The following is adapted from The Entrepreneur’s Guide to Financial Well-Being.
As an entrepreneur, you’ve worked extremely hard and taken many risks to succeed. It’s essential you have mechanisms in place to leverage and protect the wealth you’ve accumulated. Typically, you can accomplish this through insurance, but insurance is complicated and expensive. You must read the fine print.
Insurance companies work under what’s called the law of large numbers, similar to casinos. Casinos know that when 1,000 people walk through the door, 520 of them will lose a significant amount of money, while the remaining 480 might win a little bit. An insurance company’s goal is to minimize the cost of those 480 claims, and they do.
I have clients who have paid long-term healthcare premiums for decades only to have the insurance company terminate those plans because they were too expensive for the firm to continue to offer. Rarely do you see the insurance company losing money.
Entrepreneurs buy a great deal of insurance, but not solely for wealth protection. The insurance products they buy are “hybrids,” designed for protection andinvestment.
For example, variable universal life insurance can serve as both life insurance and an investment vehicle. The insurance company takes post-tax dollars as a premium and invests those deposits as tax-deferred growth.
Costs on such products are high, and when you withdraw, the gains are converted and taxed at ordinary income rates rather than at lower capital gains rates.
While there are limited cases where hybrid products may serve a particular purpose, my view is that, in general, for most entrepreneurs, insurance is too expensive to be used as an investment vehicle. It has additive costs plus a legal contract.
That contract might use a term like guarantee, but you have to read carefully to understand what that means. Often, a guarantee is valid…until it isn’t.
Again, it is an insurance company’s job, as part of meeting their shareholders’ expectations, to make sure the firm earns more than it pays out.
My belief is insurance should be purchased specifically for asset protection and risk reduction as it relates to long-term care, disability, or life circumstances. Countless entrepreneurs buy hybrid insurance products from “advisers” who reap big commissions from these products when a simpler, less costly insurance solution may be available. These advisers may not be truly helping people evaluate the insurance they need.
With insurance, every situation is different, and you need to examine your family history and circumstances to tailor your coverage. I want to reiterate it is imperative with any kind of policy or product that you drill down to understand the contract.
With hybrid products especially, you must understand not only the contract, but also the landscape in which it is being presented. For example, let’s say you have $100,000 and are concerned about putting it in the stock market.
On the advice of an adviser you decide to put it into a variable indexed-annuity policy designed to protect you from market downturns. The adviser assures you that you will never take a market loss; you will always get the upside.
The way things will very likely play out is more complicated. Your product is tied to an index; for purposes of this example, I’ll use the S&P 500. Your contract stipulates you get a 1% increase for every 1% increase of the S&P 500, up to a cap of either 1% per month ora total cap of 6% for the year. If you look at how the stock market really works, it does drop significantly occasionally, but it also rises significantly.
You may believe 1% per month equals a 12% return. In reality, the fine print states you can only ever get 6% because that’s the true cap. The bottom line is that actuaries have gone to great lengths to figure out statistically how much the insurance company needs to keep for itself when the market goes up (keep in mind the casino metaphor).
A contract’s cap can be tied to many different variables, all of which may be difficult for you to determine. You typically can’t exit these policies without a stiff penalty for at least ten or twelve years, depending on the cancellation schedule. The penalty typically erases any benefit you might have achieved, and then some.
Far more times than I can count, I’ve seen entrepreneurs realize that many of these contracts are not in their best interest. Unfortunately, that realization has come only after they’ve signed on the dotted line.
Many times, entrepreneurs seek safety through such products. A trustworthy adviser will be able to direct you to what is truly prudent. They can see what you can’t.
You don’t want to risk missing the opportunity to have the volatility of the market work on your behalf. You don’t want to react from fear because, unfortunately, fear is the tool used to market these products. Working with an interpretive adviser – one who will research all your options and guide you to your best solution -- helps round out a conversation. They’ll have stepped back and asked whether such an investment is logical.
A product might provide protection in a specific situation, but if such a situation is uncommon, buying that protection is a waste of resources. An adviser who has worked with entrepreneurs and has seen multiple situations will have a far more accurate, objective perspective than one selling products outside of the fiduciary standard.