The Basics of Life Insurance
Life insurance is one of those things that most of us don't like to talk about. After all, buying a policy is like gambling against our own lives.
Still, life insurance can provide some unique and valuable financial benefits, especially for those with dependents to support. It is the most effective way to guarantee that your loved ones will be financially secure should you die prematurely or preserving your estate for heirs.
Life insurance also has other uses. Businesses buy key man life insurance to compensate for the expense of replacing an important executive, or to help fund buy-sell agreements.
At its most basic, a life insurance policy is a contract requiring you to pay an annual premium (usually in monthly installments). In the event of your death, the beneficiary(ies) you designate in the policy will receive the face value of the policy.
The amount of the premium depends on several factors, including the amount of coverage - the greater the face value, the higher the premium. Cost also depends on the type of insurance (term or permanent), your age, health and lifestyle. Smokers, for example, or people in dangerous occupations, can expect to pay higher than normal premiums.
Life insurance can be valuable in a number of situations, but it is a complex financial product. The breadth of choice currently available lets you tailor your insurance to your exact needs. You may need some skilled advice to pinpoint those needs and find the best solutions.
To find out more...
Life insurance can be a unique and valuable financial planning tool, especially when it comes to looking after the needs of your loved ones. Nothing else can provide the same degree of financial security for your dependents. Question is how much insurance do you really need?
The answer depends on your age and your circumstances. Children, for example, have little need of life insurance, although parents sometimes buy policies in their name as a savings vehicle.
Young singles have little need for life insurance either, except perhaps to cover funeral expenses and any debts not insured elsewhere. Mortgages and car loans, for example, can be purchased with their own insurance protection.
If, however, you have dependents - a spouse, children, or others - then life insurance is often the only feasible way to provide financial security in your absence. The question of how much insurance you need depends on your family's income requirements.
To calculate how much insurance you need, first you must add up your family's expenses, deducting any income they would receive from pensions, survivor benefits, or from their own employment. A rule of thumb is that you should multiply their annual income needs by ten to arrive at the coverage you require. For example, if your dependents will need $50,000 per year, a $500,000 policy might be appropriate.
You must then consider various other expenses, such as unpaid taxes or debts, or the cost of funeral arrangements. There may also be special costs, such as post-secondary education for your children. These costs can be offset by assets you already have, such as RRSPs, GICs, or other property that can be sold to help cover living and other costs.
Get a more accurate picture using a calculator...
Life insurance can be useful in planning your estate. There are no inheritance taxes in Canada, but when you die, your estate executor must file a final tax return. Normally at this time, all accrued gains on assets like stocks and real estate, and the proceeds of all registered plans (RSPs, RRIFs, LIFs, and certain pensions) become taxable all at once. On large estates the result could be a tax bill close to half the total value of the estate.
Various strategies can be used to reduce the impact of this inevitable tax bill, including life insurance. For example, say you own a cottage and want to leave it to your children. Accrued gains on the property may give rise to such a large tax bill that they are forced to sell it. Tax-free life insurance proceeds could be used to cover the taxes instead, so your children can keep the cottage.
Or, say you want to divide your estate equally between three children, but it consists of a $200,000 house and a $200,000 RRSP. Rather than selling the house to accommodate a three-way split, life insurance can be used to pay all taxes and provide another $200,000 bequest. Business assets can also be preserved using life insurance.
Almost all life insurance falls into two main categories – term or permanent (permanent is sometimes called whole life or cash value insurance). Both require premiums and both pay the face amount upon the death of the insured. But they have some distinct differences.
Term Insurance
Often called pure life insurance, term policies provide coverage for a fixed period. The term can range from one to 25 years (it's typically 5 or 10 years), or even to age 65 or 70, depending on the policy. At the end of each term, the policy must be renewed. Premiums rise with each renewal, reflecting the fact that you are getting older and are more likely to pass away.
Since coverage is limited to a fixed period, premiums for term policies are initially much lower than for a comparable amount of whole life coverage. Term costs do increase over time, though. Eventually the premiums may exceed those of whole life, and beyond a certain age (usually 65 or 70), you can no longer buy term insurance at all.
Permanent (Whole Life) Insurance
Whole life and other types of permanent coverage are more complicated than term policies. The coverage is for life with no time limit, and premiums generally are set for life at the time of purchase, meaning they will never be increased, no matter what happens.
Initially you pay much more than with a term policy. The difference can be viewed as a reserve that is used partly to cover the higher premium requirement in future years. At some point the reserve may even cover all future premiums, at which point the policy is said to be paid up.
The reserve is also used to generate a cash value for policyholders. This cash value can be used in a number of ways:
- You can borrow from the insurer, usually up to 90 per cent of the balance.
- You can use it to pay your premiums for a while, sometimes at reduced face value.
- You can discontinue coverage and convert the cash value into income.
- You can cancel the policy and receive the cash surrender value (generally the same as the cash value).
Because of the cash value aspect, whole life is often referred to as life insurance with a savings component. But shortcomings in regular whole life policies - particularly their low effective yields - have prompted the industry to introduce a few variants:
Term-to-100
Despite the name, this is really a permanent contract. You pay fixed-level premiums and receive coverage to age 100. If you live to age 100, the policy terminates but you receive a cash payment equal to the face value or more (depending on contract terms).
Many Term-to-100 policies do not have a cash value per se - one that can be accessed during the life of the policy. As a result, Term-to-100 is sometimes described as stripped-down whole life, and is much less expensive than whole life. It has become popular since its introduction in 1979, and accounted for about 8 per cent of all new individual life insurance policies sold in Canada in 1997.
Universal Life
First introduced in 1982, this type of policy keeps the savings and insurance components completely separate. Within policy limits, you can decide how much or how little you want to pay into the reserve, or even pay a single premium to fund the entire policy. You have some choice over how the reserve is invested, and can withdraw cash from it, not just borrow against it. You can adjust the premium and the face value. Universal Life is a direct industry response to the buy term and invest the difference argument, and it has become very popular as well.
Which type of insurance is best - term or whole life? Both sides have pros and cons, but in many cases it comes down to the simple issue of cost.
For a young family struggling to pay the bills, term insurance is often the only affordable choice. The difference in premium costs for whole and term life policies of the same face value can be significant.
For example, the premium for a 5-year renewable and convertible policy for $100,000 on the life of a 40-year-old male non-smoker would initially cost about $200 a year. A Term-to-100 policy for $100,000 would cost $600, and a whole life policy such as Universal Life could cost almost $1,000 a year.
Vendors of permanent life insurance point out that the premiums will never rise as with term policies and this, coupled with the build-up of cash values, represents a favourably-taxed savings feature. Detractors suggest that you can earn a better yield by simply buying term insurance and investing the difference in premiums over the years.
Advocates of whole life insurance argue that whole life yields are improving, particularly with the advent of Universal Life, and that permanent insurance is a product geared towards different needs; it shouldn't be compared in terms of yield alone. For example, beyond age 65 or 70 (depending on a policy's details) you may have no choice but to buy permanent life because term is no longer available.
Both sides have merit, and the arguments continue. There is no easy answer as to which type of policy is best for each individual or situation. Cost is important, but your life insurance needs depend on additional factors and change over time. The best solution is often a combination of both types of insurance.
What kind of life insurance policy should you buy? It is a complicated question, because the answer depends on your needs, which will change over time, as well as the details of the contract. It doesn't help that there are a dizzying array of policies and options that you can use to achieve your insurance objectives.
Insurance needs change over time, but everyone follows a typical pattern consisting of four separate stages:
- As a young single person, your only need is to cover debts and obligations, so someone else isn't saddled with them.
- When you get married and/or have children, you must ensure that your family will be financially secure if something happens to you. This is usually the period of maximum life insurance needs, but also the time you can least afford high premiums.
- Eventually the children grow up, and as dependents become self-supporting, your life insurance needs decline.
- As you age, you need to plan your estate. Permanent insurance can be useful for covering obligations such as your final year's tax bill.
The type and amount of insurance you require will vary during each of these phases. At first, a simple term policy may be adequate and inexpensive. Looking ahead, though, you may want to put some coverage in place for your estate. A whole life policy bought now could be much cheaper than if purchased later in life.
A typical compromise is to buy a small amount of term coverage until marriage, then increase that coverage as your needs grow. You may also want to consider buying a permanent policy. If estate needs are substantial, some additional permanent coverage may be purchased even after retirement. Many people find the flexibility of Universal Life very attractive in this situation.
Choices depend on many factors. Quite often, the best result can be obtained with a combination of policies that accommodates your changing circumstances. The various features and options on different policies may provide additional choices.
There's no getting around it, life insurance has a lot of strikes against it. Not only do few people want to acknowledge their own mortality, but it's hard to make a financial bet on your early demise.
Once you've gotten over those hurdles, you run into a maze of features. Unfortunately, if you want to get the most for your insurance dollars, you'll have to educate yourself in the jargon to make an informed decision.
Before you put off your life insurance needs for another year and go play catch or watch the game, take heart. Below you'll find a straightforward explanation of the various features of life insurance policies. And if you need to motivate yourself, think of all the money you'll spend on life insurance over the next several decades. The only way to get the most for your money is to know what you're buying, and whether it's necessary.
Term Insurance Features
If you've decided to buy term insurance, there are a number of choices you'll have to make. Here are the features you'll need to consider.
Length of Term
Term insurance premiums are fixed, but for how long? You can purchase term insurance so that the premium goes up (adjusts) annually, or every 5, 10, 15, or 20 years. The older you are, the more likely it is that you will die, so the higher your premiums will be. As a result, the less frequently your premiums adjust, the higher the premium will be, relative to a shorter term.
A policy with a 5-year term, for example, is going to be cheaper than for 10 years, but when you renew, the next 5 years will be more expensive. It can be reassuring to know what your insurance costs will be for many years. On the other hand, if you want to change the amount of coverage, you don't want to have yourself locked in for a couple of decades.
In general, choosing a 5- or 10-year term offers a good balance between price and predictability. If you want to look at the overall bill, ask your broker to run through a few net present value calculations. This allows you to compare apples and apples. Essentially, it looks at the lifetime cost of various terms in today's dollars. The results will let you compare the total cost of selecting different terms.
Guaranteed Renewability
This provision means that when each term ends on your existing policy, you can sign on for another term at rates that are guaranteed today. Without this critical feature, your insurer could demand, for example, that you undergo a medical examination. If your health had declined they could simply set the premiums for your new term at whatever level they felt appropriate. A policy that is guaranteed renewable means that the insurer has to renew your policy at the agreed upon terms regardless of your health.
Guaranteed Renewal Rates
There's no point in having guaranteed renewability unless the level of the premiums you'll be renewing at is spelled out. Ensure that what you'll pay for each renewal is laid out term-by-term in your policy.
Guaranteed vs. Negotiable Premiums
If premiums are guaranteed, the insurer will adhere to a fixed rate of increases as specified at the time of the initial purchase. Negotiable basically means the issuer can charge whatever they want upon renewal. Some firms also provide preferred rates - they're guaranteed, but subject to a medical and lifestyle examination. A policy that is both renewable and guaranteed is best.
Convertibility Option
Most term policies are convertible. This means you can convert to a whole life policy at a stipulated premium and face value. There may be restrictions on the type of whole life policy to which you can convert, as well as the time(s) it can be done. This can be a valuable option, because going the permanent route later on in life might not otherwise be affordable, particularly if your health declines.
Whole Life Insurance Features
Whole life insurance comes with its own set of features and options. Here are some of the main points to familiarize yourself with.
Premium Structure
Some whole life policies require fixed annual premium payments for the life of the contract (straight life). Others provide for payments for a fixed period (e.g. for 20 years, or until age 65). Yet others provide for premiums or face values to fluctuate based on various factors. The choice you make depends largely on your future cash flow.
Non-Forfeiture Value
This is the amount guaranteed if you cancel the policy. It is usually the equivalent of the cash value. Also called the surrender value, it can vary widely between policies. Term-to-100 policies often have no surrender value.
Participating Policies
Some whole life policies incorporate an additional savings element, and pay periodic dividends to policyholders. These are not normal stock dividends, but special amounts that can be taken as cash or used to help fund the policy. These insurance dividends are never guaranteed and amount to little more than a partial return of inflated premiums. In general, you should avoid buying participating policies.
Your home is a source of pride. There is no place more important than a home where your family feels comfortable, secure and protected. But what would happen to your home if you were to die today? Would your family be able to keep making the mortgage payments? Would your family have to sell your current home?
You can protect your family home with Mortgage Life Insurance. Mortgage Life Insurance, offers flexible, low-cost coverage designed to provide the protection you need in insuring your mortgage, one of your largest outstanding financial obligations.
Read more about Mortgage Insurance (pdf)
Reading the Contract: What to look for in the fine print of an insurance policy
An insurance policy is a contract between the insurance company and you, the insured party. The insurance company is obligated to pay a sum of money (called the "benefit amount") to the insured's beneficiary(s), but it is important to know that the contract could be made void if information has been omitted or if false statements have been made. The following, while by no means exhaustive, is meant to provide an overview of some of the more important terms:
Grace Period
Most policies allow for a grace period of 30 days should the policyholder miss a premium payment. Provided the policyholder pays all outstanding premiums before the end of the grace period, the policy will remain in force. If a payment is not made before the end of the grace period, the policy may have to be reinstated (see "Reinstatement" below).
Reinstatement
If you have allowed your insurance policy to lapse, you can reinstate it by paying all outstanding premiums, plus interest, and providing new medical evidence. So long as you pass the medical, it will be as if the policy had never been out of force (ie there is no new policy fee or new premium scale). You have two years in which to reinstate a lapsed policy, although some companies may offer longer period in their contracts.
Incontestability
Once a life insurance policy has been in force for more than two years, the insurance company cannot revoke coverage. If the owner has misrepresented information on the contract, the insurer can only refuse to pay if they can prove that the insured made the misrepresentation (e.g. failed to disclose a medical problem) with fraudulent intent.
Here's an example: in one court case an insurer attempted to deny a claim on the grounds that the client was an alcoholic and failed to disclose it when asked if she had received "treatments for illness over the previous five years". The court ruled that the client wouldn't have regarded her drinking as an illness, since denial is a part of alcoholism. The insurer had to pay the claim.
Renewability
This provision, which specifies the conditions under which a term policy may be renewed after the initial term is up, can vary from insurer to insurer. Most companies offer "guaranteed renewable" term, meaning that the contract can be renewed at a specific rate and without submitting new medical evidence. Some policies however, may require you to re-qualify at renewal – meaning that if your health has changed, you may have to pay higher premiums, or you may be unable to obtain coverage at all.
Right of Rescission
Having received the contract, you usually have a 10-day period to examine the policy. Should the terms prove to be unacceptable, you may rescind the policy – return it to the insurer in exchange for a full refund of premium.
Suicide
In order to discourage individuals from purchasing life insurance prior to committing suicide, insurers insert a clause into the contract that only provides a refund of premiums should the insured party take his or her life during the first two years that the policy is in force. After two years have elapsed however, the insured's beneficiary will receive the full face value even if the death is a result of suicide.