Most people understand the need for insurance for their car, house, health, and some even for flight cancellations. However, I find that most people don’t really understand life insurance and its various applications. As a Wealth Advisor, my role is to look at every opportunity to improve a client’s financial situation and life insurance should be part of that discussion.
There are two main types of life insurance: term and permanent. Most people are familiar with term insurance. With term insurance, the objective is to transfer the risk of a loss (death) from you to an insurance company for a period of time, “term”, in exchange for a fee, known as the premium. Insurance companies invest the funds securely, so it can grow and pay out when there’s a claim (death of the insured). The death benefit is paid out as a tax-free lump sum.
A financial plan can help you determine how much term insurance you need. There are also insurance calculators available online. The general rule is to determine your financial obligations in the event of your death (e.g., income that would need to be replaced, mortgage balance, other debt, funeral expenses) and subtract your liquid assets such as savings. How much you will pay for term insurance is based on your age and health because, generally, the risk to the insurer of having to pay out on a policy rises with age. Group insurance rates also tend to be cheaper so if you have group life insurance through work you should explore that option first. Although term insurance is pretty straightforward, there are some issues with it that you should be aware of:
- If you need it for longer than the term you have purchased, then you have to re-apply and typically go through the medical testing all over again.
- It can get prohibitively expensive as you get older because it is designed to be temporary.
- There is no investment component to your premiums so there is no policy cash value when the term ends.
Your other option is permanent insurance which addresses some of the deficiencies of term insurance:
- Permanent insurance is often called whole life because it covers you for your whole life.
- The premiums charged tend to remain fixed for the duration of the policy.
- Some types of permanent insurance have an investment component that grows on a tax-deferred basis just like your investments in an RRSP do. So there is a policy cash value.
- It also provides some flexibility because, as the cash value builds, you can borrow against it or pull money out of it.
What’s the downside of permanent insurance? The cost. Permanent insurance is significantly more expensive than term insurance. So, how do you decide between the two types?
Choose term life if you:
- Only need life insurance to replace your income over a certain period, such as the years you’re raising children or paying off your mortgage.
- Want the most affordable coverage.
- Think you might want permanent life insurance but can’t afford it. Most term life policies are convertible to permanent coverage. The deadline for conversion varies by policy.
Choose permanent life if you:
- Want to provide money for your heirs to pay estate taxes. While some of my clients believe their heirs are fortunate to receive any inheritance, there are others that would prefer to see their lifelong savings go to their heirs rather than CRA (Canada Revenue Agency). A financial plan can show you what your estate tax liability will be and a permanent insurance policy can be used to pay the tax so that more money ends up with your heirs.
- Have a lifelong dependent, such as a child with disabilities. Life insurance can fund a trust to provide care for your child after you’re gone.
- Want to spend retirement savings and still leave an inheritance or money for final expenses, such as funeral costs.
- Want to equalize inheritances. If you plan to leave a business or property to one child, permanent insurance could be used to compensate other children.
- Have more money than you need for your lifestyle and want to tax shelter the excess (rather than pay CRA for the annual earned income and gains), have it grow until you die and provide your heirs with a tax free gift.