|Neil Alexander, CFP, is the president of Alexander Capital Consulting, a Los Angeles-based consulting firm that helps clients understand financial products used for wealth preservation. He can be reached by e-mail at Nalex@AlexCap.com|
Many CPAs are regularly faced with clients who walk into their offices with armfuls of life insurance policy proposals and ask, Which one should I buy? While not all accountants are life insurance experts, they are very familiar with their clients individual financial circumstances, which puts CPAs in a good position to help clients decide what insurance is best for them. Often the best way to judge the merits of various insurance companies, agents and the policies they offer is by using common sense. This article provides CPAs with seven steps they can follow to unearth the facts about recommended life insurance policies and the important business decisions they represent for clients.
EVALUATE THE AGENT
Most insurance agents are commissioned sales representatives who profit financially from the advice they give. A CPA can help mitigate the risk this represents by asking the agent for third-party client references. While they most likely will be favorable to the agent, the references will provide some indication of his or her credibility. The CPA also can request the names of other accountants or attorneys the agent has worked with and then ask those professionals about their experiences regarding the type of policy recommended, its appropriateness to client circumstances, commissions, the agents knowledge of the products he or she represents and his or her overall ability to meet the clients insurance needs.
Professional qualifications. Most insurance agents have an alphabet soup of initials following their names representing the insurance or financial planning designations they hold. These include
- Chartered life underwriter (CLU). Offered by the American
College, this designation requires an individual to complete 10
insurance-related courses and have at least three years professional
- Chartered financial consultant (ChFC). Also offered
by the American College, this designation similarly requires 10
courses, some of which overlap with those required for the CLU
- Certified financial planner (CFP). This designation
is more familiar to many CPAs. It requires individuals to complete
courses in six financial planning disciplines, including insurance,
and pass a comprehensive exam administered by the CFP Board of
Standards. If a candidate does not have a bachelors degree, he or
she also must have five years of professional experience before
sitting for the exam.
License to sell. While all states require insurance agents to be licensed, not all agents are licensed to sell the full range of available insurance products. Its important for the CPA to check the licenses an agent holds because an unlicensed agent cannot sell a particular product even if it is the best solution for the client. For example, a regular life insurance license issued by California requires 40 hours of class work, 12 hours of ethics classes and a passing grade on the states insurance examination. (Other states have similar requirements.) To sell variable insurance contracts, however, an agent needs a regular insurance license as well as a series 6 license issued by the National Association of Securities Dealers or a NASD general securities registered representative license (series 7). If an agent intends to sell in more than one state, he or she also must carry the NASD uniform state sales license (series 63).
Longevity. The insurance industry has a 98% agent dropout rate in the first two years. This can have a serious impact on policy service if the original agent leaves the agency or changes the insurance carriers he or she represents. The longer an agent works in the industry, the more stable and the more likely he or she is to be around in succeeding years to serve the clients needs. A CPA should ask to see the agents succession plan for servicing the client should the agent leave the agency. The client could become an orphan policyholder and be assigned to an inexperienced agent. Determine in advance who appoints the new agent and if the client has the right to select his or her own agent. This may prevent the client from having to establish a new relationship with a less qualified agent.
Independence. Some insurance agents have arrangements that allow them to sell policies issued by a variety of insurance companies. Others represent only one company. The former offer clients a degree of objectivity that is not always found with an agent who represents only one carrier. The CPA should ask whether the agent has a first call agreement with any company. This amounts to a right of first refusal by the carrier on any insurance application the agent takes from a client. Such an obligation limits the agents independence and makes it difficult to recommend the policy that best meets the clients needs.
UNDERSTAND THE AGENTS MOTIVATION
Buying insurance from a commissioned salesperson does not present a problem unless the commission structure drives the agents recommendation of a particular policy or carrier. The CPA should ask the agent whether the recommended policy design and commission structure can be changed to make them more competitive. (For information on so-called low load insurance policies, see the article, " Take A Load Off ".) Most carriers allow agents to make such policy changes, reducing commissions and enhancing the benefits to a client for the same or a lower premium. Both California and Florida allow commission rebates to clients on life insurance only, not on variable contracts. Other states may permit similar arrangements, under which the agent rebates part of his or her commission to the client. This gives the CPA and the client a way to negotiate the best possible price for the necessary coverage. However, the CPA should be aware that a rebate could trigger an adverse tax consequence for the client. The issue becomes even more complicated if a trust owns the policy and the rebate goes to the insured rather than to the trust.
Front-loading sales commissions. Some insurance policies pay out most of the agents compensation in the first few years. This is referred to in the insurance industry as front-loading commissions. Such an arrangement works as follows:
- Commissions paid as a percentage of the first-year premium:
55% to 115%.
- Commissions paid as a percentage of premiums in
years 2 to 10: 2% to 10%.
- Commissions paid as a percentage of premiums in
years 11 to 20: 12 to 13 of the prior years commission.
Because so much of the premium goes to sales commissions rather than to investments that yield the policyholder a return, front-loading can have an adverse effect on the policys cash value buildup. There are other disadvantages as well. If the client changes carriers within the first 10 years on a front-loaded policy, he or she leaves a substantial amount of money behind that went to pay sales commissions. Policy loans also are limited because front-loaded policies have little cash value in the early years, reducing the clients borrowing power.
Whats the alternative? The policy should pay the agents commission equally over the first 10 years of the policys life. Not only does this allow the insurance company to invest a larger portion of the premium on the clients behalf but also cash value builds up more quickly as a result. Fortunately, extended commission payouts are a growing trend in the insurance industry.
UNDERSTAND THE COMPUTER ILLUSTRATIONS
Virtually all insurance agents give prospective customers policy performance forecastscalled illustrationsto give them an idea of a policys required premiums and expected benefits. CPAs should remember that these illustrations are simply the companys speculation about an insurance policys expected performance. The only thing certain is that policy performance will change. CPAs should use the questions in exhibit 1 as a guide to help them better understand insurance illustrations and why the agent selected the recommended policy.
|Exhibit 1: Questions for the Insurance Agent|
Does the illustration assume the insurance policy will
still be in force by the time the client reaches age 95 or
Does the illustration assume a cash value that is
equivalent to the death benefit at those ages or does it
assume a zero cash value?
Can the agent provide a copy of the carriers illustration
questionnaire designed by the American College of CLU &
Does the state where the client resides subscribe to the
National Association of Insurance Commissioner standards?
On what basis did the agent select the carrier and the
What financial ratings do the proposed carriers receive
from the independent rating services?
Who is responsible for notifying the client of changes in
Study the underlying assumptions. Like all computer simulation models, insurance illustrations base their projected outcomes on assumptions, including variables such as future interest rates, expenses, lapse (cancellation) rates, mortality rates and investment returns. Changes in any of these assumptions can alter a policys benefits, return on investment, cash value and premiums.
The actual experience of each insurance carrier should reflect the assumptions used in their illustrations. One example is the projected lapse rate. Canceled policies present no future liability on the companys part to pay death benefits. This is a critical assumption that affects a policys overall investment return. The less a carrier has to pay out in benefits, the more money it has to invest and distribute among ongoing policyholders.
Updating illustration assumptions. Like any other financial model, the assumptions an insurance company uses to prepare insurance illustrations get stale. Most companies update their illustrations at least annually. When reviewing a policy illustration on a clients behalf, a CPA should
- Look for the date at the bottom of the illustration, which
represents the presentation date. If there is no date, ask the agent
for a current illustration.
- Ask the agent for an illustration with the carriers current dividend rate and one showing a drop of 100 basis points and another with a drop of 200 basis points. This way the client will have the most likely as well as best- and worst-case scenarios.
- Ask to see the ratings from all entities rating the carrier. Any
carrier the client is seriously considering doing business with
should meet the minimum ratings shown in exhibit 2.
- Ask the agent to provide illustrations on identical
policies from different companies. Compare the internal rate of
return and life expectancy shown on each illustration. They should
be similar. If not, there may be a problem. Since insurance
companies use similar life expectancies and investments, policies
should be similar as well. Remember that illustrations are
projections, not guarantees. Actual policy performance may differ.
|Exhibit 2: Minimum Insurance Carrier Ratings|
By rating agency
SELECT AN INSURANCE CARRIER
At a minimum, the carrier selected must be in the business of writing the policy that is appropriate for the clients specific circumstances. For example, if a client clearly is in an upscale marketannual income of more than $250,000any carrier the CPA is considering must be a significant player in the market.
Assessing a carriers financial stability. It makes little sense for a client to buy a policy from a carrier that might not survive as long as the policyholder. Many professional insurance advisers require a company to have a rating of at least AA by Standard & Poors, Moodys and Duff & Phelps or A+ by A. M. Best. The higher the rating, the more conservative the carriers investment philosophy. This, in turn, slows the policys cash value buildup. An American Bar Association publication, The Insurance CounselorLife Insurance Due Care , explains the relationship between policy performance and carrier ratings.
Most insurance carriers disclose their investment portfolio holdings and who is managing them to prospective policyholders. The CPA should ask the agent for a copy of this information and check for
- Undue concentration in any particular investment sector.
- Unwarranted exposure to high risk or volatile
investments such as urban real estate or junk bonds.
Using common business sense, it pays to be careful of companies that also write property and casualty insurance. Such companies have little or no control over potentially enormous claims payouts following natural disasters. The costs of those claims could be indirectly passed along to life insurance policyholders.
Compare similar proposals from different carriers. This is another area where the CPAs training and analytical skills add true value. Large disparities between the results of two comparable policies signify a difference in key assumptions. Ask the agent which assumptions are different and why. The CPA should be satisfied that the assumptions used in each policy under consideration are reasonable. Remember, if it sounds too good to be true, it usually is.
STRUCTURE THE POLICY TO MEET SPECIFIC CLIENT NEEDS
While it generally is the insurance agents job, the CPA also can help the client meet his or her financial planning objectives by verifying that the policy will meet the clients stated objectives over its entire life. The CPA should find out from the insurance agent
- What riders the policy includes. Most standard policies add
riders to meet the insureds particular needs. For example,
survivorship policies may contain riders that divide the policy in
the event of divorce to help accommodate the estate planning needs
of both spouses.
- Whether the insured can request premium changes.
Does the policy permit the insured to increase or decrease premium
payments as financial circumstances and ability to pay change?
- Whether premium amounts will increase due to policy
performance. The CPA should ask the agent to project premium
requirements under the worst-case scenario if the policy does not
perform as expected. This will make it easier for the CPA to
determine whether the client will be able to afford future premiums
should changes occur.
SCRUTINIZE PREMIUM PROJECTIONS CAREFULLY
A good financial adviser keeps his or her clients out of trouble. Here are some tips the CPA can use to uncover potential premium problems before they happen:
- Plan for a possible premium increase based on changes in
interest and mortality rates. Ask the agent how much the premium
would be if actual policy performance fell 100 and 200 basis points.
Be sure the increased premiums will not present a hardship for the
- Premiums projected to last only 10 years may have to
be paid longer if policy performance or mortality rates differ from
the assumptions the agent used in the illustration. Premiums also
may have to be paid longer than the projected period if the actual
interest rate declines or the mortality rate increases. The CPA
should be sure the client can continue to pay premiums beyond their
original projected obligation.
- Make sure one spouse can continue to make premium
payments on the policies on his or her life if the other spouse
dies. This is especially important for survivorship policies that
will be needed at the death of the second spouse to die.
ASSESS THE CAUSES OF POLICY MALFUNCTIONS
Common sense governs the analysis of any clients insurance needs. Here are three commonsense reasons why some insurance policies do not live up to the expectations of their buyers or the CPAs who advised them.
- The carrier offered the policy using unrealistically low
- The carrier suffered financial reversals due to
ill-advised investment selection, poor management or shabby business
- The agent priced the policy assuming an interest
rate higher than those currently available. A further market change
then caused the carrier to adjust premiums and benefits to reflect
For most policyholders, any of those situations is potentially disastrous. Unrealistic premium projections mean an adjustment is likely in the future, usually to the policyholders detriment. The same is true of unrealistic investment return assumptions. Financial reversals or the insurance carriers bad management also require that the policy terms be adjusted eventually if the carrier manages to stay in business.
A BUSINESS DECISION
While most CPAs are not trained as insurance professionals, they possess an enormous advantage because they are familiar with clients financial affairs and also enjoy their trust. By making the purchase of insurance a business decision, CPAs can use their training, financial expertise and analytical abilities to do clients a valuable service and make sure they buy the right life insurance policies from the right companies.