Insurance is one of the areas I spend time working with clients to save them money and add value to the financial planning process. My analysis often makes a compelling case to lower insurance premiums, saving the client money. Here’s how I frame things to clients to give actionable advice.
The five frameworks I use to evaluate insurance
- Insurance companies (even mutual companies) need to make a profit after covering costs, commissions, and claims. On average, the client is likely to lose money on most insurance. Thus, they should only buy insurance for what they can’t afford to lose.
- The purpose of insurance is to protect wealth – either human (life or disability) or investment capital (liability and health). This differs from the purpose of investing, which is to grow wealth.
- Some insurance becomes less important as clients get older (life and disability, to protect human capital) while others become more important (liability, to protect investment capital).
- Certain types of insurance provide better deals in the early years of a policy (disability) while others provide better deals in the later years (term life).
- Clients typically fall prey to the most powerful force in the universe – inertia. This leads them to keep paying for insurance they don’t need and not do routine price comparisons.
Explaining with two extremes
I don’t have collision or comprehensive insurance on my family’s cars. Granted, if I have a wreck, I’d regret that decision, but it wouldn’t change my lifestyle. In fact, if I had a $2,000 fender bender and did have a collision while holding a policy with a $1,000 deductible, I’m not sure I’d file a claim, as I’d likely see my insurance premiums go up. Auto insurance is often a deferred payment.
I have liability insurance on the cars and an umbrella liability policy on top of that. While the probability of a catastrophic event costing millions of dollars is low, the adverse consequences are high, as my family’s lifestyle would be dramatically changed.
Life and disability
The greater the amount of human capital, the more critical it is to protect those years of earnings. Over time, however, the amount of human capital depletes while, hopefully, investment capital grows, and one can self-insure. Though expensive, disability insurance is often more important than life insurance because one becoming disabled lowers or eliminates income while increasing health care expenses.
Both life and disability protect human capital, yet I analyze them very differently. Let’s look at an example of a couple, Bill and Sue, who are both 35 years old. Sue is a physician with high income and Bill is a stay-at-home dad. Sue bought a $3 million 30-year level term policy when she was 35 years old and a $10,000 monthly long-term disability policy. Bill bought a $1 million 30-year level term policy.
Fast forward 25 years and Sue and Bill are your clients, and both are 60-years old. Sue plans to work another five years until she turns 65.
Depending upon how much they have saved, they may not need to keep the life policies for the remaining five years. Obviously, if one of them were in bad health, they would want to keep the policies. But, even with good health and being financially independent, I may recommend keeping them. That’s because the value in the later years of a level term policy is far greater than in the earlier years. For example, the probability of mortality is higher during the last five years of a term policy than the first five. Sue’s probability of dying is nearly 10-times higher at age 65 than at age 35 when she bought the policy.
Disability is the opposite. If Sue became disabled shortly after buying the policy and the policy had a six-month elimination period, she could collect $10,000 a month for 34.5 years, assuming the policy paid to age 65. That’s a $4.14 million payout. On the other hand, if she became disabled on her 60th birthday, she only collects for 4.5 years or $540,000. Yet the premium Sue is paying is the same, falling prey to inertia. I’d likely advise them to jettison this policy. In fact, I’ve seen clients 63-years old who are still paying the full premium with very little potential benefit remaining.
Though some disability insurance policies have what I call “teaser” small benefits past age 65, the concept is the same.
As far as mixing insurance and investments with permanent insurance policies, I generally recommend growing wealth by direct low-cost investing rather than through an insurance company. With that said, often a client has an older whole-life policy with guaranteed cash value increases better than bonds. Universal life, however, typically has a geometrically increasing cost of the death benefit and often the least-bad solution can be to cash out, understanding the tax ramifications and possible penalty if under 59.5 years old.
Property and casualty
The analysis on protecting possessions is simpler. One can either (virtually) fully insure, partially self-insure, or completely self-insure any asset. The more financial wealth the client has, the more they can self-insure which, on average, will result in a better economic result, disintermediating the insurance company and the agent.
As I mentioned, the client may not need collision and comprehensive insurance on their cars if the potential loss isn’t material to their net worth. At least have the client consider opting for a higher deductible. The house is typically too material to go self-insured and there is no option to do that if there is a loan, as the bank requires insurance. But the likelihood of a total loss is low as the foundation will typically remain intact. Though the insurance company will usually resist, they will often relent and allow a lower amount of insurance.
Despite having been a financial officer to two multi-billion-dollar healthcare companies (Kaiser Permanente and Anthem), I have no solution to our current situation which has the U.S. spending more than twice per capita on health care than any other country. But having healthcare insurance is critical and is an exception to rule #1 where you will pay more having insurance than not having. That’s because insurance companies negotiate provider discounts and paying the full rate without insurance can be many times higher. A catastrophic health event like an organ transplant could easily cause financial ruin.
I often recommend that clients look into a high-deductible health savings account (HSA). This accomplishes three things – partial self-insurance, the negotiated provider discount, and greater tax efficiency. The client gets a tax savings each year they contribute to the HSA account and then later as it grows. I advise clients to keep track of their healthcare expenditures but not reimburse themselves for decades. This allows the account to grow and the client to later take it out tax-free by reimbursing themselves for those expenditures that can be decades old. Just make sure the client does reimburse themselves as it does not pass on to heirs with any tax efficiency if your client passes away.
Another type of health insurance is long-term care (LTC) insurance. I wrote about evaluating that option last year. It was the hardest article I’ve ever written, because data is inconsistent and it’s a very emotional topic. I received many “colorful” communications about it. Joe Tomlinson wrote an excellent follow up.
Unlike basic health care insurance, there are no provider discounts. And the only two options are to buy pure insurance and gamble on whether high-rate increases will continue or to buy a hybrid mixing permanent insurance with LTC. My conclusion was that wealthier clients should self-insure, and the main purpose of LTC insurance was to protect the inheritance for their heirs.
An umbrella policy typically sits on top of an auto liability policy with the goal of protecting wealth from a catastrophic event like injuring or killing someone. It’s typically very cheap but, when you buy $10 million or more, the cost per million goes up and there are few insurance companies that will underwrite these larger amounts. The rule of thumb I’ve heard numerous times is:
Buy umbrella insurance equal to your net worth.
I’m skeptical. I’ve researched this rule and can’t find any logical basis for it. A client could have a $50 million net worth with that much umbrella coverage yet still be sued for $100 million. So how much to buy is a judgment call.
I take into account that company retirement plans like 401(K)s and 403(B)s are typically protected by ERISA from liability claims. IRAs and one’s home are often protected by the state. In fact, paying down the mortgage increases home equity which often protects a greater portion of the client’s net worth without paying a premium.
Another thing to consider is the amount of risk the client may have. Do they have a swimming pool or participate in extreme sports where they could accidentally injure someone? If the client is elderly, doesn’t drive, and rarely goes outside the house, they may not need much.
No matter what types of insurance the client needs, it pays to shop. Most of my clients are frugal, which is how they saved millions of dollars. Many will spend some time to save a few bucks yet haven’t shopped for insurance in years. And, for some time, I was guilty of the same.
But those commercials stating “facts” like, “Customers who switched to XYZ saved an average of $473 a year,” are misleading in that they exclude customers who didn’t switch because XYZ was more expensive. Clients should talk to an independent insurance agent who can write from many insurance companies as well as to captive agents who can write a policy from a company an independent agent can’t.
The incentives for the insurance company and the agent are not going be aligned with that of your client. That doesn’t make them evil – just human. They may not be getting the best price from the best carrier or letting you know when to lower or eliminate some insurance. Because our clients typically have higher credit ratings and because some insurance companies provide lower premiums for those with high FICO scores and low records of past claims, fighting inertia can save a bundle.
Advisors spend a lot of time trying to add investing alpha in their client relationships. But we can add far more alpha by saving clients a lot on taxes and insurance. This puts the client first, and there is a benefit to advisors. When the client pays their next insurance premium, they will think of you and how much money you saved them. They may tell their friends and family what you did for them.
Allan Roth is the founder of Wealth Logic, LLC, a Colorado-based fee-only registered investment advisor. He has been working in the investment world with 25 years of corporate finance. Allan has served as corporate finance officer of two multi-billion dollar companies and has consulted with many others while at McKinsey & Company.
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