You may be used to ensuring key assets – such as a car or home – against loss or damage. But it’s important not to overlook insurance protection for your most important asset which is you.
While the chance of your premature death is remote, there are significant financial risks to those you leave behind if you don’t have life insurance protection. So it pays to understand how it works, the coverage options available and the role that it can play in protecting the financial well being of your family.
Here are 10 things you need to know about life insurance.
1. How life insurance works
Life insurance is a contract, called a policy, that you have with an insurance company. In exchange for you paying a fee or premium, the insurance company promises to pay a tax-free, lump-sum amount to your beneficiaries upon your death. So if you buy a $100,000 insurance policy, this is the amount the insurance company will pay upon your death.
The cost of life insurance will depend upon many factors, most notably the type of policy you buy, the amount of the death benefit, your age, sex, smoker status, and health. Before you are accepted for insurance coverage, you may need to undergo a simple health exam, depending on the insurer and amount of the policy.
2. Why you may need life insurance
Life insurance can be used to meet many potential financial needs. Here are some of the key ones:
•Income replacement. If your family relies on your income, life insurance proceeds can provide the money your spouse or dependents need should you die unexpectedly.
•Repayment of debts. This includes a mortgage, ensure your dependents don’t have to sell the house and can maintain their standard of living.
•Child care and education. This includes daycare and ongoing costs and post-secondary school expenses.
•Funeral expenses and estate fees. Even a modest funeral can cost thousands of dollars, and estate costs – such as probate and executor fees – can add thousands more. Life insurance can provide your dependents or your estate with the cash it needs to settle these expenses – without the sale of key estate assets.
•Estate planning. Life insurance is often used to meet longer-term estate planning needs, such as covering capital gains taxes due at death or providing a guaranteed pool of money for a beneficiary, such as a disabled dependent.
3. How much coverage do you need?
To calculate this amount, consider:
•The amount needed to pay off your debts
•Any final expenses and taxes that will be owing on your death
•The amount your family will need to maintain its lifestyle
•The education costs for your children
4. Factor group benefits into your plan
If you or your spouse has group insurance coverage through an employer, life insurance coverage is likely part of the package and you should factor this into your planning.
For example, a basic life insurance benefit that’s equal to your current salary may be adequate at an early career stage if you are single and relatively debt-free. But if you have dependents or debt obligations such as a mortgage, this level of coverage is likely far less than what you need. Most group benefit plans let you pay for additional levels of insurance at very cost-effective rates – an option worth considering if you need more coverage. And if you leave your employer, you may be able to convert your coverage to an individual policy.
5. Term and permanent insurance
There are two main categories of life insurance: term insurance and permanent insurance. In a nutshell, term insurance provides protection for a specified number of years. Permanent insurance provides insurance protection for your lifetime. Under the permanent insurance banner, there are three main policy types that you can purchase: whole life, universal life, and term to 100 insurance.
The life insurance types under both categories are explained in the sections below.
6. Term insurance explained
The term is the most affordable and common type of insurance. It pays a tax-free lump sum benefit upon death and provides this coverage for a specified renewable term that you choose (typically 5, 10, 15 or 20 years). Unlike permanent insurance, term insurance policies only provide guaranteed coverage to a specified age, usually between 60 and 75.
With term insurance, your payments are the same for the length of the term you choose and are cheaper than permanent insurance. Your insurance is also guaranteed to be renewable, even if you are in poor health and would not otherwise qualify.
However, term insurance premiums increase with each renewal term – often significantly – so renewals can be quite expensive. If the term life policy is convertible, you can also convert the policy to a permanent policy without a medical exam, up to a specified age.
With higher rates upon renewal, and life insurance coverage ending at a specified age, term insurance is best suited for shorter-term insurance needs (20 years or less) rather than for longer-term estate planning needs that require guaranteed insurance coverage into old age.
7. Creditor life insurance
When you take out a mortgage or other loan, the financial institution will most likely offer you a form of term insurance known as creditor life insurance that will pay off the debt upon your death. While this coverage can be a convenient option, it’s important to realize that the policy proceeds are paid to the financial institution, not to your beneficiaries, so you lose flexibility in how the proceeds are used. In many cases, a more cost-effective and flexible option is to buy individual term insurance to cover the debt amount.
8. Permanent insurance – Whole life
With whole life insurance, death benefits are fully guaranteed for your lifetime, so these policies are ideal for longer-term insurance needs, such as estate planning. The premium is fixed when you purchase the policy and don’t increase over the life of the policy, but they are significantly higher than those for term insurance.
Whole life insurance also has a cash value, with savings that build over time. You can use the savings as collateral to take out a policy loan, or access the funds if you surrender the policy before you die. Some whole life policies are also participating in policies, which entitles you to dividend payments from the insurance company.
9. Permanent insurance – Universal life
Like whole life, universal life also fully guarantees death benefits for your lifetime but offers greater flexibility in terms of the size of the payment you make. With a universal life policy, you make ongoing deposits, with a portion of your contribution used to pay the premiums for your insurance coverage. The remaining amount stays in the policy and is invested – with any investment growth tax-sheltered, allowing you to boost the value of your long-term savings.
When you die, your beneficiaries receive the entire policy value – which includes the insurance amount and the investment proceeds – tax-free. You may also be able to borrow against the policy savings you’ve built up and use the borrowed funds to supplement your retirement income. When you die, the policy proceeds can be used to pay back the loan.
10. Permanent insurance – Term to 100 explained
Term to 100 insurance is a permanent form of term insurance that provides guaranteed coverage to age 100. Your premiums remain level until age 100, or may in some cases be payable over 20 years. A term to 100 policy is a good choice if you need long-term insurance protection but don’t want or need the additional savings of universal life or whole life policy.
Paul Russell is a Toronto-based writer and communications consultant, with a background as a pensions lawyer. This article was prepared for Moneyville’s launch.