Your Most Common Insurance Questions Answered
A full discussion regarding insurance could fill many volumes and cannot be adequately accomplished here. However, let’s briefly discuss some basic insurance concepts:
What is insurance? Insurance is an arrangement by which a company provides compensation for specified loss, damage, illness, or death in return for payment of a premium. Essentially, the risk of loss is transferred to an insurance company for a price.
Should all potential losses be insured? In a word: No. Some losses cannot be insured while others are not suitably covered by insurance.
What types of potential losses are best to insure? I would have you look at two factors:
- Is the loss unlikely to occur? For example; a house fire is quite unlikely. The risk borne by the insurance company can be spread over many insureds, resulting in low premiums.
- If the event were to occur, would it be catastrophic? Again, we can use the house fire as an example: it would certainly be catastrophic to have a substantial or total loss of a home due to fire. A large risk can be transferred to the insurance company.
An event that occurs frequently or that does not result in catastrophic loss is less appropriate to insure. For example, we all have ongoing dental costs and will need dental work at some point. The cost of it is not catastrophic to most people. The premiums paid over a lifetime for a dental insurance policy are very likely to exceed the benefits we receive, and we don’t reduce our risk substantially by having it. Essentially what we are doing is paying the costs of the dental work through an intermediary, and also paying their overhead and profit on top of that. Most of us would be well advised to simply pay the costs out of pocket.
In keeping with the concept that the best losses to insure are catastrophic, it makes perfect sense to select high-deductible plans in return for lower premiums.
When is life insurance suitable?
Life insurance is appropriate when an unexpected death will cause a dependent to become destitute. It follows that a single person with no dependents does not need life insurance. The exception to this rule is the use of life insurance in estate plans, where it can be useful for high net worth investors in limited situations.
The most ridiculous misuse of life insurance is the common practice of placing insurance on the life of a child. Yes, we love our children, and we want to contribute to their future financial success and security. But will anyone become destitute upon the death of a minor child? Of course not. It is callous to say, but the reality is that parents will actually incur lower expenses if a child passes away. Life insurance on a minor child is never appropriate. If the goal is to begin to save money for the child’s future, an investment that is not encumbered by the costs of life insurance will certainly be superior to a life insurance policy.
A young breadwinner with a dependent spouse or children should consider life insurance. As a couple ages, the need for life insurance declines. By definition, on the retirement date, accumulated assets are sufficient to provide sufficient retirement income for the couple for a lifetime, so they are certainly sufficient for a survivor who will have lower expenses. At that point, life insurance is no longer needed.
What type of life insurance is appropriate?
Life insurance comes in two flavors: permanent and temporary. Permanent insurance, such as whole life or universal life, is priced with the expectation that the insured will not cancel the policy, and that a death benefit will need to be paid eventually. Since the insurance company on average must collect more in premiums than it pays in claims, this type of insurance is relatively expensive. Temporary insurance, also known as term insurance, is priced with the expectation that few policyholders will die during the term of the policy. As a result, this form of insurance is relatively inexpensive. Since the need for life insurance declines over time and disappears at retirement, it is generally more appropriate to purchase term insurance. The holder of a permanent policy essentially pays for a benefit that is not needed in later life.
Give me more details regarding term insurance.
Term insurance is pure insurance. Just as with other types of insurance, term insurance pays a benefit only if the event occurs during a stated time frame. The simplest of term policies carries a term of one year, and is called Annually Renewable term, or ART. The insurance company charges a cost of insurance based upon the insured’s age, and each year as the insured renews the policy for another year, the cost of insurance is increased to reflect the higher age.
A level term policy has a level premium for a term of greater than one year; often ten or twenty years. The actual cost of insurance increases every year, so in order to make the premiums level, the issuer increases the premiums in the early years to subsidize lower premiums later in the term. For this reason, it may be unwise to cancel a level term policy near the end of its term.
Some term policies are guaranteed renewable. This means that the coverage can be continued beyond the original term at the insured’s option without evidence of insurability. This can be important if the insured contracts an terminal condition or illness before the end of the term. Keep in mind that while the coverage can be renewed, it will certainly be at a much higher cost if the insured cannot prove insurability. It is not unusual to see a schedule of level premiums for ten or twenty years, followed by years of prohibitively high premiums in subsequent years. Any insured who can demonstrate insurability through a medical exam at the end of the term, and who wishes to continue coverage, is well advised to apply for another term.
Tell me about permanent insurance.
Permanent life insurance comes in many flavors, but the two primary types are Whole Life and Universal Life.
Whole life insurance is a policy that:
- Has a level death benefit for life
- Has a level premium for life
- Has a premium, part of which pays for insurance, part for a cash value account
- Comes with the ability to withdraw or borrow from the cash value
Commonly touted advantages of whole life include the tax deferred status of the cash value account. While the tax deferral is beneficial, much of the advantage is negated by the high ordinary income tax rates that are paid on withdrawals. These rates are higher than the long term capital gains rate paid on equities and equity mutual funds in non qualified accounts.
Another often mentioned advantage of whole life insurance policies is the availability of tax free loans from the cash value. While this feature has advantages, the ultimate death benefit is lowered to the extent of loans taken and not repaid.
- The premium term is for life. This very long term means that premiums in the early years are much higher than the actual cost of insurance.
- The commissions paid to agents are generally very high. These commissions add to the cost of the policy. The issuer, who pays the commission to the agent, is protected from early withdrawal through the use of surrender charges, which can last for ten years or longer.
- The permanent nature of the policy means that insureds are paying for the cost of insurance even in old age, when life insurance is not needed.
For thirty years, from 1940 to 1970, whole life insurance was very common. More recently, Universal Life insurance has almost completely replaced Whole Life insurance by avoiding some of the weaknesses in the Whole Life design:
- Whereas with Whole Life the cost of insurance is level for a lifetime, the cost of insurance assessed to a Universal Life policy is one year at a time. This lowers the cost of insurance in the early years of the policy, resulting in more of the premium going to the cash value account, and higher cash values.
- Whereas both the death benefit and premium are level for life in a whole life policy, they can both be changed at will within a Universal Life policy. This flexibility is valuable, especially when a lower death benefit is needed as time passes.
- Whereas the cash value in a whole life policy is usually a fixed account paying a low rate of interest, Universal life policies are often variable life policies, meaning that the cash value is invested into equity sub-accounts, which are generally more attractive for a long term investment such as a permanent life policy.
Although the universal life design is generally superior, the same drawbacks remain: ordinary income tax on withdrawal, high costs, illiquidity due to surrender charges, and inappropriate coverage in old age. It should be noted that there are now a few insurance issuers who offer universal life insurance without a commission. This serves to eliminate the surrender charges and excessive expenses.
Our general opinion is that if it is an investment that is appropriate, invest without the encumbrance of insurance charges. If it is insurance that is needed, buy pure term insurance. Combining the two together is not generally beneficial.
How much insurance coverage should I have?
Like most rules of thumb, the often cited rule that you should have seven to ten years of income in coverage is inadequate. There is no rule of thumb that suffices. A competent financial advisor will run a gap analysis that illustrates the death benefit required to restore your dependents to the financial condition that would have occurred had there been no unexpected death.
Life insurance agents are notorious for believing that everyone needs massive amounts of life insurance. For this reason, it is vital that this analysis be conducted by an objective, fiduciary advisor. The choice of policy type is also fraught with conflicts of interest when that choice is made by a commission- based insurance agent. Career life insurance agents have a very positive view of permanent life policies. It makes sense to have the fiduciary advisor determine the amount and type of insurance, and then to have that policy purchased through a competent and trusted insurance agency.
What about Disability Insurance?
Disability insurance is designed to replace earned income in the event of a disability. As such, it is especially important for young workers who are at risk of losing many years of income. Like life insurance, disability insurance becomes less important as retirement approaches, and in retirement there is no earned income to replace.
Issuers of disability policies are concerned with moral risk, which is the risk that a dishonest insured will choose to pretend to be disabled which would allow them to collect an income without working. For that reason, disability benefits are generally limited to about 60% of income.
Insurance companies are also interested in the occupation of the insured: a logger or fisherman is more likely to suffer a disability than a doctor or lawyer. For that reason, the premiums vary considerably from one occupation to another.
Many large companies provide employer paid short and long-term disability insurance coverage. Many offer group plans that are partially or entirely paid by the employee. Participation in the long-term disability plans is usually a good idea, as a long- term disability is unlikely and can be catastrophic.
Entrepreneurs or professionals who have no employer provided long term group disability plan are well advised to obtain private individual long term disability coverage.
Should I Buy Long Term Care Insurance?
There is disagreement regarding the odds of needing long term care, but it can be agreed that although it can be a catastrophic expense, it is relatively likely to occur. In other words, it does not fit our ideal event to be insured; catastrophic and unlikely to occur. As a result, in recent years the premiums have been increased. Even existing policies which are designed with level premiums have experienced large premium increases. The fine print in these policies allows the issuer to petition for higher premiums if their claims experience threatens to cause insolvency. The actuaries who set premiums are quite experienced in the area of life insurance, but it turns out that they underestimated the claims in the much newer field of long term care.
Often the sale of a residence will provide as much capital for long term care than any insurance benefit would. Of course the use of the home or other asset to pay for long term care costs disinherits the heirs, and for this reason many people would prefer to pay long term care insurance premiums.
For those who are struggling to retire successfully, long term care insurance premiums can make it much more difficult. In these cases it may be appropriate to earmark the home and other assets for long term care policies. On the other hand, people with more financial means may decide that a long term care policy is a luxury that they can afford. Generally we would rather not pay premiums for an event that is so likely to occur. It is advisable to accumulate enough wealth to become self- insured against a long term care scenario.
The Medical Insurance Fiasco
The current state of affairs regarding medical insurance can be summarized: It is a confusing mess! In a happier world we would have a free market, where insurance companies were not encumbered with red tape, and where innovative plans could be created to compete for your business. This would result in lower costs and greater choice. Unfortunately, we live in the real world, where excessive and confusing regulations reduce choice and increase cost and confusion.
If you are fortunate, your employer has the wherewithal to have navigated all of the rules, and has designed a compliant and effective group medical insurance plan. These plans are almost always either partially or totally paid by the employer, and for that reason it is wise to participate in them.
For those who are not fortunate enough to have a group employer plan, the costs for comprehensive medical coverage can be very high. It is not unusual for private insurance coverage to carry a premium of well over $1,000 per month. A high-deductible “catastrophic” plan will have a lower premium.
In keeping with our philosophy, if there are no significant health issues, we approve of a high deductible policy, especially if that allows for participation in a health savings account (HSA). An HSA allows for up to $3,450 per person or $6,900 per family per year to be contributed before tax. Withdrawals from an HSA for medical costs are free of tax. This combination makes an HSA the most powerful tax advantaged account in existence. Much of the advantage is the tax free buildup in the account over many years. For that reason we normally advise a strategy in which the holder of an HSA does not use the account for current medical expenses. Rather, the HSA balance is allowed to increase over many years, and is used for medical expenses later in life. Unfortunately, we know that there will be no shortage of medical expenses in old age.
Beginning in the month that is three months prior to your 65th birthday, and ending in the month three months after your 65th birthday, you can apply for medicare insurance. Failure to apply until after that time frame may result in a higher lifetime medicare premium. Although the choices within medicare are many, in general terms medicare consists of:
- Medicare Part A: Hospital, free
- Medicare Part B: Doctor; $134 per month premium, and increased premiums if income is higher than $85,000 for an individual or $170,000 for a couple. Premiums can be as high as $428 per month for very high income taxpayers.
- Medicare Advantage and Supplemental Policies: Premium varies; this coverage is available through many different types of plans, and is designed to pay for costs that are not covered under Medicare Parts A and B.
- Medicare Part D: Pharmaceutical; premiums tend to be quite nominal, coverage for prescription drugs
Payroll taxes assessed on statutory (W2) employees and their employers include a Medicare Tax of 2.9% of pay. For this reason, Medicare should not be viewed as an entitlement; rather it is government insurance. Although the desirability of the insurance is questionable, and the availability of medicare providers continues to shrink, at this date a consensus is apparent, in that almost every taxpayer applies for medicare, rather than wasting the medicare tax they have paid over the years.
How should I design my Homeowners and Auto Insurance?
Lenders understandably require homeowners to carry insurance for as long as a mortgage is outstanding. In addition, catastrophic losses to a home are unlikely and catastrophic. For these reasons, homeowner’s insurance is almost universal among homeowners.
Every state except for New Hampshire requires auto insurance liability coverage. Lawsuits connected to driving are rare and can be catastrophic as well. For these reasons, every responsible driver purchases auto insurance.
Both of these types of insurance offer not only liability coverage, but also property coverage. In keeping with our concept of unlikely and catastrophic, it makes perfect sense to design these plans with high deductibles in return for lower premiums.
It also makes sense to acquire flood and earthquake insurance if your property is especially vulnerable to these rare and catastrophic hazards.
Should I have Umbrella Insurance?
Umbrella insurance covers only losses that are bigger than the base coverage in homeowners, auto, and other insurance policies. It is unlikely for this large a loss to occur, and it would cause catastrophic financial loss, making umbrella insurance an attractive way to transfer large risks. Keep in mind that in Washington State, IRA and other retirement plan accounts are exempt from lawsuits, and if the asset list is substantially composed of retirement plan assets, umbrella coverage may not be advisable.
We believe that it is your best interest to obtain general insurance advice from a fiduciary advisor. In this way, the conflicts of interest that exist when advice is obtained from an insurance agent can be reduced. In our opinion, your advisor should not profit from the sale of insurance. Rather, the advisor should make recommendations to competent insurance agents to sell the policies that you and your advisor have agreed upon:
- A life insurance agent: for life and disability insurance
- A property casualty agent: for auto, home, boat, earthquake, flood, and umbrella insurance
- A medical insurance specialist: for medical and medicare policies
- A long term care insurance specialist: for long term care insurance
Disclaimer: the topic of insurance is vast and complex. The comments above are generalizations, and are not to be taken as personal advice for your unique circumstances. Before making any decisions regarding insurance, speak with your financial advisor, and implement your decisions through a competent insurance agency.