What Are The Different Types Of Life Insurance?
Fee-for-service financial planner and founder of PlanEasy.ca
Risk management is an important consideration in any financial plan. There are many risks that must be managed to have a solid financial plan. For example there is investment risk, inflation rate risk, longevity risk… and of course the risk of an unexpected death.
To help reduce the risk of an unexpected death we can use life insurance, but there are many types of life insurance to choose from, so what type of life insurance is right for your situation?
Although it can be difficult to think about, reducing the risk of an unexpected death is very important to consider when creating a long-term plan. This is especially important in certain circumstances. For example, life insurance is extremely important when there are dependents who need to be provided for in the event of an unexpected death, or when there is a large tax liability that could be triggered by an unexpected death.
In this post we’ll explore the different types of life insurance that are available and some of their important features, but first it’s important to understand the purpose behind life insurance.
The Purpose Behind Life Insurance
Insurance in general is meant to help cover risks that are too large to manage on your own. The type of insurance most of us are familiar with would be home insurance and vehicle insurance.
Houses and vehicles are two of the largest assets we own. If our house were to be damaged by a fire, or our vehicle be damaged in an accident, this would typically be a major financial set back for most families. To reduce this risk we purchase insurance.
Many people may not realize, but our ability to earn an income is one of our biggest assets. It’s usually worth more than a house, a car, or anything else we might own. Losing the ability to earn an income is a big risk for most families.
When it comes to life insurance, this risk is largest when you have people who rely on your income. If you were to pass away unexpectedly this would cause a major financial set back for your dependents.
Typically when we think of dependents we think of small children or a spouse or partner. But dependents could also be aging parents, dependent siblings, extended family, or even friends etc.
Life insurance is meant to protect your dependents from the loss of your income for a period of time. This period depends on your personal circumstances. Children may no longer be dependent once they’re adults and living on their own. Spouses/partners may no longer be dependent once they’re reached retirement age. Plus your earning potential will decrease over time, especially as you get closer to your target retirement age. These factors, as well as other factors, can influence how much life insurance you need and how long you need it for.
When deciding on how much life insurance to purchase and for how long, it’s important to determine what risks you’re trying to minimize because these can change and get smaller over time.
Types Of Life Insurance
Once you’ve determined how long you need life insurance coverage and roughly how much you need, the next step is to decide what type of life insurance fits best. There are different factors to consider…
Type 1: Term life insurance
Term life insurance is probably the most common type of insurance for the average family. Term life insurance pays a “death benefit” if the insured individual dies while covered. Term life insurance is purchased for a specific length of time, aka “the term”, and this is usually 5, 10, 15, or 20 years. If you pass away unexpectedly during the term then your beneficiary will receive the death benefit. The death benefit is purchase in dollar amounts like $100,000 or $250,000 or $500,000 and are paid for by a monthly insurance premium.
The benefit of term life insurance is that it’s usually the least expensive to purchase. Because it only covers a specific period of time it can be very inexpensive when purchased at a young age. A family in their 30’s who have small children can purchase a 20-year term life insurance policy that is very inexpensive, this is because the coverage ends before the risk of dying unexpectedly starts to increase. So by providing coverage from age 30 to age 50 the insurance company isn’t take a big risk, the chance of a payout is small, and the monthly insurance premiums are also small.
Term life insurance is great for situations where the risk of dying unexpectedly goes away in the future or gets smaller over time.
There are also various options for term life insurance. There are guaranteed renewal options, inflation options, joint options for couples (joint first to die, joint last to die) etc. etc.
Type 2: Permanent life insurance
Permanent life insurance is just that, it’s permanent. This type of life insurance is meant to last for your whole life. It’s meant to cover a different kind of risk than term life insurance, it’s mean to cover a risk that doesn’t go away or doesn’t decrease in the future.
This type of life insurance can be very beneficial in certain circumstances. For example…
It can be beneficial for families with a disabled child who may need assistance well into the future.
This type of life insurance can also be beneficial for individuals who own a business and wish to pass on these business assets to their children. The tax impact of this transition can be huge and permanent life insurance can help decrease this risk if the business owner passes away unexpectedly.
This type of life insurance can also be beneficial when planning for family properties like a cottage, vacation property, or family farm. The tax implications of an unexpected death could mean losing the property if there isn’t enough liquid assets to pay the income tax at death. This is where a permanent life insurance policy can help reduce risk by paying the income tax bill if there is an early or unexpected death.
Some permanent life insurance policies can also include an investment option. This is often highlighted as a way to invest in a tax efficient way. With this type of policy investments inside the life insurance policy aren’t taxed until withdrawn. This is typically only an advantage in unique circumstances where TFSAs and RRSPs have already been maximized, income splitting options have been maximized, and there are a lot of non-registered investment assets incurring income tax each year.
The other interesting aspect of a permanent life insurance policy, one that includes an investment option, is that these investments inside the insurance policy have additional creditor protection. Because the investments sit inside an insurance policy they benefit from being less accessible to creditors. This can be an advantage in certain situations where there is a higher risk of being exposed to creditors (ie medical professionals, business owners etc).
There are many different types of permanent life insurance, each with their own pros and cons. There is whole life insurance, universal life insurance, term-to-100 insurance etc etc. There are also participating life insurance policies that benefit from receiving dividends. Choosing the right type of permanent life insurance will depend on your needs.
Type 3: Mortgage insurance
The last type of life insurance is mortgage insurance. This isn’t really life insurance per se, but we’ve included it in this list because its a relatively common type of insurance and often pays when there is an unexpected death.
Unfortunately the cost of mortgage insurance can be quite high. We’ve seen instances where the mortgage insurance premiums essentially add an extra 1%+ to the annual interest. The mortgage could have a low interest of 2.5% but the mortgage insurance premiums add an extra 1% to this annual cost.
Often it can be less expensive to purchase private insurance that provides the same or better coverage as the mortgage insurance.
Check your mortgage statement, if you’re currently purchasing mortgage insurance then you may want to speak with an independent insurance broker about getting less expensive coverage through them.
The Different Types Of Life Insurance…
There are many types of life insurance to choose from. The average family would likely benefit from a term life insurance policy but may benefit from a permanent life insurance policy in certain circumstances.
Our ability to earn an income is one of the largest assets we own. If you have dependents, or someone who relies on your income, then insurance coverage is an important consideration to reduce the risk of an unexpected death.
A typical term life insurance policy can be quite inexpensive when purchased at a young age and can provide a significant amount of protection and peace of mind.
But how much life insurance you need, how long you need it, or whether you need life insurance at all will depend on your unique circumstances.
Financial planner, personal finance geek and founder of PlanEasy.