I Love It. I Hate It. Insurance Keeps Proving Its Value

Brian Kearns, CPA, CFP, RIA Founder, Haddam Road Advisors
Best Practices in Financial Planning

Insurance is foundational to the functioning of our economy, and having spent a long time in the financial planning world, I’ve learned just how valuable it is to a client’s personal financial well-being. But truth be told, my relationship with insurance has been a complicated one—I both hate and love insurance. Let me explain.

My first foray into the personal financial planning world was at a large insurance firm in downtown Chicago. I walked in with my certified public accountant (CPA) credential and 20 years of business experience ready to serve my new clientele!

Yet, despite my enthusiasm to change people’s lives for the better, it didn’t quite turn out that way. What I thought would be a great experience in learning how to best implement planning and investment strategies turned out to be a lesson in just how aggressive the hyper-sales model dominates personal finance in the United States. Needless to say, it made me wary of the insurance space.

POOR PUBLIC PERCEPTION

The industry has done itself no favors in the public eye over the years. The financial press loves highlighting occasions where policies are mis-sold or outright fraud is perpetrated. Yet despite the bad press it sometimes gets, it’s important to know that most advisors in the insurance industry are there to help clients make prudent decisions, and they expend a lot of time and effort explaining insurance-related benefits.

NOT AN INVESTMENT

In the past, insurance has inadvertently been sold as something it’s not. If an insurance salesman suggests selling an investment to fund an annuity, this is considered “investment advice,” and they may have violated the Investment Act of 1940 (and not even be aware of it). The fact is that insurance isn’t an investment—it’s a risk-shifting contract (which I’ll get into later). While there may be an internal rate of return on balances within a contract, that alone doesn’t constitute an investment.

NOT ‘TAX-FREE’

Often, you’ll hear the words “tax-free” in the insurance space. Sorry folks, almost all insurance is funded with after-tax money. After-tax money isn’t tax-free, nor is the accumulation of contract funds. This is a fundamental issue with any financial plan, and clients need to understand the implications.

IT’S CONFUSING

Insurance can be opaque. The illustrations used to promote various plans are often confusing, with a bunch of columns labeled “Illustrated” and “Guaranteed.” Additionally, the idea of “cash value” is often difficult to explain to clients, especially when talking in terms of decades-long runways. Insurance can also be convoluted. Over the years, I’ve attended many insurance webinars, and when I hear, “But wait! You can borrow against your policy value ‘tax-free’ and blah, blah, blah,” I wonder how far into the seventh level of purgatory I’ve fallen.

Of course, despite the many reasons I hate insurance, a few subtleties also remind me of the value that insurance brings to a client’s portfolio. For instance, for a small fraction of someone’s overall net worth, insurance allows their overall personal financial system to be sheltered or protected from certain shocks or headwinds.

So, this brings me to the complicated reasons why I love insurance.

CONTRACT MONEY

Let’s take out all the noise and focus on what insurance really is: It’s contract money. In light of a specific event occurring (accident, fire, medical issue, death, etc.), insurance promises a pre-defined dollar amount to be paid out to an individual under certain conditions. That literally is it. Of course, in these situations, there’s often nuances involved with the type of event or payout—but that’s where CPAs and financial planners can come in and bring their expertise to truly benefit their clients.

HEDGE PROTECTIONS

As I’ve previously pointed out, insurance isn’t an investment: It’s a hedge. In the risk management world, hedges cost money, but that cost can be the most valuable allocation to any planning strategy. Why? Because that hedge will protect either income streams or balance sheet values or both.

Here are two situations where a hedge can benefit your clients:

1. Long-Term Care

Fifty years ago, the first long-term care policies were priced like those of a disability event. That was a mistake. Long-term care is much more costly, and the insurance industry has been scrambling to address this issue ever since. Also, the policies were typically reimbursement based, which were a nightmare to manage (submit receipts, fight for payment, rinse, repeat).

About 15 years ago, the industry turned to one of its most powerful features: the accelerated death benefit for long-term care rider. This benefit is an indemnity-based plan, which offers a truly flexible solution to protect both a client’s income and assets. Here’s how it works: Upon the inability for the beneficiary to perform two of the six standard activities of daily living, a straight percentage of death benefit is paid monthly.

Long-term care is a critical issue in this country, and this benefit goes a long way to help hedge the potential costs of health care for a concerned family and, collectively, for our aging population.

2. Legacy Planning After SECURE and SECURE 2.0

When the individual retirement account (IRA) was created in 1974, conventional wisdom talked up the idea of deferring income until the “bracket drop,” when clients would retire, receive lower incomes, and IRA balances would be distributed and taxed at lower rates. What proceeded was one of the largest economic expansions in history, and these IRA balances have grown in parallel and retiree incomes haven’t gone down as expected. According to the Investment Company Institute, about 40 million Americans hold about $40 trillion in IRAs. A vast amount of these balances will be inherited, many through a stretch-IRA where beneficiaries can plan out their distributions for multiple decades.

However, now Congress wants that tax revenue. So, with the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, SECURE 2.0, and the 10-year rule, inheriting a traditional IRA has become a potential planning nightmare for beneficiaries. For example, a beneficiary of a $2 million IRA could potentially end up with an added income of $200,000 per year and be in the highest tax brackets for a decade. That’s not what the plan was when mom and dad originally set up their IRAs.

Even author Ed Slott, CPA, a nationally recognized IRA expert, has gone on the record saying that IRAs are the worst possible asset for wealth transfer and estate planning, all thanks to the SECURE Act. Slott also says the tax exemption for life insurance is the single biggest benefit in the tax code and not used nearly enough because most people don’t focus on lifetime benefits.

So, what are some potential solutions to this IRA kerfuffle, you ask? Either, mom and dad can look at a Roth IRA conversion strategy to take some of the tax pain in their lifetimes or, you’ve guessed it, fund an insurance policy for the next generation. Or, some combination of the two. It’s the planner’s job to figure that out.

Again, a well-constructed insurance policy can take a miniscule percentage of a client’s overall wealth and fund a lump-sum payment to beneficiaries outside of the estate and without tax implications.

STRONG LOBBY

Lastly, it’s important to remember that the insurance lobby is absolutely massive in Washington, D.C. Unfortunately, there’s no IRA/401(k) lobby fighting for your clients’ IRA rights. What this means is the legal landscape for insurance plans probably won’t change much. As for IRAs and 401(k)s? Who knows?

My relationship with the insurance industry might be complicated, but time and time again, I’m reminded just how vital a mindful insurance policy can be to a person’s financial well-being. Which is why, when properly utilized, I love insurance.

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