatic difference in purchasing a new policy and continuing an old policy that’s beyond the high early year transaction costs. Just because I don’t recommend new purchases doesn’t mean that I endorse casually dropping old policies. This decision is influenced by your age, health, investing alternatives, and largely the caliber of your policy.

Yesterday’s client should keep the Lafayette policy. An in force ledger revealed cash value earning 4%, and he already had a lot of cash earning next to zero. His immediate priority is putting his low earning cash to better use. He should have never bought the Lafayette policy to replace a Northwestern Mutual whole life policy, but that’s water over the dam now, and at least this time he’s getting advice before acting.

My local client averted a mistake by asking for an unbiased opinion first. Replacing a 30-year-old Northwestern policy with a new John Hancock policy would have only profited the agent.

Consumers don’t recognize commissions on a whole life policy are one to two year’s premiums (!), a flagrant violation of John Bogle’s eternal triangle principle of minimizing cost. It’s usually impossible for improved nuances of a new whole life policy to overcome such a blow. Adding insult to injury, switching from Northwestern Mutual to Lafayette or John Hancock were steps down in quality, only underscoring the lack of discernment and/or self-interest of the agent.

There’s another valid perspective on whether to keep a whole life policy. Whereas the Lafayette cash value was earning a net 4%, and that’s very favorable compared to a savings account, it’s unfavorable compared to long-term stock market returns averaging around 10%. And make no mistake, a life policy is a long-term investment if kept until death.

However for both these clients the cash values were a minor portion of their assets much of which were already invested in equities. Also each had a lot of low-earning cash which became the most-likely-to-improve candidate. Had this not been the case, replacement was more of a possibility, but for the sake of putting proceeds in equity returns and certainly not to buy another whole life policy. Client context can swing the decision either way.

If you’re tempted to cash in an old whole life policy:

  1. Understand what rate of return is being earned on its cash value. (Not the published rate, but the real rate.) It’s usually higher than alternatives of similar risk.
  2. Agents recommending replacing old cash value policies with new ones are often the fox guarding the hen house. Rarely can improvements overcome new commissions.
  3. If a financial guru categorically suggests replacing any whole life insurance he is often throwing out the baby with the bathwater.

What’s the take-away from these cases? ASK before you ACT. The Virginia client’s mistake eight years ago was an uninformed response to an uninformed agent. This time he’s ASKING. The local client averted a similar mistake by ASKING upfront. It grieves me to see such waste so easily avoidable. Calculating the true rate of return on your current policy is child’s play for me and my charge is small potatoes compared to what’s at stake. Proverbs 20:18.

Corollary: ASK an IMPARTIAL source. Ironically the supposed authority, the licensed insurance agent, precipitated these mistakes.

Qualification: We’ve been talking about old policies. If a whole life policy is less than three or four years old (before transaction costs have been paid) it may be best to discontinue ASAP, after replacing with cheaper coverage first, dependent on several considerations.

Surrendering a Cash Value Policy? Don’t Waste the Loss

I see many misguided initiatives to drop cash value policies, coming from a guru’s generalization that “whole life insurance is bad”, or an agent’s effort to make a new sale. Dropping a cash value life insurance policy warrants careful consideration: calculating the real (not nominal) rate of return, comparing alternative investing strategies, assessing the current health of the insured, one’s current need for death benefit, and the taxation upon surrender.

If the policy is a poor value, no longer needed, and without a taxable gain, the common advice is to surrender. Not so fast. If there is no gain there must be a loss. How much is it? Could it be used to offset the gain on other life policies or annuities? Often it can by merging the losses on some contracts with the gains of others, via a 1035 tax-free exchange.

I recently had two clients who were dropping cash value policies at a loss- the surrender value was less than the cumulative lifetime premiums. Normally upon surrender no tax deduction is allowed. However both these clients also had annuities with gains. Annuity gains are tax-deferred until withdrawn, when they are taxed as ordinary income. I’m not a fan of annuities, but these were unusual. One client’s annuity was issued October, 2007 (market peak before Subprime mortgage crisis) with the guarantee it would double after 10 years. The insurer bemoaned the day it made that guarantee, but it’s a vintage annuity that shouldn’t be dropped (until after it doubles), when it will have a large taxable gain. The other client had a Fidelity no-load annuity, also with a gain.

Both clients were “self-insured” through other assets, healthy, and the life policies were poor quality, so termination was appropriate. Standard procedure is surrender since there’s “no gain”. However the loss can be rolled into the annuities to offset its gain which must ultimately be recognized.

If there’s a loan on the life policy it must be paid off first and this can be a problem since you don’t want to stuff more cash into the annuity, particularly if it’s a commissionable annuity. However one could open up a commission-free annuity (Fidelity or Vanguard), pay off the loan, and then roll over the life policy (with its loss) into the annuity. Once the rollover is complete, the cash could be withdrawn from the annuity, at least if the annuitant is over age 59 1/2, or if the loss totally or at least mostly negates the gain.

Again I don’t like annuities, where the tax wrapper becomes the major selling point while the investments within languish in less than optimum strategies. I’m only suggesting using them as a temporary tax strategy, and then get back to better investing strategies.

Withdrawals from annuities, before age 59 1/2 are subject to the 10% early withdrawal penalty, to the extent of the taxable gain, and it’s gain out first. However the loss of the life policy would reduce and sometimes eliminate that gain, so this penalty may become moot.

It’s important to only use commission-free annuities such as with Fidelity or Vanguard.

In summary here are the four ingredients to make this work:

  • A poor cash value policy you want to drop, with a tax loss.
  • An annuity or life policy with a gain or prospect of a gain.
  • Preferably over age 59.5.
  • A no-load annuity.

It’s a rare scenario that has all elements present, but with this happening with two clients in the same week, it may have broader application than I’d thought.

“I am an Insurance Salesman” – Case Study # 9

I just finished a case that started as a call to the radio show, Money Wise. This listener’s agent encouraged him to replace a whole life cash with a new term policy and put the $45k cash value in an annuity. “Term is cheaper and the cash value will earn more”, sounded plausible. Mark Biller of Sound Mind Investing was the guest and recommended he call me.

First I evaluated the whole life policy to see if it needed replacing and then assessed his overall need for life insurance. The cash value was earning 3.87%, much higher than money in the bank, but lower than long-term equity investments. This wasn’t bad, but it was an inordinate amount of his net worth tied up in a relatively low long-term return.

He was no longer married, and had a 22 year old independent working son and 19 year old student daughter. He already had two good life policies: the 150k whole life and a 200k term policy costing only 342/yr with level premiums for another nine years, more than long enough to see his daughter to independence. The agent recommended a new $400k 20 year term policy costing 1492/year. He didn’t need insurance for 20 more years and he didn’t need that payment.

…there comes a time when emphasis needs to shift from the what-if-I-die scenario to the what-if-I-live scenario…

He had a Roth IRA which he hadn’t been able to fund in recent years. He also had 200k of debt. He’s in his young fifties and dedicated to his children, however there comes a time when emphasis needs to shift from the what-if-I-die scenario to the what-if-I-live scenario. Also, one should never fund an annuity (tax-deferred) when eligible but not funding a Roth (tax-free).

We returned the annuity and rejected the new term policy. The dividends on the whole life policy had bought paid up additional insurance which we surrendered for 13k of the 45k cash value. He will use that to fund his Roth for 2013 and 2014. We’ll keep the whole life at least until Roth funding is due for 2015, then maybe whittle it down further or discontinue it altogether if his daughter becomes independent. He’ll apply that extra $1492 to his mortgage.

I explained the rationale behind these decisions to the agent. He acknowledged it made sense, but then added, “I am an insurance salesman”. That code language meant, “My responsibility is to sell policies; besides I’ll forgo a $1k commission if I don’t place the life policy, aside from the $1500 commission I lost not placing the annuity.” I respected his candor and expected him to try to place this term policy. Indeed he did, but my client had a balanced understanding of the risks of both rejecting the policy (premature death) and accepting the policy (opportunity costs) and stood firm.

It’s not a matter of understanding, but of motivation. What saved this client was reaching outside the traditional box of advice exclusively from a salesman, and getting input from someone who understood insurance nuances and the marketplace, investment alternatives, and had the proper motivation. His retirement should be larger, his debt and taxes smaller, while he saves his fee back three times per year for two decades. It started with a phone call.