What is life insurance?
Life insurance provides financial security and support for your loved ones. In the event of death of the insured person, a tax-free amount will be paid to beneficiaries, like a spouse or children. This may help them cover costs associated with death, like funeral costs, debts and legal fees.
Note that life insurance isn’t for you – it’s for your loved ones. It is to help them continue living a comfortable life when you pass away. It should give you peace of mind that they will not struggle with financial commitments if you die. That includes paying the mortgage, bills, education costs and future expenses.
Is life insurance really needed?
Whilst life insurance is not mandatory, it is worth considering if you have dependents. The following points should be considered before deciding whether you need life insurance:
- Are you in a committed relationship?
- Do you have dependents? This can include parents; not just children or grandchildren.
- Could your family live comfortably without your income?
- How much money do you have saved?
- Do you have a mortgage? If yes, how many years are left on the mortgage?
- Do you have outstanding debts or loans that your family would be responsible to pay after you’re gone?
- Do you have savings (a RESP for example) for your children’s education? Is it large enough?
- Do you want to cash out a life insurance policy to make a big purchase in the future?
- Do you want to leave money to charity?
Answers to these questions should give you an idea if your loved ones would benefit from you having a life insurance policy.
How much life insurance do you need?
If you believe life insurance is necessary, it’s best to calculate what the payout should be when you die. As a general rule, this amount should be 10 times your annual income. This might seem high, but it needs to be enough to cover your mortgage or debts. It could even support the income of your loved ones too.
A simple way to calculate how much insurance you need is based on the DIME method. This stands for: Debt; Income; Mortgage; and Education.
| Debt | If you have any debt or loans, consider this amount that your insurance can pay it off when you die. This can include funeral costs. As an example, you are $10,000 in debt and your funeral cost is around $10,000 as well. So you would need at least $20,000 of life insurance to cover these. |
| Income | This is the amount of your income you want to be replaced. This can be calculated in a few ways. You could use before-tax or after-tax numbers. Perhaps the monthly amount your family needs to live comfortably. As an example, you earn $45,000 a year after taxes and deductions. Using the general rule of 10 times your annual income, you would need $450,000 of life insurance. A point to consider is how long your dependents will need the income replacement for. In the above example, the life insurance amount has been calculated for 10 years. You may choose more or less time based on how old your dependents are and where they are in their life. |
| Mortgage | If you have a mortgage, this could cause huge problems for your family or dependents when you die. The property may have to be sold if the life insurance amount does not cover the mortgage. As such, it’s best to add the outstanding mortgage amount to the life insurance policy. If you are mortgage-free or if you rent, this amount is not needed when calculating your life insurance needs. |
| Education | This amount is for children who may start, or are in post-secondary education or university degrees. This amount should be added to your life insurance policy if you wish to fund their education. As an example, let’s say a degree costs $15,000 a year. If you wish to fund a three-year degree for two children, you will need $90,000 of life insurance. |
So, your life insurance policy amount = outstanding debt + income for your dependents + outstanding mortgage + education costs
You may choose to deduct your savings from the amount of insurance needed. But this formula gives you a fair idea of what you need and allows you to adjust the amounts in line with your goals.
What type of life insurance is available?
Life insurance broadly falls into two types: Term and permanent. Within each type, there are different policies that may best suit your needs.
Term insurance
Term insurance is an amount of insurance you buy for a specific time, as an example for a year or 30 years. So coverage has an expiration date. The policy is based on your age and your health at the time the policy starts.
It is often the cheapest insurance to buy; this is because if the policy holder does not pass away during the term, the insurer will not have to pay an amount. So the risks for the insurer are lower, with the premium cheaper than permanent life insurance.
Permanent insurance
Permanent life insurance provides coverage until you pass away, or cancel the policy. Your beneficiaries will receive an amount if you pass away whilst the policy is in effect. The policy can also build up cash value, meaning you get money back if you cancel the policy. The death benefit and cash value presents permanent life insurance as both a product and an investment.
The price is higher than term insurance because at some point the insurer will at some point have to pay the amount of insurance. As this type of insurance lasts your entire life, it won’t need to be renewed.
Universal life insurance
Universal life insurance is an actual investment account and policy combined. Similar to permanent life insurance, it has a cash value. But the account can be used to make investments, allowing you to potentially build wealth for your beneficiaries. The policy can also allow withdrawals and loans.
It’s important to understand that the return on your investment can impact your premium. The death benefit and cash value may fall if the investment has a poor return. So the premium may increase as a result.
A big advantage of universal life insurance is that the death benefit is tax-free for the beneficiaries. So their tax-free amount is bigger than if the policyholder just had an RRSP or TFSA. Universal life insurance is a good option if you wish to leave a large amount for your loved ones.
FAQs
What impacts your premium?
An insurer will provide a personalized quote based on the coverage you want and the information you provide about yourself. This generally includes:
- Your age. As a general rule, the older you are, the more expensive the cover will be.
- How much cover you want. The bigger the death benefit, the more it will cost.
- How long you want the cover for. The longer the policy, the more it will cost.
- Medical conditions that you have. It's important to provide this information; failure to do so may invalidate the policy.
- Any extra coverage you want added on.
What is a beneficiary?
A beneficiary could be anyone that may be financially impacted by your death. For most people, that would be a partner and children. But it could also be siblings, grandchildren, a best friend or even an organization.
If you name more than one beneficiary for your policy, your insurer will usually divide the death benefit between them. It's also possible to assign different amounts of your benefit to each beneficiary.
Note that a beneficiary can be revocable or irrevocable. If revocable, you change the beneficiary without telling them. If irrevocable, you will need the beneficiary's written permission before making a change. If you live in Quebec, and your spouse is a beneficiary, they are classed as irrevocable unless you specify different.
If your beneficiary is under the age of majority (18 or 19 depending on which province you live in), a trust might be worth setting up. You could designate a trustee or administrator that will hold the benefit for the minor. Note that without a trustee or administrator, the province/territory will hold the benefit in a trust until the beneficiary is at the age of majority.
You could also name your estate as the beneficiary. In such an instance, the estate will distribute the death benefit according to your will. Note that the benefit will be subject to estate taxes, and as part of your estate, creditors may claim it to settle your outstanding debts.
Should you ever change the amount you need?
It's a great idea to review your insurance coverage every couple of years, or when there is a change in your family. As an example, the arrival of a child, buying a house or starting a business. This gives you an opportunity to review your family's level of comfort in the event of your death, or to cover an increase in debt.
How do you get the cash value from your policy?
It is possible to cash out a whole life insurance policy. Most permanent/whole life policies have an investment account that should grow over time. If life insurance is no longer needed, or money is needed urgently, there's a couple of ways to access the cash value:
- Ending or canceling the policy. You would be entitled to the surrender value, that is the cash value minus any fees. In this scenario though, your beneficiaries would not receive anything when you die.
- It's possible to take out a loan against the cash value, where the policy would be used as a security.
- It's possible to withdraw a portion of the cash value without canceling the policy. But that would reduce the death benefit amount.
Be aware that by taking a loan or canceling the policy, you may face tax consequences. This is because the cash value is only sheltered from tax whilst in the account. Talk with your insurer to understand exactly what is possible based on the policy you may have.
Do you need a physical exam?
A physical exam is not necessary but may be requested. You will be asked a lot of questions about your health though. An insurer will use this information to determine your level of risk based on your habits and medical history.
Is it possible to switch policies and save money?
Whilst it is possible to switch to a cheaper policy, note that life insurance does get more expensive with age. So savings aren't always possible. It doesn't hurt to get a quote, particularly if your health improves (i.e. you've stopped smoking).
Essential information
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