Life Insurance: An Interview with Insurance Expert Anthony Steuer

Anthony Steuer has been in the insurance business for many, many years. He not only owns and operates his own insurance agency, he is also the author of Questions and Answers on Life Insurance, as well as several online courses.

Anthony recently took time to provide extensive information on life insurance and life insurance policies. If you are thinking about purchasing a policy for yourself or for your family members, you don't want to miss out on this informative interview.

What exactly is life insurance?

Life insurance is a type of insurance that pays money when someone passes away. That's it. Simple enough in theory. Life insurance is designed to replace income for someone or something that is dependent upon the insured. If that does not exist then there is no need for life insurance.

However, to understand what life insurance is today you should look at how life insurance originated. Life insurance is one of the very oldest types of insurance/financial products in existence. It stems from the old principle that if a villager's house burned down, and then the other villagers would help to rebuild the house.

The function of insurance is to safeguard against misfortunes by having the losses of the unfortunate few paid by the contributions of the many that are exposed to the same peril. This is the essence of insurance - the sharing of losses and, in the process, the substitution of a certain small "loss" (the premium payment) for an uncertain large loss. (Reference - Black, H. & Skipper, K.; Life Insurance, Twelfth Edition, Prentice Hall (Englewood Cliffs, NJ), p. 18)

Life insurance, like any other financial product is a tool to assist you in accomplishing a specific goal (or goals). As such, it will assist the beneficiary when there is an economic loss, due to the death of the insured that extends well beyond just funeral or final medical expenses. The loss of future income, due to the death of a breadwinner can have a severe impact on the lifestyle of the surviving family members. Debt owed by the deceased may become due and payable as well as possible estate or inheritance taxes. Life insurance can create an immediate source of funds to enable the payment of these expenses and to provide a source of future income.

The purchasing of life insurance is an uncomfortable task for many people and the image of most life insurance advisors leave something to be desired with examples such as Bill Murray in Groundhog Day and Mel Brooks in High Anxiety. Typically, there is recognition of an obligation to protect one's dependents from the financial hardship an untimely death may cause, however no one likes to think about the fact that they will die someday. This is another reason aside from the potential discomfort of dealing with a life insurance advisor that can make it easy to delay and put off the decision to purchase life insurance.

Keep in mind that as you go through this process that life insurance is not for you, it is for your survivors. Therefore, you typically will only have a need for life insurance when you are leaving behind someone or some entity that is dependent on your income.

How can someone determine how much life insurance they need?

There are as many ways to determine how much life insurance you need as there are people to ask this question of. The methods range from the simple to the exceedingly complex. Even choosing a method that you feel makes the most sense for you still leaves the issue that you are trying to hit a moving target.

There is no one "right" method, as most methods have sound reasoning for their existence, though some are definitely more questionable than others. If you don't understand it, then you probably shouldn't use it.

Life changes and the perfect amount of life insurance today may not be the right amount tomorrow. Therefore, as with all financial assets, it's a good idea to review your coverage needs for life insurance every so often especially if you have a major life change.

The accuracy of any calculation depends on the method chosen as well as on the information used. Your needs will have to be adjusted at certain milestones, such as children graduating from college, retirement, moving, etc. Along with calculating future income and expenses, you will also need to estimate your life expectancy. The most commonly mentioned method of calculating life insurance needs is the simple rule of thumb of using a multiple of your income (anywhere from 6 to 15 times). While rules of thumb may be helpful, they do not take each individual's situation into consideration. Also, though a spouse may not have an earned income, it is important to recognize their value to the household budget.

If you know the amount of income that needs to be replaced (assuming that this a permanent level income), you can perform a reverse calculation by dividing the income stream needed by a conservative, reasonable rate of return if you were to invest the entire proceeds and leave the principal intact (such as a 5% annual rate of return). For example, if your need is for an annual before tax income stream of $50,000 then divide by 5% ($50,000/.05) resulting in a death benefit of $1,000,000.

The following is a worksheet that you can use:

Life Insurance Worksheet

INCOME NEEDS:1.) Annual income your family would need if you die today (typically between 60%-80% of total income)- Consider any lifestyle changes, and include any current expenses such as mortgage/rent, groceries, clothing, utility bills, entertainment, travel, transportation, child care, etc: $______________

2.) Annual income available to your family from other sources - Include all salaries, dividends, interest, current (or estimated) social security benefits, along with all other sources of income: $______________

3.) Annual income to be replaced (Subtract line 2 from line 1.) : $______________

4.) Funds (Capital) needed to provide income for your required number of years? $______________

Multiply line 3 by the appropriate factor below:

  • 10 YEARS X 8.1
  • 15 YEARS X 11.1
  • 20 YEARS X 13.6
  • 25 YEARS X 15.6
  • 30 YEARS X 17.3
  • 35 YEARS X 18.7
  • 40 YEARS X 20.0

EXPENSES:

5.) Funeral expenses - average cost of an adult funeral is about $10,000: $______________

6.) Administrative Expenses (also referred to as an Emergency Fund and/or Final Expenses (approximately six months - 50% of the higher wage earner's salary); - can vary for cleaning up the affairs of the deceased, e.g., advisor fees, filing taxes: $______________

7.) Mortgage and other outstanding debts (credit card debt, car loans, home equity loans, etc). It may make sense to pay off these debts, considered if the survivor will have a substantial income: $______________

8.) College costs: 2002-2003 cost of a four-year education: public college-$51,346; private college $109,412. Multiply by number of children and keep in mind that costs are increasing more rapidly than inflation $______________

9.) Capital needed for college - Multiply line 8 by the appropriate Years before college Factor: 5 years X .82; 10 years X .68; 15 years X .56 and 20 years X .46: $_____________

10.) Total capital required Add lines 4, 5, 6 and 9: $_______________

ASSETS:

Keep in mind that current asset value may be considerately different at time of liquidation as well as the value may be significantly discounted due to forced sale such as real estate, family business or other investments:

11.) Bank accounts, money market accounts, CDs, stocks, bonds, mutual funds, real estate: $_______________

12.) Retirement savings IRAs, 401(k)s, Keoghs, pension and profit sharing plans: $_______________

13.) Present amount of life insurance (including group life insurance assumes that it will continue): $_______________

14.) Total income producing assets - Add lines 11, 12 and 13: $_______________

15.) Life insurance needed - Subtract line 14 from line 10: $_______________

Why would someone need life insurance?

  • Personal Life Insurance Uses: Family Protection, Mortgage Protection, Income Replacement, funding for estate tax liabilities
  • Business Life Insurance Uses: Loan securing, buy-sell funding, key-person indemnification.

Is life insurance a good use of retirement funds?

Ah, a hot topic. The answer here is not the popular answer in the industry. Before you can get dazzled by the tax-deferred inside build up of cash values on most life insurance policies, remember that you must need life insurance in the first place. It's very easy for someone to say, look, put money into a life insurance policy, it will accumulate on a tax-deferred basis and then you can recover it on a tax-free basis at retirement.

For those of a certain age group - Danger, Will Robinson, Danger. The tax issues and issues go far beyond the scope of this interview and in no way does this interview give any type of tax or legal advice. Remember that you should have a need for life insurance before purchasing life insurance, just as you would have a need for a can opener before buying one. Then take a look at all the hypothetical costs affiliated with a life insurance policy and calculate out the actual build-up and you'll see that life insurance is in most case not a smart way to accumulate money for retirement. Also keep in mind that by doing something based on tax laws, you're counting on them remaining the same-which is almost surely a sucker's bet. I can almost guarantee you that there will a change in tax laws before you know it. Don't base decisions on current tax laws alone.

Should children have life insurance?

In almost all cases, there is no need for there to be life insurance for children. The usual "selling" point is for future insurability - in other words getting the child life insurance while they can qualify for the best available rates. However, there is seldom a need for life insurance for minors as there is no certainty of a future need for life insurance. Remember, the needs for life insurance in the previous question.

What is the difference between term life insurance and permanent (cash value life insurance)?

This is a question that is fiercely debated in and out of the industry. Deciding on the type of life insurance is keeping in mind that life insurance is a financial tool that will assist you in meeting your overall financial goals. As with a lot of financial questions, there is no right or wrong answer. Term life insurance is typically the best option in most circumstances. Depending on your age, a term life insurance policy can be purchased for up to a thirty year guaranteed level premium period. Keep in mind that if you are healthy enough to qualify for a competitive premium, then your life expectancy will be longer than the term period. Therefore, if you need coverage longer then twenty or thirty years, then you should consider permanent life insurance.

Permanent life insurance will cost at least five to ten times more than term life insurance. Some recently available universal life policies will provide a guaranteed death benefit under very stringent guidelines. Carefully consider your needs before making your decision.

Let's look at the differences between term and permanent life insurance. For our present purpose, permanent life insurance includes any policy that is not term life insurance (i.e., one that gradually accumulates a cash value). Typical examples include whole life, universal life and variable life policies). Unfortunately, it can get confusing. When a term policy accumulates a cash value, then it is typically a form of universal life policy and not term insurance at all. But there are exceptions. For example, a "term to age 65" policy will typically accumulate a cash value in the intermediate in-force years. This cash value will then gradually reduce to zero by age 65, when the coverage automatically ends.

Here is a summary of each of these kinds of insurance:

TERM INSURANCE:

  • As the name implies, it is purchased for a specified term of years.
  • The cost (premium) is lower, especially for younger applicants.
  • Premiums systematically increase year by year as you get older.
  • Term insurance has no residual value. That is, it expires without value at the end of the term.
  • Less than 1% of term policies ever pay a death benefit, according to a 1993 study of over 20,000 policies by Penn State University. Don't be misled by this statistic. Most term policies cannot be renewed beyond age 75, but annual renewal term policies ("ART") may usually be renewed to age 100. However, ART policies become prohibitively expensive at the older ages, so renewing them much beyond age 70 or 75 is impractical for most people.

PERMANENT INSURANCE:

  • Premium payments usually (but not always) remain the same each year.
  • Premium payments generally are considerably higher than for term life insurance policies in the early years of the contract.
  • Premium payments may be discontinued under certain circumstances. Some policies provide significant degrees of flexibility.
  • Interest or other earnings on the cash value is tax deferred.
  • Permanent policies typically make no sense without a long term commitment from the buyer, since little or no cash surrender value accumulates in the first few years in (most cases).
  • Coverage may stay in-force to age 95 or greater and the policy will have a residual value (cash value - sometimes called cash surrender value).
  • Access to the cash value is available through loans and withdrawals.

Are there any particular benefits or drawbacks to choosing term life insurance over permanent (cash value) life insurance?

Having your insurance terminate before your need terminates. Remember, that you are purchasing life insurance for a certain purpose. Sometimes this purpose can last longer than you expect it to.

This can be offset by a frequent review of coverage and making sure that any term life insurance you obtain has a conversion option. The conversion option should allow you to convert to any permanent (cash value) policy then offered by the company without any further evidence of insurability. Almost all term policies offer such an option, however some options won't last as long as the number of years of level premium or the carrier may only conversion to certain policies (which may be unattractive).

When shopping for life insurance, how many different quotes should one get?

The key isn't how many quotes you get, as long as are getting competitive quotes. Being able to determine whether you are obtaining a competitive sampling of available products is the concern. It seems as if every institution and advisor is selling life insurance, especially term life insurance.

Just because it's a company you know or a "trusted" advisor doesn't mean that you are getting the "best" policy out there. Sometimes, even the advisor doesn't know for sure. Even though your advisor may be willing to sell you a life insurance policy, doesn't mean that they are able/willing to offer you a competitive premium or know what they are doing. Consider finding an independent agent/broker who is a Chartered Life Underwriter (CLU), a designation for life insurance professionals - information and referrals available at www.financialpro.org.

Something to consider is what is the motivation/incentive for the person/entity proposing the insurer? Almost all life insurance policy sales pay a significant first year commission ranging from 50 percent to 100+ percent of the first year premium. If your advisor is a "captive", in other words aligned to one company, then chances are, you should get other quotes.

If you are working with a broker, someone who represents multiple companies, then you should make sure that you are viewing two to three companies. Keep in mind that they are selecting the two to three companies for you. The selection of the companies may be in your best interest as some companies may have very low premiums that they advertise, which in turn can be extremely difficult to obtain. So, if you have an advisor who knows what they are doing, they may be selecting the lowest rates that you have the best chances of obtaining.

Just because a low premium is advertised doesn't mean that you can qualify for it. Companies have many levels of rate classes, and for some companies, only a very small percentage of applicants (less than 10%) can qualify for the best available rates.

Is there any way for consumers to save money on their life insurance premiums?

There is always a way to "save" on something, depending on your definition of the word - save. There are oftentimes ways to use your premium dollars more efficiently, in other words, get the most bang for your buck.

With term life insurance, this can be fairly simple. If you are comparing apples to apples - ten year guaranteed level premium policies with two companies that both have solid financial strength ratings, then the lowest premium will be the best way to go.

Permanent life insurance is very tricky. The products are highly complex and there are many ways to end up worse off then you started with. In the majority of cases, replacements are ill-advised. While you may find an illustration that shows a lower premium, remember that illustrations are just that - illustrations and as such are not guaranteed. Unless, there is sufficient reason to move and you are able to move to a product with a quality company (see below) that provides a guaranteed death benefit, then you probably shouldn't change your coverage.

There is a shortage of advisors who are qualified to assist in this area, so proceed with caution. At a minimum- as discussed in a prior question, you should consult with a Chartered Life Underwriter (CLU), a special designation for insurance sales people, information and referrals available at www.financialpro.org.

How do I choose a life insurance company?

While determining your life insurance needs and the type of life insurance coverage are the first steps, it is critical to choose the life insurance company wisely. Life insurance, even a ten-year term policy, is a long-term proposition. You have to take into consideration whether your life insurance company will be around to pay the claim. This can quite a challenge as there over 1,600 life insurance companies offering thousands of life insurance products to residents of the United States.

Fortunately, there are some common sense guidelines that will help you narrow the field to a more manageable selection of companies and products. Let's cover briefly how to evaluate a life insurance company from a financial perspective.

Many "net-savvy" consumers are pros when it comes to looking up and analyzing financial data on stocks, bonds, and mutual funds. Performing insurance company due diligence, however, presents a new challenge. Fortunately, many of the leading sources of information make their ratings and "analysis" available to the online public and almost all of it is free. Most likely this will change as the rating services will view this as an income stream.

Don't get caught in the trap of simply comparing two companies and choosing the better one. Instead, hold each company up to a pre-determined set of benchmarks. If an insurance agent wants to sell a particular company or product, it is not uncommon for the agent to offer two or three alternatives that look worse than the one the agent wants to sell.

Finally, don't assume that it costs more to purchase insurance from a top-rated company. Remember, product illustrations are poor indicators of how a policy will perform. Since insurance companies generally have comparable expenses, reserve requirements, and overall investment strategies, buying from the best does not necessarily result in higher premiums.

When selecting or evaluating a life insurance company, a logical place to begin is by reviewing the ratings given by the five major insurance company rating services. In a rating, the rating company or agency expresses its opinion of the life insurance company's financial soundness and creditworthiness. In some cases, the life insurance company will ask one or more rating companies for an evaluation and rating, and the company will then pay a fee ($25,000 to $30,000 is common) to the rating agency. Generally speaking, this fee does not compromise the rating because rating companies are extremely protective of their reputation for objectivity. Without public credibility, a rating is useless, so rating companies strive to maintain their credibility.

Five firms currently rate insurance companies. They are:

  • A.M. Best Company
  • Standard and Poor's Corporation
  • Moody's Investors Service
  • Fitch
  • Weiss Research

Each firm employs its own rating system, and some rating agencies are considered to be more stringent than others.

Not all insurance companies are rated by each agency. Each agency employs its own techniques for determining a given insurance company's rating. Areas of consideration may vary and these include financial leverage, management stability, recent performance, and the rated company's overall financial situation. External factors such as competition, diversification, and market presence may also be considered.

Each rating agency provides a description of its analysis and defines the meaning of each rating from the highest to the lowest. Since there are differences between rating agencies, this can make a fair comparison between different ratings somewhat confusing. Information on how to contact each rating service will be found below (including some useful links). The chart at the end of this report compares the ratings given by each agency. To obtain the latest ratings, please check with the appropriate rating service.

The following summary describes each rating service and the rating criteria used, along with a brief explanation of how insurance companies initiate the rating process. It is important to keep in mind that these criteria may change.

  • AM Best Company - Simply enter the name of your company under the "Search Ratings" category and in addition to providing you with an up-to-date rating, under the various folder tabs you will find the following: 1) the age of the company (a minimum of 50 years' experience is recommended); 2) the corporate address; 3) the company ownership structure (stock or mutual); 4) the Financial Size Category (recommended minimum is IX); 5) the business overview, and 6) the history of the company including any mergers and acquisitions. In addition to this free data, AM Best also offers a complete company report for $19.95 which provides financial statistics for the past five years. But unless you're proficient at interpreting insurance company financials, this report may prove rather overwhelming. (Web site is: www.ambest.com).
  • Standard & Poor's - To access the Insurer Financial Strength Ratings, click on the Ratings Lists link, and then choose the Insurance category. When you have located your company, the resulting report is quite detailed. In particular, pay attention to the following data:
  1. Total assets for five years (goal is moderate growth over this period with a recommended minimum of $2 billion in assets)
  2. Total liabilities (should experience roughly the same growth rate as total assets)
  3. Net income (should remain relatively stable)
  4. Business review and history
  5. A pie chart indicating the company's product sales.

The last category is particularly important in times of change. If a company sells too much of any one product type (individual annuities, or permanent life insurance, for example) a sudden shock to the marketplace, such as a change in the economy or tax system, could result in a sharp decline in the company's business. Lack of product diversification was a leading factor behind the failure of Mid-Continent Life. The company primarily marketed one policy type and, when that product proved to be under priced, the entire company was at risk. (Web site is: www.standardandpoors.com).

  • Fitch - The Financial Strength Ratings Reports can be found under the "Insurance" category. In addition to a letter rating, the Fitch website will provide you with a detailed business review and overall outlook for the company. In particular, you should pay attention to the following: 1) the product mix (life, annuities, group insurance); 2) the company's marketing focus (upscale and advanced marketing is usually a sign that much of the company's business is tax-oriented; 3) the primary states where the company sells insurance (diversification between several states is advised); 4) the company's reinsurance practices, and 5) the quality of the assets in which the company invests. High-risk investments (junk bonds and defaulted mortgages, for example) have caused the downfall of several large insurance companies such as Executive Life, First Capital Life, and Monarch Life, and a company's exposure to such investments should be very limited. (Web Site is at www.fitchratings.com).
  • Moody's - Insurance Financial Strength Ratings can be found under the "Insurance" category. (Web Site is: www.moodys.com).
  • Weiss - Weiss is the only major rating service that charges for its current ratings. The cost is currently $7.95 per company and the only information you will receive for that price is the letter rating. To purchase a rating, click on the "Ratings Online" button. (Web Site is: www.weissratings.com).

The web site addresses given here are the main home page for each rating service. The page where the ratings can be found changes so you may have to look for it on the web site. It also can be a challenge to find the page; however they are there. At the time of the writing of this book, you do need to establish a free account for some of these services. A high rating is not a guarantee that a company will meet its projected earnings or that it will survive. Similarly a low rating does not mean that a company will not meet its projected earnings or that it will fail. A rating is simply an expression of opinion about selected aspects of the current financial condition of an insurance company. Each rating service also has extensive information on their philosophy and the criteria on their website.

Do you have any additional tips for LTK readers in regards to life insurance?

Keep in mind the adage that you don't want to "insurance rich" and "cash poor". In other words, don't overextend yourself. While life insurance (as with all types of insurance) may very well be needed, it won't do you much good if you have to cut other necessities out of your budget. Balancing your overall financial needs should always be your primary concern. Remember that your insurance needs will constantly be changing especially with major life events, so it's important to review your life insurance needs at least every two years.

Additional Resources

If you are interested in learning more about life insurance and life insurance products, pick up a copy of Anthony Steuer's book, Questions and Answers on Life Insurance available at Amazon.com or visit him online at TonySteuer.com.

Life Insurance: An Interview with Insurance Expert Anthony Steuer