Financial Underwriting: How Much Life Insurance Can I Get?
There are two major components to underwriting life insurance protection for your clients. Medical Underwriting, which is the primary focus in most of the cases we see at AgencyONE, generally concerns the health and medical conditions of the applicant. The second component is Financial Underwriting, which determines whether the applied for death benefit is in line with the financial loss the beneficiary might realize. Because we are seeing more of these cases, this ONE Idea will discuss and define aspects of the financial underwriting process.
INSURABILITY
How much insurance protection is considered reasonable before it becomes a concern for the carrier issuing the protection? Components of insurability that must be considered by the carrier include the clients’:
- income;
- net worth; and
- ability to make the required premium payment.
INSURABLE INTEREST
The underwriters are looking right to the beneficiary line. Is there an insurable interest between the parties in the contract? Underwriters tend to focus on insurable interest questions as a function of loss. If the named beneficiary will suffer a loss upon the insured’s death, then it’s just a matter of documenting the financial loss that would occur. A few states actually do not require an insurable interest to exist, but they are rare. The Stranger Owned Life Insurance (STOLI) concerns of 20 years ago brought these issues to the forefront of financial underwriting and most states now have robust insurable interest regulations.
ADVERSE SELECTION
Why is Insurable Interest so important to an underwriter? Because it prevents the insurance company from the danger of Adverse Selection Risk. When a life insurance contract creates a situation where someone is worth more dead than alive, you’ve created an Adverse Selection Risk. This is the subject of Hollywood dramas and real family tragedies. Adverse selection concerns are very real and a very important factor when considering how much insurance protection can be issued.
DEBT PROTECTION & LIFE INSURANCE
Protecting families, the widows and orphans, is the very premise on which life insurance protection is based – to make sure the family can economically survive after the death of the breadwinner. Financial justification for protection is easy to prove when a policy is needed for a home mortgage or loan payback. Replacement of the breadwinner’s income is also justification for larger amounts of life insurance protection. Underwriters have formulas for determining the amounts of insurance that can be issued before concerns of adverse selection are raised. Different carriers have varying formulas. The 20X or even 30X income multipliers are typical, but that number will fluctuate based on the insured’s age and years of expected loss of income stream.
WEALTH REPLACEMENT & LIFE INSURANCE
Another name for this might be estate protection. AgencyONE is seeing requests for more of this type of protection as the advisor community is now encouraging an estate spend down while clients are alive and replacing that “LOSS OF WEALTH” with tax free life insurance death benefit protection. A good rule of thumb guideline for the insurance amount would be to NOT exceed the insured’s current net worth. Even a 1X net worth guideline can be a stretch for older individuals. Watch for another ONE IDEA coming soon on this very specific topic.
BUSINESS INSURANCE
Once again look to the beneficiary of the policy. Is it the company? Is it a business partner? Is it a third party like an investment firm? The question from the Underwriter is always going to be the same: HOW is this named beneficiary going to suffer a loss upon death of the insured and can we:
- quantify;
- document; and
- justify the death benefit being requested?
BUSINESS BUY-SELL
This policy will generally be owned by the company with the company as the beneficiary and is justified by the value of the stock or financial interests of the insured that will transfer back to the company upon death. Justification for the amount of protection involves basic math – “if Bob owns 50% of a company valued at $2 million, then justification exists for $1 million of Buy-Sell protection.” When the purpose of the insurance is a Buy-Sell agreement, the underwriter cannot approve an amount of insurance above the documented company valuation and percentage of ownership. This aspect of Business Insurance protection is probably the only area that is truly black and white.
BUSINESS KEY PERSON
How “KEY” is a key person? The underwriter is bound by the formulas in the underwriting manual and most carriers use the 10X rule of income. If the company feels this person is “key”, then they should be paid as KEY so the underwriting formulas were based on that simple premise. Essentially, if the company is paying the key person an income (W-2) of $100,000, then a $1 million policy is generally justified (10X income). AgencyONE sees many of these key person cases that need far in excess of the usual 10X formula. With necessary documentation, we can usually supply the needed justification for carrier underwriters to sign off on higher multipliers – like 20X. Many start-up businesses have key executives taking minimal income for maximum returns later. We just need the justification to make sense.
INVESTOR PROTECTIONS
With the previous Financial Underwriting sections in mind, this particular segment of Financial Underwriting can be complicated and generally involves a great deal of money from various investors. Protecting these investors in a business is certainly a NEED…and there will certainly be a LOSS involved, but how do you VALUE that with concurrent concerns of an adverse selection risk that potentially REWARDS the investor if someone dies? A case scenario might go like this: An investor puts $3 million into a small company and requires Key Person protection of $3 million to cover their investment. While that certainly makes sense on the surface, does it really? After the investment is made, the company loses money and the investment tanks, but the death of the key person could make the investor financially whole again. Hollywood or real-life tragedy? When value is created by death of the key person, we are dealing with Adverse Selection again. When a third-party investor is the beneficiary, extra caution is required and different, more conservative justification formulas are employed.
Our AgencyONE 100 Advisors frequently ask Financial Underwriting questions. We are ready with the answers and happy to walk you through any justification process you will be facing. Your cover letters are instrumental in painting the picture for the underwriters.
Contact AgencyONE’s Underwriting Department at 301.803.7500 for more information or
to discuss a case.