Teach clients how best to balance accepting and transferring risk

By Alexandra Baig

In addition to running my fee-only financial planning practice for people with disabilities and their families, I also teach personal finance to college students. I introduce the module on insurance by discussing the four ways that one can deal with risk: Avoid it, reduce it, transfer it, or accept it. 

I explain these concepts with the example of how, if a friend invites me to go skydiving, I have four choices: 1) Make sure to schedule a family event at the same time, so that I can refuse politely (avoid); 2) wear a helmet and pads, test the harness, and make sure my jump instructor has a five-star rating (reduce); 3) hire a risk-loving body double to take the jump for me (transfer); or 4) just stir up my courage and try it (accept).

As financial planners, one of our jobs is to help our clients understand that they have all four strategies at their disposal to deal with the various risks to their financial security. Then we help our clients put together the combination of strategies that most suits their risk profile and that is most financially advantageous to them.

Property and casualty insurance

Property and casualty insurance is often the most straightforward risk-reduction strategy. I have never run across a client who did not want—or insisted they did not need—insurance coverage for their residence, valuable property, and vehicles. Best practice (as well as the structure of many homeowners’ contracts) supports insuring 80% of a home’s replacement value as well as a certain amount of personal liability coverage. All states stipulate a minimum amount of coverage for autos. Beyond that, we can help the client think about whether they want to pay for coverage above the minimum (transfer more risk) or pay budget-friendlier premiums (accept more).

Health insurance

Health insurance is also relatively simple. I have never had a client who, in an environment of opaque and ever-rising treatment costs, has suggested accepting all of the risk of the family’s potential healthcare costs (without transferring any of it) by skipping health insurance altogether, even though there is no longer a healthcare mandate enforced by an income tax-related penalty. We can help clients think through whether they might want to, for example, transfer less of their risk by combining a high-deductible policy with a health savings account.

On health insurance, we sometimes help clients evaluate the financial incentives to reduce risk by pursuing wellness programs offered by their employer or by the employee group health plan. Health insurance for my particular client niche is somewhat complicated because many people with disabilities may qualify for Medicaid and/or Medicare but may have to follow certain rules to obtain or maintain that coverage.

I have found in my own practice that when the clients and I get to the big three categories—disability insurance, life insurance, and long-term care insurance—client attitudes and approaches fall on a spectrum. Some people are highly skeptical of insurance and want to accept their entire risk by self-insuring with investment assets, but others are risk averse and want to transfer away all their risk despite the cost-prohibitive premiums that requires. Therefore, I spend considerable time looking at the costs and benefits of various combinations of reducing, transferring, or accepting the risk of disability, long-term care needs, or premature death, and then explaining the options to my clients.

Disability insurance

Disability insurance can be a hard sell. Clients who are employed often expect that they have transferred sufficient risk through their employer’s group coverage. My first step in those cases is helping the client see the true risk of long-term disability that emerges during one’s working years. A client making $100,000 who expected to work until their mid-sixties but becomes disabled in their mid-forties experiences an effective loss of $1.6 million—the present value of the now-forgone future income stream. And that is before considering any future raises or promotions or the loss of auxiliary benefits such as low-cost employer health coverage for their family or employer match for their retirement contributions. The client has to appreciate the size of the risk that they must either accept or transfer, because disability will be impossible to avoid, and there are limited ways that one can reduce that risk.

My second step is making sure they understand the terms of their employer group coverage. Just how much of that substantial risk have they really transferred? Many employer plans only provide 60%–70% salary replacement, with a cap that further limits highly compensated employees. Moreover, the benefits are subject to income taxes to the extent that their employer has paid the premium. If that level of replacement will endanger the security of their retirement, they need to consider whether it is worth the additional cost of private coverage to transfer away more of their risk.

Then, too, the private coverage should be managed over time. The closer the client gets to retirement, the less remaining income they have to lose, and the more they should consider reducing or even discontinuing the additional personal coverage.

Life insurance

I have never had a client argue that they will be immortal and thereby avoid the risk of death, but I have had some significantly underrate the possibility that they will die long before they retire. As with disability insurance, clients need to understand the value of the lifetime income their family will forgo if they die prematurely, and how this will be particularly devastating if it happens before they can pay off their home, accumulate enough to put their children through college, and so on.

Virtually no clients are willing to totally accept the risk of premature death when the cost of transferring the risk of death for 20–30 years via term insurance is affordable. Even so, we look at whether a ladder of policies makes sense so that both the risk transferred and the cost of transferring can decrease as the worker ages and potential lost income shrinks.

It gets more complicated (and I can add more value) when the client needs to consider whether they are willing to accept risks that extend beyond the last mortgage payment or the expected launch year of their youngest child. Clients who are business owners, who might have taxable estates, who have blended families, or who have children with disabilities that limit their ability to live independently have risks that may last their lifetimes and may grow, rather than diminish over time. I help them cost out longer-term or permanent insurance solutions.

Long-term care insurance

For me and for many of my clients, potential long-term care costs present the biggest risk management conundrum. First, while everyone will die, not everyone will have a certain amount of long-term care needs, or even any at all. Second, the cost of covering long-term care, particularly extended care, can decimate a client’s asset portfolio and endanger their retirement and any legacy goals. This is particularly acute when one spouse develops long-term care needs relatively young or when the client needs to fund a special needs trust to provide for a perpetually dependent child. Third, the cost of transferring away long-term care risk, precisely because it is so variable and difficult to predict, can be remarkably high.

I begin by telling clients that we do not have to use an all-or-nothing strategy. They can look at the relative cost and benefit of accepting or transferring away varying amounts of the risk. Paying the premiums to cover three out of five years, or $150 per day out of $300 per day of long-term care costs, may be financially preferable to either having full coverage or to having no coverage.

I also help clients to look at hybrid life/long-term care solutions, which may be more affordable and carry less “use-it-or-lose-it” risk. My education challenge is to explain that although the client has, hypothetically, transferred two different risks, the family will end up having to accept one of the two. If the policy is used up covering long-term care, there will be little or nothing left to pay a death benefit.

 

Risk is a fact of life that clients cannot avoid and, in many cases, have limited ways to reduce. There are costs and benefits to both accepting risk and to transferring it away using insurance. Our role is to help our clients use various kinds of insurance to their best, overall lifetime financial advantage.

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Alexandra Baig (alexandra@companionsonyourjourney.com) has an MBA from the University of Michigan, her Certified Financial Planner^® designation, and practical, professional experience in both finance and disability support. She focuses her practice on people with disabilities and their families, helping them to maximize public and private resources to underwrite a quality life.

image credit: istock.com/Mauricio Graiki