A Sole Proprietor, a Term Policy, and a Seven-Pay Pitch
Priya, 41, is a sole proprietor netting $140,000. Her husband earns $62,000. They have two children, ages 8 and 13, a $310,000 mortgage at 6.2% with 24 years left, $22,000 in credit-card and auto debt, and $95,000 in savings and a 401(k). She wants each child to have $110,000 for college and wants the mortgage and debts retired at her death. Her existing coverage is a $250,000 10-year term policy with six years remaining. A producer is urging her to drop the term and buy a $1,000,000 indexed universal life policy at $1,450 a month, funded 'as heavily as she can' for seven years, arguing the cash value will pay for college.
1. Build a defensible death-benefit target from the facts given. State each assumption and show the arithmetic.
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Use a needs approach, and make the assumptions visible.
| Need | Amount |
|---|---|
| Mortgage payoff | $310,000 |
| Other debt | $22,000 |
| College (2 x $110,000) | $220,000 |
| Final expenses and estate costs | $15,000 (assumed) |
| Income replacement | ? |
Income replacement. What the household loses is not her $140,000; it is the gap between the household's need and the husband's continuing $62,000. Family income is $202,000. At a 70% household need (about $141,000), the annual gap is roughly $79,000 until the youngest, now 13, clears college - about 9 years. Undiscounted that is $711,000; discounting at 3-4% brings it to roughly $600,000. Nine years is a defensible floor; she may reasonably want coverage through age 60.
Total need: $332,000 + $220,000 + $15,000 + $600,000 to $711,000 = roughly $1.17M to $1.28M. Resources available: the $250,000 term policy, plus non-retirement savings only - the 401(k) is not really spendable. Call it $250,000 to $300,000. Gap: roughly $870,000 to $1,030,000.
So a $1,000,000 face amount is defensible. That is the one part of the recommendation that survives scrutiny. The amount is roughly right; the product and the funding plan are the problem.
2. The proposal replaces in-force term coverage. What must the producer do before the new policy is delivered, and what facts favor keeping the term?
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Treat it as a replacement even though the products are different. Before delivery the producer owes:
- A signed notice of replacement and a comparison of the existing and proposed contracts: premium, cash value, surrender charges, guarantees, and specifically what the client gives up.
- Notice to the existing insurer, which triggers that insurer's right to furnish the client with information about the policy being replaced.
- Delivery of the new policy with the free-look right explained, and a suitability file showing why a permanent contract with this funding level fits her stated objectives.
Facts favoring keeping the term:
- $250,000 of death benefit for a small fraction of $1,450 a month, against a need that is mostly temporary income replacement - the textbook case for term.
- Six years remain, but the policy likely carries a conversion privilege: guaranteed insurability she can exercise at 47 even if her health changes. Dropping it forfeits that option permanently.
- A new contract restarts the contestability and suicide periods from issue, so the new $1,000,000 is not fully protection for two years.
Facts favoring new coverage: the term expires at 47 and renewal will be at attained-age rates.
The defensible structure is usually both: convert or keep the term for the death benefit and use a separate vehicle for college.
3. Evaluate the claim that the policy's cash value will pay for college, and the 'fund as heavily as she can' instruction.
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The claim is doing two jobs with one product and failing at both.
- Tax. Premiums paid above the 7-pay limit make the contract a modified endowment contract. Loans and withdrawals are then taxed gain-first, with a 10% penalty before age 59 1/2. At 41 with a nine-year horizon, the design punishes access at precisely the moment she needs it.
- Illustration risk. Indexed UL credited rates are capped and participation-limited, and the cost of insurance rises every year. The projected year-9 cash value is not guaranteed, yet it is the number the illustration makes look best.
- Arithmetic. $1,450 a month for seven years is $121,800 of premium against a $220,000 college goal - and every loan not repaid reduces the death benefit. If the policy lapses with an unpaid loan, the loan becomes a taxable distribution.
- The wording is the tell. 'As heavily as she can' is a funding instruction, not a suitability analysis. It pushes the contract toward MEC status and toward a lapse if her income dips.
Better structure: term insurance sized to the $870,000 to $1,030,000 gap, plus a 529 or other dedicated college account for the $220,000. If permanent coverage is wanted for estate or business reasons, fund it at the 7-pay limit and disclose that limit in the file.