Clients want to know: Why do I need insurance? The Risks Addressed by Life Insurance

Transcription

1 Clients want to know: Why do I need insurance? After reading this chapter you should understand: The ways that life insurance can lessen financial risk. The Risks Addressed by Life Insurance All people experience risk in their lives. No matter how cautious a person is, there is always the risk of the unpredictable or the unknown. An accident may cause death, sickness, or disability, a disease may be fatal or financially devastating, or perhaps the bite of taxes after death prevents children from receiving an expected inheritance. Ensuring financial protection of loved ones will always be a primary reason to buy life insurance. Risk has an impact on both individuals and their families. Married people worry about what might happen if their spouse should die or how they will pay the bills in case of an illness that prevents them from working. People with children are rightly concerned about the financial future of their children if they die. Those who are single and without children may be worried about who will care for them as they age. Most fears about risk boil down to a single issue: money. How would the surviving spouse support the family? Can the spouse fund future education costs for the children? People ask themselves, Where would the money come from if I died? If I got sick? If I lived to age 97? If, if, if. Copyright 2010 Oliver Publishing Inc. All rights reserved. 31

2 LLQP Life insurance was invented to address the risks of living. In fact, life insurers define the three predictable risks of living as death, disability, and old age. Very simply, life insurance provides the financial security people need in order to live their lives without worrying about the ifs. It does that by providing a wide range of products that address predictable risks. The product choice is personalized, according to the amount and type of risk a person wishes protection against. The insurer charges a fee based on the risk of the person and of the product solution for that risk, and ultimately provides the financial benefit if the risk should come to pass. Life insurers weigh the proposed risk of the person to be insured against the fee the premium that they will receive. An agent will analyze client information to find where risk exists, and then show the client how risk can be managed by a combination of risk retention, risk avoidance, and risk transfer via life insurance. In this way the agent can significantly affect a client s life by removing what if? worries. Understanding the concepts of risk and risk management is fundamental to being a successful life agent. Managing Risk The study of risk is a science. There are two measures of risk: severity and frequency. In other words, one has to assess how bad the risk is and how often it is likely to happen. A loss of life can happen only once, but certain risks may increase the chances that death will occur. The risk of death faced by an average person is less than that faced by a race-car driver, because deaths during race-car driving are relatively frequent. Conversely, less-severe risks are likely to happen more often. A sickness, such as pneumonia, could strike many times during the course of a lifetime. 32 Copyright 2011 Oliver Publishing Inc. All rights reserved.

3 The Need for Insurance The financial implications of the most severe risks are critical. Financial ruin (i.e., bankruptcy) could result. Risks that are less severe require financial adjustments that could result in a lower standard of living. When the severity of a risk may lower the standard of living, the risk is said to be material. There are certain risks that we face whose frequency may be medium or low, and whose severity has a financial implication, but not to the extent that it affects the standard of living. The severity of such risks are said to be minor. Being exposed to risk is inevitable: you cannot live without being exposed to some types of risk, in some measure. However and this is crucial to life insurance risk can be planned for, controlled, and managed. By doing so, you can decrease the probability of loss, and you need not fear it as you might otherwise. Life insurance is the key risk management tool. Risk is managed by: Risk avoidance; Risk control, which includes loss-prevention and loss-reduction techniques; Transferring and retaining risk, also called risk financing; Risk retention. Risk Avoidance This is a strategy that must be used when the frequency of risk is high and the severity is critical. For example, take the case of a person who participates in dirt-bike racing as a hobby. If he has a young family, and the family is dependent on this person s income, in the case of death the family faces the risk of bankruptcy, which is critical. Risk transfer for a high-frequency critical risk could be prohibitively expensive and can perhaps be afforded only by professional dirt-bike racers who may have sponsors. Therefore, a solution would be for the person to avoid participating in dirt-bike racing. All of us practise some amount of risk avoidance. Risk Control This is a strategy that generally falls into the realm of safety. All of us practise risk-control strategies. For example, workers wear hard hats at a construction site or wear safety shoes when entering manufacturing plants. We maintain our cars in good condition and change worn tires to reduce the risk of skidding. We get vaccinations against diseases to reduce the chance of getting the disease. Risk control may not eliminate any risk, but it certainly reduces the chances of Copyright 2011 Oliver Publishing Inc. All rights reserved. 33

4 LLQP accident, injury, or illness. Risk-reduction strategies work for risks that are high-, medium-, or low-frequency, but the severity could be critical, material, or minor. Risk Transfer This is a strategy by which the financial implication of the risk is transferred to a third party (an insurer) in exchange for premium payments. This strategy is used when the frequency of the risk is medium or low, but the severity is critical or major. For example, the death of a person may lead to bankruptcy of the survivors or lower their standard of living. In this case, risk transfer is recommended as a strategy. The frequency of a person dying in a car accident is low, but the severity could be critical or major, in which case a risk-transfer strategy is recommended. Risk Retention This is a strategy used for risks whose frequency is medium or low and whose severity is minor. For example, a young healthy family may not be at risk for medical treatment and the associated costs in the immediate future. They may choose to retain the risk and spend the money as and when required for small ailments that the family members may suffer. Risk retention is a strategy that all of us practise to some extent. The deductible for car insurance or an elimination period for disability insurance is the amount of risk that the person is willing to retain. The balance of the risk is transferred to an insurer. Retaining more of the risk lowers the premium. The Process of Transferring and Retaining Risk One way to lessen the financial implication of a risk is to transfer some of the risk to someone else. Life insurance transfers risk of a loss of income or a loss of wealth from the policy owner to the life insurer. To transfer risk, the amount of risk facing an individual must first be quantified. This means, a dollar figure must be calculated for the risk. For instance, if a person fears losing his income if he should become disabled, then it is necessary to assign a dollar figure to that income loss. That person may have savings that could be used for some part of the period he is disabled. He then transfers the balance of the loss to the insurance company via a disability income policy. Determining the severity of a loss is a first step in the insurance process. It is accomplished in a needs analysis. In other words, the amount of insurance that is needed is determined in consultation between the agent and the life insurance 34 Copyright 2011 Oliver Publishing Inc. All rights reserved.

5 The Need for Insurance applicant. Life insurance need is calculated very differently from disability insurance need. You will learn how to make these calculations. The amount of insurance determined in the needs analysis may, or may not, be accepted by the applicant. He or she may retain some risk by planning to use personal resources to foot the bills. The applicant will also retain some risk if he or she is willing to decrease expenses, thus reducing the amount of insurance that is needed. There is also the option that he or she may end up picking the amount of insurance according to the cost of the premium. Term life insurance provides a large amount of insurance for a small premium; thus, a large amount of risk can be transferred inexpensively. However, the policy owner risks paying the premium and never receiving the insurance benefit. This would be the case if the life insured did not die during the term of the policy. Term insurance is used to cover temporary risks faced by individuals. A temporary risk is defined as a risk for which an end period is determinable. Say parents of children aged five and six want to cover themselves for their children s period of dependency. One can determine that the children s dependency period will last for a maximum of 20 years for this couple. Therefore, they could cover this risk with a 20-year term insurance policy. Similarly, a couple that has a plan to clear their mortgage within a specific period can cover their outstanding mortgage with a term policy, since they can determine the term of the risk. Term insurance is the least-expensive way to transfer risk. A needs analysis tells me the amount of insurance coverage my client needs. In other words, it provides a dollar figure for the amount of risk she faces. That risk is transferred via the insurance policy. It is important my client knows what the needs analysis recommends as the correct amount of insurance, even though she may disagree and pick another amount. Copyright 2011 Oliver Publishing Inc. All rights reserved. 35

6 LLQP Permanent insurance includes whole life insurance and universal life insurance. Permanent insurance is more costly, because it is in force until death. Because death is inevitable, the life insurance company knows it will have to pay a death benefit at some point. The risk to the insurer is absolute. Permanent insurance is best suited to cover permanent risks, such as funeral costs, estate taxes, and estate creation (leaving money for a loved one or a charity; this may also be called a legacy or a bequest), or estate equalization (to achieve equitable distribution amongst heirs). It is also useful to assure that, when the first spouse dies, money is left for the surviving spouse, so that the surviving spouse can maintain their desired lifestyle. There is a much higher probability of disability than premature death. Disability income insurance is quite costly. This is because the risk of disability is much higher than the risk of premature death. Also, disability income insurance must address the frequency with which sickness or accident may occur over the duration of the policy. The insurance company therefore takes on considerable risk, and in turn transfers some of its costs back to the policy owner in the form of high premiums. Loss of Income Loss of income can result from both death and disability. Death Premature death permanently deprives dependents of a source of income, and saddles them with expenses that result from death. Two forms of expenses will be experienced by the remaining family: last or final expenses and continuing expenses. Last expenses are paid once. Last expenses are one-time costs. Once paid, they will not have to be paid again. They include the cost of a funeral, legal and tax issues that must be settled after death, and usually the elimination of debt, such as a mortgage. Paying off the mortgage is typically considered a final expense, because it is assumed that the survivors would want to continue to live in the family home without the financial burden of mortgage payments. Ensuring home ownership without a mortgage is an objective when paying final expenses. 36 Copyright 2011 Oliver Publishing Inc. All rights reserved.

7 The Need for Insurance Continuing expenses are ongoing costs that the family must pay after a death. When the income earner who makes the greatest financial contribution to the family dies, those expenses will be significant out-of-pocket costs. They can include day-to-day living expenses, education savings, and perhaps retirement savings for the remaining spouse. If the spouse who dies was responsible for child-rearing and family management, then continuing expenses will include the cost of replacing the contribution of that spouse. Money will have to be found for child care, for instance, or for tutoring, house cleaning, and maintenance, etc. It is very important to be able to cover all family costs during the dependency period for children. This is the time until the youngest child is no longer dependent on the parent. For normal children, this is usually considered to be up to age 18, or to age 25 if the child is attending school full-time. Disability Disability, whether brought about by sickness or an accident, is measured by the inability to work. It can deprive an individual of an income, either permanently or temporarily. This can have a significant impact on an individual and his or her dependent family. Loss of Wealth Wealth can be diminished as a result of: Medical expenses that are not covered by provincial health-care plans, medical expenses incurred while travelling abroad, or long-term-care costs for a nursing home or other care for seniors; Age, in which financial resources are outlived; Financial inadequacy of the estate (typically addressed by estate planning) to pay bills that will be due upon death and to ensure that bequests can be granted as desired by the deceased. Estate The estate is the whole of one s possessions, including all the property and debts left by one at death. Estate planning The activity of planning for the distribution of the estate according to the wishes of the estate owner. Copyright 2011 Oliver Publishing Inc. All rights reserved. 37

8 LLQP Medical Expenses Government health care covers a wide range of needs. However, expenses such as prescription drugs are not covered. Having to pay costs that are not covered by government programs can: Diminish the family or individual standard of living; Interrupt programs for savings; Deplete savings; and Reduce the ability to budget and make future plans. This need for insurance will be addressed by the variety of accident-and-sickness policies that you will learn about in this course. Age Long-term health-care costs deplete savings. Our aging population indicates the need for considerable wealth to pay for longterm health-care costs, such as for facility health care for seniors who choose to live at a old age facility. The cost for such services can run into hundreds of thousands of dollars over a lifetime. Another risk of aging is outliving financial resources and suffering a decline in the standard of living as a consequence. This risk can be addressed by investment and retirement planning. Investing and retirement are modules in this course. Estate Planning Estate planning may be concerned with issues of estate equalization that is, ensuring all beneficiaries of an estate are treated equally. It will also address the taxes that will be due upon death. These taxes range from a settlement of income taxes through to the more complex issues surrounding the taxation of assets, such as a second home (perhaps a cottage or cabin). While assets may pass tax-free to a spouse, when the last of two spouses dies, all tax must be paid. Some assets, like investments, can be sold easily and typically without emotional attachment in the amount needed to cover the tax bill. Other assets are less easily disposed of, such as ownership of a small business. 38 Copyright 2011 Oliver Publishing Inc. All rights reserved.

9 The Need for Insurance Keeping the cottage in the family can be a highly emotional issue. Life insurance can control the risk of keeping such an asset by ensuring tax can be paid when the cottage owner dies. Some assets, such as the cottage or cabin, are often to be retained by a remaining family member or members but to do so, the tax bill must be paid. These bills, which are sometimes substantial, can seriously erode the inheritor s savings or personal wealth, and if funds are not available to pay the taxes, then the property must be sold. As you will learn, life insurance provides valuable solutions to these risks. You should now have a good understanding of how risk is transferred from the applicant to the insurance company in an insurance contract. Classifying Risk and Pricing Premiums Insurers price the risk they assume by charging premiums according to the risk represented by the proposed insured. Underwriters may require additional information to make the correct risk assessment, and the additional information may be obtained from a variety of sources, including: The applicant; Third-party sources that report on medical, consumer, credit, and lifestyle issues; Credit and motor-vehicle reports. There are three classifications of risk that are used, and on which policies are issued. Preferred risk This classification is used for a person whose physical condition, occupation, way of life, and other characteristics indicate that their prospect for longevity is better than that of an average person of the same age who is unimpaired. Copyright 2011 Oliver Publishing Inc. All rights reserved. 39

10 LLQP Standard risk This classification will be used for a person who is entitled to insurance protection without extra rating or special restrictions. Sub-standard risk Roughly 10% of applicants are identified as special risks or substandard risks when they apply for life insurance. This actually means that they present a greater risk to the insurer because they are more likely to make a claim. A medical condition, medical history, occupation, or lifestyle can give rise to higher mortality rates than those used to determine the insurance company s standard premiums. For substandard risks, one of the following treatments compensates for the additional risk posed by the life insured: A policy is rated, which means the insured must pay a higher premium than a standard person of the same age; Exclusion riders or waivers are added, which means the condition causing the additional risk is excluded from coverage. If the applicant is offered a rated policy that carries higher premiums, the insurance company should confirm that the applicant will accept a rated policy before it is issued. The insurer will issue the policy with an amendment that the policy owner must sign before the policy can come into force. For life insurance policies, rating is generally used to deal with medical and other risks that make the life insured a substandard risk, though the insured may be offered a choice between getting a rated policy or a policy with an exclusion rider. For instance, a person who scuba-dives may be given an option of getting a rated policy or an exclusion. If he elects to go for an exclusion rider, the policy will be issued as a standard policy, but excluding death while scuba-diving. For disability insurance, the premiums are rated based upon the occupational classification of the insured. Such a rating is automatic. However, for other risks, such as medical conditions, the underwriter generally excludes such conditions from coverage by the policy. For example, an insured who applies for a policy and who has suffered earlier from knee injuries will be given a policy with exclusion for claims arising from the knee. Such a policy with an exclusion rider is called a modified coverage policy. 40 Copyright 2011 Oliver Publishing Inc. All rights reserved.

11 The Need for Insurance The rated policy will increase premiums on a: Permanent or temporary basis; Flat-dollar or percentage-increase basis. Permanent or Temporary Increase The extra premiums are either permanent or temporary, depending on whether the special hazard or risk is expected to last for the complete term of the insurance or for only a portion of it. If the policy was issued at a substandard rate, and the cause for that rating no longer exists, a request from the client, accompanied by medical evidence, is usually enough to remove the substandard rating. After a standard policy has been issued at regular rates, the insurance company cannot later convert it to a substandard rate. Flat Dollar or Percentage Increase The higher premiums for a substandard rating may be set out in the policy and applied in a variety of ways. They can be based on a flat-dollar amount per unit of coverage or on a percentage-increase basis. A flat-dollar amount might, for instance, be calculated as $15 per $1,000 face amount of coverage. So, if a policy had a face amount of $100,000, the premium would be increased by $1,500. For disability income insurance, the insured who has a history of lower back pain and an occupation in which lifting is involved may be offered a policy that would exclude any claim originating from problems with the lower back. Copyright 2011 Oliver Publishing Inc. All rights reserved. 41

12 LLQP If a percentage rating is used, the standard premium is increased by a stipulated percent. These are also referred to as table ratings. Sometimes both methods will be used. For example, if the condition that gave rise to the rated premium is severe, but is expected to abate if the life insured survives for more than three years, the rating might be based on a 40% increase in the standard premium for life, plus an additional $15 per $1,000 for the initial three years. A decline to issue insurance to an applicant will occur when no amount of premium is sufficient to convince the insurance company to accept the risk. The insurance company will avoid accepting the risk by: Rejecting the application. Offering a modified life insurance contract that would exclude a specific risk. This is called an exclusion rider. + FILE See file 3 for discussion on reinsurance Rejecting the application When an applicant poses too great a risk, an insurer will deny the application. Less than 2% of all life insurance applicants and over 10% of disability income and health insurance applicants fall into this category. It may be difficult for the agent who has sold the policy to tell the applicant that the policy will not be issued, but it is the responsibility of the agent to do so. The rejection of the insurance must be confirmed in writing, and any money paid by the applicant returned to him or her. Exclusion Rider The exclusion rider would describe the circumstances under which the life insurance benefit would not be paid. For example, if a proposed life insured skydives, the applicant may be offered or opt for a policy with an exclusion rider that would not pay the death benefit if the life insured died in a skydiving accident. My client, Rick, is a motocross stunt rider. He would not ordinarily qualify for insurance, because stunt riders often die while competing. However, we managed to qualify Rick for a life policy by taking on an exclusion rider that would eliminate any claims that might arise from his riding. 42 Copyright 2011 Oliver Publishing Inc. All rights reserved.

13 The Need for Insurance Selling Risk Management as a Concept to Clients Your job as an agent includes looking at the total financial situation of the client to determine where that client faces risk before recommending any financial and/or insurance solutions. The agent may identify a large mortgage that would need to be paid off, a tax liability that needs to be funded, or the necessity to get the value from a business. This is one aspect of the process of financial planning. Once risks have been identified, the agent can illustrate the correct policy and coverage that will manage the risk. Decision-making in regard to insurance will be motivated by personal need. It is often difficult to convince a client that he or she needs insurance if that client believes that the probability of loss is low or that the severity of a loss would not severely affect his or her financial security. Therefore, the agent must communicate both how probable a loss is and the impact of that loss. Risk comparison is an effective way to approach the concept of risk with a client. A comparison of risk between two time periods (e.g., risk of death today when children are ready to go to university compared to the risk of death ten years from today, when the children will have graduated), or comparing the risk to a benchmark (e.g., the risk of long-term disability for a person in the same occupation as the client) can assist in making the concept of risk less abstract. Another approach involves comparing the risks of doing or not doing something (e.g., establishing a retirement savings plan or not), or the risks that arise from one option compared to others (e.g., the earnings that accrue from interest, against the earnings that are possible from a high-growth mutual fund). The agent s objective is not to make the client feel exposed to risk, but instead to reinforce the concept of risk as a manageable part of living. Copyright 2011 Oliver Publishing Inc. All rights reserved. 43