Term insurance
Term insurance is a form of life insurance, i.e. a contract that pays a sum upon the death of the life insured.[1] Term insurance gets its name because the contract is in effect only for a specified length of time, typically from one to 30 years. As long as premiums continue to be paid during the contract term, the contract will pay off should the covered person or persons die before the term expires (cf. permanent life insurance). If the policy is not renewed at the end of term, it will expire worthless[1]: term insurance is a form of pure insurance, without a savings/investment component.
Life insurance proceeds, including those from term insurance, are generally received free of tax by beneficiaries.[1]
The most common term insurance policies are employment benefits and are typically one year renewable. If an employer pays some or all of the premium on such policies, a taxable benefit arises for the employee.
Those with term insurance needs over and above employer-provided coverage should contact an insurance agent. Costs for term insurance can be approximated using an online service such as Term4Sale.
How much insurance and for how long?
The death benefit should ideally be such that if you die before retirement, your family can maintain the same standard of living. What you are insuring is your human capital, the value of your future earnings.[2][3] If you are no longer around, your paycheque can be replaced by income earned on investing the death benefit.
The primary purpose of life insurance is income replacement for dependents.[4] When you fully retire from paid work, you are no longer converting your human capital into a paycheque.[3] On the other hand, you probably have accumulated significant financial assets in preparation for retirement. So the need for life insurance is either much less, or nil, at retirement, assuming your assets can be transferred to your surviving spouse.
The following graph (modified from [5]) shows, very schematically, how human capital decreases over time, while financial capital increases (or at least it should, if you are saving enough and investing in a diversified portfolio!). Meanwhile, the required face value of life insurance (here represented conceptually by renewable 1 year term policies) decreases.
In summary, you generally need term life insurance when you have dependents, until you retire or become financially independant. The amount of coverage should be enough to replace your future after-tax employment earnings.[5] You can estimate this amount using rules of thumb, or calculators such as Barney's Life Insurance Calculator and Milevsky's Human capital calculator[dead link] . This will probably be a much larger number than you anticipated.
Note that if you use human capital to estimate life insurance needs, you could use your after-tax salary, because the death benefits are not taxable[6], although if the death benefit is invested in a non-registered account, interest, dividends and capital gains will be taxable. Furthermore, you could subtract the present value of your subsistent consumption (the minimum you need to survive on) from your gross after-tax human capital, yielding the net after-tax human capital.[7] This figure is considered an upper bound for estimating life insurance needs. See this detailed example.
Group products
Many employers offer group life insurance as part of their employee benefits package. These packages typically break down the offerings into employee term insurance, dependent term insurance, and optional term insurance. The terms of the plan also may provide for group life conversion, within specific time limits, if their group insurance ends, say through job loss. There are tax implications for group insurance, depending on who is paying the premiums. If an employer pays some or all of the premium on such policies, a taxable benefit arises for the employee.
The terms and conditions of group products vary by provider and by employer. You should review and understand the terms and conditions that apply for your specific plan.
Employee term insurance
Coverage is for the plan member only and various benefit levels are available, typically a multiplier of annual salary.
Dependent term insurance
Plan members’ spouses and dependent children are covered and the coverage amount is usually fixed to an amount designed to pay for the insured's last illness and funeral expenses, not to replace the deceased's future lost income.[8]
Optional term insurance
This coverage provides additional coverage options for the plan member and possibly spouse. You have the opportunity to increase existing insurance coverage, at low group rates, to reflect their individual needs. As part of prudent planning, you should be aware your insurance coverage is now tied to your employment, although most group products do allow conversion, within specific time limits, to an individual policy without providing medical evidence of insurability.
Before you sign up for optional term insurance through work, you may want to compare what is being offered by the group plan with a quote from an online service. Purchasing a term policy independently could be cheaper, depending on your age, health, etc.
Individual term policies
If you don't have life insurance coverage through your employer, or if the coverage is insufficient, consider adding an individual term insurance policy. This will involve contacting a life insurance agent or broker. You will have to answer numerous medical questions, and probably submit a blood or urine sample. In exchange for this minor unpleasantness, you will get protection for your dependents, and healthy people get better pricing (unlike in group insurance).
The premiums can be paid month or yearly, and commonly remain constant during the term.[1]
Typically available terms are 10, 15, 20, 25, 30, 35, 40 years.[9] At the end of the term, the contract is typically renewable for a further term, usually for a higher premium because the life insured is now older (greater mortality risk), but without proof of continued good health.[1] If a person is in good health, and needs continued coverage, a cheaper alternative is to shop around for a new policy before the end of the term.
Selecting the term of the policy
There are two strategies when selecting the term of a policy.
Entire period
The first strategy is to cover the entire period during which the person will need life insurance.[10] For example, a 35 year old person planning to retire at 65 could purchase a 30 year term policy, of a term to 65 policy.[4] Or, someone planning to become financially independent in 20 years could purchase a 20 year term policy.
The advantages of this strategy is that (1) the premiums are flat and known in advance[10][11]; (2) there is no need to renew coverage after the first ten years, so no need to worry about declining health.[10][11] The disadvantage is that if the person cancels coverage during the term because it is no longer needed, the person paid too much during the initial years (compared to a cheaper ten year term policy).
Ten year renewable
An alternative strategy is to take the cheaper 10 year term, even if the insurance needs will likely extend longer. Then, if the insurance needs indeed persist, the person would re-apply for a new 10 year policy at the then-prevailing rates, which would be higher because the person is now older (greater mortality risk), and perhaps not as healthy, as 10 years ago. For someone who stayed in good health, this strategy should be cheaper than the 20 year or 30 year term.[12] The only inconvenience is having to re-apply every ten years.
However for someone forced to take the guaranteed renewal, due to bad health, the renewal premiums will be much higher.[10][13]
In summary, the "entire period" strategy is safer, with a known total cost; the ten year renewable strategy might be cheaper, or more expensive, depending on how your health evolves.
Declining needs?
If you need more life insurance coverage in the next 10 years than in the subsequent 10 years, you can combine a 10 year term policy with a 20 year term policy.[13] This is also known as "policy laddering", and will be cheaper than buying a single 20 year term policy for the full amount.
The following graph shows how progressively declining life insurance needs over a 30 year period (represented by the green curve) could be covered by laddering three policies.
Price inflation will also reduce the purchasing power of a constant death benefit anyway: $100k won't buy as much in 20 years as it does now.
Mortgage life insurance
When taking out a mortgage, your lender may offer mortgage life insurance. If you already have enough life insurance to replace your paycheque, you don't need extra insurance to cover your mortgage. If you have dependents, a mortgage, and no (or not enough) life insurance, consider an individual term policy, which has many advantages over mortgage life insurance.[13]
See also
References
- ^ a b c d e Chapter 8: "Mortality risk and life insurance" in N. Chapurat, H. Huand and M.A. Milevsky, 2012, Strategic financial planning over the lifecycle. Cambridge University Press (ISBN 0521148030)
- ^ Bob Barney, The Mistake Many Will Never Know They Made, Canadian MoneySaver, September 2014 issue(subscription required), viewed January 28, 2017
- ^ a b Moshe Milevsky (March 30, 2010). "The lowdown on insurance salesmen and warranty peddlers". The Globe and Mail. Retrieved January 21, 2017.
- ^ a b Bob Barney, Responding To The Challenge - ManuLife Rolls Out Level Term To 65, Canadian MoneySaver, May 2013 issue(subscription required), viewed January 28, 2017.
- ^ a b Chen P, Ibbotson RG, Milevsky MA, Zhu KX (2006) Human capital, asset allocation, and life insurance. Financial Analysts Journal 62:97-109, DOI 10.2469/faj.v62.n1.4061, available on SSRN
- ^ see page 158 in Chapurat N, Huand H, Milevsky MA (2012) Strategic financial planning over the lifecycle. Cambridge University Press, 367 p. (ISBN 0521148030)
- ^ see page 159 in the same textbook.
- ^ Great-West Life | Life Insurance, viewed August 26, 2012.
- ^ Based on products listed on term4sale on June 9, 2019.
- ^ a b c d Robert Barney, Term Renewals – Watch Out!, Canadian MoneySaver, November 2001 issue, viewed January 28, 2017.
- ^ a b Deanne Gage, Life insurance: Should you go for 10 years or 20?, Morningstar, March 20, 2012, viewed June 7, 2019.
- ^ Post by 'Clason' in Financial Wisdom Forum, topic Life and Accident Insurance for young family, June 6, 2019, viewed June 7, 2019
- ^ a b c Colin Ritchie, The Perm/Term Squirm: Deciding Between Permanent And Term Life Insurance Policies – Part 1 – Term Life Insurance, Canadian MoneySaver, January 2014 issue, viewed January 28, 2017
