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Risk Management Paper


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Risk Management Paper

  1. 1. EXECUTIVE SUMMARYPersonal Recommendations Life Insurance o Universal Life on both Charles and Kay  Recommended amount: $5,000,000 each Survivorship Life Insurance o For Estate Equalization  Recommended amount: $6,000,000 Irrevocable Life Insurance Trust o Used for Survivorship Life Insurance Special Needs Trust (for Andrea) o Amount needed: $350,000 o Funded through Universal Life Insurance Auto Insurance o Increase deductible to $500 per car o Add under- and uninsured motorist coverage o Increase coverage to $250,000/$500,000/$100,000 Medical Insurance o Increase deductible to $2,000 Personal Umbrella Policy o Add Personal Umbrella Policy for $1,000,000 Emergency Fund o Increase to $84,000 Update Will o Include pretermitted children o Include Special Needs Trust Farm Note Payment Schedule o Recommend lowering annual payments Investment Risk o Consult Investment Advisor on:  Kay’s 401(k)  Emergency Fund  Brokerage Account Mortgage o Refinance Homeowners Insurance o Increase coverage Page 1 of 15
  2. 2. o Increase deductible o Schedule property o Inflation guard endorsement o Home business insurance coverage endorsement Disability-Income Insurance o Add for both Long-Term Care Insurance o Add for bothBusiness/Farm Recommendations Liability Insurance for the Family Farm o Add Commercial General Liability policy Convert Fertilizer Company to LLC Buy-Sell Agreement (Fertilizer Company) o Funded through Life Insurance Liability Insurance for Fertilizer Business o Purchase Errors and Omissions Insurance o Add for Kay Page 2 of 15
  3. 3. INTRODUCTION We have examined the information you provided us last time we met and haverecognized certain areas in which your risk coverage can be improved. Due to your unique andspecific circumstances, in order to accomplish your desired goals, we have set forth ourrecommendations on how to manage risk exposures. The analysis is divided between your personal and business/farm risk exposures. Eachsection identifies a risk exposure, explains the need to compensate for that risk, and ourrecommendation on how to manage that particular risk exposure. In doing so, we hope that youuse our recommendations to consult with specialists and other advisors who can help you carryout our recommendations. Risk can be expensive to manage, however, the consequences of failing to do so can bedrastic and prevent you from accomplishing those goals which you have mentioned. We believeat WCM Financial Group that risk management is a vital area of the financial planning process.Alleviating risk exposures can help to eliminate future complications as well as providing apeace of mind for our clients. Page 3 of 15
  4. 4. PERSONAL RECOMMENDATIONSLife Insurance When analyzing your life insurance coverage we assessed your capital needs at death.We determined that your current coverage is not sufficient. Currently, you each have term lifepolicies: $700,000 for Charles and $500,000 for Kay. The company that provides your currentlife insurance is rated poorly by Moody’s rating agency. Companies with poor ratings run higherrisk of default, thus leading to a higher risk of not receiving your death benefit. We determinedthat your needs will be best satisfied through the purchase of three new life insurance policiesfrom a life insurance agency with a rating of A or better. Universal Life Policy on Charles’s and Kay’s Lives o Each person will have a policy on their life o Policy will have a minimum level premium and guaranteed death benefit o We recommend $5,000,000 policies on each life  Our analysis calculated that $5,000,000 is required to satisfy debt obligations, as well as other needs, at the death of either Charles or Kay. The needs we included are Final Expenses Readjustment Fund (one month) Emergency Fund (six months) Education Fund Current and long-term debt obligations Andrea’s lifetime care costs 80% income need  (Please reference Appendix A – Life Insurance Capital Needs Analysis) o Universal life allows you to have flexible premiums in the event of a need to increase or decrease  Increasing or decreasing premiums alters the final death benefit paid to the beneficiary or cash value during the life of the policy Survivorship Life Insurance o Additionally, we recommend you purchase a survivorship life insurance policy to satisfy your desire for estate equalization o Survivorship policies pay the death benefit after the death of the second spouse o We recommend that you purchase $6,000,000 of survivorship life insurance to satisfy your goal of estate equalization  This amount is relatively large due to your desire to transfer the farm ($2,500,000) to Sarah at death Page 4 of 15
  5. 5. Therefore, you must compensate the same value to Chelsea, Dennis, and Derek  This assumes that through the use of each individual life policy (mentioned above), Andrea’s needs are satisfied separately through the Special Needs Trust o Funded through an Irrevocable Life Insurance TrustIrrevocable Life Insurance Trust Irrevocable Life Insurance Trusts (ILITs) are established so that the grantor (creator) cantransfer assets into the trust and the trust can, in turn, purchase life insurance on that grantor.This results in the trust owning the policy on the grantor and it designates those individualswhom the grantor wishes to be the beneficiaries of the life insurance policy. This ensures thatthe insured individual owns no interest in the policy, meaning that it will not be includable in hisor her gross estate. Therefore, it will not be subject to estate taxes at death. Estate Taxes in the Future o On January 1, 2013 estate and gift unified credit amounts are likely to change. Please be aware that the amount of unified credit allowed to individuals after this date is unknown and subject to legislative action. If no legislation occurs, unified credit amounts per individual will revert back to pre-2001 amounts of $1,000,000.Special Needs Trust Special needs trusts are important for families planning with special needs. In the event ofyour deaths, you wished that Andrea’s care be fully funded. In order to fund her care, wesuggest that you add $350,000 to each of your life insurance policies. Special needs trusts areneeded to keep Andrea’s assets outside of her ownership, thus allowing her to receive federalsocial security benefits. Based off of the social security administration benefits calculator,Andrea will receive $18661 in the event of your deaths. The estimated assisted living facilitycosts in Texas are $2800.2 Amount Needed: $408,000 o (See Appendix B –Andrea’s Special Needs) Existing Funds (Grandparent Trust**): $65,000 Total Amount of Insurance Needed: $350,0001 (Assumed Birthdays: Kay – 12/15/1961; Charles – 12/15/1962)2 Page 5 of 15
  6. 6. **The Grandparent’s existing revocable trust assets should be transferred to the newly createdspecial needs trust.Auto Insurance Your current auto deductible of $100 is very low compared to industry standards. Wesuggest you raise the deductible in order to save money on your monthly premiums. Werecommend that you raise the deductible on each car to $500. This amount is within your budgetdue to your current financial standing. Additionally, we recommend the following: Add underinsured and uninsured motorist coverage o This will mitigate the risk of being hit by someone with not enough or no auto insurance o Having this coverage is faster than recovering your loss from a lawsuit Increase your coverage to $250,000/$500,000/$100,000 o Your assets can become subject to a lawsuit in the event one of your family members causes a car accident resulting in catastrophic loss o This will help to protect your family’s personal assetsMedical Insurance Your current major medical policy should be sufficient for your current needs. In orderto save money on premiums, we suggest raising the deductible to $2,000. Considering thenumber of family members you have, satisfying the $2,000 deductible in a single year is likely tooccur. Over the course of your lives, you should be able to compensate the increase indeductible through savings in premium payments.Personal Umbrella Policy In order to supplement your auto insurance coverage, we recommend purchasing aPersonal Umbrella Policy on each of you. This will add to the existing auto insurance andprotect the farm and other significant assets which you do not want subject to a lawsuit.Personalumbrella policies offer excess liability coverage and extend broad coverage to potential lossexposures. The umbrella policy will cover a loss if the loss is not covered by an existing policy.These policies are reasonable in cost. For example, you can receive a $1,000,000 personal Page 6 of 15
  7. 7. umbrella policy for less than $350 per year.3 We recommend a $2,000,000 policy due to yourexisting net worth. (See Appendix C – Financial Statements)Emergency Fund We suggest that you increase the emergency fund to approximately $84,000. This willprovide your family’s nondiscretionary needs in case of emergency for 6 months. Typically, werecommend that clients have a fund that will satisfy their needs for between 6 and 12 months.For your specific needs in the event an emergency occurs, the 6 months we recommend wouldsuffice due to the stability of each of your jobs.Update Will As your will sits right now, it is inadequate to fulfill the goals you set forth, as well as thesuggestions we have made to manage the risk areas of your lives. We suggest that you contactyour attorney and update your wills so that your goals may be fulfilled in the event of yourdeaths. The following are concerns that you may want to bring up with your attorney: Include Chelsea, Derek, Dennis, and Andrea in the will Testamentary Special Needs Trust o This trust will be established to satisfy Andrea’s special needs Distribution of Assets (Estate Equalization) Designation of Guardian (for Andrea) o In the event of death, you will need a guardian to make decisions for Andrea Designation of Guardian (for Chelsea, Derek, Dennis)Farm Note Payment Schedule Your current farm note payment is relatively high, at $200,000 per year. In order tosatisfy some of the recommendations that we are making, we suggest that you consider loweringthe payment amount if possible. Our recommendations are to help satisfy the risk areas in yourlives. In order to fund these recommendations, the resources saved can be allocated to fundingthe certain risk management solutions in our analysis.3 Principles of Risk Management and Insurance; 11th addition; George E. Rejda, p. 557 Page 7 of 15
  8. 8. Investment Risk We suggest you contact your investment advisor as to the following investments: Kay’s 401(k) o Kay’s risk tolerance is low; however, an investment advisor may suggest some allocation to equities due to her age and potential future goals Emergency Fund o The Emergency Fund is for to fund immediate needs in the event of an emergency. o Funds in this account should be allocated to cash or its equivalent Brokerage Account o You should ask your investment advisor as to the proper allocation between fixed income and equities for this account o Leaving this in cash runs the of the funds losing their purchasing power due to inflationMortgage We believe the current interest rate that you are paying on your mortgage is high. Due toyour high interest rate, you are spending more than you need on interest payments per month.We suggest that you refinance to recapture some of the money you spend on interest. Thefollowing are current rates quoted:4 Fixed (APR): 4.229% ARM (APR): 2.975%Homeowners Insurance The current HO-3 policy you have on your home only covers $600,000 of the $685,000value of your personal residence. We suggest that you increase the coverage to at least 100% ofthe replacement cost of the dwelling. Our recommendation is that you increase the coverage to$685,000. With your current coverage, you will not incur a penalty, due to it being at least 80%insured. However, increasing your policy coverage to the full replacement cost will eliminatethe risk of loss having to incur the lacking coverage through self-funding in the event of acomplete and total loss of your home. In addition to the increased coverage, we recommend thefollowing: Add personal property replacement cost loss settlement endorsement4 Page 8 of 15
  9. 9. o Under this endorsement, property will be covered on a replacement cost basis rather than an actual cash value basis Make sure you look over your HO-3 policy exclusions o Your coverage covers everything except those specifically excluded 1% deductible is sufficient o If you believe you can afford a higher deductible, your premium payments will decrease Add scheduled personal property endorsement o Currently, your policy only covers $1,500 worth of jewelry o This will allow the full $45,000 value of the diamonds to be covered Add an inflation guard endorsement o As your house increases in value with inflation, the increased value will be covered by this endorsement o Otherwise, over time your house will become underinsured Add a home business insurance coverage endorsement o Any essential assets used for the their businesses can be covered, including: equipment, files, paperwork, and loss of business incomeDisability-Income Insurance It is important to you and your family that you seriously consider investing in someDisability-Income Insurance. An injury on the job can cause serious financial insecurity, and it isimportant that you have a way to fund these substantial work earnings lost from being disabled.We recommend that the two of you purchase a Disability Insurance Plan. Disability Insurancepays benefits in monthly income to those who have become Totally Disabled. It is important tonote that you should always consider and understand what your insurance company definestotally disabled as. The most basic definition of being totally disabled is the complete inability ofthe insured to perform each and every duty of his, or her, own occupation.5 As shown in thegraph below, there is a much higher chance of becoming disabled before age 65 than most wouldassume. We strongly encourage that you purchase Disability Insurance to cover any lossesincurred from missed work and to help insure financial security. Elimination Period o Disability Insurance policies usually contain an elimination period. This is a waiting period in which the owner of the policy does not receive benefits from the policy. Elimination periods can range from 30 days to 365 days. We recommend that you have an elimination period of 90 days. Though this may seem like a substantial amount of time it can significantly lower your premiums. The longer your elimination period is the less you have to pay in premiums. After examining5 th Principles of Risk Management and Insurance; 11 addition; George E. Rejda, p. 325 Page 9 of 15
  10. 10. your current financial position, we feel that 90 days is a sufficient elimination period. Benefit Period o The benefit period is the length of time that disability benefits are payable after the elimination period is met. Most Disability Insurance plans offer a benefit period of 2 years, 5years, 10 years, or up to age 65 or 70. 6 We recommend that your Disability Insurance policy have a benefit period that will cover you both up to the age of 65 or 70. This will cause the premium payments to be higher but the coverage is the most important thing to consider. You have a growing family and it is important to consider the costs and needs that will remain through age 65 to 70. Chances of Being Disabled before 65 40% 35% 30% 25% 20% 15% 10% 5% 0% 25 30 35 40 45 50 55 7 Age6 th Principles of Risk Management and Insurance; 11 addition; George E. Rejda, p. 3267 Page 10 of 15
  11. 11. Long-Term Care The chance than any one person will need long-term care during their lifetime isrelatively high. The U.S. Department of Health and Human Services estimates that those whoreach the age of 65 will have a 40% chance of entering a nursing home.8 It is important that youpurchase long-term care insurance because of the dramatic increase in nursing home costs. Thefinancial burden caused by those who need long-term care can be alleviated with long-term careinsurance. The cost of long-term care can range between $70,000 and $100,000 annually.9 Thesefacilities have significantly better resources and provide a better standard of living than thoseprovided by Medicaid. We recommend the following for your long-term care insurance: Comprehensive Policy o Covers care in a nursing home, assisted living facilities, and hospice care Elimination Period o We recommend a 60 day elimination period o Longer elimination periods reduce premiums It more cost efficient to purchase long-term care insurance today, rather than purchasingit later in retirement where the costs can substantially increase. BUSINESS/FARM RECOMMENDATIONSLiability Insurance for the Family Farm A Commercial General Liability or CGL policy would also be beneficial to own for yourfarmland. Workers whom you employ can subject your farm to potential liability due to the riskof injuries. This risk poses a threat to the large value of the farm. The CGL policy can limit therisk of your farm to potential lawsuits by providing insurance protection to pay in the event of amajor accident. Due to the farm’s value, we suggest you buy an additional Commercial Umbrella Policyto cover the value of the farm in excess of the CGL policy. This can supplement the retainedlimited covered by the CGL policy and provide additional coverage to prevent the full value ofthe farm from being subject to lawsuits.8 Principles of Risk Management and Insurance; 11th addition; George E. Rejda, p. 3219 Principles of Risk Management and Insurance; 11th addition; George E. Rejda, p. 321 Page 11 of 15
  12. 12. Limited Liability Company Limited Liability Companies (LLCs) are easily formed by filing with the Secretary ofState in the state in which you reside. LLCs are formed by the owners (or partners) of acompany which are now “members” of the LLC. The members of the LLC are protected fromlawsuits, therefore limiting their exposure to risks. The LLC shields members from liability bylimiting the members’ liability to the investment in which each member has in the LLC. Theshield provided by the LLC protects the personal assets of each member from being drawn intolawsuits brought against members.10 Charles’ fertilizer business can benefit greatly by forming an LLC to replace the currentgeneral partnership in which Charles and his two partners run the company. Looking over ourprevious discussion, we noted that Charles has a concern that the partners of the fertilizercompany had not signed any type of financial agreement (currently they distribute profits evenlybetween the partners). In the by-laws of the newly formed LLC, the partners can set out an agreement as to the distribution of profits in the event that one or more partners contribute more to the business than the others. Additionally, the LLC can help prevent liabilities such as the one arising from the former employee lost two fingers in a fertilizer accident. o At the time of the accident, the fertilizer company’s assets were sufficient to compensate the employee for his lost digits. o However, had the company lacked resources to pay the employee, the partner’s personal assets could have been subject to a lawsuit. o Losses that could have been incurred upon your family were limitless – if the victim died for instance. o The loss of a large, income producing asset, such as the farm, could prove to be detrimental to your future earnings capacity. o However, the formation of an LLC for the fertilizer company will shield your current personal assets from liability of the company – ultimately reducing your risk dramatically.Buy-Sell Agreement (Fertilizer Company) Closely held private companies have a major problem arising when a partner dies. Unless anagreement is written, the death of one or more partners results in the partnership being dissolved.Dissolving the partnership will cause the partnership assets to be liquidated (sold) and distributedbetween the surviving partners and the heirs of the deceased partner. If the surviving partners10 Page 12 of 15
  13. 13. wish to continue the same line of business, they will be forced to fund the costs of recreating thepartnership or reorganizing the partnership in some way. Additionally, the surviving partners, aswell as the heirs of the deceased partner may have issues such as estate settlement costs, heirsbecoming partners, and buying the heir’s share in the partnership.11 These issues may be solved through a buy-sell agreement established by the partners of thefertilizer partnership. The most efficient means of funding a buy-sell agreement are through theuse of an insurance policy. The steps of a buy-sell agreement with the use of life insurance are asfollows: First, the partnership enters into a buy-sell agreement. The agreement sets forth that the partnership will purchase the interest of which the deceased partner owns from the heirs at a predetermined price. The partner purchases a life insurance policy on each partner’s life. It pays the premiums, is the owner, and the beneficiary of each policy. When a partner dies, the partnership receives the death benefit (no income taxes). The partnership then purchases the deceased partner’s interest from the estate for the predetermined price. The heirs of the deceased partner receive the proceeds of the sale.12 This agreement, as applied to the fertilizer business, will provide Charles and his partners ameans of preventing the business from dissolving at one death and provide the heirs withadequate payments for the deceased partner’s shares.(See Appendix D – Buy-Sell Agreement)Liability Insurance for Fertilizer Business The fertilizer business may also benefit from purchasing some form of commercialgeneral liability (CGL) policy. CGL policies are used by businesses to cover potential exposuresthe business may have in the form of lawsuits. Charles’ fertilizer company has previously dealtwith an employee which they had to compensate due to the loss of fingers on the job. The fundsused to compensate this employee were paid for out of the partnership’s assets. In order topreserve these assets, purchasing a CGL policy can cover any future liabilities resulting frombusiness related activities. In the event a claim is made against Charles’ fertilizer companyagain, the assets will not only be able to be preserved, but they can be retained to increase futureearnings and expansion of the company.11 Page 13 of 15
  14. 14. Farm – Generational Transfer In reviewing your desire to transfer the farm to Sarah over time, we have decided torecommend that you transfer her “working equity” in the farm in trust. Additionally, Sarah’sinterest in the farm which she will gain in the event Charles or Kay dies should also betransferred to the trust. In doing so, the trust document should include a clause requiring Sarahto sign a prenuptial agreement with whomever she decides to marry. The prenuptial agreementshould set forth that the farm is her separate property, and in the event of a divorce, it would notbe subject to being divided with her husband.*** Please consult an attorney to draft legal documents such as trusts. Our recommendations areto help guide the attorney understand your goals and objectives when drafting your legaldocuments. These recommendations are not legal advice.Errors and Omissions Insurance We recommend that Kay purchase an Errors and Omissions (E&O) Insurance policy. Errorsand Omissions Insurance is a type of professional liability policy. Many professionals need E&Oinsurance, including: Architects Insurance Agents Real Estate Agents Brokers Attorneys Engineers And many others who give advice to clients. Errors and Omissions Insurance is designed to meet the needs of each different professionand professional. There are many new liabilities appearing the today’s service related industries.It is important to not only purchase insurance that covers a business’s basic needs and risks, butto also hold insurance to cover any damages that are created through the service that a business isproviding. Errors and Omissions Insurance protects businesses and professionals from suchclaims and liabilities.13It is generally paid on a claims-made basis. This is because the insurancecovers errors made during the current policy period.14 It is important to note that while E&O Insurance has moderately few exclusions claims thatresult from dishonest, criminal, fraudulent, or malicious acts by the insured are specificallyexcluded.1513 Principles of Risk Management and Insurance; 11th addition; George E. Rejda, p. 61115 Principles of Risk Management and Insurance; 11th addition; George E. Rejda, p. 611 Page 14 of 15
  15. 15. CONCLUSION The detailed recommendations mentioned above were created after a thorough riskassessment. After examining your current risk coverage, we concluded that the current coveragewas inadequate to you family’s needs. We separate your risk exposures into personal exposuresand business/farm exposures. Along with the identification of each exposure we explained yourspecific needs in managing the risk and our recommendations on what we believe is the best riskmanagement solution. The first issue we analyzed was your personal risk exposures. We determined that agreater need for life insurance is needed to fulfill expressed goals. Concerning Andrea, a specialneeds trust is needed to meet her future needs in the event of your deaths. Your auto, medical,and homeowners policies need alterations to limit risk exposures and broaden coverage.Additionally, we recommend purchasing the following insurance policies: personal umbrellapolicy, disability-income insurance, and long-term care insurance. Other areas of concern areincreasing your emergency fund, updating your will, decreasing farm note payments, mortgagerefinancing, and consulting an investment advisor concerning your asset allocations. The other issue analyzed was your business/farm risk exposures. First, we recommendthat you purchase liability insurance for the family farm. We also recommended that Charlesconvert his fertilizer company to an LLC, create a buy-sell agreement with his partners, andpurchase liability insurance on the company. Finally, we recommend Kay purchase Errors andOmissions insurance for her engineering occupation. In future meetings we may discuss the following areas of concern: 529 Plans for education funding o (See Appendix E – College Costs) Andrea’s college needs as she approaches college age Retirement Planning Updates on what recommendations you chose to follow Page 15 of 15