Out in the field, life insurance policies are generally not selected, designed or funded to most effectively support today's complex estate plans and premium-paying strategies. The mismatch between plans and strategies on the one hand and products on the other often creates real trouble down the road. Let's fix that by following some practical guidelines for determining a policy's suitability.

Life product suitability is critical for a number of reasons.

First, clients, especially high-net-worth clients, buy life insurance to fulfill any number of needs, in any number of planning contexts and with any number of premium-paying arrangements. The insurance industry offers a wide range of products that are, or can be, designed to enable clients to meet those needs and to work well within an infinite number of planning contexts and premium-paying arrangements. Carriers often makes things a lot easier for us by actually naming the products in ways that tell us what the carriers had in mind when they designed the products.

Given the diversity of client-driven buying parameters on one hand and the diversity of product offerings on the other, it's a tactical and strategic imperative to have a process to determine the characteristics of a policy that are well suited for what a client is trying to accomplish and how that client wishes to accomplish it. After all, this might be the last policy the client is ever able to buy.

Second, particularly when a client needs to use a multi-factor dependent approach to pay the premiums, involving all members of a planning team in determining product suitability should result in greater connectivity between the selection and design of both the premium-paying approach and the insurance product. That kind of connectivity is too often lacking today. Frequently, advisors choose a premium payment approach for one set of reasons and the insurance agent selects the policy for a different set of reasons; the client is lucky if the twain ever meet. Rigorous guidelines for suitability would go a long way towards linking case design with product selection.

Third, guidelines for suitability would make life a lot easier for buyers, agents and advisors. Guidelines can make it easier for clients to understand how a product works and why it fits in their situation. Agents would find it easier to identify appropriate types of products, then fashion presentations of those products in terms that the client expects and understands. Also, guidelines can offer the agent some protection from an advisor's bringing in another agent to quote the case. And, they can be a very valuable item for the agent's file in case there is a change in the client's circumstances and somebody decides to revise history and seek redress for a supposedly “unsuitable” product. Guidelines help advisors because they can make it easier for the advisors to work with agents to more seamlessly integrate the otherwise disparate components of the estate and insurance planning (the connectivity.)

Most of all, if drawn in a truly arm's-length setting that involves rigorous debate, guidelines can offer the client some protection against any given member of the planning team dominating the conversation and making the client see his issues solely in that person's terms.

Suitability Criteria

So, how do we establish suitability guidelines? Perhaps we can take a cue from financial planners. When financial planners talk with investors about asset allocation, they generally talk in terms of asset classes such as cash, fixed income, equities, commodities, real estate and alternative investments. Each class presents a unique constellation of features, benefits and risks. Each finds a place in the portfolio according to the client's needs and risk tolerance. Once the planner and client come to terms on the allocation among the asset classes, attention turns to allocation within the respective asset classes, that is to say, how each broad bucket of the overall allocation should be filled.

Of course, this simplistic description of the investment allocation process doesn't begin to suggest the sophisticated analysis that many financial planners apply. But it does help us draw a parallel between the investment planning process and the process of determining the right type of life insurance product (or products) for a given client in a given planning context.

In much the same way that each of those investment asset classes offers a unique constellation of features, benefits and risks, each of the most common types of life insurance products essentially packages the components of mortality, investment and expense in a way that can make it more or less suitable than another type of product in a given situation. To be absolutely clear, one type of product is not inherently better than another. But just as clearly, one type of product can absolutely be more suitable in a given situation than another.

The parallel doesn't stop here. It is naïve to think that either the investment allocation process or life insurance policy selection is conducted in a clinically pristine environment, free of the practitioner's professional experience, biases, risk tolerance, compensation and business considerations and organizational constraints. Practitioners may not be able to create their own black or white, but they can certainly cast the discussion in whatever shade of gray suits their purposes.

The existence of some kind of process, some kind of evaluation by all of the stakeholders in the case that takes into account the client's criteria, the planning context and the likely premium payment arrangement, can go a long way towards illuminating what is “right” for the client today and stands a good chance of being right for the client tomorrow.

With variations on the theme according to the circumstances, I believe that a sensible approach to identifying appropriate life insurance product (or products) starts with the agent sitting down with the client and the other advisors and going point by point through the individual policy characteristics that I will talk about in a moment. The end result of this, and no doubt the subsequent meetings the group will have as they refine the case design, should be a succinct writing, a prescription as it were, for the agent to take to the marketplace.

First, some caveats. What I am about to describe is not a rote exercise. It's not “yes” or “no” and it's not check the box. The team will find it very difficult to arrive at a conclusion about any of these characteristics without considering it in the context of some of the other characteristics. And, as the agent will properly remind the rest of the team, there could be underwriting and reinsurance considerations ahead, so for the time being, no conclusion will be conclusive.

Finally, discussion of some of the characteristics could become contentious, which is good, inasmuch as I believe that absence of “constructive conflict” between agents and advisors is a root cause of the lack of connectivity between the estate planning and the insurance planning. Still, I am confident that at the end of the day, the client will be a very well informed buyer and the team will have fashioned a well integrated estate and insurance plan.

The Guidelines

Here, in the context of an estate-planning case, are the characteristics the client and team must address to determine the right product(s). For most effective absorption, try to consume each in the context of the others, that is to say, consider premium flexibility and premium guarantees during the same seating.

  1. The amount of insurance —This is the initial amount of insurance, which might or might not be the amount of insurance that the client needs or wants over time. The agent obviously needs to know this as he goes to the marketplace. We'll return to this topic in a moment when we discuss type of death benefit and, indirectly, suitability for the premium-paying arrangement.

  2. The duration of the need —This is actually a two-part inquiry. First, a client who will implement a robust wealth transfer program sooner rather than later theoretically should not need that initial amount of insurance forever. In such a case, the client might want the flexibility to seamlessly reduce the death benefit and do so without cost or surrender charge.

    The second part of the inquiry involves the client's longevity. Many agents and advisors will urge the client to fund the policy as though he is going to live longer than Noah. If the client is healthy, that's one thing. But when a client is underwritten at standard, not preferred, and even that took some doing, does he really need to buy a ticket on the ark and pay a premium sufficient to carry the policy to age 120? That argument might not hold water. One approach that can be helpful, however, is to provide clients with projections of their life expectancies based on their age and underwriting classification. Clients can use the projections as guidelines for funding their policies.

  3. The type of death benefit: level or increasing —This is another multi-faceted inquiry. Clients who use life insurance as a default estate plan, meaning they will not do any wealth transfer planning but will designate the life insurance as the bulk of the inheritance, are generally quite satisfied to use a level death benefit. Similarly, clients who will implement estate reduction strategies sooner rather than later could be satisfied with a level death benefit. On the other hand, any client who is considering split-dollar or some other premium financing approach has to decide if he wants to keep the death benefit for the beneficiary level net of the loans. If so, then either an increasing death benefit option or a return-of-premium option is appropriate, and the cost of the policy will increase accordingly.

  4. The budget —Speaking of cost, I have found over the years that most clients will put a topside or ceiling on what they are willing to spend for the insurance. Sometimes that figure is governed by pure economics and cash flow. Sometimes it's governed by available annual exclusions. While it might take some time for the client to settle on (or even to ballpark) that figure, the sooner the agent can get an indication of what the client has in mind, the better.

  5. Premium duration —Some clients would like to complete the funding of the policy as quickly as their cash flow or tax position allows. Others are reluctant, at least initially, to pay any more annual premium than is required to support the death benefit for the targeted duration. I say “initially” because the agent might be able to show the client that their product of choice is apt to perform more efficiently and safely over the long term if funded more rapidly up-front. In any event, the agent is unfortunately going to have to illustrate various approaches to funding the policy, knowing full well that underwriting could eventually send him back to the drawing board.

  6. Premium flexibility —In simplistic terms, we are talking about the ability to increase the premium without additional underwriting or to decrease the premium without immediate loss of death benefit. We might also be talking about the ability to skip some premiums without losing any death benefit and without triggering a policy loan or without having to pay an unduly expensive toll charge to bring the policy back to an adequately funded position. Some products offer this kind of flexibility. Others do not.

    In my experience, premium flexibility gives the client and planning team far greater ability to construct a safer yet more gift tax efficient plan than if they have to deal with the requirements of a product that mandates a certain premium. It is also my experience that premium flexibility can be the single most critical component of any attempt to salvage an insurance arrangement that just hasn't worked out, such as a trust-owned policy that still needs many more years of funding until it's self-sufficient or a split-dollar arrangement that didn't meet the promise of its press clippings. And, putting the sophisticated planning aside for the moment, my sense is that in today's world, where families, jobs, careers, cash flows, and tax laws are so “fluid,” the more flexibility a buyer can have with an insurance product, the better.

    But it has also been my experience that premium flexibility is one of the three topics over which life insurance policy selection can become a contact sport. (The other two are premium guarantees and use of a general versus separate account product. Both topics are discussed below.) True premium flexibility is typically associated with products such as traditional universal life or variable universal life, which many agents don't want to sell for any number of reasons. Reasons I have heard over the years, let alone in recent weeks, range from a fear that such a product poses unacceptable and unnecessary risks to the client, the agent or both, is unreasonably service-intensive, is so transparent as to confuse the client with too much information, and so forth. Therefore, flexibility either doesn't get discussed at all or is simply buried under the discussion of matters the agent wants to focus the client on, like guarantees, which are discussed below.

    Let me hasten to add that many agents are quite comfortable with recommending flexible premium products, only to be told by the advisors (but not the client) that such products are too risky and “the client wants guarantees.” Does the client want the guarantees or do the advisors want them? Does the advisor understand how that lack of flexibility could potentially undermine the sustainability of the client's estate liquidity planning and budgeted cash flow or tax planning? I am not saying that premium flexibility is the policy characteristic that should trump all others. There are legitimate arguments in favor of a policy that trades off true flexibility for the guarantees. But true premium flexibility is the policy characteristic that, for all the wrong reasons, has the toughest time getting shelf space!

  7. Premium guarantees —This is the policy characteristic that is at the core of the most serious debates among insurance professionals today. We're talking about the insurer's guarantee that the planned premium will support the death benefit until the targeted age, regardless of policy performance. The products most closely associated with that characteristic are no-lapse universal life and certain types of whole life. But even within so-called “current assumption” products, meaning products in which the sufficiency of the premium or the planned duration of the premium payments is largely dependent on future policy performance, there are components that provide the guarantee of the sufficiency of the premium.

    Eventually, we're hoping that the client, once well informed about what guarantees bring to and take away from the table and how they impact such characteristics as premium flexibility and cash value accumulation, will tell the team how he feels about buying that kind of product, either alone or as part of a large insurance portfolio. To get to that point, we typically have to wade through a lot of discussion that is supposedly about premium guarantees but is in reality about an agent's risk tolerance, the product portfolio of his carrier(s), the relationship between the level of guarantees in the product and his compensation, and so forth.

    Or, the discussion might not be about the agent at all. It might be the advisor's risk tolerance, even if he is not selling the policy and won't have to live with the consequences of its performance.

    Often, the discussion is about both.

    There is no question that the client and team should have an illuminating discussion about premium guarantees and the products that offer the same. They should be shown how those products work, when they might be appropriate, their pricing compared to other products (or policy designs) that incorporate less of a guarantee and their performance characteristics with respect to the accumulation/distribution of cash value. And, where applicable, the client and team should hear the pros and cons of using a “guaranteed” product versus a current assumption product in the context of an arrangement such as split-dollar or third-party premium financing.

    The client should see representative illustrations for the guaranteed product and the current assumption product. The problem is that far too often, one product or the other is not shown, and the client is precluded from seeing the best that the marketplace can offer.

  8. Cash value accumulation/distribution —I wish I had a dollar for every time I've been told that “cash value” isn't important because the policy is in an irrevocable trust, the client won't ever need the money, etc., etc., etc. Tell that to the client (or trustee) who wants to exchange the policy for another. Or tell that to the client who wants the policy value to be the bedrock of an exit strategy from split-dollar or premium financing. Or tell that to the client who says to the team, “With all due respect to your definitions of risk, my view is that the best way to minimize my risk with an insurance policy is to be able to get my money back as soon as I can.”

    My point is that the need for cash value build-up in a policy is going to depend on a number of factors, such as how the client defines risk, how he plans to pay the premiums, and what other planning he is willing to do in conjunction with the premium-paying strategy. If the client and team are going to use split-dollar, the client is willing to trade-off premium guarantees for flexibility and current performance, and policy values are going to be an integral part of the exit strategy, then the agent will know to look for a product that not only accumulates cash value efficiently, but distributes cash value efficiently as well.

  9. Control over the investment of the cash value —A lot of clients are very interested in (or insistent upon) buying insurance products that give them some measure of investment control over the cash value. That's variable life in its various forms. Once again, we find ourselves in a zone of contention. Some agents (and advisors) simply will not recommend variable life and indeed, might only grudgingly acknowledge its existence. Others are much more constructive on the product and believe that, if funded properly and promptly and attentively managed over time, it might be a safer product over the long haul than a general account product. What's more, some modern versions of variable life are available with premium guarantees that, depending on one's perspective, offer the client the best of both worlds.

    In much the same way and for many of the same reasons that the client might be deprived of seeing either a guaranteed product or a current assumption product, clients can be deprived of seeing and learning about variable life. Yet control over investment of the cash value is a critical item on any checklist for policy suitability.

Remember

Products are to successful estate planning with life insurance what ingredients are to gourmet cooking. No matter how delicious that dish looks in the picture, if you use the wrong ingredients, you're cooked.

The views expressed in this article are those of the author and don't necessarily reflect the views of Ernst & Young LLP. This document should not be construed as legal, tax, accounting or any other professional advice or service. No one should act upon the information contained in this article without appropriate professional advice after a thorough examination of the facts of a particular situation.


Charles L. Ratner is the national director of personal insurance counseling at Ernst & Young, LLP, Cleveland