An Introduction to Insurance and Risk Management – Part 2
Life insurance probably ranks up there with wills and estate planning when it comes to enthusiasm for the average person. They both have to do with death. Really, life insurance should be called death insurance since it insures against the risk of financial loss for your loved ones were you to die. A will does more or less the same thing, but instead of paying a premium to an insurance company you are paying a fee to a lawyer so that your affairs are dealt with according to your wishes after you are dead.
In the event of your death, life insurance may be critical in providing replacement income for your family and for funding your estate.
In retirement, life insurance may be helpful to cover your estate’s tax liability once you die, but you will likely have fewer debts to pay off and no need for income replacement to support your immediate family.
Life insurance premiums are generally not tax-deductible. However, the proceeds received by the beneficiaries are not taxable.
There are generally two types of life insurance: Term Insurance and Permanent Insurance.
Term (or “pure”) insurance policies usually have lower premiums at younger ages. You are paying the cost of insuring against the risk of your death in the current year. It is often used to cover a temporary need. Consider a married couple with minor children and a mortgaged home. If one of the spouses were to die, there would be a significant loss of income. Can payment of the mortgage be sustained in such a circumstance?
Assume the spouse who dies was staying at home to care for the children and manage the household. Even though that spouse may not have had any earned income, paying for childcare now becomes a new expense. How is that going to be funded? Or maybe the surviving spouse needs to take a leave from employment in order to care for the children for the first year under this new reality. Again, how is that time away from work going to be funded?
If, however, the family reaches a stage in life where the mortgage is paid off and the children are out on their own, the need for this sort of insurance decreases dramatically. Many times, term insurance is accessed via a group plan from employment. If retirement occurs after the mortgage is paid, after the children have become independent, there may be no need to insure against your death for the benefit of your loved ones and so ceasing insurance coverage at that time makes good sense. In that way, it is like a general insurance policy for your home or car. You pay insurance to cover against loss to your property, but if a claim is never made, the insurance company never pays out.
Again, like general insurance, as long as you continue to pay the premiums, your coverage will continue; many policies guarantee renewal without additional medical evidence. However, the cost of premiums will increase dramatically in later years as you age and the probability of death increases. Most term policies terminate at age 70 to 75, which is lower than the current average life expectancy. However, there are also “term-to-100” policies, which provide lifetime coverage. Premiums are typically payable until age 100, at which time the policy becomes paid up and continues for the rest of the life insured’s life.
A permanent insurance policy (often called “whole life”) is designed to be in force for one’s entire life. Unlike term insurance, the cost of premiums is often much higher but is designed to stay level throughout the insured person’s entire life. The reason the premium is higher is that part of it goes toward a reserve. At the end of the term set in the policy, it is often fully paid up and no more premiums need be paid. The policy can be designed so that the cash surrender value accumulates tax-free. Such a fund can be borrowed against or “cashed out” in later years. However, doing so will have a tax cost.
Permanent insurance products are often desirable for the following purposes:
- Tax funding – when you die, you are deemed to have liquidated all your assets, which may result in a substantial tax burden. Insurance, which is paid out tax-free, can cover those taxes.
- Estate equalization – a small business owner with one child who is active in the business may choose to leave the business to that child and fund via insurance an equivalent amount to other heirs who are not involved in the business.
- Long-term, tax-effective investment strategies – if you routinely fully fund your registered plans (e.g., RRSP, TFSA), it may be to your advantage to buy a permanent insurance policy with a portion of your investments that would instead go into a non-registered account.
When buying insurance, you can name beneficiaries in your life insurance documents. Consider who should be the beneficiary. The proceeds will go directly to them, avoiding both the related costs of probate and a delay in your named beneficiaries receiving the insurance proceeds.
A typical situation is one in which each spouse will name the other spouse as the primary beneficiary (the first person entitled to receive the proceeds) and the children named as secondary beneficiaries (the children receive the proceeds if the primary beneficiary spouse is also deceased). If it is possible that another child may be born between the spouses, then naming the children as a “class” avoids having to change the beneficiaries.
If your estate is the beneficiary, the insurance proceeds will form part of your estate on your death, and will be subject to any claims that creditors have on your estate. The proceeds will also be subject to probate fees. Note that the investment fund or cash surrender value of a permanent policy can be protected from creditors during your lifetime where certain beneficiaries are named.
My next post will address an often-overlooked item: Disability Insurance.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, accounting or legal decisions.