Guaranteed issue life insurance policies are life insurance policies aimed at providing access to insurance. You may have heard of this policy in television commercials where insurance is being offered to an older gentleman without the need for a physical or medical questionnaire.

Most guaranteed issue life insurance policies will also insure a holder even if they have pre-existing conditions (cancer, diabetes etc) which typically results in an insurance payout being denied (emphasis on the word “most”. Details vary from carrier to carrier). Premiums also will not increase. In other words, this is insurance for the masses- in whatever shape or form.

In return for insuring the potentially uninsurable and not increasing premiums, the policy holder is paying for the insurance company assuming this risk. Most notably, insurance premiums are high.  Insurance payouts also tend to be modest ranging from $5,000 to $25,000 (although some policies pay as much as $125,000) – IF you survive a period of time after obtaining the policy. A policy holder typically has to live 2 years in order to qualify for the death benefit. Otherwise, the death benefit is only the return of premium.

In summary, the uninsured are not uninsurable but at a cost.

Example 2 deals with Manulife’s  Synergy policies. Quite simply, it is a 3 in 1 product which provides life, disability and critical illness insurance in 1 policy. The insurance brokerage industry loves the product since it is being sold as a cost saver. Some insurance agents are selling the product as helping to shave 30% off purchasing each insurance policy individually.

However… you get what you pay for in life. As this fee-based financial planner points out, disability coverage is limited to 2 years (rather than up to 65 on many disability policies), the maximum payout is $500,000 (which sounds like a lot but, if you are relying on the disability and critical illness policies, can be used quickly) and there are age limits.

Is the product a cleverly designed product? Yes. But, one should avoid buying it solely as a cost savings vehicle and look to see whether it fits the contextual need.

As always, one rarely gets to have their cake and eat it too. These products are designed to meet certain market needs but come with a cost. Conduct your due diligence and proceed cautiously.

Assume the best case scenario. Assume a person has back-stopped an emergency situation with short-term disability insurance and long term disability insurance (the different between the two insurance policies is that short-term insurance typically pays out for a shorter period of time and, as such, the insurance premiums tend to be lower). Since the risk insured is loss of income potential due to accident or injury, disability insurance should ideally back-stop the financial consequences of a rainy day.

In the insurance lingo, short-term and long-term disability insurance have a provision known as an “elimination period” (sometimes called a “qualifying” or “waiting” period).  In plain English, an elimination period is the amount of time between the disability and when the insured receives benefits. In short-term disability policies, the elimination period can be as short as  7 days from the commencement of a disability. The shortest elimination period I could find in a long term disability insurance policy was 17 weeks with many elimination periods being in the range of 90 days or 180 days.

If one uses 17 weeks as the shortest elimination period one can reasonably expect to pay (an insured could go shorter but I suspect the cost is quite prohibitive at that point), then the emergency fund issue has more grounding. Mainly, even in a best case scenario, one should be carrying at least 17 weeks of fixed funds. It seems more reasonable to carry 90 to 180 days which gets us to the often used 3-6 month mark.

(I am cognizant of the fact there are government programs which provide benefits but they tend to be capped at a modest amount or open to a small class of beneficiaries. Disability insurance policies also tend to claw back amounts paid if you are on government benefits).

Now layer in a second level of analysis. Most long term disability insurance policies only pay a portion of monthly salary. Most policies I found paid anywhere in the range of 60-70% of salary (not including bonuses). The gold plated standard seems to be the Workers’ Compensation Insurance Board of Ontario which pays 85% of take-home pay for those injured on the job. All these payouts are subject to caps.

If one’s fixed monthly costs is above the 60%-70% insurance payout, even if insured and covered, the insured is in a negative cash flow position at the end of every month necessitating even a greater emergency fund equal the dollar figure above the insurance payout monthly.  One could argue that the insurance company believes we should all be living on 60-70% of our take-home salary monthly.

It is not a perfect way to calculate the amount of emergency funds one needs but I hope it adds some real life context to the calculation.

However, in reviewing my home insurance policy, I noticed something interesting. “Water damage-ground water and sewer” and “weight of ice, snow or sleet and above ground water damage” are actually additional riders in my home insurance policy (my home insurance provider is Meloche Monnex; this is one of the few cases where being asleep at the switch helped me).

In other words, water damage is not a standard rider in a home insurance policy. I looked further and oil damage, for those with oil tanks, is also not a standard rider in a home insurance policy.

Finally, for those running home businesses, a typical home insurance policy will NOT cover damage to your business assets. Many home insurance policies now provide home business riders as well.

For those who wonder “how will my insurer know whether the replacement computer is for personal and business use?” consider that in most commercial insurance policies the second most important coverage, after replacing damaged or destroyed goods, is business interruption coverage.  This type of coverage typically gives the policy-holder money to temporarily locate and keep the business running. Thus, if your house is substantially damaged enough not to run your business, this may be a rider to consider.

The moral of the story being to check your home insurance policy and make sure you are covered.

In a perfect world, the amount of coverage should correspond with the specific risk one is insuring against. For most middle class households, term life insurance should insure against the payment of the largest debt of a household, mainly the mortgage. The theory is that as our financial responsibilities lessen over the years (mortgage and/or household debt is paid down, kids are no longer as large a financial burden etc.), the amount of term life insurance should decrease.

Thus, many term life insurance policies have declining coverage with payout declining over a set schedule. This is in contrast to level term life insurance policies where the payout will remain constant over the term of the policy.  Since the insurer’s risk is reduced over time, term life insurance with declining coverage, and with no other riders, tends to be the cheapest form of life insurance policy. Hence, affiliate program life insurance policies (think of the insurance policies pitched to University alumni or members of an association) can sometimes be declining term life insurance policies.  The attractiveness in pricing tends to lure in clients.

But what happens if the risk the policy-holder is insuring against is actually not decreasing over time but increasing? This is most likely a probability insurers did not account for until recently when becoming leveraged became popular. Or, more positively, what if the net worth of an individual is increasing and the insurance does not cover the tax bill on death (with a growing number of unmarried households, a tax deferral to a spouse is no longer automatic)?

It is this gap between the financial cost of the risk and insurance payout which is the problem. In a level life insurance policy, the problem certainly exists if the financial costs of the  risk being insured continues to increase. But the problem is magnified if a policy holder has a declining term life insurance policy and the financial cost of risk does not decrease (household debt continues to go sideways) or increases (household debt increases). In that case, the bill for the risk is covered less and less by insurance.

Is there a solution?

For those struggling to meet monthly financial obligations, unfortunately, the answer is there really is no answer. With resources strained, converting and/or obtaining declining term life for level term life is theoretically correct but practically a no go.There are so many other priorities to address.

For those who are younger and require insurance (mostly because of young dependents) but know that debt levels will remain high for years to come (think of the household who put very little down on a home and has a mortgage with a long amortization), serious consideration should be given to obtaining a level term life insurance policy rather than trying to cheap out with a declining life insurance policy. Alternatively, a level coverage rider should be brought and/or requested upon the next term life renewal.

Insurance works much like banking; the policy-holder pays the insurance company (substitute deposits in banking with insurance premiums in insurance) who safe-keeps the money and promises the return of the insurance premium plus some rate of return in the future. The insurance company makes money on the difference between the return on investment of the insurance premiums and the promised rate of return to the policy holder.

Since death is a 100% eventuality, and assuming the policy holder maintains the premiums in a permanent life insurance policy, the insurance company cannot exactly bet the insurance premiums on some speculative venture. It has to keep it in safe investments which are typically government backed bonds.

If the insurer believes interest rates in the short to medium term will remain low, it has to raise the price on insurance premiums to make up any possible shortage on return of investment. This is not the sole reason why insurance premiums rise.  But insurance companies, having to balance long term liabilities with short-term assets, are interest rate sensitive.

Thus, a rise in premiums is a signal that the insurance companies think that interest rates in the short to medium term will remain low. Insurance companies have been wrong before (Exhibit A, B, C and D: Manulife) but with insurance companies being very cautious, caught between rising death rates and lower return on investment, insurance companies are good signals of interest rate trending.

Instead, the Province of Ontario is lowering the basic level auto coverage to levels comparable with most other Provinces. For example, after September 1, non-catastrophic medical and rehabilitation benefits are being reduced from $100,000 to $50,000. The income replacement benefit will also be reduced from 80% of gross income up to $400 per week to 70% of gross income up to $400 per week.

While the lowering of the basic auto coverage is being spun as giving the consumer more choice and reducing insurance costs, the underlying rationale may be much more depressing. Simply put, the cost of injury claims are out of control and reducing the amount of money available for assessment and treatment is believed to help rein in costs (so the theory goes).

The issue, as illustrated by James Daw, is that to purchase additional auto coverage post September 1 to get back to the pre September coverage will cost a household significantly more especially if you live in a large urban centre. On an apples to apples comparison, many households will actually be going backwards to get the same level of basic auto coverage. At the end of the day, we are paying more for less.

Finally, regardless of location, for those looking to reduce or cap auto insurance premiums, the tried and true words advice are always:

1. Raise your deductible. There is a temptation to have the insurer cover damage but I understand two claims of any amount will generally raise your premiums going forward. Think about how much it would cost you to pay the additional premium  year over year versus paying out of pocket $1,000 or $1,500 instead of the standard $500 deductible.
2. Don’t speed.  Speeding tickets, especially multiple speeding tickets, are known to increase auto insurance premiums dramatically. If you are caught speeding, consider challenging it.
3. Combine your insurance. Many insurers give discounts if you obtain auto and home insurer policies together.

MISTAKE: Failing to buy enough insurance while you are still healthy.

Medical evidence is required when you buy life insurance.  This evidence usually consists of a list of questions to elicit your medical history, a brief exam by a nurse, a blood and urine specimen and possibly a report from your doctor.  If at a later date you decide that you really need more coverage, the process begins again.  If your health has changed you may have to pay higher premiums.

MISCONCEPTION: Cheapest is the best.

That term policy premium might be cheap in year one.  But most term policies renew at regular intervals (every 10,20 years) and the renewal premium rises at each interval because it reflects your new age.

In general, a 10 year term policy is the cheapest but by year 13 it is actually more expensive than buying Term 20. In other words, if you think you need coverage beyond 10 years, it is better to chose a 20 year term now.

MISTAKE: Failure to understand your options

So on each renewal the premium rises at each interval as stated above.  But you do have options.  Most term policies include a free option to convert your policy to permanent coverage before age 65.  Converting to permanent coverage make sense especially if you have had a change in health. Even better, you will not require a medical to convert.

The types of permanent coverage eligible for conversion usually include whole life and universal life but these also vary by company.  If you buy term coverage do so with a company that offers several options for the converted policy.

MISCONCEPTION: Buying through the internet is cheaper (no commissions to be paid)

Insurance comparison services on the internet say “buy direct and save money”. The fact is, you cannot receive a discount in the price of life insurance by avoiding a life insurance agent.  Sales charges and costs (such as commissions) are built into the premium that you pay for any life insurance policy that you buy. You will be paying those built-in charges regardless of where you buy the insurance.  Finding and using a local life insurance agent will not cost you more than dealing with someone in another city or province by telephone or mail.

MISCONCEPTION: Association insurance has cheaper rates.

Associations include organizations such as universities, credit card companies and consumer groups like CAA.  Sometimes association rates are cheaper but in many cases the rates go up every five years.  Associations are like groups where several insureds are lumped together and pay a premium relative to the group being covered.  Even where limited medical questions are asked, the premiums reflect the inability for the insurance company to fully assess individuals and the group like rates is charged.  Association groups also may offer very limited conversion opportunities.  Therefore if you cancel your credit card or if you are no longer a CAA member you coverage is cancelled.

As a smart consumer, obtain an individual insurance quote and compare the products for price, renewal options and conversion options.

MISTAKE: failure to understand that buying term is like renting life insurance.

Permanent (whole life) plans are more expensive in the early years but the premium stays the same for the duration of the contract.  Because you pay more in the early years, you have some equity (cash value) in the policy.  If you decide to cancel the contract you get the cash value back.  However, you have no equity in a term policy.  You pay premiums applicable to your age and this rate rises at every scheduled renewal.  Because you are paying the true cost of coverage, there is no equity in the policy.  If you cancel the coverage 10 years down the road because the renewal rate is too expensive, then you walk away.  Bottom line, you are renting coverage briefly and won’t have it when you need it or more importantly when your family needs it!

MISTAKE: paying your insurance premium on a monthly basis

The insurance company charges extra to those who pay monthly as they incur extra expenses to administer monthly payments.  If you are able to pay the yearly premium it can save you up to 10%.

MISTAKE: paying extra for benefits (the frills) that you may never use

Waiver of Premium Benefit: the insurance company will waive the premiums if you become disabled.  Few people understand that you must be totally disabled in order to be eligible.  Also if you have term insurance the insurance company will usually pay only to age 65 while for some types of permanent insurance they will pay the premiums beyond age 65.

Guaranteed Insurability Option: In a nut shell you pay more now just in case you want to buy more insurance in the future without having to provide proof of health.  It essentially insures your insurability.  However, your premium for the new policy will be at current age rates.  One more reason to buy all of the insurance that you need now and at your current age.

Accidental Death Benefit: This benefit guarantees that if you die in an accident, your beneficiary will receive an additional predetermined amount of money on top of the base policy amount Again, I’d say if you need accident coverage buy it rather than depending on an ADB rider hopefully supplementing the amount of coverage your family really needs now.

MISTAKE: buying coverage because no medical evidence is required.

This might sound appealing but in actual fact you will pay more for this insurance and the amount of coverage available will be limited.  If you are healthy, take the time to prove it and pay premiums that truly reflect the good risk that you are.

MISCONCEPTION: the premium I see on the internet is what I get.

Insurance companies offer several classes of standard rates.  Those in the top physical condition and with no risk factors will get the best rate.  Premiums on the internet usually default to the top preferred category (the cheapest).  However, keep in mind, only a certain percentage of applicants will actually qualify for the best rates.

MISCONCEPTION: waiting until you lose weight or stop smoking in order to get the best rate.

This is just procrastination.  Yes, you may pay higher rates now but did you know that if you quit smoking or if you keep the pounds off  for one year, you can apply to have your rate reassessed.

With the world being, or seemingly being, a dangerous place, is life insurance an appropriate product for your child? According to a recent television commercial I watched, the answer should be yes; you never know when you need life insurance even for a child.

However, the general answer is no for two main reasons.

Firstly, statistically speaking, the child mortality rate is  low. According to the National Center for Health Statistics, there were 81,216,835 children between 0-19 years old living in the U.S.  in 2003. There were 53,539 child deaths that year or 65.9 deaths per 100,000 children. This is less than 1% of  children between 0-19. The leading cause of death in this age group was perinatal conditions (14,364 deaths) which the World Health Organization defines as deaths occurring under 5 years of age. In other words, if we assume 2003 was a typical year, the chances of an unfortunate and tragic death of a child are quite low and lower once a child survives past 5.

Thus, the probability of the risk of death for a child is low so paying an insurance premium to transfer risk of loss to an insurance company seems to be a waste of resources, considering there are more productive ways to spend money on a child.

Second, one of the primary reasons why people obtain life insurance is to mitigate against the financial consequences caused by the death of the insured. In the case of a minor, there generally is little to no lost income to be replaced. Obviously, there are funeral costs to consider if a child passes away but, given the low statistical chance this will happen, the financial risk of paying for a funeral is generally small enough to live without life insurance.

The exception to the general rule is if the child has a medical condition which is not severe but can affect their health (diabetes- to the extent diabetes can ever be thought to be minor- would be one example) or there is a genetic tendency towards certain type of disease in the family. In that case, assuming this is disclosed (to avoid a denial of claim based on pre-existing medical condition not disclosed), a term life insurance policy may be suitable in order to make it easier to obtain insurance later in life.

Having said that, one must weigh the cost of obtaining insurance with buying health insurance to supplement existing health care plans or investing in the child’s education. This type of balancing of priorities, obviously, involves contextual factors such as the medical condition at play, financial means, the number of children etc. etc.

The point being, if your child brings home a brochure offering life insurance after the first day of school, it may be an educational piece to read but perhaps not to act on.

No post tomorrow or Friday. I am on a mini-vacation. Enjoy the weekend.

Is this growing trend a good thing for the consumer, the shareholder and the economy as a whole?

THE CONSUMER

On the retail front, we have all heard about financial institutions wanting to capture all of our business as your “one stop” cradle to grave financial services shop. However, anecdotal evidence  suggests that customer loyalty at banks really does not pay and is there any evidence to show that the retail consumer benefits from pricing power from banking, borrowing, trading securities or buying insurance from one shop?

Granted, there are small discounts if you buy different types of product offerings under one umbrella (State Farm Insurance is known to give a discount but you have to move all your insurance to them) but why give up leverage of moving around from financial institution to financial institution if there is no corresponding monetary benefit to shopping under one roof?

More concerning, the dirty little secret of insurance sold by banks is that banks are actually selling other insurer’s products or white-labeled products. Scotiabank will be selling Sunlife products. My insurance broker once told me that, at that time, RBC insurance products were white-labeled Manulife policies. If the banks are acting as distribution channels for insurers, obviously, there are costs of sales and their margins to consider. For a business with such large over-heads as banks, the cost could be great and they will be downloaded to the consumer.

But, to defend the banks for a minute, this may also be a good move if, and only if, this starts a price war. Banks have been selling insurance for years but if they move in scale, this may trigger price movement downwards. The key, as a smart consumer, is to obtain multiple insurance quotes from the banks, insurance brokers, on-line insurance quotes using the same assumptions and determine if different distribution channels have different price structures. If they don’t, I would still purchase insurance from someone other than the banks to avoid giving up all your leverage as a consumer; rarely is the lazy consumer, the smart one.

THE SHAREHOLDER

Increasing revenue sources means increasing revenue which, hopefully, means increased earnings. However, if the banks engage in a pricing war with the insurance companies (assuming the banks underwrite their own products) and vice versa (remember that some insurance companies are beginning to build out their banking divisions as well), what’s good for the consumer is bad for the shareholder. The recent supermarket price wars are a good example of happy consumers and unhappy shareholders.

On the downside, insurance is also a tricky risk management product. Actuarial calculations on probability of payout are really educated guesses into the future. Already juggling fallout from the credit crisis, if a bank dramatically increases its insurance exposure, it may have to build greater capital ratios (both for deposits and insurance exposure) which is a drag on earnings. Once again, the question becomes how well can a bank manage risk?

THE ECONOMY

There’s a rather deafening silence in the dialogue about financial services reform- the reinstitution of the Glass-Steagall Act. This Act, passed at the height of the Great Depression in the U.S., separated banks, investment banks and insurance companies from owning one another. One justification was that traders should be barred from using bank deposits to trade; banks are supposed to limit risk on deposits and they should not allow traders to have access to deposits given their relatively riskier functionality.

The act was repealed in 1999 under intense lobbying by financial institutions. Citigroup was the most well-known institution to consolidate deposit-taking, trading and insurance functions under one financial services holding company after the repeal of the act. Citigroup also became the poster-child for the credit crisis as its large derivatives exposure and imprudent trading practices put depositers’ money at risk.

Many countries continue to prohibit the consolidation of banking and investment trading functions. The U.S. sits on the other extreme of non-regulation. Canada occupies the grey zone. A financial institution can do a bit of everything- as long as its not under the same roof (a rule only a bureaucrat could convincedly think would work in real life).

If banks become insurance juggernauts, are we exposing our deposits and insurance premiums again to traders with much higher risk tolerance than the retail consumer? Perhaps the practical regulatory solution is to mandate higher capital ratio levels on both the deposit taking and insurance side once exposures reach certain levels and limit the use of revenue derived from safer divisions by riskier functions. Certainly,  risk-taking and innovation are opposite  sides of the same coin but one wonders if such risk taking should be done with grandma’s money.

However, the devil is in the details and there are two larger and worrying trends in the insurance industry. The first is that insurance companies don’t want to be boring old insurers anymore but asset managers. The second is a general consolidation of the industry. In Canada, three insurers- Manulife, Great-West Life and Sun Life- now control approximately 65% of the market. In the United States, companies dominant insurance niches. While the public opposes big banks, the insurers quietly reached a scale the banks would die for.

The result is that most insurance companies need to pay out as little as possible to maintain or grow their assets under management (in fact, many insurers sell policies as loss leaders while making money on asset management) and a consolidated industry means pricing power. Neither is particularly  good for the consumer.

On a more specific level, what are 5 warning signs that you may have an improper insurance policy?

1. No medical required before obtaining an insurance policy

Four Pillars and I  have written before about post-claim underwriting. While illegal in many jurisdictions, there are many ways to re-characterize a policy to be potentially within the scope of the legislation (and require expensive litigation to resolve).

A “no medical required” insurance underwriting process may not indicate per se that you are subject to post-claim underwriting but it could be a warning sign you could be sold a policy subject to post-claim underwriting. It may make the process of obtaining insurance easier but the potential future-risk is greater.

2. The purpose of insurance is not being used for risk management

As reported by Riscario Insider, the 10/8 program, which involves using insurance policies as collateral towards a loan to the policy-holder to be used for business or investing purpose (thus making the interest tax deductible), is being reviewed by CRA.

Depending on the specifics, some insurance policies were designed more as tax shelters than insurance. In such cases, the insured could run audit risk for what is supposed to be a risk management tool.

While no one knows what will happen to the 10/8 program (and you know there is too much money at stake not to have the insurance company fight this out), the larger point to consider is why you are entering into an insurance contract. If you are being sold something who’s primary purpose is not risk management then think twice since you have opened yourself to other risk factors.

3. Watch the exclusions

Insurance policies are drafted to set out what it does not cover rather than what it does. Just because it is called critical illness insurance, does not mean all type of critical illness are covered and if you have a family history of certain critical illness, the insurer could deny you on the grounds you failed to disclose a pre-existing condition.

The point is to ask your insurance broker what the policy does NOT cover as well as covers so you understand the limitations of your policy. If you may possibly fall under an exclusion, then the policy is not right for you.

4. Unnecessary insurance

Life insurance for minor children. Mortgage insurance. Credit balance insurance. Flood insurance for someone living in North Dakota. There are a lot of insurance products that are ideal for a small subset of the population but sold to everyone. The fundamental question to be asked is always: (i) am I actually at risk (chances of a minor child dying are slim; and (ii) does the risk of occurrence actually require transfer of such risk (a minor child has no dependents so who really needs the money on death?)?

5. Too much insurance

This one is always tricky but insurance brokers tend to start high on their coverage (for their commission). The question to be asked is always: how much money do I really need in case something happens to me? This requires some cash flow projections based on your own life-style rather than what the insurance company tells you.