Life Insurance Financial Underwriting [Comprehensive Guide]

You may be surprised to find out that all the best life insurance companies require financial underwriting of prospective applicants when applying for coverage typically around $100,001 or more.

That’s because when most people think about life insurance underwriting, the first factors to come to mind are usually age, gender, and medical history.

For typical underwriting, an insurance company might want to know your date of birth, BMI, blood pressure levels, whether you have asthma or anxiety—that sort of thing.

Most people understand that these factors play a big part in an insurer’s underwriting analysis—often, the biggest part.

But many prospective applicants are surprised to learn that financial underwriting plays an important role, too.

Life insurance carriers consider financial information as part of the underwriting process to both help evaluate potential insurer risk and to ensure that the coverage level requested is reasonable in light of the applicant’s financial circumstances.

If an applicant is asking for a lot more coverage than would ordinarily be necessary to replace his or her income, that could be a red flag for the insurance company, justifying a closer inspection of that applicant.

But it could also just mean that he or she has a unique circumstance that necessitates higher coverage.

Why Do Life Insurance Companies Need Financial Information?

When issuing a new policy, a life insurance company wants to know that the policy will in fact protect against a real risk—specifically, the economic loss that would result from the death of the named insured.

And the company also needs to verify that the person who stands to benefit from the policy actually bears at least some of the risk being insured against.

This concept is referred to as an “insurable interest,” and it needs to be present in one form or another in every life insurance policy.

The most obvious example is a family member who relies on the insured’s income for support, but there are plenty of other potential insurable interests.

Financial underwriting lets an insurer verify that a bona fide risk and insurable interest are present and that the coverage sought is rationally related to the interest and risk insured against.

Multiple of Income

For instance, if an applicant is purchasing a policy for income protection that names a spouse as beneficiary, the insurer will use a multiple of the current annual income to estimate the total lost income the family might sustain in the event of an untimely death.

It’s not a straight dollar-for-dollar calculation–since people tend to earn more as they get older and provide economic value to their families beyond just income.

But current income levels serve as a concrete baseline for approximating potential future losses.

Multiple of Income Chart

The following personal coverage income replacement multiplier chart is based on the general criteria insurance companies use, but is not reflective of any one specific company.

Age	Multiply Earned Income By
Under 30	30-40X
31-39	25-30X
40-49	20X
50-59	15X
60-69	5-10X
70+	Individual Consideration

So, why do insurers use an income multiplier?

Insurers want to avoid a situation known as “over-insurance,” which is where the death benefit payable to a beneficiary significantly exceeds the actual financial loss that would result from the insured’s death.

As a practical matter, avoiding over-insurance keeps policyholders from paying for coverage that they don’t truly need.

And, as an ethical matter, insurers don’t want beneficiaries in a position where they’d be better off financially if the insured was no longer around.  It sounds a little morbid when you put it that way, but it’s a real concern.

Killer Debt

Financial information can also be useful in gaging the risk level an insurer is undertaking and—as a result—the premiums it will charge for the coverage.

A wide variety of data can correlate with life expectancy and insurer risk.

Different carriers do things differently, but certain financial indicators like credit history, bankruptcy filings, and debt-to-income ratio can all affect premiums.

See Killer debt: Study shows link between debt and mortality rates

Ability to Pay

An additional reason for requesting financial information is that it helps insurers judge an applicant’s ability to pay for coverage.

If premium payments will eat up an disproportionately large chunk of an applicant’s income—and if another reliable source of cash isn’t available—an insurance company may be reluctant to issue a policy it views as likely to lapse due to non-payment.

How Does Financial Underwriting Work?

Typically, an insurance company creates internal guidelines—made available to agents within field guides—establishing maximum coverage amounts for potential insureds in various categories.

Guideline Factors

Financial underwriting guidelines consider factors like the prospective insured’s age, income and wealth levels, the type of coverage, the beneficiary’s relationship to the insured, and the reason the policy is being purchased.

As a general rule, applicants qualify for greater coverage if they are younger and have higher income and/or wealth levels.  Conversely, older applicants with less income and wealth qualify for less coverage.

An insurer’s guidelines set the high end for what the company considers ordinary coverage under the circumstances.  Up to the maximum, insurers are comfortable concluding that an insurable risk is realistically present.

The maximum is generally not a hard cap, though.  If coverage is requested in an amount that exceeds the guidelines, an applicant might be asked to provide clarification as to why higher-than-usual coverage is needed.

Most life insurance applications ask for basic financial information, like annual income, from all applicants.

When a death benefit is requested outside the applicable guidelines, a carrier might also ask for a more detailed financial statement and documentation.

Or, for especially high coverage amounts, financial statements and documentation might be necessary regardless.

Supplemental Documentation

When supplemental financial underwriting documentation is needed, the agent typically collects the relevant paperwork from the insured and forwards it to the carrier’s underwriters, along with an explanation as to why the requested coverage goes outside the guidelines.  Then, the underwriters consider the application in conjunction with the additional materials.

Underwriting is a technical, data-driven process, but it also leaves some room for the subjective judgment of experienced underwriters.

A thorough, well-documented application accompanied by a rational justification for the coverage sought may be approved even if the proposed policy would technically exceed the company’s ordinary guidelines.

How Does the Type of Coverage Affect Financial Underwriting?

Financial underwriting guidelines consider coverage categories when setting caps, so the same insured might qualify for a certain level of coverage in one scenario, but not in another.

A lot depends on the type of policy and, in some cases, who the beneficiary will be.

In most cases, the insurance company wants the death benefit to reasonably approximate the financial loss that would be sustained by the proposed beneficiary in the event of the insured’s death.

Income Replacement.

Policies written for income replacement are intended to protect beneficiaries against the loss of an insured’s lifetime earning capacity.  Frequently, the beneficiary is the insured’s spouse, child, or another close family member.

(Income replacement is a good criteria to use when determining how much life insurance is needed, but your Human Life Value might be the better option for a thorough assessment of your true lifetime need.)

Most insurers establish coverage limits for income-replacement policies using the insured’s current income and an age-based multiplier, as shown in the chart above.

A typical multiplier for a new insured in his or her forties is ‘20X.’  So, the coverage cap for a 45-year old would be equal to his or her current income times twenty.

For older applicants, the multiplier is reduced because they will probably have fewer wage-earning years after the policy is issued.  For a 55-year-old applicant, for instance, a typical multiplier is 15X.

Depending on the carrier, other factors affecting the death-benefit limit might include the applicant’s marital status, number of dependents, and a likely increase in future earning capacity.

To avoid over-insuring the applicant, an insurer usually also asks if the applicant is covered under any other life insurance policies.

When personal coverage is requested in excess of ordinary guidelines, insurers usually ask for additional materials like copies of recent tax returns and a detailed financial statement.

For particularly high coverage, an applicant might also need to provide financial verification from an attorney or CPA and/or financial account statements—or sometimes have an interview with one of the company’s underwriters.

Underwriters then review the application and all the materials to decide whether the policy will be issued.

Other Personal Coverage Types.

For some insureds, individual income alone does not sufficiently reflect ordinary coverage needs, and so insurance companies use alternative data in financial underwriting guidelines.

Stay-At-Home Spouse

When evaluating coverage for stay-at-home spouses, insurers might consider aggregate household income, dependents, coverage in place on the other spouse, or other factors impacting the financial loss that would result from untimely death.

Students

When the prospective insured is still a student, financial underwriting guidelines typically consider the applicant’s field of study, proximity to graduation, anticipated future earnings (when possible), and student loan balances.

Minors

Financial underwriting for minor children, takes into account the income and wealth levels of the parents and coverage amounts in place for the parents’ other children, if any.

Insurers anticipate that life insurance for children will be geared more toward policy growth than death benefit.

Life Insurance for Estate Planning.

Permanent life insurance can be a useful tool in estate planning for purposes like mitigating estate tax liability, providing reliable liquidity, and efficiently leaving a guaranteed legacy for beneficiaries.

Financial underwriting guidelines on life insurance used for estate planning are generally based around a formula that considers the prospective insured’s current net worth and current age, anticipated expenses and growth, and the types of assets held.

Depending on current resources and the amount of coverage sought, an applicant may need to provide a financial statement, documentation or appraisals for any assets that constitute a large percentage of the estate, and an explanation of the need for coverage.

If a trust will be the beneficiary of the policy, insurers often also require a copy of the trust certificate or other documentation of the trust.

If a charity will be beneficiary, insurers usually consider the insured’s history of charitable giving and any existing relationship with the specific charity.

Permanent Coverage for Retirement Savings.

Some whole life and universal life policies are designed to emphasize cash-value accrual over death benefit.

Applying this approach, a larger portion of premiums is devoted to cash value than to underwriting costs, allowing the policy to accumulate interest-earning, tax-deferred cash value at a faster rate.

By design, the cash value whole life insurance policy provides a lower death benefit than what might otherwise be available for the same premium because the primary objective is for the policy’s value to eventually serve as an asset to fund retirement.

Because the death benefit is de-emphasized, premium-to-income ratio is the central metric applied to policies designed for retirement planning.

Underwriting guidelines establish a percentage of annual income, varying by age, that the proposed policy’s annual premiums should not exceed.

For instance, an insurer might not want a 35-year-old policyholder’s yearly premiums to be more than 15% of his or her income.

Typically, the acceptable percentage is higher for older applicants.  This is because older applicants have less time till retirement and need to build value faster and because older individuals tend to have lower fixed expenses and more disposable income.

Business Policies.

When a life insurance policy has a business-related purpose, an insurer’s financial underwriting guidelines need to consider alternate factors. As with personal policies, the precise factors and necessary documentation depend on the purpose of the policy.

Key Person Insurance

Key Person insurance policies are intended to protect a business from the financial loss that would result from the death of a critical member of the organization.

Underwriting guidelines often set ordinary maximum coverage at around ten times the key person’s annual salary.

However, the multiplier may be higher or lower depending on the insured’s age, which acts as a proxy for anticipated years of future service.

Insurers often require an explanation of a key person’s role in a company to justify higher coverage amounts.

Buy/Sell Agreements

Buy Sell Using Life insurance is the combination of a buy sell agreement funded with life insurance which establish terms for purchase of a departing partner’s ownership interest upon death, retirement, or other separation from the business.

When evaluating a policy that will fund a buy/sell, insurers consider the company’s value in relation to the insured’s ownership interest.

So, for instance, if a business has an appraised value of $1 million, and the prospective insured owns 50%, the ordinary limit would be $500,000.

For underwriting, an applicant may need to provide a financial statement for the business, details of the company’s ownership, and a copy of the buy/sell agreement itself.

Deferred Compensation Packages

Along similar lines, cash-value life insurance can also provide a source of funding for Deferred Compensation Plans.

Underwriting guidelines typically consider the nature and value provided by the package, with coverage amounts not to exceed what the insured employee would qualify for if applying for an income-replacement policy.

Creditor Policies.

Creditors sometimes take out life insurance policies on individuals (or principals of organizations) who owe significant loan balances to the creditor.  The coverage is intended to protect against the financial loss that would result from non-payment in the event of the insured’s death.

An example would be life insurance for an SBA loan.

Because, absent some other relationship, a creditor’s insurable interest is limited to the amount of debt, financial underwriting guidelines ordinarily set creditor coverage caps equal to outstanding loan balances.

Creditor policies are sometimes structured so that death benefits gradually decrease over time—reducing coverage to correspond to reduced financial risk as the loan is gradually paid down.

This both allows for lower aggregate premiums and avoids a future situation in which the creditor has coverage significantly beyond its present insurable risk in the insured debtor.