A Fistful of Dollars: Financial Underwriting in the Real World

1. A Fistful of Dollars: Financial Underwriting in the Real World Anastasia Ammon, FLMI, ACS, AALU VP Underwriting & Chief CI Underwriter US & Canada Optimum Re Insurance Company September 10th, 2007

2. As an Underwriter When the Premium is Large and it is a high-profile case do you feel like you are “under the gun”?

3. Financial Underwriting • The purpose of Life Insurance is to protect against economic loss resulting from the death of the insured • If the amount applied for is in excess of the amount of the potential economic loss, then poor persistency or adverse selection may occur • The role of the Underwriter is to insure that the amount applied for is justified based on the potential economic loss • This process is called Financial Underwriting

4. “Don’t let the perfume of the premium overpower the smell of the risk.” --Slogan in Underwriter’s Office

5. Insurable Interest • There must be insurable interest at the inception of the contract; in the absence of insurable interest it becomes mere speculation and is prohibited by law • The continued life of the insured must have greater value than that provided by the death benefit resulting from the premature death of the insured

6. “Sometimes the dead can be more useful than the living.” (Clint Eastwood in A Fistful of Dollars) http://en.wikiquote.org/wiki/A_Fistful_of_Dollars

7. Personal Insurance • Personal Insurance replaces lost earnings caused by premature death • This includes special needs such as mortgage life insurance and college funds • Young professionals such as doctors or lawyers are usually allowed higher amounts than their current income would allow since their future income is very likely to increase significantly

8. Personal Insurance( Cont.) • Multiples of income are usually used to justify personal insurance amounts; most individuals do not have as much insurance as they could qualify for so amounts in excess of the tables should be analyzed carefully to be sure they are justified • Inspection reports, copies of tax returns, income statements by CPAs, copies of employment contracts etc can be used to verify earnings if the amount applied for appears unusually large

9. “A man's life in these parts often depends on a mere scrap of information.” (Clint Eastwood in A Fistful of Dollars) http://en.wikiquote.org/wiki/A_Fistful_of_Dollars

10. Age 18-40 Age 41 - 50 Age 51 - 69 Over 69 20 x Income 15 x income 10 x Income 5 x Income Typical Personal Income Tables But what if the amount applied for exceeds these multiples?

11. Guidelines are intended to guide our decisions but Are not the same as rules which must be obeyed That’s why our Financial Guidelines are not carved On Stone Tablets--

12. Underwriting Judgment is needed to make reasonable exceptions To the guidelines when it is appropriate to do so.

13. Questions to ask: • Does it make sense? (Thank You, Charlie Will!) • How good are the sources of your information? • Will the person be worth more dead than alive to family or business? • --Ross Morton (RossMartin.com)

14. Estate Conservation • Life Insurance can be used to prevent forced sale of Estate assets for estate taxes • Life Insurance can also serve to conserve the estate for heirs • Creation of an estate, however, by insurance in excess of estate conservation needs is speculative and uninsurable

15. 2004 2005 2006 2007 2008 2009 $850,000 exempt $950,000 exempt $2,000,000 exempt $2,000,000 exempt $2,000,000 exempt $3,500,000 exempt An example of Estate Tax Tables http://www.irs.gov/formspubs/article/0,,id=112782,00.html#estate_exclu_2003

16. Older Age Risks

17. Mature Market • Longer life expectancies and wealthier senior citizens have created a significant market for Life Insurance in the Mature Market • Mortality is volatile as older individuals are more vulnerable to impairments than younger individuals • Adverse selection is potentially greater as children who are aware of problems seek insurance for their parents

18. Juveniles

19. Juveniles • Juvenile policies are often purchased for savings, as gifts and to guarantee future insurability • Beneficiary should be parents; Grandparents may be owner and/or premium payor • All siblings should be similarly insured • Parents should have a significant amount of coverage as well; usually twice the insurance on the juvenile • Parent or guardian must sign app to show agreement for the insurance and to attest to correctness of application questions

20. Underwriting for Persistency

21. Persistency • Early lapses affect the profitability of the life insurance policy • Many companies underwrite for persistency as well as mortality aspects of the risk • Look carefully if short term need, unemployed, unstable finances, history of multiple replacements or lapses, premiums in excess of 25% of annual income

22. Charitable Giving with Insurance

23. Charitable Giving • Charitable Giving uses life insurance to insure against loss of contributions (cash or time or other services) due to the premature death of the contributor • Insurable interest is established by showing a regular pattern of support to the charity: financial contributions, other support or fund raising activities • The amount of Life Insurance should be limited to the present value of future contributions unless extraordinary circumstances can be documented

24. Trusts

25. Trusts • Trusts can protect assets from adverse taxation that would otherwise diminish the value of the assets • A Trust can be revocable (provisions can be altered or the Trust can be cancelled) or irrevocable (the agreement cannot be changed or cancelled without the agreement of the beneficiary)

26. Trusts (Cont.) • A Life Insurance Trust gives the trustee the right to own and hold life insurance policies in order to exclude the insurance proceeds to be exempt from taxation • Trusts of this nature shield income from current taxation, protects wealth from diminished value at probate and estate settlement and enables the conservation of wealth • Death benefits should not exceed the potential tax liability and asset loss for the beneficiary

27. Bankruptcy

28. Bankruptcy • The Bankruptcy Code allows Chapter 13 or Chapter 7 for individuals and Chapter 11 or 7 for Businesses • Chapter 7 releases individuals from almost all debt after non-exempt assets have been liquidated and paid to creditors • Chapter 11 allows businesses to reorganize and restructure debt subject to court approval • Chapter 13 allows individuals to set up a repayment plan subject to court approval; often for less than the original debt

29. Bankruptcy(Cont.) • Life Insurance for individuals still in the bankruptcy process involves persistency risk • Adverse selection may be present if there is significant personal stress suffered by the individuals or business owners • Medical history of alcohol or drug abuse, employment instability, adverse driving record, hazardous avocations are all indications of potential adverse selection • Recovery from the bankruptcy should be documented and stable income established in an amount to justify the amount applied for

30. Business Insurance Evaluation

31. Evaluating Business Insurance • As with personal insurance there must be a greater value from the continued life of the insured than that provided by the death benefit resulting from the premature death of the insured • Over-insurance is speculation and can lead to suicide or homicide if the policy on the insured has greater value than the economic advantage provided by the continued life of the insured • The business must be in good financial health in order to justify any type of business insurance

32. Venture Capital and Startups

33. Venture Capital and Startups • More than half of all new businesses will fail within 5 years due to insufficient funding or planning • Look carefully at experience of management team, product or services to be offered and anticipated profitability projections • Look at source of funds to be sure from a reputable source and amount of funding to be sue the business can survive the initial years of losses to become profitable

34. Key Person Insurance

35. Key Person • The value of a key person to a business must be demonstrated based on skills, contacts or knowledge • Usually evaluated based on multiples of compensation for the number of years needed to replace the person and recover the losses (5-10x) • Compensation includes gross salary, regular bonuses, benefits, significant “perks,” stock option values and profit-sharing arrangements

36. Key Person(Cont.) • Look for other key persons in the firm to be similarly insured • Avoid accepting risks where key person is significantly impaired as this usually represents adverse selection • Key Person insurance on individuals nearing retirement is not acceptable except for minimal amounts unless satisfactory justification is provided

37. Buy and Sell

38. Buy and Sell • A Buy and Sell Agreement prevents forced sale of business assets by heirs of the deceased at reduced values • The insurable value for Life Insurance is equal to their ownership percentage of the net worth of the business plus a modest growth factor • The business should be stable and viable and demonstrate no financial problems

39. Insurance to cover a loan

40. Creditor • There should be collateral for the loan so more than 75% of the amount of the loan should not be required • Loan terms should not be for less than 5 years • Loans should not be extensions of existing loans or refinancing • Loans should involve stable and viable business concerns only

41. Financial Statements

42. What To Look For In Financial Statements • Assets are anything owned by the individual or the business that has value • Liabilities are anything the individual or the business owes to others • Equity is the net worth of the business and is Assets less Liabilities

43. Financial Statement Analysis • Three types of CPA Reports: Compiled, Reviews and Audited • Compiled reports are not investigated by the CPA but rely on numbers provided by the business or individual • Reviews are somewhat more in depth but the CPA does not investigate all source documents • Audited reports should reflect a thorough investigation of all source documents and an in-depth analysis of the financial records

44. Financial Analysis(Cont.) • Compiled reports are more commonly seen and are the least reliable • Reviews and Audited Reports are more costly and are usually seen on larger businesses • Look carefully at the CPA’s notes for any variations from generally accepted accounting principles that may affect the viability of the business

45. Income Statements • Income statements summarize the results for a specific period of time; also called “profit and loss” statements • Sales minus Cost of Sales equals Gross Profits • Gross Profits minus operating expenses equals net profit after taxes • Net profit after taxes is the profit (or loss)

46. Balance Sheet • Snapshot of the company’s financial position at a single point in time (such as close of business at the end of the year) • Assets are listed on the left; liabilities and capital on the right; both sides should be equal or in balance • If current assets are less than current liabilities it may indicate a business that is in trouble as other assets may be difficult to liquidate quickly enough to satisfy the demand to pay current liabilities

47. Ratio Analysis • Certain ratios give a quick picture of the viability of the business • Current Ratio is Total Current Assets divided by Total Current Liabilities; should be at least 2:1. • Debt/Worth Ration is Total Liabilities divided by the Tangible Net Worth; usually less than 1.0—if debt load too great the company may have trouble acquiring additional funds if needed

48. Does It Make Sense? • Charles A. Will’s 1973 text “Does It Make Sense?” can be summarized by the title • With all the guidelines, Financial Underwriting can be summarized by just these few words applied to the case at hand: • “Does It Make Sense?”

49. Stranger Owned Life Insurance (SOLI) • Premium Financed Life Insurance, the great debate!! • Will be addressed in greater details at our next seminar

50. Before the Case Studies: Are There Any Questions Now?