term life insurance

Whole Life and Universal Life Insurance

Why You Need To Know the Difference

I once wrote an article about the use of Universal Life Insurance Policies for those who had used up their RRSP limits or whose taxable income was so low that they did not get a meaningful tax credit for RRSP contributions. The article elicited a number of questions about the difference between traditional “Whole Life” Policies and the new “Universal Life” Policies. I felt that the discussions I have had with several clients might be of interest.

First, there are essentially four parts to both whole life and universal life insurance policies.

Mortality Cost – the part of the deposit that covers the pure cost of the life insurance death benefit. We recommend that this cost of insurance be level or the same over the insured’s lifetime.

Administration charge – this is the charge for administering the policy and premium tax.

Savings or Investment. This is what is left from your deposit after the above two charges – the cost of insurance and the administration charge are deducted. You will have been provided with an illustration of how your savings will grow – it is frequently referred to as the “Cash Value”, “Fund Value” or “Cash Surrender Value” of your policy.

Return on the savings – this is the interest rate that is credited to the cash value in your account each year.

In addition, some policies guaranty that the above costs will not change and a minimum return on investments.

Whole Life Policies were designed to provide permanent insurance (the kind that you plan to have when you die) plus have a savings component at a single monthly premium. There has been a lot of this product sold over the years.

Whole Life Insurance has a level cost of insurance where the costs do not increase each year – what you pay in the first year is the same as in the last year but they do not disclose the cost of insurance. They also do not disclose the administration costs. After the “cost of insurance” and “administration costs” are covered, the balance of the premium is the savings or investment portion. The returns on the savings or investment part is dependent upon excess interest and investment earnings, savings in mortality costs, the operating expenses and the will of “the insurance company board of directors” – they choose what they will pay.

To summarize, apart from a minimum guaranteed return, the policies do not disclose the cost of insurance, the administration costs, or how they calculate the returns on your savings portion. You can not choose where the money is invested and they do not disclose the return you are receiving. You will have an illustration showing a guaranteed “cash value” and another cash value which reflects non guaranteed projected returns.

Universal life insurance policies were designed to provide an answer to the advice that you should “buy term insurance and invest the difference”. In addition it provides an answer to some of the complaints about Whole Life Insurance’s failure to disclose how the premium is allocated between the cost of insurance, administration costs, and investment portion and to provide investment options that you can choose.

In a Universal Life Insurance Policy, the mortality charges are disclosed and, as mentioned before, I recommend that they should be level (they do not increase as you get older). The administration charges are also identified and frequently guaranteed not to change for the life of the policy. They are generally in the $100 to $125 per annum range. Consequently, the cost of insurance and administrative costs can be shown on the illustration.

It is the investment options inside a Universal Life Policy that have grown dramatically over the past four years. While some of the older policies did not disclose how the returns were calculated, the newer ones are offering a list of investment options that have similarities to mutual funds. In fact, some are designed to provide returns that mirror well known mutual funds and they are managed by mutual funds managers. Examples include, Standard and Poor Index Accounts, Canadian Index Accounts, Canadian and American Equity Index Accounts, Bond Index Accounts, and 1, 5,and 10 Year GIC Type Accounts.

The returns inside an insurance policy are generally slightly lower than mutual funds will generate but they have four significant advantages compared to mutual funds.

The funds grow tax-free – you do not pay any income tax on the growth. This is similar to an RRSP, however unlike RRSP’s there are ways to have the use of the money on a very tax favoured basis. This was the subject of my previous article on Leveraged Deferred Compensation Plans. I would be pleased to forward a copy of this article to those who feel that it might be of interest.

You can invest 100% of the savings/investment component in an index where the returns are based on the performance of an index outside Canada. Options include S&P Indexes, American and Global Equity Indexes, and Bond Indexes. Some indexes are tied directly to the performance of well known mutual funds with one policy offering access to indices that emulate over 400

The funds are “creditor proofed” if the policy is set up properly. Creditors can not get at the funds inside this policy, which is important for many business owners and others who are concerned about lawsuits.

If the policy is set up properly, the entire investment account plus the face value of the insurance policy goes to the beneficiary tax-free on death of the insured. There are not even any Probate Fees. The same applies to a whole life policy but the cash value may or may not be in addition to the face value depending on the type of Whole Life Policy

Let me provide an example of the different tax treatment on money in an RRSP and a Universal Life Insurance Policy on death. Let us assume that Peter had $100,000 in the investment part of a Universal Life Insurance Policy and $100,000 in a standard mutual fund and died. The entire investment account of $100,000 would pass to Peter’s beneficiaries (provided they were identified in the policy) together with the face value of the policy with no taxes or probate fees. Further, the cheque could be issued within a few days of proof of death. The same applies to the Whole Life Policy with the caution of point 4 above.

The mutual fund $100,000 would be subject to both income taxes (likely at a tax rate of about 43%) and probate fees and the funds may not be released until after the estate has gone through probate and has been settled.

It is my experience that Universal Life Insurance Policies are being used for estate planning as much as they are for meeting traditional insurance needs. There are numerous tax saving and estate planning strategies that utilize this type of insurance.

It may be advantageous to stop contributing to an RRSP when you believe that you already have sufficient RRSP funds for retirement and set up a Universal Life Policy. It should be noted that consideration of whether this strategy would be of benefit and then when to start it, should be part of your retirement and estate planning process.

The face value of the policy can cover anticipated estate taxes and a savings component grows tax-free and will pass on to your beneficiaries without the probate fees and a potential 50% tax hit that the RRSP funds experience. You can still get at the money in the savings portion if it becomes necessary but in a significantly tax favoured basis compared to withdrawing money from an RRSP. The downside is that you do not have the tax credit on your RRSP contribution but it still may make sense from an estate planning perspective.

This is a complex subject and I could have written a small book on it but I hope that you will find this overview of benefit.

 

Life Insurance Fundamentals

Term Insurance Explained

Life insurance comes in two types – temporary and permanent. Most people have some type of temporary insurance either as a term insurance policy, mortgage insurance, or group insurance policy (likely through work or an association plan like an automobile club). Some also have permanent insurance either in the form of whole life, insurance, universal life insurance, or Term to 100 Insurance. ce.

The purpose of this insurance is usually for a short term or temporary need (to age 55 or 65 while the family is growing up and you are saving for retirement. It is to provide cash in the event of your death so those who depend on you will have the money to:

Settle your debts – mortgages, loans (business & personal), remove guarantees, make up for the income you provided to the family – Remember the impact of inflation when doing this calculation. At 3% inflation, a need to supplement income by $25,000 will grow to $50,000 in 24 years.

Provide for children’s education, marriage etc.

Complete the funding for your spouses retirement plan – very important and why many need some term insurance to age 65 – this can also be a consideration for those looking for permanent insurance as well.

For businesses, it can be to fund a buy/sell agreement or to provide insurance on a key employee to provide cash to find a new person, absorb the financial shock of the loss and have additional funds to pass on to the family.

You can see the temporary nature of this insurance. It has a specific relatively short term purpose which will no longer apply by at least age 65. This insurance can be very inexpensive for the amount you are purchasing ($1 million can cost between $60 and $100 per month depending on age, sex and smoking habits) because most people will never collect it. It is purchased to cover you life when you are relatively young and the need is frequently gone by age 55 or age 65 for some of those concerned about saving for retirement.

It generally comes in 5, 10, 15, and 20 year terms. This means that the premiums are guaranteed for that period of time and they will automatically renew at a higher rate for the next term period. For example, a 10 year term policy has guaranteed rates for the first ten years and then you can renew it for another ten years without a medical at a set rate contained in the policy. Do not renew it if your health is good as the renewal rates can be 25% to 100% more than the premiums if you shop around for a new policy. The assumption is that you only renew if you are too sick to get a new policy.

Money Saving Tip 1: Over half the people renew term insurance and pay these high premiums – get a new policy – with preferred term rates it might be less than you were paying.

At one time, insurance premiums were divided into smokers and non smokers. However, the companies now have statistics that enable them to determine those who are least likely to die based on lifestyle, family history and blood pressure and some measurements they get from blood samples, such as cholersterol levels. About half the people will qualify for a preferred rate. At the time of this writing, a 35 year old should be able to purchase $500,000 for about $35 per month at regular rates but preferred rates would be in the $25 per month range. Some companies also offer a preferred smoker rate for those who would qualify for a preferred rate but they smoke.

Finally, there is the issue of convertible. You will see most policies are renewable which means you can renew them for another term of say 10 years and convertible. Convertible means you have the right to convert all or part of the policy to a Permanent Policy at any time during the term without a medical. You just pay whatever the rates are at the time of conversion. If you policy was issued on a preferred basis some allow you to convert on a preferred basis if they have preferred universal life insurance rates. This is an inexpensive option that is usually built into the policy cost and worth the extra price. A few companies will offer policies without this conversion option for a small savings.

Money Saving Tip 2: Ask for preferred rates. Refer to the sample questionnaire to see if you would qualify at Preferred Insurance Levels.

Money Saving Tip 3: There are significant differences between some companies in the percentage of people who will qualify for preferred rates ranging from under 50% to over 75%. Ask me about this.

Money Saving Tip 4: If you are a smoker of cigars or enjoy a pipe, some companies will consider you to be a non smoker. Make sure you get this rate.

It is not expensive to move the financial risks to your family of your death to an insurance company and it is the responsible thing to do.

Remember, the impact of inflation when doing this calculation. At 3% inflation, a need to supplement income by $25,000 will grow to $50,000 in 24 years.