Life Insurance isn’t fun or flashy. It’s a conversation you need to have and something that needs to get settled.
So where do you start? Let’s break things down and get a bird’s eye view of Life Insurance. What types can I choose and how do I start figuring it out? We’ll organize your options into categories and point you in the right direction, so you can save some time on your research.
Where do I start?
As much as the Life Insurance Industry new products and coverage, there are only 2 types of Life Insurance. Yes, I said it. There are only 2 types! Permanent Life Insurance or Temporary Life Insurance.
I lump all Life Insurance into these two categories because most policies are really just a variation on one or the other. Either the Life Insurance is Temporary (example: for 10 years only) or it is Permanent (thus, stays active) until the day you pass away.
No matter what options are built into the policy – renewals, conversions, increasing premiums, fixed premiums, investments, cash surrender values, etc., it’s still fundamentally a Temporary Life Insurance or a Permanent Life Insurance.
Within those 2 big families of coverage, there are many different ways that you can structure coverage. Let’s take a closer look at each.
Temporary Life Insurance
As compared to its Permanent cousin, Temporary Life Insurance is a relatively straight forward Product. You choose the length of time you would like (typically, 10, 20, 25, or 30 years) and the coverage will be active during that time. If you choose a 10-year term, the coverage will disappear at the end of the 10-year period.
Temporary coverage usually comes with a Renewal Option for multiple terms after the initial period. If you’re in your mid-forties, you could purchase a 10-year temporary life insurance and subsequently renew it for many 10-year terms. In practice however, this isn’t feasible. The renewals are priced for what we call Adverse Selection because this policy is fundamentally priced and underwritten to be a 10-year term policy. To get a sense for this concept, here is a real life situation:
Assume someone purchases a 10-year life insurance policy and they are at the end of the term. If they are in relatively good health and still insurable, this person would be willing to shop around (at the 10-year mark) and undergo new medical tests in order to obtain competitive rates. If all is OK medically, there will be multiple insurers looking to win their business and offering competitive quotes.
As such, the renewal pricing built into temporary life insurance policies is always more expensive than the future market rates because future market rates benefit from new medical tests and fresh underwriting. Therefore, the first insurer’s renewal rate is blind to future market rates (no crystal ball) and thus, must assume that only un-insurable clients will renew for another 10-year term. Hence, the negative feedback loop that forces renewal rates to be very high.
Renewals in temporary life insurance are only a worst-case backup for people who have rapidly deteriorating health issues. However, they are not useful for people in good health.
Permanent Life Insurance
Permanent Life Insurance has more layers than Temporary Life Insurance because it lasts indefinitely.
Permanent Life Insurance stays in place indefinitely as long the premiums are paid on time. There are many methods (including underlying investment vehicles and tax structuring) that can lower the net cost of coverage, but it is essentially the same idea. As long as you pay the premiums, the insurer will pay the Death Benefit one day.
Within Permanent Life Insurance, there are multiple products with slightly different twists:
- Term to 100
- Universal Life
- Whole Life
The difference between these 3 subcategories of Permanent Life Insurance is the timing of the payments, the amounts of payments, and the cash that can be withdrawn from the policy. Each of these policy subtypes has their own payment and cash profile. Many of these variables can even be custom tailored to suit your specific situation. For example, if you’d like to have frozen premium payments for 10 years only, you could use a Universal or Whole Life policy with a structured payment schedule that can leverage tax efficiencies permissible under the Canada and Quebec Income Tax acts.
Are there other (lesser-known) types of Life Insurance?
What about Mortgage Life Insurance? Isn’t this another type of Life Insurance? Actually, no. Mortgage Life Insurance is just a decreasing balance Temporary Life Insurance with a term that matches your mortgage. If something happens to you during that period, it pays off the remain balance of the Mortgage. If you have the bad luck of worsening health and lost insurability, it will be tough to renegotiate your mortgage rate at the renewal because you will not be able to shop around with another bank (lest you lose your insurance because Mortgage Insurance is tied to your Mortgage). Lots and lots to discuss here but I’ll leave this for another article…
What type of Life Insurance should I choose?
Normally, I advise clients in 2 steps. The first step establishes the timing of and the amount needed (what’s at risk and for how long?). The second step is where I’ll try to find the most suitable coverage that works for your unique situation (what insurance fits best?).
Step 1: Timing & Amount
Regarding timing, the insurance needs fall into 2 main buckets.
- High amount for a defined and period of time.
- Constant amount for an indefinite period of time.
In the first case, there’s a high amount needed (say to pay for debts or replace your salary) for a very specific period of time (let’s say 10 or 20 years until retirement). For example, if you’ve recently started a family, you need Life Insurance to ensure that your income can be replaced until all kids are adults. This is the interplay between what’s at risk and for how long. Here, you would need Temporary Life Insurance.
In the second case, the need could be constant and for the rest of your life (indefinite period). For example, if you were investing in real estate for your retirement, you might need insurance to pay off the debts and taxes at death. Alternatively, you might want to ensure that there is some money left over after retirement for an inheritance. Here, the interplay is different. You have multiple needs (for the foreseeable future) and they need to be satisfied simultaneously. Here, you would need Permanent Life Insurance.
Step 2: Product Fit
Type of Premiums, Timing of Premiums and the Ability to Recuperate Payments.
Type of Premiums: Regarding Premium Payments, there are two options:
- Yearly Renewable Term (increasing premiums)
- Level Cost of Insurance (frozen premiums)
Yearly Renewable Term begins lower than Level Cost of Insurance. However, it increases exponentially with age. This makes sense because the Level cost is frozen forever. In theory, one could opt for the Yearly Renewal Term, and then invest the savings. Unfortunately, pulling this off successfully requires a break-even rate of return in excess of 7%. In addition, the timing of returns needs to be consistent (early losses or underperformance hurt proportionally more because of ongoing premium payments).
Timing of Premiums: Regarding the timing of payments, it’s very situational. Sometimes it makes more sense to stretch the payment schedule while sometimes it’s better to compress the accordion and have the payments spread on 10 or 20 years only.
Ability to Recuperate Payments (Cash Surrender Value): This is also very situation dependent. Unless we’re in the context of estate planning, I tend to favour insurance coverage that doesn’t have an ability to recuperate insurance premiums (via cash surrender values). This is because the most efficient insurance programs (cost-wise long term) are those that are committed to the insurance payout without the need for bells and whistles in case we change our mind in the future. Therefore, it’s important to do a detailed needs analysis from the get-go to establish the correct amount of coverage needed and then commit to it. Life changes, and we can still adapt. However, the best way to adapt is often to decrease coverage rather than pre-pay a higher amount to have the benefit of pulling money out of the insurance structure.
NEVER CHOOSE YEARLY RENEWABLE TERM!
I do not make a habit of speaking in absolutes and I don’t like to be rigid in my thinking. Never choose Yearly Renewable Term. However, with regards to this, I have seen too many people lose their coverage and even their life savings. Suffice to say, the level of financial sophistication needed to pull off the strategy with success is too high for most people.
Some things to watch out for…
You can Lose your ability to purchase Life Insurance
It’s important to think about the future when buying Life Insurance. You don’t want to account for every possible situation (the costs would be prohibitive), but you do want to take a few steps to future-proof your situation. Your insurability isn’t guaranteed. If you get sick or have a health challenge, you might not be able to purchase Life Insurance anymore.
In order to future proof, buy insurance at an early age and having a small layer of permanent insurance (as a foundation). This is smart and cost-effective (and normally the Life Insurance Need will increase with age anyways). The objective here is balance.
Also, don’t put off your decision to get Life Insurance because it complicates your file and makes the insurance more expensive. Start the underwriting process early and request the upper limit of the amount you are considering. You can always reduce the coverage during the underwriting process (and even during the term of the policy) without penalty. This will protect your insurability and is highly recommended.
Can I blend different types of Life Insurance?
Absolutely! And you should. Often, your insurance needs (i.e. the Timing & Amount) won’t be black or white. Rather, it will be a combination of needs all at once. Therefore, we often start with a layer of permanent coverage (that will secure the constant need) and then layer-on temporary coverage that will drop off after 20 or 30 years when the needs have changed. This type of structure is great for satisfying your insurance need while protecting your insurability without breaking the bank.
What if I have Life Insurance through my Employer?
You’ll want to check into this. It’s often equal to 1 or 2 times your salary and can provide for a small temporary layer of coverage while you remain with the same employer. The cost of this insurance increases every year, has a modest amount of coverage, and only remains while you are with your existing employer. As such, it’s usually a start but inadequate on its own.
Are there any Tax Benefits to Life Insurance?
There are many tax benefits related to Permanent Life Insurance. Both Canada & Quebec’s Income Tax Acts provide for advantageous tax treatment of Permanent Life Insurance. Often, these rules will make corporate ownership of Life Insurance attractive. In all cases, personal life insurance will usually be tax free to your succession.
Conclusion
There are two main families of Life Insurance – Temporary Life Insurance and Permanent Life Insurance. All Life Insurance Policies fall into these two categories.
By evaluating the amount and timing of your insurance need, you’ll be able to choose which type of coverage is most appropriate. At that point, you’ll look product fit and weigh the pros and cons based on Premium Amount, Type, and Cash Surrender Values. Finally, watch out and be cognizant that you can lose your insurability; therefore, it’s wise to blend coverages and act early.
