What you need to know about business financial underwriting Article added by Adrienne Wilson on July 29, 2013
Ranked: #1381 (100 pts)
An application for life insurance requires an analysis of not only a proposed insured’s health, but also his or her financial needs. Financial underwriting can be a critical component of the underwriting process; a proposed insured may be in perfect health but unable
to secure life insurance coverage because of lack of financial justification for the amount of coverage requested.
The core of financial underwriting involves the valuation of continued human life. Associated factors in this valuation include age, occupation, dependents, income and net worth. It is this financial picture that correlates directly to the presence or absence of insurable interest. Financial underwriting seeks to answer these questions:
From this valuation of continued human life, it is determined whether the amount of insurance requested is justified. Every life insurance application is evaluated for the presence of insurable interest that must exist at the inception of the insurance contract.
- Are the applicant’s insurance needs in line with the applied for amount? If the applied for amount exceeds the insurance needs, then there may be the indication of speculation, anti-selection or questionable insurable interest.
- Is the client able to reasonably afford the premium associated with the applied for amount? If the premium does not appear affordable, there may be concern for policy lapse or an undisclosed method of premium payment.
- Does the amount of life insurance coverage make sense in terms of meeting a financial planning
Types of business financial underwriting
Business continuation: Business continuation planning is a common reason that life insurance is sought. Businesses often purchase insurance coverage on certain individuals to cover parties involved in contractual business relationships and to ensure that the terms of the contract are completed, even if premature death of one of the parties occurs. An insurable interest, that which meets the pecuniary or financial test, is usually present if the premature death of one party of a business relationship would cause a business or its surviving owners a financial loss.
A major underwriting consideration for business insurance is the fair market value (FMV) of the business. The technique used for the actual calculation of the FMV of the business is usually stated in the underlying legal document, such as the buy-sell agreement. There are three basic valuation techniques. Valuation techniques can be complex, but a ballpark figure is typically sought
for underwriting purposes. The three business valuation techniques include:
- Book value
- Market value
- Capitalization of earnings
Buy-sell coverage is a form of business insurance with the purpose of assuring business continuation in the event of the death of a partner. For the analysis of buy-sell financial justification, the maximum coverage is generally limited to the ownership value based on the fair
market value of the business. A copy of the buy-sell agreement is useful to substantiate this financial need.
Often businesses consider certain employees as “key” to the continued success of their business. The business may purchase life insurance on the key employee to protect against the financial loss that may result due to the premature death of that key employee. Key employees possess skills and talents that are vital to the continued profitability of the business. This may be related to their knowledge and expertise of the industry or their ability to raise capital through favorable debt arrangements.
Officers of a closely held corporation, partners, high sales producers and uniquely talented individuals are likely to be key person applicants. The business uses the death benefit to pay the costs of obtaining a suitable replacement for the key person and to help cover lost sales or revenue due to the loss of the key person. A generally acceptable amount for face amount applied and in force is 5 to 10 times the key person’s annual compensation. For
key person coverage, the policy owner and beneficiary is the business/employer as well as the premium payer.
Sole proprietorship insurance is essentially personal insurance with the elements of a business situation. Insurance on the life of the sole proprietor beyond his or her personal needs is logical for two reasons. First, the decedent’s family may need to pay the salary of someone hired to run the business after the sole proprietor’s death. Secondly, the family may need to be compensated for lost potential income
resulting from failure of the business if the sole proprietor’s skills cannot be replaced. Alternatively, sole proprietor insurance may be part of an agreement where the employees of the business agree to purchase it after the sole proprietor’s death.
Stock redemption is similar to partners’ buy-sell insurance. Instead of an agreement between partners and a partnership, the agreement is between a corporation and its principal stockholders.
When a loan or debt agreement is negotiated between two parties, credit insurance is often used to guarantee the payment of the remaining balance of the loan to the creditor if the debtor dies before the loan is repaid. Often, the creditor will request a collateral
assignment on the policy. Life insurance underwriters typically allow up to 70 percent of the loan balance because of the declining nature of the loan balance. Credit insurance is typically evaluated to make sure it’s not speculative by looking at cash flow of the business and the loan details.
There are numerous employee benefit concepts that use life insurance as the funding vehicle. The beneficiary is usually the spouse, children or estate of the proposed insured. The death benefit payable to the employer is usually limited to a refund of the premiums
the employer has paid on the employee’s behalf.
Deferred compensation is a salary arrangement offered to highly paid key employees where a portion of the employee’s income is deferred until a future date. It is often used to entice key employees to stay with the employer. The employee is paid the deferred earnings at retirement in addition to the company’s retirement plan. The funding vehicle used to pay this deferred income is the accumulated cash value of a life insurance policy. If the employee dies before the deferred income is received in its entirety, then his or her designated beneficiary as outlined in the deferred salary arrangement receives the death benefit. The business is the policy owner and beneficiary, as well as the premium payer.
How to help get favorable financial underwriting
For favorable financial underwriting, it is imperative that the associated details are properly disclosed on the application, cover letter and inspection report. Typically, large face amounts require supplemental supporting documentation that can involve third-party
verified financial statements, financial supplements and tax forms. Consistency in the figures provided is crucial. The absence of consistency can result in additional underwriting scrutiny and requests for further financial documents and explanation.
The application provides the initial financial picture. It contains the proposed insured’s age, occupation, income, net worth, amount of insurance in force, any concurrent applications, the face amount applied for and the cost of the coverage. The level of relationship
between the policy owner, proposed insured and beneficiary are examined for presence of insurable interest.
The best source of financial documentation is a well-written cover letter. A cover letter details the purpose of the coverage, formulas used to derive the face amount applied for, and reference documents used in the needs analysis. The cover letter can explain any unusual policy owner/beneficiary designations. Also, any medical or nonmedical aspects of the file that may pose underwriting concerns can be
The information provided on the application and in the cover letter is compared with data provided in the inspection report. The detail of the inspection report varies with the amount of insurance applied for and ranges from a personal history interview to a direct interview of the proposed insured and use of financial references, such as the proposed insured’s accountant or banker and pursuit of credit reports.
A third-party-verified financial statement is required for larger face amounts. For example, the client’s CPA may provide a signed statement detailing the client’s personal net worth.
In summary, financial underwriting is equally important to medical underwriting in the process of evaluating candidacy for life insurance coverage. Favorable financial underwriting is dependent on proper presentation of the financial need analysis and appropriate
objective documentation with consistency in all figures and details.
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