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How Much Life Insurance is 'Too Much' Life Insurance?

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Solomon S. Huebner, the father of the CLU (College of Life Underwriters) and the insurance profession, told all his incoming students at the Wharton School that a “person who dies without life insurance absconds.”

Most of us didn’t end up as life insurance agents, but that idea had a lasting effect on many of our lives. Yes, we all should have life insurance – but how much is enough?

Huebner typically followed that thought with a lesson about “insurable interest” – the economic and psychological human connection between the insured and the beneficiary. It is apparent that policy coverage should replace lost earning power from such intangible assets as a family business, creative talent, patents, copyrights, and, in this era, even software.

It’s clear that defining “insurable interest” in specific dollar terms is more of an art than a science. To undertake an appraisal, though, adds professionalism to the life agent, separating them from the guesstimate. The client knows that coverage is based on a reasonable economic logic and not in any way tied to what the market will bear. The policy fills and satisfies a specific estate’s need, and provides comfort to the insured.

Until we know exactly where our economy is heading and future rates of return, we must estimate – not specify – insurable interest. It is critical that we undertake the valuation of the several sources of income.

The family business

The biggest ‘black hole’ is the family business. Most of these are closely and privately owned, and most do not have succession plans or a critical first step – an agreement about the transfer of ownership with a regular and objective appraisal and funded with life insurance.

The valuation of a family business starts with the past five years of financial statements and tax returns. Comparable company survey data is available from several sources, and in the process of comparing a business with its peers, it becomes apparent that the business is a going concern – worth more alive than dead.

Most businesses are worth more alive than in liquidation; however, bankruptcy and senility go hand in hand, and the affected party is sometimes the last one to know the condition exists. The delusion can go on for generations because of the sentiment attached to an enterprise that carries the family name and reputation, but fewer and fewer customers.

IRS Revenue Ruling 59-60 offers three valuation approaches – the asset, earnings, and market techniques. Defining a “going concern” usually requires the formulation of a model of future performance, which measures the returns from the business and from alternative investments.

The process is not exact, but the exercise by both the appraiser and the owner yields immediate intelligence, and timely consideration of alternatives can awaken other family members to the need for insurance coverage.

Intellectual property

Many insureds hold claim to patents, copyrights, and even software. The valuation mandate for objective and timely valuation of these is equally important, and leads to adequate – not excess – policy coverage.

How are these types of assets valued? Like any earnings asset, a patent is valued at the present worth of the earnings, or cash flows. This requires an analysis of projected royalties, or royalties that a licensee might pay. The same applies to most similar intangible assets.

Along the way, you must acknowledge that opinions of fair market value reflect only one price – what a willing buyer has paid in a transaction. It would be a much happier world if such transactions were widely available, yet sadly, these intangible assets often go unsold until a death occurs. Hopefully, before that happens, an appraiser will have formulated a cash flow model for the estate’s executor. If a regular valuation has been presented before death, it can support your client’s point of view with the IRS in probate.

Changing with the times

Of course, few, if any, assets have unchanging values. Things go up and down, and businesses deteriorate or are sold. Insurable interest can go up or down with these developments, and it is possible that the insured will be both over and underinsured as the years pass. Seasoned life insurance agents are ready to adjust to these changing conditions, however. Buttressed with a professional appraisal, the ongoing coverage question is answered with precision – not guesswork.

An important element in defining insurable risk is the question of where to go for an appraisal – and where not to go. Clients typically refer their life insurance agent to their attorney, accountant, or financial advisor – people who the client has known for many years, and who have delivered reliable advice. Some of these professionals feel that they are competent enough to prepare valuations, assuming that they are up to the task because of their close contact and relationship over the years. It is better, however, for a new face to be added to the team – someone whose valuation services will be subject to constant checking and review by the family business accountant and attorney.

Walter L. Zweifler is the senior financial appraiser of Zweifler Financial Research. He can be reached at 973-763-5534.


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