LIFE INSURANCE Life insurance has developed a bad name; or rather those who sell life insurance, perhaps. Often it s because people don t understand life insurance. Those who sell it, especially in the past, have added to the bad name by not educating their clients, preferring to use a smoke and mirrors approach, or emotion, in the sales interview. Life insurance, like any other financial product, has its purpose. It s like any other insurance product: you pay a year s premium and you have a year s coverage. The premiums are based on three main factors: mortality experience (claims), investment return (how much investments will earn), and administration (costs of doing business). There are other secondary factors which drive premium rates: cash returns to policyholders (living benefits, dividends, cash values, etc) and the lapse rate (whether the policy will lapse before the claim is paid). These items are factored into the premium for various types of life insurance policies by actuaries (people in the business of studying probabilities). Their idea of probabilities is the number of people, out of ten thousand who were born during the same year, who still will be alive at the end of each year. Not which ones, just how many. What does life insurance do? It pays a death benefit when an insured person dies. The death benefit is stipulated in the insurance policy. Usually, or at least some of it is, and that is the basic purpose of life insurance. But the industry has muddled the purpose, and the product, over the years to make the purchase process more complicated. Why is it so confusing? The main issue is the tax-exempt status of a life insurance policy, which permits the tax-free accumulation of funds within a life insurance policy. This factor is over-sold by many who sell life insurance as the reason to buy it, which is nonsense for most would-be purchasers. The reality is that life insurance is simple: if you die you collect and, if you don t, you don t. Most of the rest is smoke and mirrors. We shall try to develop this by starting with the basic and leading into the more sophisticated aspects of life insurance. Term Insurance is the original form of, and by far the simplest kind of, life insurance. Like fire insurance, term insurance provides coverage for a year at a time: if you die while it s in force you collect; if you don t, you don t. Period. Using the ten thousand people scenario, obviously some will die each year and the premiums each insured person paid are used to pay the death benefits; the next year the remaining people alive put up the money for the next year s death benefits. So, each year, fewer people are there to pay the death benefits on a larger number of people who will die in each succeeding year. It does get expensive as you get older and as the likelihood of your death increases. This is why products have been developed to help overcome the problem of the rising cost of life insurance over time. Before leaving term insurance, however, we should deal with the several kinds there are: annually renewable, five year term, ten year term, 20 year term, term to age 65, and more. The basic is annually renewable term insurance, wherein the premium rises each year, just as in
the ten thousand people scenario. Most popular, and most competitively priced, are ten and twenty year renewable term; the premiums remain level for ten or twenty years, increasing substantially at the end of each ten or twenty years. These are good planning periods in that you know how much the coverage will cost for several years at a time. There are other term periods such as five years, to your age 65, and others. How long the premium will stay level before rising has a direct impact on the cost. This is because there needs to be a higher premium in the beginning years to build a reserve which will offset the higher mortality claims during the later years of the term period. Just how long the level premium period chosen is going to be makes a major impact on the annual premium. The longer the premium is to stay level, the more the level premium has to be. It is vitally important to understand that term insurance, as explained so far, is not available, at any price, for as long as you shall live. Term insurance comes to an end, hence the term term. Usually it is programmed to expire before you do and to cover off only the possibility of your premature death, not death at the end of your actuarial life expectancy. There is the odd plan that is renewable to age 85 or so, but the pricing toward the end is prohibitive, and you still might live beyond its expiry date. The reality is that term insurance generally prices itself out of the market by one s sixties: it is designed to provide large amounts of cheap coverage while you are getting on your feet financially, and to offset the rather unlikely possibility you may not live to see your financial dreams come true. If you still need it when you are into your fifties or sixties, or if you know that you will when you get there, you should be looking at something other than term insurance, and we shall discuss what that is shortly. Renewable and Convertible Term: Most Canadian term insurance (though not all) has renewability and convertibility features. Why is this important? You don t want the policy to lapse before you stop needing it, so you need to be able to renew it. In renewing it you would like to know how much it will cost and that is specified in the policy contracts issued by most Canadian life insurers (unlike most term insurance policies issued in most other countries). Guaranteed renewable at a price specified in the contract. Important. What is convertible? It means you have the right, up to a certain date, to convert your term insurance (which probably will expire before you do) to permanent life insurance (which won t expire before you do). You may think you won t need your insurance for more than, say 20 years, so being able to convert it to more expensive permanent insurance is not, you think, important to you. But what if you do need it longer than you thought? What if one of your children turns out to have a severe disability and you will have to provide liberally for their support? This is why convertibility is important. Usually non-convertible term is no less expensive than convertible, so why quibble? Make sure your term insurance is both R and C. Group term insurance is a lot like other term insurance except that you do not own the policy. Owning the policy has some significant advantages in that the coverage cannot be terminated or otherwise changed without your specific consent, so long as you pay the premiums on time. With group insurance, the policy is owned by the group (ie employer, Chamber of Commerce, union, etc) and the insurance is only in force for a year at a time. At the end of any policy year the insurance company can choose not to renew, the employer may not be able to pay the premium, you may have lost your job, or any of a number of factors could occur that would cause the insurance not to be renewed.
This would mean you don t have your group insurance anymore and there is precious little you can do about it. At that point, if you are not insurable, you have a serious problem. Usually group term insurance, or some of it, is convertible within 30 days of your leaving the group (or of the group ceasing to exist). However, usually it is only convertible, without your being medically fit, to expensive permanent insurance which is not overly competitive. This is because nobody much converts their group insurance except those who cannot get life insurance any other way. Therefore, be sure you have enough individual term insurance that you yourself own, and treat your group insurance as a top-up. You can t be sure of always having the group insurance, while you can be sure of owning your own. Permanent Life Insurance is a refinement of term insurance. You understand how ten year term costs more than one year term does in the first year, but ends up costing less over time because the premiums were higher to start and lower later on. This levelizing can be done, not just over ten years, but over one s lifetime. It s called whole life. At least it used to be, still is in some circles. Whole life has become a pariah for many life insurance brokers because of the bad name given it largely as the result of over-selling by greedy commission-driven agents in the past. And that s too bad since the product does have a place. I prefer to call it permanent life insurance. Permanent life insurance has two components: one is the death benefit, or the insurance. The other is the savings, or cash value reserve. The insurance component gradually reduces during the lifetime of the policy as it is replaced by the cash value. In a typical $100,000 permanent life policy, say, twenty years into the plan, there could be $25,000 of cash value and only $75,000 of actual insurance to make up the $100,000 death benefit. This is where much of the misunderstanding has developed: who owns the $25,000 cash value? The insurance company owns it and if you want it you have either to borrow it at current interest rates or surrender the policy (which means no more death benefit). Sometimes insurance companies will encourage older individuals to redeem their life insurance for the cash values, as this will save them paying a death claim, which is a lot more money. A variation on this whole life scenario is participating whole life, wherein the insurance company charges more than it needs for the actual policy and then returns some of the excess premium to you as dividends. Often the salesperson will talk you into leaving the dividends in the plan to supplement the death benefit or to accumulate in cash. You will sometimes see a policy that consists of a small amount of guaranteed permanent insurance (say one-third of the policy) with a supplement being funded by the non-guaranteed dividends, consisting of a combination of paid-up additions (tiny single premium whole life policies contained within the overall policy) and annually renewable term, to bring the total to a specified amount which, usually, the purchaser thinks is totally guaranteed. These schemes can look attractive but don t bet on it being a good investment, or even a good way to buy life insurance. Usually the fully guaranteed aspect lasts only a few years and, then, is subject to how well the dividends perform. You may find you need to pay more to keep the full death benefit in force, or you could find you have more death benefit than specified at the outset a large part of this type of policy is not guaranteed. You could have more or less than you thought but in my view fully guaranteed is better this is insurance, after all. Traditional whole life, in the main, is not a good purchase since other forms have been developed which are better. Term to age 100, with or without values, is an improvement. This really means the same thing as whole life but it s modified to stress death benefits rather than cash values. Most
of the time term to 100 is a superior product since it is what it says it is and it cannot be marketed very easily in the false hope it will do something it won t. I call term to 100 stripped down whole life because that is what it is. You pay a level premium for the rest of your life and, when you die, the death benefit is paid. Should you live to be 100 years old, the plan is paid-up and, in some cases, the death benefit is paid out to you. It is sold on the basis that the death benefit will be paid, not that it will only be paid if you die prematurely. Very, very important point. It s leaner and meaner and much more cost-effective than traditional whole life. Some term to 100 products offer a cash value or a paid-up value after, say, 20 years. This is really a parachute designed to give you a partial refund or other value for the money you put into the plan, in case you find you didn t need it after all. A reduced paid-up policy is a paid-for policy for a smaller amount of death benefit than you would keep if you kept paying the premiums. Plans and circumstances do change and this type of product has more flexibility to it than a plain pay- til-youdie term to 100 policy. As with any term insurance product it is important to be sure you know what you will be charged. Remember you are buying a product that guarantees major financial benefits for many years into the future. Some policies provide a variable premium schedule showing a best-case and a worstcase scenario, perhaps pegged to prevailing interest rates of some other factor. This means you will be charged something in between the low and the high to keep the policy in full force. Do you want that? Other policies will guarantee the price for the duration of the contract and it seems to me this is better since it lays off the risk to the insurance company and that is what they are in the business of accepting. Why else are you buying life insurance? Universal life is a complicated product which, in my view, is oversold. It has its merits and it has come into its own as a viable alternative when one is apt to need differing amounts and types of coverage for various time periods. It is especially applicable for the individual who has or expects to have a very high and sustained income tax bracket as time passes. Typically, the principal breadwinner in the family could provide, say, $500,000 of permanent coverage, beef it up with another $1,000,000 while he has a mortgage to pay off and children to educate, insure his spouse for $250,000 to cover the period while the children are at home and in need of full-time care. Then as needs diminish he could drop some or all of the coverage, or convert it to permanent coverage if the needs do not diminish. All this is paid for with pre-tax income from the investment return of a fund within the policy to which he deposits money and from which he can withdraw funds as needs dictate. Universal life is designed to answer the call buy term and invest the rest. It is a tax shelter in that the monies invested in the funds within the policy, generally, accumulate tax-exempt as do those in an RRSP. But like any tax shelter, it doesn t work if you don t fill it up with money. How well does an RRSP work for you if you don t contribute to it? Same with a UL policy! But, most people, when they get an insurance premium notice, treat it as an expense rather than as an investment opportunity. And this is where universal life policies meet their doom. People will opt to deposit the minimum rather than the maximum premium, with the result that the policy becomes an expensive way to buy necessary protection and fails dismally as a tax-deferred way to accumulate investment assets.
The investment fund in the UL policy can be invested to provide a tax-exempt growth of capital, some of the return of which is used to pay the actual insurance premiums, pre-tax. Riders such as critical illness insurance, long term disability insurance, and term riders on other family members can be added and paid for with tax-exempt investment returns in the policy. It really does work! But, for you, look carefully before you leap. Don t just assume universal life is not for you. It might be perfect. But it might not. You might like to review the author s article on Universal Life if you think you are interested. Living benefits are usually available with most Canadian life insurance companies. They provide for a portion of the death benefit to be paid to the insured person if they are diagnosed with a lifethreatening illness that is expected to reduce their life expectancy to a matter of a few months. They are not usually contractual provisions but, if this happens to you, you should contact your insurance company to see what can be done for you. These are usually handled on a case by case basis and it is usually better to go this route than to sell the policy to a viatical settlement firm (firms which buy death benefit policies from terminally ill policy holders on a discounted basis in order to collect the death benefits). There are lots of purposes for life insurance. The obvious is to protect a young family from the financial disaster of the premature death of the principal income earner. There are all kinds of variations on this theme such as providing education funds, supplemental retirement income, a taxsheltered investment fund. Most of these really work better with universal life if funds are available for the higher premium it requires to make it work properly. Business associates often insure each other to provide the cash to buy out the shares of a deceased partner or shareholder. An employer might take an insurance policy on the life of a key employee, one without whom the business would lose some of its viability. Owners of businesses and other appreciating assets will insurer themselves (or have others insure them) to provide the cash to pay capital gains and other death taxes so the business or assets do not have to be sold at death, quite probably at a discount. Borrowers buy life insurance to provide the funds to pay off debt in the event of their death. Charity-minded individuals purchase policies on themselves or others in order to provide a major benefit to the charity of their choice. Properly set up, the premiums can be receiptable charitable donations and the charity knows that at some point in the future it will receive a substantial benefit to continue its mission or ministry. Many of us have old tiny life insurance policies that are of little consequence to our current financial planning. Usually cashing them in will attract income tax. But donating them to your church or charity can provide a charitable receipt which, after tax, can be worth almost as much to you as the after-tax value of the cash you would receive by surrendering them. Then the charity can cash them in and have the full cash value, non-discounted by tax, since they operate in a tax-free environment. If you are interested consult the author s articles on the subject of gift planning. Most people need life insurance. To establish how much and what kind, the buyer needs to ask a lot of questions. These questions should relate to what you need the insurance for. Protect your dependent children or your spouse? If so, for how long and with how much money? What s in it for the sales person? How do they get compensated? Are the renewal premiums guaranteed?
For how long is the policy convertible? And to what is the policy convertible? Often the insurance company will not permit conversion to all of their product line, just to the more expensive whole life plans. What s it for is a question I like. Listen for a reasonable explanation! CompCorp (now Assuris). This is the consumer protection agency for the life insurance community. It is roughly equivalent to The Canada Deposit Insurance Corporation (CDIC), with which all bank depositors will be familiar. It works quite differently, however. Assuris consists, effectively, of all the member insurance companies guaranteeing each others life insurance obligations in the event of the insolvency of one of their members. It does not have governmental backing as does CDIC. It is backed by the insurance companies themselves. For life insurance death benefits Assuris now guarantees the first $200,000 of the death benefit or 85% of any guaranteed death benefit stated in the policy, whichever is greater. It also guarantees up to $60,000 of guaranteed cash value in a policy. And it guarantees any guaranteed income payments from life insurance policies, up to $2,000 per month. For most of us this eliminates the need to spread the risk among a number of life insurance carriers except when very large death benefits are required by an insured person. Details of Assuris insurance on life insurance can be found at their website: www.assuris.ca Invitation. As an independent life insurance broker I invite your call to review your life insurance needs, see how you have dealt with them to date, and investigate how they might best be met now. Routinely I deal with a large number of life insurance companies in an attempt to find the best value for my clients. The current rates for most of the companies are on my website and on my computer, readily available to help you when you visit the site www.yorkminster.ca - or when you call.... provided as a service for the clients and associates of... e&oe STEPHEN B H SMITH, CEB, CFP, PRP YORKMINSTER INSURANCE BROKERS LIMITED 105 Dorset Street West Port Hope, Ontario, L1A 1G4 Telephone: (905) 885-4977 Facsimile: (905) 885-2556 Toll-Free: 1-800-668-1751 Mobile: (905) 373-5670 sbhs@yorkminster.ca www.yorkminster.ca