When you are responsible for others, you worry about what will happen to them financially if you pass on. Life insurance provides income to beneficiaries if you die. The beneficiaries are typically family members, but they can also be a company or entity of some kind. The reason it is called life insurance is because the payout happens when life is lost or death occurs. The insurance is designed to help beneficiaries maintain a standard of living in spite of death. This concept is similar to other types of insurance that are designed to maintain a given lifestyle should something be lost – a car, a house, health or a job.
There are two main types of life insurance you can buy in Canada: permanent and term insurance. Permanent insurance has two main categories: universal and whole life insurance. Permanent means the insurance is valid and you will be paying the premiums for as long as you live. For term life insurance, the policy payout is in effect and the premiums are paid for a set amount of time.
Why purchase term life insurance?
Many people ask why someone would buy term life insurance when the payout is only good for a set period of time. The key things to consider are loss of money and time. If I die tomorrow, will someone who depends on me be short of money?
Is there some obligation that I would normally pay off over time which would get interrupted should I die unexpectedly? A common example of this is a mortgage or other types of long-term debt. Life insurance can also cover health care costs, education costs or pay off a business loan. Rather than have the beneficiaries forgo the asset or have to pay for debt themselves, the life insurance covers amounts owing without disruption to the beneficiaries. If money is not an issue for the people depending on you at the present moment, or you do not have a lot of obligations that need to be paid, you might not need life insurance at all.
A second benefit from term life insurance is saving money on taxes. Life insurance payouts are generally tax free (but not 100% of the time). It depends on how the policy is set up. If you are receiving the premiums you are paying back, or are receiving an amount equivalent to the promised payout as stated in the policy, these amounts are tax free. If you are getting an amount over and above these items, it is considered earning interest. The payout will be taxed as income. This usually happens if the life insurance policy is also being used as an investment.
A possible third benefit is that life insurance provides an alternative way of conditional wealth generation. It’s conditional because with term life insurance, it is not guaranteed that you will receive the payout, but the payout will occur should you die prematurely. The policy can be constructed so that the payout exceeds the amount of money owed to obligations and can serve as a windfall of extra money. As an example, if you have a mortgage of $400,000 and you buy life insurance to pay that off in case of death, you can buy a policy that pays $1 million. If you pass away within the period that the policy is active, $400,000 can be used to pay the remaining debt and the $600,000 can be used for any other purpose. To accumulate $600,000 in savings may not be possible or it may take much longer than with a life insurance payout.
What are the costs of these benefits? The obvious one is the premiums which you have to pay each month. (However, it’s worth noting that term life insurance policies are generally very affordable.) A second cost is the fact that the risks change over time. As you get older or have more health problems, premiums could go up.
The trade-off between what you receive and what you pay is less favourable for you if you have to buy a new policy when the original policy runs its course. Since term insurance is designed for a certain length of time, this may not be an issue for you. Term insurance policies can be extended longer than the original time limit, but the costs and payouts differ due to risks changing for the insurer.
Term life insurance is a tool that can be used to address certain financial needs at a certain time in your life. As with all financial products, term life insurance should be examined with your financial situation in mind so that you can get the best use of what it has to offer.