Life insurance can be a sensitive topic but it is a effective risk management tool that allows you to transfer risk to a third party. It should be an important part of your financial strategy as it can help you cover final expenses, build a legacy, protect your family, leave an inheritance and much more!
When you apply for life insurance, you’re applying for a contract, also known as a policy. This policy is usually with an insurance company and in exchange for coverage, you’ll be paying a fee or a premium. Upon death, the insurance company would pay a tax-free, lump-sum amount to your stated beneficiaries. Settlement options differ. For example, if you purchase a $200,000 life insurance policy, upon death, the insurance would pay the beneficiary $200,000.
Common Uses of Life Insurance
- Income Replacement: Your human capital or your ability to earn an income is one of the most important assets in life. If you have family members who rely on your income, upon death, life insurance proceeds can help provide your family with funds to support themselves.
- Child Care & Education: Life insurance can help alleviate the costs of daycare and the cost of education should the unexpected happen in your life.
- Repayment of Debts: Life Insurance is a great tool to cover final debts such as mortgage, credit cards, line of credits, etc. should you pass away.
- Estate Planning: One of the most common uses of life insurance is Estate Planning. Upon death, life insurance can help cover final expenses, capital gains due to deemed dispositions, or provide a guaranteed stream of income to a beneficiary or a dependent.
- Charitable Donation: Individuals also buy life insurance to the benefit of their favorite charity. Upon death, you can ensure that your philanthropic goals are met.
- Corporate Planning: When a business partner or shareholder passes away, life insurance can be a used as a tool to buy out the shares from the deceased shareholder’s estate, usually set up as a Buy-Sell agreement. Using corporate owned life insurance to fund the buyout helps ensure that business operations carry on.
Types of Life Insurance Policies
1. Term Insurance
Term insurance is as the name says. It’s life insurance that provides protection for a specified number of years. Is it one of the least expensive forms of insurance and recommended for individuals who need protection but have limited cash flow. Term insurance stated period can vary as terms may be 1 year, 5 years, 10 years, 20 years, 30 years. At the end of the term, the insurance policy is either terminated or renewed at a higher premium. Term insurance can be converted to a permanent insurance in order to cover longer term needs.
Term-to-100 Policy – There are term insurance policy that may go to age 100. These policies are often seen as permanent policies but have similar characteristics of term policies. They’re considered one of the most economical ways to cover taxes payable at death. Note that these insurance policies don’t build cash value or pay dividends. They provide a death benefit to age 100 and have a steady premium regardless of changes in age or health.
Renewable Term Insurance – Renewable term insurance policies have a feature that guarantee the right to renew the policy for another term. The renewable term is often for the same duration, without providing proof of insurability. However, keep in mind that at the time of renewal, premiums may increase but they cannot increase because a change of insurability (i.e. health). Renewal rates could be as is or at a renewable term as in the policy.
Convertible Term Insurance – Convertible term insurance is term insurance that allows the policy holder to convert it to a permanent insurance without providing proof of insurability. The features of the policy usually stay the same and the amount of the death benefit may not increase. If an individual wants to make any changes to the policy, such as increase in the death benefit, they have to start a new application. Life insurance companies that offer convertible insurance have their own policies and requirements that must be met such as limit on the time holding the policy, health status and age. These type of insurance contracts are more expensive as it exposes the insurance company to more risk.
Situational Examples of Term Insurance
- Matt recently bought a home with a $500,000 mortgage and 20 year amortization. If he were to pass away, he wants to ensure that his mortgage is paid off for his family
- Denise and Joe wants to ensure that their children’s education is paid off. The children are 5 years old and would be in school until 25.
2. Whole Life Insurance / Permanent Insurance
Whole life insurance is a popular type of permanent insurance. As the name says, it provides protection for the whole life of the insured individual. Whole life insurance is also sometimes referred to as straight life insurance or ordinary life insurance that is guaranteed to remain in effect as long as the premiums are paid. At the time of purchasing a whole life policy, the premiums are determined ahead of time and are not to set increase over the life of the policy. As the death benefit and the premiums are guaranteed not to change over time, the insurance company would bear any consequences if they were not to meet these obligations.
The younger when purchasing whole life insurance the more affordable your premiums will be.
Cash Value
The unique feature of whole life policies is the fact that they provide a cash value. The premiums that a policy holder would pay monthly are invested and the income that gets earned creates a cash value. This cash value can be access and used in several ways which are discussed below. The longer you’ve owned the policy, the larger the cash value is and more options for the individual.
Cash Value Withdrawal – The policy holder withdraw from the accumulated cash value in the policy. This withdrawal would affect the growth of the cash value and reduce any benefit that would be paid. If the withdrawal exceeds the pro-rated adjusted cost base, then a taxable disposition would occur, triggering taxable income.
Cash Value Loan – A policy holder can access the accumulated cash value of the policy in a form of a loan. The loan would be issued by the insurance company and interest will be charged. Rates charged can differ. The policy would continue to grow uninterrupted but if the loan isn’t paid back, it would be deducted from the death benefit, including interest.
**Keep in mind that the cash value can also be used a collateral at third party institutions if needed**
Surrender the Cash Value – The policy owner can surrender or terminate the policy at any time. The individual would be entitled to benefit from the excess premium payments. The surrender can be whole or partial.
Keep in mind that the insurer may charge you surrender charges to cover their administrative costs. The longer the policy is in effect, the lower the surrender charges.
Automatic Premium Loan – Whole life policies have a automatic premium loan feature which is by default. If the policy owner misses their monthly premium, the insurance company would borrow against the cash value in order to prevent the policy from lapsing.
Policy Dividends
Whole life insurance pays out dividends and when the policy owner submits the application, they have to decide on how the dividends should be dealt with. Below are some of the common options that are provided to the policy owner.
Cash Receipt – The dividend would be paid out to the policy holder every year in cash.
Premium Reduction – A policy holder can reduce the monthly premium that they pay through their dividends payouts. Consider a policy holder who has an annual premium of $4,000 but is eligible to receive $1,000 in dividends. He can reduce his next year’s annual premium to $3,000.
Paid-up additions – A policy holder can use the dividends to buy new paid up whole life insurance. This is the most common option that policy holders select.
Dividends Accumulation – Dividends can be accumulated in an investment account where it earns interest income. The income will be taxed depending if the policy is an exempt policy or non-exempt policy.
Term Insurance – With the dividends, a policy holder can buy term insurance with no proof of insurability required.
3. Universal Life Insurance
Universal life insurance also known as UL insurance is a type of permanent insurance that provides the most flexibility in terms of setting up the policy. The policy holder can choose the amount, frequency, timing, duration, and investments of the contract.
Premiums paid into a Universal Life Policy go into the investment account, where they earn income and grow tax free. The investment accounts can be broken down into:
Investment Accounts
- Tax Sheltered Investment Account (CSV)
- Daily Interest
- Guaranteed Interest Account
- Index-Linked Funds
- Mutual Funds
Out of this investment account, the insurance company deducts the monthly insurance cost. A policy holder can access their investment account as long as there is enough to cover the monthly premiums. Universal life insurance is suitable for wealthy individuals who have excess cash flow and are seeking alternative investments to grow their assets. Universal life policies offer the potential for tax deferred growth.
4. Joint Life Insurance
Joint life insurance is an insurance policy usually between spouses or business partners. It is less costly to buy joint life insurance policy instead of two separate policy. This type of policy is less costly but the death benefit is usually paid on “first to die”. However, there are insurance companies that provide “last to die” policies for estate planning.
5. Group Life Insurance
Group life insurance is a type of life insurance contract where a single contract covers an entire group of people. The policy owner is usually an employer or an entity such as a union. The policy is issued without medical examination and is set up for the benefit of the employees. Premiums on group life insurance policies are lower than individually owned policies. Group life insurance policies have less features and choices in comparison to the individual life insurance which is why it’s important to review your group insurance.
Factors Affecting Premiums
Factors that affect the life insurance premium is based on a number of things. Below we’ll highlight the most common considerations.
- Age – the older you are, the higher the premium would be
- Gender – historically women live longer.
- Smoking Status – this could involve cigarettes or marijuana.
- Rating – certain individuals may pay higher premiums if their risk rating level is high. Example – 40 year old man with diabetes.
- Family Health History – taking a look at the family health.
- Hobbies – individuals who have high risk hobbies such as skydiving may pay higher rates.
Occupation – Pilots are considered riskier than office workers.
Policy Riders – adding certain policy riders could increase your life insurance premiums.
Calculating Life Insurance Premiums
When an insurance company calculates how much your monthly premium would be, they take various things into account such as your mortality cost, their administrative expenses plus their investment returns. The formula is
- Mortality cost is the chance that the policy will have to be paid out as a claim. To determine your mortality cost, the life insurance company would look at the factors mentioned above.
- Administrative expenses include salaries, commissions, wages, office expenses of the actual insurance company.
- In regards to investment return, the insurance company collects premiums from groups of people and invests those premiums.. Depending on the rate of return that is generated, the investments could lower the cost of premium.
Beneficiaries of Life Insurance
The beneficiaries of a life insurance policy can either be named beneficiaries or estate as beneficiary. There are consequences regarding each. Keep in mind that the named beneficiary can be revocable or irrevocable. Most policies are considered to have the beneficiary designation as revocable unless stated otherwise. With revocable beneficiary designations, the policy holder can designate new beneficiaries if required.
When the Beneficiary is an Individual
- The name of the beneficiary would be written out in the policy
- Death benefit would be paid directly to the beneficiary
- The payment would flow to the beneficiary tax free and non-contested
- The amount would be under creditor protection
When the Beneficiary is Estate
- The insurance proceeds would be a liquid asset for the estate
- With the insurance payout, the executor would settle the estate much easier
- Keep in mind that the death benefit would be prone to probate fees.
- Life insurance proceeds could be susceptible to creditors
*** if a beneficiary is a minor, then it is handled by the courts until the child turns 18.***
How Much Life Insurance Do You Need?
When it comes to how much insurance an individual would need, there is no right answer. It depends. There are a number of important factors to keep in mind when deciding on how much insurance to purchase. Some factors to consider
- Tax needs at the time of death, estate costs
- Final medical expenses, burial costs
- Outstanding debts such as mortgages, credit cards, car loans, income tax
- Ongoing financial needs such as monthly bills and expenses, day care costs, education costs, retirement expenses, etc
Using the 5 step approach below would give you an indication of how much life insurance one would need approximately.
- Determine Cash Needs at Time of Death
- Last Expenses
- Mortgage Balance
- Personal Debt Levels
- Education Funds
- Other Expenses
- Determine On-going Income Needs
- Current Annual Income
- Calculate the Capital Needed using a Discount Rate
- Example: Say that you would need $50,000 per income for the next 25 years. Using a discount rate of 5%. (50,000 / 0.05 = $1,000,000)
- Calculate all Total Assets Available
- Any Existing Life Insurance
- RRSP
- Non Registered Accounts
- TFSA
- Death Benefit
- Savings
- Calculate the Additional Life Insurance Needed
- Add cash needs at death (1) + capital needed to provide level of income (3) and then subtract current assets available.
Taxation of Life Insurance Plans
- As mentioned, the death benefit is tax free to the beneficiary or estate.
- Policy dividends are not taxable because they’re considered a refund of premiums.
- Investment earnings with a policy such as a whole life policy is considered an asset. The value of the asset is determined by its cash value that has been accumulating.
- The investment accumulated may either be taxable depending if the policy is exempt or non exempt.
Assuris Protection
Every life insurance company in Canada is required to be a member of Assuris, a regulatory body that aims to minimize the loss of benefits if an insurance company becomes insolvent. Assuris guarantees that policyholders will retain at least 85% of the insurance benefit that they were promised. The benefits include Death Benefit, Health Expense, Monthly Income and Cash Value.
