Focus on protection aspects of insurance

One of the most common objections to purchasing an insurance policy is: “If I just saved that money instead of paying for this policy every month, I’d end up with more money than the insurance would pay me.”

I’m sure every advisor has heard that argument at least once, and the simplest rebut is, “Sure, but if something happened tomorrow (death, disability, critical illness or the loss of independence) then you would lose that bet. And it would take you a lifetime to save up those premiums. That uncertainty is why you are getting this insurance; to make sure that if the unexpected happens, you and your loved ones will be financially taken care of.”

Protection, not profit, always has to be the primary consideration for anyone looking to be insured.

I’ve said this countless times. Sometimes people see my point off the bat, other times clients or their other trusted advisors (lawyers, accountants, etc.) need to be convinced they’re getting something worthwhile.

And that’s when I turn to my “return on insurance” debate and analyze the return a client will make on his premiums when or if his policy were to pay out. Once I show the concerned party that insurance will not only protect him but also provide a healthy return on investment, the debate usually ends.

Case study

Each of these examples use the following client profile:

• male
• Average health (A health style rating of 3 out of 5)
• occupational class 3 (out of 5)
• Levelling factors

  

  Level premium universal life, T-100 and whole life all have something in common that other forms of insurance don’t. They are 100% guaranteed to pay out to the beneficiaries at some point in time, because death is certain. Therefore when speaking to a client about these types of policies, the return numbers I provide are also guaranteed.

  When examining the time-weighted average rate of return exhibited by the selected $500,000 policy, we can make the following observations:

  • The return provided by this policy is enormous in the first year (almost 13,000%) and decreases rapidly over the first few years; and
  • The rate of change decreases annually and levels off into a gentle downward path.When talking to a client about these findings I usually make the following points:
  • If the client died prematurely, no other investment will provide his or her family with as high an after-tax return as a life insurance policy. If he or she dies before age 80, the investment in this policy will pay the net of 6.5 to 13,000%;
  • To get the same return from a guaranteed investment (the comparison should always be to guaranteed investments because insurance in itself is guaranteed), assuming a top marginal tax bracket of approximately 45%, the client would have to net between 12 to 26,000% per year on a pre-tax basis. Such a yield is just not realistic; and
  • Even if the client lives to age 100, he or she will still receive a return of 2.74%. This is comparable to a pre-tax rate of 5% and similar to what you could expect to yield in the long run if investing in five-year GICs. I also point out there are only four downsides to an investment in a life insurance policy:
  • It’s illiquid;
  • You have to die in order to cash in on it;
  • It doesn’t benefit you directly, but it does take care of your loved ones; and
  • If you cancel the policy, you won’t get your money back.

  However when we consider that life insurance is not there to protect you, but the ones you leave behind, these negatives become irrelevant.

  Term Life

  

  This example uses a 10-year term that expires at age 85. Term insurance – unlike permanent – only guarantees a return prior to expiry. However, due to term’s lower premiums in the first 20 years, when compared to a permanent policy, it exhibits considerably higher rates of return than permanent in the first 33 years of the contract. How much more? Between 36% and 515% more than a permanent policy. The trade-off is, of course, that term is a temporary policy that becomes prohibitively expensive and will pay you nothing if you die after the expiry date.

  Critical Illness

  Unlike life insurance, critical illness insurance insures you against a possible event, not a certain one. Therefore the returns are only possible, not guaranteed.

  As you might expect, the return numbers follow the same decreasing patterns as life policies, however, the returns themselves are more muted due to the higher cost per thousand of this type of insurance. This is, of course, linked to the fact the probability of a critical illness occurring prior to age 75 is significantly greater than death. In fact, the probability sits just below 50% according to data from Munich Re.

  

  Despite these comparably muted results, the return pattern as a whole stays comparable to a guaranteed alternative until approximately age 85. So in this case the alternative investment actually becomes the better solution after age 85. That being said, the argument still goes back to the nature of insurance itself: If we knew with certainty when such an event would occur we could select the best option. Since we don’t have that benefit of certainty, the insurance option again proves to be the best solution.

  Disability

  In the case of disability, these calculations become a little subjective, because we’re now dealing with several variables, specifically:

  • What the maximum lifetime benefit receivable is for the given date of disability;
  • When a disability event would occur; and
  • How long it would last.

  Since the benefit of DI is stated as a monthly amount until the end of a benefit period, the total benefit is constantly shrinking. For example, in this scenario, a 45-year-old with a $3,000/month disability policy would be entitled to up to $711,000 if he became disabled the day after the policy settled, and remained so until he turned 65. However if he became disabled at age 64, he would only be entitled to as much as $36,000.

  

  In order to handle these issues with clients, I like to illustrate the worst-case scenario. I tell them what the realized return would be assuming the client became disabled at the age in question and remained disabled for life, receiving the full benefit amount to which he is entitled. The results in the table demonstrate some interesting points:

  • The return on investment remains very high over the life of the policy. In fact, in its last year the policy would still return 6.67%. Prior to that the potential return remains firmly above double digits; and
  • Should no disability occur, the return on investment is guaranteed to be zero.

  Just as was the case with CI and term insurance, DI can provide very high returns, however, they’re not guaranteed to occur. But, if you take into consideration the devastating impact of disability, this lack of a guarantee becomes moot.

  I have on occasion had people attempt to poke holes in my logic by pointing out I assume the worst-case scenario, which of course may not ever take place. There’s some validity to this, but I argue it’s vital to consider the worst-case scenario as that’s the one that would have the greatest impact on the client.

  I also ask clients to reconsider the payback period. With an annual premium of $1,809 and a monthly benefit of $3,000, a client would only have to claim disability for 20 days in order to break even on every year’s worth of premiums. For example, if someone were to pay for this policy for 10 years, he or she would only have to receive the benefit amount for six months in order to break even. After going through both arguments, I’ve found there is little to no debate remaining.

  Long-term Care

  

  Long-term care insurance has the same three additional variables seen with DI. However, there are a few additional variables:

  • Unlike all other forms of insurance, LTC premiums are not guaranteed;
  • The probability of a loss-of-independence event occurring is typically only significant when a client is more than 65; and
  • A loss-of-independence event will typically reduce a client’s life expectancy.

  In order to deal with the first issue, I typically use a policy that has a 20-year pay period; guaranteed premiums for five years; and a maximum lifetime premium increase of 50%. I then illustrate the worst-case scenario of premium payments: A level premium for five years and a 50% increase for the last 15.

  The second issue is handled by generally focusing on the post-age-65 return numbers. Despite ignoring the very high and improbable return numbers in the early years, the return scenarios generally look very good. They remain in double digits until around the time the client turns 85 and remain healthy until after the client turns 95.

  As for the last issue of reduced life expectancy, the solution is simple: I revise my illustration so that the client only receives benefits for a few years. When I do that, the returns still prove positive.

  Alternatively, I use an argument similar to the one applied to disability insurance [DASH] the policy’s payback period. Even if a client paid for the policy for 20 years and experienced the worst-case scenario of a 50% premium increase for 15 years, the total premiums paid would equal $32,021. A $100-per-day policy would pay pack the premiums in only 321 days [DASH] that’s a payback period of less than one year. Given that the average loss of independence claim far exceeds one year, the point quickly appeases most clients.

  Case closed

  The return should never be the primary reason for purchasing insurance. Protection of one’s self and one’s loved ones is always the primary concern. But if an advisor can support this point with evidence that shows insurance is a wise investment decision at the same time, he or she will only create a more compelling argument.

  On more than one occasion a spreadsheet and calculator have proved to be the deciding factor for the client. This kind of analysis has also proven to be a differentiating factor when being compared to other advisors, and serves as a means of demonstrating a level of product understanding and professionalism.

  Every insurance advisor should dust off his or her financial calculator and show a client how a good protection decision can also make for a good investment decision.

  Jason M. Pereira, MBA FCSI FMA, is a financial consultant with Woodgate Financial Partners (IPC Investment Corporation) in Toronto.