Insurance

Insurance is one way to manage some of the risks we face in our lives. It won’t prevent the tragic or unexpected from happening but it can help us deal with it. There are also other ways to manage some of these risks. The key is to understand what the risks are and the consequences of the options available for dealing with them, and then to be comfortable with your decision.

Insurance Overview

Insurance is a method of managing risk by sharing it with others and we pay a premium for the privilege of pooling that risk. In some cases, the purchase of insurance is mandated by regulations.

We can’t drive a car legally on public roads without having some form of insurance. Our basic health care costs are covered by premiums that are mainly paid for out of our taxes. Employment insurance premiums are taken from employers and employees before we ever see the money.

The benefits of insurance seem obvious. For a fee you can have a significant portion of expenses that you would otherwise be responsible for covered by a pool of money into which you and many others contribute. If that unexpected expense arises, then everyone helps pay for it through the premiums they have paid.

The disadvantages of insurance are less apparent.

One drawback is the cost. Insurance companies are in the business of making money. They could not exist if their expenses exceeded their revenues and on top of all those expenses, the company must earn a profit for its investors. Although as an individual you may collect on a policy, it is impossible for everyone who buys insurance to ever recover their expenses (the premiums that have paid).

This is not to suggest that people should never buy insurance but to recognize that the voluntary purchase of insurance is not always the most cost effective approach. A closer examination of our lifestyles may reveal that insurance is appropriate in some instances but in other instances the risks can be more effectively managed through other means.

Keep in mind that should you decide upon insurance as a solution, the theory behind the purchase of insurance is that its purpose is to mitigate risk rather than to earn a return on investment.

Who Needs Life Insurance?

If you have dependents who are reliant on your income, they will continue to need financial support in the event that you die. In this case, a life insurance policy makes sense. Some examples are:

  • If you are supporting a family, you need life insurance.
  • If you have children, you need insurance at least until they finish college.
  • If you have special-needs children, you might need a life insurance policy that will protect them at every age.
  • If you have a non-working spouse, you need life insurance to protect your spouse at least until their government benefits, such as Old Age Security and other sources of retirement, kick in.

If you are single with no dependents, you don’t need life insurance at all; certainly you don’t need more than your employer might automatically provide. Don’t let anyone tell you otherwise.

How Much Insurance Do You Really Need?

There is no one right answer to this question but a guideline might be 5 times your annual income plus enough to pay any outstanding mortgage and tuition fees for any post-secondary education your children may choose to pursue. If you have an employee-sponsored life insurance plan, it only needs to be supplemented to an appropriate level.

The death benefit that your beneficiaries receive is generally not subject to federal income tax or provincial income tax. The size of your policy should be based on your after-tax income because that is what you are used to living on.

Just as a banker makes more money by offering you the largest loan you can afford, the life insurance agent makes the most money by selling you the life insurance policy with the largest premiums.

Know what you need and don’t be oversold.

Term Insurance or Permanent Insurance

Cash-value policies are considered permanent insurance because the policies stay in effect as long as you continue to pay the premiums. Term policies, as the name implies, expire at a specified time.

Cancelling your policy

Make your choices carefully because cancelling an insurance policy is not like opting out of an investment plan. There is a good chance that you will get very little or none of your money back if you cancel that policy in its early years.

It may be shocking to find out how much of your money can disappear in sales commissions and related expenses if and when you go to cash in a permanent insurance policy. If you cancel your policy, you should do so cautiously, even if you no longer need life insurance. Administrative costs and agents’ commissions can take so much of the cash value that what is left for you can be far less than you expect.

A study sponsored by the Life Insurance Marketing and Research Association (LIMRA) and the Society of Actuaries in 2005 found that nearly 40% of all individual life insurance policies lapse in the first five years.

Another study by LIMRA International in 2009 found that an average of about 7.5% of policy holders allowed their policies to lapse on an annual basis. Those who had their policies in place for a long period of time tended to allow policies to lapse at a lower rate while those with newer policies tended to allow their policies to lapse at a higher rate.

Other industry statistics indicate that almost 20% of all cash-value policies terminate in the first year, and that 40% terminate in the first 10 years or so because the policy owners fail to keep up premium payments. If you surrender some policies early on, you may get nothing and you may be required to pay surrender fees.

Common sense tells us that in the event of financial hardship policies with higher premiums are more likely to be cancelled than those with lower premiums. If you decide that life insurance is appropriate for your situation and decide to purchase a policy, try to ensure that you will be able to maintain your premium payments even when times are tough to prevent your policy from lapsing.

Term Insurance

 If you check term insurance on Wikipedia, you will find the following definition:

Term life insurance . . . provides coverage at a fixed rate of payments for a limited period of time, the relevant term. After that period expires, coverage at the previous rate of premiums is no longer guaranteed and the client must either forgo coverage or potentially obtain further coverage with different payments or conditions.

If the insured dies during the term, the death benefit will be paid to the beneficiary. Term insurance is the least expensive way to purchase a substantial death benefit on a coverage amount per premium dollar basis over a specific period of time.

The key term is that it is the least expensive way to purchase a substantial death benefit. Since the entire purpose of life insurance is to provide a death benefit, term insurance makes a lot of sense . . . IF you need insurance.

Death benefits from a term insurance policy can be used to pay off your mortgage, fund the education of your children and provide income for your spouse. You don’t need multiple policies to cover these liabilities; one policy will do and will likely be the least expensive approach. Banks, in particular, will often try to sell an expensive mortgage insurance policy to homebuyers.

Since term insurance is the least expensive insurance, the chances are that you will be out the least amount of money should you cancel your policy or should it lapse due to the non-payment of premiums.

Permanent Insurance

Permanent insurance (in contrast to term insurance) can have a tax-deferred “savings” feature of permanent insurance. These policies are often billed as investment and savings vehicles; however, they are not well-suited to achieving that end.

There are many variations of permanent insurance, each with a slightly different name, making the entire process a confusing one. Most of these policies are either whole life or universal life.

In simple terms, a whole life policy is a permanent policy in which the premiums are the same for the entire life of the policy. You accumulate a cash reserve within the policy but the insurance company, not you, decides where it is invested. Typically, the insurance company invests it in low-risk securities which generate a low return.

Universal life policies combine the protection of term insurance with a savings component and you will have some choice in how the savings component is invested.

Whatever kind of permanent life insurance policy you choose, the increase in value will often be modest at best. However, the life insurance industry has been able to commingle insurance policies with investments while keeping the structure less than transparent. It is confusing and those who buy a policy are often unaware of the details.

No matter how anyone tries to package it, life insurance is not an investment; it is life insurance and that is what it should be used for.

There can be one exception. A good cash-value (permanent insurance) policy can sometimes be used as a sophisticated estate-planning tool.

Some of these strategies are appropriate if you’re a high-net-worth individual and you are not worried about liquidity (access to your capital). An individual in this group would be in the highest marginal tax bracket even after making maximum RRSP contributions. That would include those who make in excess of $150,000 per year.

If you fit that category, life insurance can be an ideal wealth-transfer asset.

Be cautioned, however, because the federal government has been gradually changing the regulations and further changes could be made in the future. It is important to keep current with legislation surrounding life insurance before making a major long term commitment to a permanent insurance policy.

Permanent insurance policies are not great investment vehicles, other than the fact that they force you to save. The premiums are high and funding them reduces your available cash for other obligations.

Some insurance agents promote buying permanent insurance policies on young children as a means to fund their future education. It is an expensive and inflexible approach. Unlike an investment program, if you cancel your permanent life insurance policy you may get very little or even none of your contributions back. It can be a 100% loss.

One common characteristic of these policies is that you lose control of your capital.

Insurance policies you don’t need

Insurance for children

Life insurance purchased on children’s lives is often an emotional choice rather than a logical choice.

The definition of life insurance is that it provides income or a safety net for those dependent on the insured. Since you are not financially dependent upon your children, you should not go to the expense of carrying insurance on their lives.

It is worth repeating that using permanent insurance as a means to fund their education is both inefficient and inflexible. A Registered Educational Savings Plan (RESP) is a better choice.

Mortgage life insurance

This type of insurance policy will pay off the mortgage on your house in the event of your death. As you pay down your mortgage, the amount of coverage is reduced by a similar amount. It is a declining benefit life insurance policy.

For the same price, or even less in many cases, you can purchase a term policy where the death benefit remains constant even as your mortgage is paid down.

Mortgage life insurance is often encouraged by your bank or credit union because the high cost of premiums, along with the declining benefits, makes it very profitable for them.

RRSP insurance for retirees

There have been cases where investors have purchased a life insurance policy to “pay the tax” on their RRSP should they die. If the person holding the RRSP account has a spouse, then upon death the RRSP assets can be rolled over to that spouse tax-free.

There is certainly no need for a life insurance policy in this case. If the person holding the RRSP account has no spouse, there will be no one reliant upon those assets for retirement income and no need for a life insurance policy.

Whether a life insurance policy is in place or not, the government will collect any taxes owed to them when an RRSP is collapsed. These taxes will be paid by the estate rather than the beneficiaries.

Those who are insistent upon leaving an estate for their adult children may want to take out a life insurance policy but it should not be purchased under the misconception that it will somehow reduce the tax liability on the collapse of an RRSP.

This strategy does allow for a larger estate but you are buying insurance for reasons outside the definition of insurance. Premiums can be costly at this stage of life and money spent on these premiums is money that is unavailable for other lifestyle expenses.

Insurance policies you should have

Life insurance

It is important to reiterate that life insurance protects those people who are financially dependent on you. Examine your situation carefully and calculate what level of insurance will allow those who are dependent upon you to continue their lives with minimal interruption. Your life insurance agent can help you with those decisions.

Long term disability insurance

Many of us have long term disability insurance through a group plan at our place of employment. If you are not covered by a group plan, you should establish your own long term disability policy that would allow you to maintain a reasonable lifestyle if you were no longer able to continue working.

If you are retired, you do not need long term disability insurance.

This type of insurance is not straightforward. Premiums can be burdensome and coverage can be limited, depending upon the policy you choose. It is critical that you work with an agent who is well versed in the nuances of long term disability insurance before choosing a policy.

Insurance policies you may want to consider

The insurance industry continues to broaden the range of products it offers. While life insurance provides financial payouts to the beneficiaries, there are two insurance policies that provide payouts to the policy holder.

They are critical illness insurance and long term care insurance.

Critical Illness Insurance

Critical illness insurance typically provides for a payout to the policy holder if they are diagnosed with a critical illness covered by the policy. Pre-existing conditions may prevent you from buying a policy and some illnesses are not covered.

On the upside, the payout is tax-free and can be used for any purpose the policy holder sees fit. It does not have to be used for the treatment of a medical condition. Some policies provide for a refund of premiums after a pre-determined number of years or at a specific age. Of course, coverage also ends with the refund of premiums.

Before you purchase a critical illness policy, understand what is covered and what is not, understand any other features and limitations of the policy and be aware of what your premiums will be.

Because many critical illnesses that are covered by these policies tend to strike more frequently later in life, it is more appropriate to have coverage in the mid-adult period of life. Purchasing a critical illness policy early in life means it is highly likely that you will be paying years of premiums to cover an event that has a low probability of occurring.

Do your homework because there are significant differences from one policy to the next with respect to the level of premium payments, illnesses covered and other factors.

Long term care insurance

These policies help provide for long term care for those who may not be considered sick in the traditional sense of the word but who may require assistance in the daily activities of living.

These policies will provide financial assistance to individuals who require long term help with basic personal activities such as dressing, bathing, eating, getting in and out of bed or a chair, and even walking. The coverage can include adult day care, assisted living, nursing home care, home care and other levels of care.

It cannot be purchased once the need for this kind of care is already established.

Long term care insurance can be one of the most complicated insurance policies to understand and the options for coverage and the premiums can vary widely from one insurer to the next.

As with life insurance policies, some people will let their critical illness and long term care policies lapse. They will pay the premiums while they are employed but may let the policies lapse when they feel they can’t afford the premiums or when they retire. This would waste all of the money spent on premiums. It is another reason to buy no more insurance than you can afford in the first place.

Another issue has arisen. In some instances insurance companies have dramatically increased the level of premiums required to keep the policy in place upon renewal. What seemed like an affordable policy when it was first taken out has become unaffordable for some upon renewal. In those cases all of the earlier premiums have been paid with no benefit. Be very cautious and inquire about premium levels.

In 2012, some insurance companies quit offering long term care insurance. While the concept may be appealing, it may have been too generous – hence the change.

Check the availability and cost of long term care insurance before making any decisions.

Life insurance if you are close to retirement

If you are “empty nesters” with a house that’s paid for and you both work or have other sources of income, it might make sense to spend your money on something besides life insurance.

However, you should consider life insurance close to retirement if you have any of the following:

  • Young children.
  • A disabled adult child.
  • An outstanding mortgage on your home or vacation property.
  • Any large outstanding loans, such as a home equity loan.
  • A nonworking spouse who is much younger than you.

Once again, ensure that the level of insurance is appropriate and covers a suitable term.

Summary

There are numerous kinds of insurance designed to cover a multitude of misfortunes and there are countless variations among policies. While a certain amount of insurance coverage may be prudent or even necessary in many situations, they all cost money. In many cases, the premiums paid will never be recouped.

Before you buy any policy make sure you understand the coverage, the terms of the policy and the costs.

Notes:

  • Term insurance is the least expensive way to purchase a substantial death benefit.
  • Permanent insurance can have a tax deferred savings feature.
  • Two common permanent insurance policies are whole life insurance and universal life insurance.
  • Two types of insurance that you should strongly consider are long term disability insurance and life insurance if you have dependents who rely on your income.
  • Three types of insurance you don’t need are life insurance for children, mortgage life insurance and RRSP insurance.
  • You may want to consider critical illness insurance or long term care insurance depending upon your situation and the cost of the insurance.

NEXT: Estate Planning

 

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