Types of life insurance and cash value

Question:

Artem, could you please explain life insurance that provides monthly payments during retirement? Thank you.

Answer:

There are two types of life insurance you can buy (actually, there are more, such as AD&D and others, but I won’t discuss them as they aren’t relevant to this question). These are:

1. Term insurance (usually from 10 to 40 years).

2. Permanent insurance (permanent for life).

Before explaining the difference, let's define a few terms:

• Insured – the policyholder (also called policy owner or policyholder).

• Life insured – the person being insured (not necessarily the policyholder; for example, a father may take life insurance for his son).

• Insurer – the insurance company.

• Beneficiary – the heir (it cannot be the same person as the life insured).

• Insurability – means that the person can be insured, i.e. their age and health allow them to be insured.

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Term Insurance

Term insurance is not cumulative, meaning the insured amount is what is paid out (there are some nuances on how the payout amount can be increased, but if the insured does not pass away, term insurance is mostly a financial expense with little benefit while alive).

Permanent Insurance

Now, let’s move on to permanent insurance, and here’s where the answer to your question lies. I will describe how most life insurance works in Canada, but please note there are exceptions, and certain contracts may work slightly differently. If you were told otherwise, don’t worry—it might just apply to your contract.

There are two types of permanent insurance: universal life and whole life.

Universal Life

The first insurance, universal life, consists of two parts: life insurance and an investment component. The policyholder (insured) can contribute additional funds to the investment part, which can be invested tax-free. The investment portion is an optional feature; the policyholder doesn’t have to contribute anything to it and is only required to pay for the life insurance itself.

If the policyholder wants to withdraw the investment part during their lifetime (before death), they must pay tax on the growth (this will not be considered a capital gain). It’s also important to note that there are different types of universal life insurance, namely yearly renewal (where the cost of insurance increases each year) and level (where the cost remains the same throughout the insured's life). It’s important to know that there are two types, but we don’t need to go into further details on that for this question.

How can universal life help during retirement?
If you do not contribute additional funds to the investment portion, this insurance won’t help you in retirement. However, if you have extra money after filling up all your RRSPs, TFSAs, and RESPs, and you still have more money, this insurance becomes useful. Note that all universal life policies issued from January 1, 2017, will be significantly reduced in the investment portion (i.e., you can invest much less money compared to policies taken before 2017). If you’re thinking about such insurance, you should act quickly, as insurance companies will be overwhelmed with applications by the end of the year.

Whole Life

The second option is whole life. This is an insurance that is typically paid for the rest of your life (although there is an option to pay it off over 20 years or more). There are two types of whole life insurance: participating and non-participating (those that participate or don’t participate in the company’s profits). You need the participating option.

How it works:
You buy insurance for a certain amount and pay the same premium every month. The insurance company makes a profit (rarely do they lose money, mostly due to crises like the fire in Fort McMurray or the flood in Calgary), and they distribute a portion of the profits to all the participants who have participating whole life insurance. The more coverage you have, the more “profits” you will receive (I’m putting “profits” in quotes because it’s not actual profit you receive, it’s dividends, which I’ll explain below).

The dividends are not the same as the dividends that shareholders of an insurance company receive. These are not related to the dividend tax credit. After the dividends are credited to your account (hence why I put it in quotes, because you don’t actually receive this money in cash), the insurance company uses them to buy more life insurance, increasing your coverage. The next year, your coverage amount increases, and you’ll earn more dividends.

Example:
If you take a life insurance policy for $100,000 and pay $150 per month, the insurance company earns money and credits you $10 in dividends. These dividends automatically buy an additional $1,000 of coverage. So, your life insurance policy is now worth $101,000. The following year, they credit you $15 in dividends because your coverage is now $101,000, and they buy another $1,100 worth of insurance.

The sum you accumulate is called cash value. You can withdraw it (i.e., in the example, your cash value will be $10 in the first year, then $15, totaling $25). If you withdraw all the money ($25), you’ll need to pay tax, and the insurance will no longer exist. You can withdraw part of the money (say, $14) and reduce your coverage, but the process isn’t proportional, and there’s a formula for this.

You can also borrow money from the insurance company using your cash value as collateral, without having to pay taxes on the loan. For example, you can borrow $20,000, pay only interest on the loan, and your life insurance will pay the $20,000 after your death, leaving your heirs with the difference.

If you bought this insurance 50 years ago (which is quite common — I set it up for children all the time), there could be quite a significant amount that could support you in retirement.

Conclusion

Permanent life insurance is often offered for long-term accumulation, but it is much more expensive than term insurance. If your budget is limited, term insurance is a better option, as it costs less and can provide the necessary coverage. If you have extra funds after filling up TFSA and RRSP, you might consider whole life or universal life insurance.

You don’t necessarily have to choose one or the other; you can combine a small whole life or universal life policy with a larger term life insurance policy for more coverage.

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If you have any further questions or would like to discuss it in more detail, feel free to reach out.

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