Approaches to Financial Underwriting in Life Insurance - Are We Making Sense?
For decades the life insurance industry has been using similar financial underwriting guidelines and making few material changes to underwriting approaches. This article is intended to plant some seeds of thought, promote dialogue, provide ideas to consider for changes in financial underwriting guidelines, and ultimately encourage you to answer for yourself whether or not your current guidelines make sense.
Income Replacement Sales
Income Replacement sales are the most common type that life underwriters encounter. Many companies utilize tables like these:
Underlying this type of table is an assumption that income will continue to steadily rise over the course of one’s working lifetime. It’s common for companies to publish that they will consider an income multiple up to 30 times income for ages 30 and younger, and in some cases 40 and younger. Can we assume one’s income will materially steadily rise over time irrespective of occupation? Does it make sense to offer coverage to someone age 18 to 25 that is 30 times their income?
- 18-year-old male, lives with girlfriend, has two young children
- Works at a fast food restaurant
- Gross annual income is $15,000
- He is eligible for $450,000 of life insurance.
- 25-year-old lawyer, single, no dependents
- Gross annual income is $125,000
- She is eligible for $3,750,000 of life insurance.
Without a second thought, many companies would issue $450,000 of coverage to the 18-year-old fast food worker earning $15,000 per year because the sale falls within the published income replacement multiple. Does it make sense? Is the policy likely to persist?
Other questions to consider here:
- Should your application or agent’s certificate/statement ask the number of dependents for which the proposed insured is financially responsible in order to gauge affordability and likelihood of persistency?
- Are your underwriters aware of the poverty guidelines?
- Is it profitable for your company to offer coverage to individuals whose income is at or below the poverty guidelines?
Income Replacement Coverage - Longer Needs
Life expectancy has increased among Americans, and people are choosing to work longer. Consider the findings from recent research:
- “Significant differences exist between the attitudes and expectations of Americans who are currently working vs. those already retired,” according to the most recent findings from Northwestern Mutual’s 2014 Planning and Progress Study.
- Most notably, the research suggests that substantial changes in retirement age and lifestyle are on the horizon.
- People expect to work longer, but a sizable number will do so by choice rather than necessity. Others—and there are plenty of them—aren’t as fortunate and don’t feel they’ll have the luxury of choice.1
Take another look at the income replacement charts in Exhibit A. Which set of guidelines best addresses the increasing trend of older age individuals working longer? Are your Income Replacement multiples appropriately addressing this trend?
Should We Continue To Use Income Replacement Charts or Find a Better Approach?
Calculate Your Life’s Economic Value:
Would a calculator by which your company sets the ROI %, inflation rate and expected income growth, resonate better with proposed insureds and producers than the income replacement charts?
Income Replacement Sales - Types of Income
There are many different approaches for determining what types of income can be considered when underwriting income replacement sales. Some examples:
- In determining income, include all sources of earned income.
- Also, include unearned investment, rent and royalty income if it is clearly a result of the insured’s personal management expertise.
- Include both earned and unearned income in calculating amounts of coverage for income replacement sales.
- Only include unearned income if it will cease at the proposed insured’s death.
What makes the most sense for your company?
Many life insurance underwriting departments consider premium-to-income ratios in the underwriting process. Some examples:
- If more than 10%–20% of income is spent on life insurance, the amount of coverage may be unreasonable.
- If net worth ≤$5 million, a premium-to-income ratio up to 25% is okay.
- If net worth >$5 million, up to 50% is okay. If net worth >$10 million, up to 70% is okay.
- When income <$50,000 annually, premium-to-income ratio should not exceed 5%; with income of $50,001-$100,000, ratio should not exceed 10%; with income >$100,000, ratio should not exceed 15%.
Do we want to allow our 18-year-old skateboarding fast food restaurant worker to spend up to 25% of income on life insurance? Some guidelines suggest it would be okay.
Our attorney earning $125,000 a year also has non-income generating real estate holdings that make her net worth $6 million. The guidelines above suggest it would be okay for her to spend 50% of her income on premiums.
Publishing one acceptable premium-to-income ratio and utilizing it across the spectrum of incomes probably isn’t a good idea. A tiered approach with an acceptable premium-to-income ratio that rises with income may be a better approach. What parameters make the most sense for your company?
Is Your Underwriting Department Using These?
Form 4506-T Request for Transcript of Tax Return
Is your company using this tool? It’s inexpensive, usually available within 48 hours, eliminates debates with producers and proposed insureds about actual income, inhibits fraud and is a great older-age and large-amount underwriting tool. If your company is not using it because agent/producers push back or say it’s too intrusive, remind them of the financial documentation needed for other financial transactions of much lesser amount, such as tuition assistance, mortgages or business loans.
They are inexpensive, quick to obtain, and improve financial underwriting, management of persistency risk and, in turn, profitability. In the near future, analytics will enable underwriters to review credit reports and predict with high accuracy an individual’s income and net worth.
Electronic Inspection Reports (EIRs)
Use of traditional commercial inspection reports in life underwriting is diminishing rapidly; we see them increasingly being used just for large face amounts over $5,000,000. EIRs are gaining in use as database queries provide ID verification and substitutes for information traditionally provided by commercial inspections. The available data will continue to grow and already includes criminal history, bankruptcies, liens and judgments, property ownership information, aircraft and FAA certifications, watercraft information, professional licenses, UCC filings, concealed weapons information and hunting and fishing license information.
The benefits of EIRs include:
- Much less expensive
- Obtainable within seconds compared to days or weeks for a commercial inspection
- No client contact required
- No risk of having a poor interviewer jeopardize the sale
- Reduced risk of fraud as the information received is not dependent on the proposed insured
Does your application include a strong financial statement? The design of a financial statement is a critical component of the financial underwriting process. It’s a tool that helps underwriters appropriately underwrite financial risk, avoid anti-selection and situations of overinsurance.
- Appropriateness - Make sure the level of detail contained in your form is appropriate for the markets in which your company operates.
- Purpose of coverage - Make sure the form requires a clear indication of the purpose of the coverage for which the proposed insured applied.
- Earned income section - Include salary, bonus or commissions, other compensation, spouse’s earned income.
- Self-employed - Design the form so underwriters can know and focus on net earnings after addressing gross sales and all business expenses. Focusing on gross earnings for self-employed individuals may result in gross over-insurance.
- Unearned - Include rents, dividends, interest, other. If your company utilizes both earned and unearned income to calculate reasonable amounts of income replacement coverage, make sure the needed data is captured.
- Net worth - Structure your form like a balance sheet: liquid assets, real estate, life insurance cash values, net business interest, personal property, other assets, mortgage or liens, other liabilities.
- Verification - Include a line for an accountant’s name, address and signature for your large amount cases that require third-party verification of financials.
- Signature coverage - Provide a signature and date line for the proposed insured to execute, or include language in your application such that signing the part one application covers the information provided in the financial statement.
- Filing - Can’t stress this enough - Make sure the form is filed and included with the policy; otherwise, it may be worthless at contestability time.
Estate Planning Coverage
Approaches and guidelines for underwriting estate planning cases vary widely in complexity from company to company. Some examples of the variation include:
- Determine future estate value by considering a maximum appreciation factor of 7% (5% if proposed insured is age 80 or over), but it can be less depending upon the mix of assets or nature of the case, and 75% life expectancy of a proposed insured (50% of age 70 and above).
- Project estate at 4% growth, use 50% of the life expectancy and deduct the estate tax exclusion of $5.34 million to determine taxable estate.(Not many people will qualify for coverage with this guideline.)
- Use an annual growth rate of 4%, or 5%, or 6%, or 7% or 8%. For projected estate growth, use 20 years, or 15 years, or 10 years, or 8 years, or consider 50% of life expectancy.
- Allow up to 40%, or 45%, or 50% of projected estate growth.
- Allow coverage equal to current net worth.
The first example gives me a headache just reading it. Perhaps it’s time to take a step back and ask which approach makes the best sense for your company and the markets it serves especially at a time when sales are flat or decreasing year-over-year for many companies. Are your guidelines clear? Are they easy for underwriters, producers and proposed insureds to understand? Do they help promote sound, profitable sales?
As you look at your company’s financial underwriting guidelines, here are some ideas to consider:
- Publish the Poverty Guidelines as part of your Income Replacement guidelines and consider whether or not it makes sense to offer coverage to individuals with incomes at or below the Poverty Guidelines.
- Consider adding an application or agent’s certificate question, such as:
- For how many dependents is the proposed insured financially responsible?
- What is the total household income?
- Consider adding an application question like:
- What is the total annual amount spent on all of your life insurance policies?
- Consider including a chart in your financial underwriting guidelines, for example:
- Discuss internally and with Gen Re how your income replacement table should be structured.
- Discuss whether you need an Income Replacement chart or if a human life value calculator would be a better resource.
- Re-visit which sources of income should be considered in determining Income Replacement guidelines.
- If you publish acceptable Premium to Income Ratios, check to see if they make sense.
- Make Form 4506-T Request for Transcript of Tax Return part of your application package and routine requirements.
- Consider implementing routine credit reports if you don’t already utilize them.
- Review your company’s financial statements—are they optimally structured? Make sure they are filed and a part of the policy.
- Review your “Estate Tax,” “Estate Planning” guidelines and settle on an approach that makes sense and is easy for underwriters, producers and proposed insureds to understand.
Gen Re is a leader in financial underwriting. Please feel free to contact us with your challenging financial underwriting scenarios and for assistance in reviewing and designing financial underwriting requirements and forms.