Is Life Insurance an investment? Are life insurance salespeople sleazy, money-grubbers who are selling wild strategies without merit? What is going on here?
We get asked about this every once in a while. Life Insurance and its salespeople get a bad rap. Some of it is incredibly well-deserved, and some of it is just not. Here’s a breakdown of some life insurance basics that you should understand.
What Is Life Insurance?
Life insurance is just that – insurance on your life that pays out when you die. The benefit is received by your beneficiary entirely tax-free.
If you name an individual, rather than your estate, the insurance will not be subject to probate fees. Depending on which province you’re in, probate fees could be a big deal (Hello, Ontario and BC!) or not really a big deal at all (Yes, you win, Alberta and Nunavut).
Term (or Temporary) Life Insurance
Term life insurance is like house insurance. You pay a flat premium for a specified period of time. If your house burns to the ground, the insurance company pays you a flat amount. Both you and the insurance company hope it never pays.
Your premiums are guaranteed for a specified period of time. Usually this is 10 or 20 years, but could also be 25 or 30. At the end of this term, the policy either ends (non-renewable) or renews automatically (renewable). If it renews automatically, the renewal premium is usually shockingly high. Why? Because many things could have gone horrifically wrong with your “insurability” during the term. The insurance company is on the hook to keep your policy going, as long as you pay your premium, to the date of expiry. They protect themselves by increasing the premium considerably at renewal. If you’re healthy, then you’ll probably go out and get a new policy, and the insurance company is off the hook.
Term Life Insurance plans are relatively inexpensive and can be used for “temporary” needs such as protecting your income while your family is young and dependent, and covering off debts such as your mortgage. The cost is based on your age, gender, smoking status, and general health. The younger and healthier you are, the cheaper it is.
Some term life insurance policies are also convertible, which means you can turn it into a permanent life insurance policy (see below) without having to show health evidence. This can be an excellent option when you get to the end of your term and have a health condition that you didn’t have at the beginning.
Even if your term life insurance policy is renewable, it will have an expiry date. This is usually your age 80 or 85 so, yes, you could pay insurance premiums for your entire life and see nothing from it. Much like your house insurance or car insurance.
Term insurance is not an investment alternative. It’s insurance.
Permanent Life Insurance (Whole Life or Universal Life)
Permanent Life Insurance (whole or universal life) is made up of two parts: insurance and cash value. It is structured such that it lasts the whole of your life. All insurance when you’re young is cheaper and when you’re older, it’s more expensive. The insurance company calculates an amount in the middle that you’ll pay for the rest of your life – this is the minimum premium. Note: This is an incredibly simplified explanation. There is a LOT of math involved in this calculation.
Essentially, you’re overpaying when you’re younger, so that you don’t have to pay as much when you’re older. The portion of your premium that is the overpayment builds up inside the insurance policy as “cash value”. In a whole life policy, the insurance company invests this on your behalf. In a universal life policy, you choose the investments.
If you close a permanent life insurance policy before you die, you receive the cash value. There may be surrender charges (usually in the first 10 or so years), and a portion of the cash value may be taxable. The calculation for both of these amounts is done by the insurance company’s actuaries.
When the cash value is inside the insurance policy, it earns money. It needs to, in order to build up enough cash to cover your future premiums. You don’t get taxed on the growth as long as the cash value stays below the MTAR (maximum tax actuarial reserve) – the amount of money that according to the actuaries, your life insurance policy can protect on a tax-sheltered basis. This is where people will consider it as an investment.
The intention is to allow the cash value to grow such that it will take over a portion or all of the premium payments when you are older. That’s why the room is available inside the policy. It’s tax-sheltered because the intention is that the funds will be used to cover a premium that you would have been paying anyway, towards a policy that will pay out tax-free to your beneficiary.
You can pay more than the minimum premium amount – you can fund that policy within inches of that MTAR line. This can increase the cash value and the eventual payout of the policy. The death benefit is always tax-free.
Why are you allowed to pay more than the minimum premium?
Because some people want to pay up their policy in a couple of years. You throw a chunk of money down, never think about it again, and the policy pays a death benefit when you die. It’s possible that there will be volatile investment years. The MTAR allows for fluctuations in value over time, without penalizing the insurance policyholder who just wants to make sure there’s money for their kids when they’re gone.
Is the Return Guaranteed?
Usually, in Whole Life policies there is at least a portion of the cash value growth that is guaranteed. In Universal Life policies, you definitely have the option to choose investments that have guaranteed growth. You can also choose investments that don’t have guaranteed growth.
The freedom to invest your funds inside your Universal Life policy, and take risks that the insurance company can’t or won’t inside a Whole Life Insurance policy, is one of the reasons people give permanent life insurance the side eye. There were a number of policies that were sold in the wild and crazy ’80s and ’90s, when insurance advisors were illustrating 8-10% annual returns. Remember: this was a time when interest rates were, in fact, that high. You could make that kind of money in an insurance policy. When the tech crunch hit – and the hits kept coming thereafter, with 9-11, decreasing interest rates, the housing boom and bust, and so much more – those 10% returns didn’t manifest and the policies often fell apart.
Remember: it’s how you use it that matters.
When is “Insurance as an Investment” a great idea?
When you have “never-never” money. Your retirement is funded, and all the other things you want to do are covered. This chunk of cash is over there, collecting money and driving your tax liability up. You plan on leaving it to your children or a charity anyways. You’d like to make it into an even bigger, tax-free chunk of change. Insurance is a great idea.
When is “Insurance as an Investment” potentially a decent idea?
When you have maximized your other tax shelters: TFSAs, RRSPs, your principal residence. You have more money flowing in, and a good chunk sitting in non-registered accounts, earning high levels of income that propel you into the highest tax bracket.
You have planned for your retirement and have more than enough to cover your prospective costs now and to the end of your life. A chunk of your non-registered accounts may not ever be required for your retirement income, but you want to make sure you have the ability to access it in case stuff comes up, like long-term care costs, or crazy volatile rates of return. Maybe you hold that chunk of non-registered funds in your corporation.
This is where it can get complex and you need customized support from specialists in life insurance, tax, and financial planning to work together. It can definitely work. It doesn’t always work. But sometimes it’s awesome.
The key to remember is that your other tax shelters (TFSAs, RRSPs, Principal Residence) are less work and less costly to maintain and manage. You want to max those ones out first and foremost. You want to have still more in non-registered investments. Then, you may want to think about using a life insurance policy and if you do, you want to work with an insurance advisor who is extremely knowledgeable in this arena, and has a structured process to support the ongoing maintenance of this policy. With insurance, the work continues on the advisor’s side long after the commission stops being paid (but the commissions*, at least in the first few years, are outstanding). On your end, you want to know that someone who understands it is going to be there to support you for as long as your insurance is in place – potentially, the rest of your life.
When is Insurance as an Investment a bad idea?
If you have not maximized your other tax shelters, your cash flow is tight, and you don’t understand what’s being offered. You are looking for insurance to cover concerns that may last 20 or 30 years – not the rest of your life. Your concerns are mortgages and protecting your family. You do not need insurance as an investment alternative. You need insurance as insurance. You’re looking at term insurance.
Note: Yes, you can buy Universal Life Insurance that has Term Insurance bits. So you guarantee that you have $X of insurance for the rest of your life at $X premium, and you add on $XXX insurance for terms of 10 or 20 years. If you put this in place, it’s because you want or need that permanent insurance for the rest of your life. It’s entirely possible. Look at the math. Make sure it makes sense.
Something worth knowing is that the insurance sales person usually makes a first year commission* of roughly the half the amount of your first year’s premium. This is known as “FYC”, or First Year Commission. Then, they earn a bonus on top of this. The bonus is based on their negotiation skills and sales prowess. It could range anywhere from 100% to 200% of the FYC. They also receive a small percentage on the amount you contribute to the cash value of the policy.
So if you’re throwing down $15,000 in annual premium (say) and tossing in another $50,000+ on top of that, the sales person could be making somewhere between $15,000 and $25,000+ in commission. It’s a “heaped commission” structure, so most of the commission is paid in years 1 and 2.
If the policy is cancelled in the first two years, the insurance advisor has to pay back 100% of the commission they receive. If not, they’re in the clear and get to keep it. There will be relatively minor commissions in the years 2 through maybe 8 or 9, depending on the insurance company.
Why does this matter? No, not because we hate people who make money. That’s silly. It matters because the advisor is not often incented to carry on providing great service after a few years. That’s why so many insurance policies end up “orphaned”, with no one to advise, and it’s why we recommend you work with professional advisors who have systems in place to take care of you and your policy for the rest of your life – because that’s how long your policy may last. When you spread the commission received over 20, 30, 40+ years, it doesn’t look quite so amazing. A good advisor has a program in place to provide you great service even after the money stops.
*Commissions are not, in themselves, evil. Just because we don’t accept them at Spring doesn’t mean that we think they and everyone who gets paid that way are “bad”. Commissions simply are, in some industries.