Money Management, Personal Finance

What Exactly is Life Insurance? Life Insurance 101

by Max Kirouac CFA® – Investment Counsellor, BMO Private Banking

Summary: Introducing Life Insurance

Human beings, like all living organisms, are vulnerable to a risk that we eventually fall victim to: mortality. This risk is more acute when there are others who depend on you for their livelihood. In the animal kingdom, this takes the form of baby birds relying on their mother for nourishment and protection. Among people, the reliance is generally financial. The idea of a social safety net is a relatively new concept; with limited employment opportunities for women in the past, the wife and children of a prematurely deceased husband were often condemned to a life of poverty unless they could rely on the goodwill of family or neighbours. This was the case until the middle of the 18th century, when human ingenuity and the understanding of a new discipline of study led to a solution for this problem. That solution was life insurance.

A Brief History

While there are individual cases of pre-modern life insurance dating back hundreds of years, it didn’t exist in its current iteration before the advent of actuarial science. This is the study of risk, and it combines mathematics and statistics in order to build mortality tables that are used to price insurance. Actuarial science relies upon the law of large numbers: while it is difficult to pinpoint at what age an individual person will die, these models can produce highly accurate results when determining the average life expectancy for a large number of individuals.

Beyond life expectancy at birth, the models can also adjust for life expectancies for different demographic categories (such as men versus women) or life expectancy based on attained age (for example, determining until what age a 65-year-old can be expected to live). Nascent life insurance companies could use actuarial data to calculate what their costs would be for insuring the lives of a large number of people (a big enough group that the law of large numbers would be applicable). And once these companies had an idea of their cost, they could determine the prices they would need to charge in order to cover their costs and still earn a profit. Just like that, a new industry was born.

What is The Point?

The logic behind insurance is risk management. When faced with any risk, financial or otherwise, we have four choices available to us: we can avoid it, reduce it, transfer it, or retain it. Clearly the risk of death can’t be avoided entirely; it comes for everyone eventually. We can do what we can to reduce the risk by leading a healthy lifestyle and by not engaging in dangerous activities. As avoiding mortality risk entirely is impossible, and reducing the risk can only take us so far, we’re left with two options for the residual risk that remains: we can either retain it or transfer it. Risk transfer is the role played by insurance.

Modern Forms

Life insurance can broadly be classified as term, whole life, or universal life.

Term is the most straightforward type of life insurance. You agree to a certain amount of coverage over a set timeframe with a guaranteed insurance premium. It is generally designed to serve as either an income replacement for a dependant spouse and children or to replace the role served by a spouse who doesn’t work but otherwise contributes to the household (such as staying home to care for young children, a role that would otherwise have to be fulfilled by sending the children to daycare at a cost). Given that term insurance has a stated coverage period, it’s designed to meet obligations that have a finite time period, such as providing for children before they reach age 18. When a term policy expires, a new one will have to be purchased in its place. As mortality risk increases with age, so does the cost of insurance coverage.

Whole life and universal life are both types of permanent life insurance policies. Once the insurance takes effect, the policy will remain in place for life unless the policyholder chooses to cancel it. Both whole life and universal life have a death benefit (just like term policies), but they also have a cash value component that is funded by a portion of the insurance premium. Whole life policies have a fixed premium payable on a consistent schedule and the cash value accumulates on a guaranteed basis, because the insurance company invests the cash value in guaranteed interest-bearing investment instruments. Whole life insurance effectively functions as a combination of a life insurance policy and a savings account. Universal life, conversely, does not offer this guarantee, but it is a more flexible alternative to whole life insurance. The death benefit can be increased (often subject to a medical exam) or decreased by changing premium payment amounts. Alternatively, premium payments can be made directly from the cash value that accumulates in the account. There is also no set schedule for premium payments. The amount of cash value that accumulates in a universal life policy will be dependent on how well the investments purchased with cash value perform.

The death benefit from any type of life insurance policy (term, whole life, or universal life) is paid out tax-free to the beneficiaries. The cash value that accumulates in whole life and universal life policies is similarly paid tax-free.

Should I Use Life Insurance?

As a general rule, if you have people that rely on your income for their wellbeing, you need life insurance. Whole life and universal life policies are more expensive because they are in place for life (meaning that the insurance company is guaranteed to make a death benefit payment at some point so long as the policy doesn’t lapse) and because they accumulate cash value. Insurance contracts have lower premiums when they are entered into at a younger age because young people carry lower mortality risk. It may therefore make sense to enter a permanent life policy at a young age when premiums are lower to guarantee your ongoing cost of insurance.

Life insurance has other functional benefits beyond safeguarding dependents. As life insurance payouts aren’t taxable, they are often used to cover taxes that can be triggered upon death, such as capital gains taxes or the income tax associated with the automatic deregistration of RRSPs and RRIFs the accountholder dies. Life insurance is also a tax-efficient means of wealth accumulation, particularly within corporations. As corporate income tax rates are lower than personal rates, incorporated individuals can purchase a life insurance policy within the corporation, where the money used to make insurance premium payments won’t be subject to as high of a tax rate. Normally withdrawals from a corporation are subject to additional taxation, but life insurance payouts are tax-free, so the death benefit can flow directly from the corporation to the benefits without any considerations for tax. Further, the cash values of permanent life policies can also be used as collateral for loans, providing additional flexibility for the funds.

Many individuals do not have enough life insurance coverage. It’s easy to understand why: no one likes to consider their own mortality, and by purchasing life insurance you are willingly sacrificing a portion of your wealth that you will never be able to enjoy for yourself. Nevertheless, there is comfort in knowing that those you love will always be provided for.

Opinions are those of the author and may not reflect those of BMO Private Investment Counsel Inc., and are not intended to provide investment, tax, accounting or legal advice. The information and opinions contained herein have been compiled from sources believed reliable but no representation or warranty, express or implied, is made as to their accuracy or completeness and neither the author nor BMO Private Investment Counsel Inc. shall be liable for any errors, omissions or delays in content, or for any actions taken in reliance. BMO Private Investment Counsel Inc. is a wholly-owned subsidiary of Bank of Montreal.

Max Kirouac
About Max Kirouac

Max Kirouac, CFA®, is an Investment Counsellor at BMO Private Banking in Winnipeg, Manitoba. If you would like to discuss this article more with Max, connect with him on LinkedIn.

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