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April 19, 2023

How does life insurance work?

10 min read

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If you’re considering life insurance, that usually means you’re at a transitional point in your life when you’re not just thinking about taking care of yourself anymore, you’re actually thinking beyond your own life, both emotionally and chronologically. Whether it be your spouse, your children, a business or a cause, life insurance allows you to care for others even when you’re not there.

At its most basic, life insurance is a way to make sure that the people you care for in life continue to be cared for after you’re gone. It’s also a way to carry your responsibilities with you beyond this life, so that in the event of your passing, your loved ones don’t have the added burden of worrying about how to pay the bills.

Of course life insurance can be much more than that too. So let’s look at the different types of life insurance, what goals they can help you accomplish, and how they actually work. Let’s start with a few definitions.

Glossary of terms

Beneficiary – This is the person or organization that receives your death benefit in the event of your passing

Cash value – If you have a permanent life insurance policy, it builds up cash value over time that you can use in various ways during your lifetime

Death benefit – The sum of money that is paid to your beneficiary in the event of your passing

Exclusion – An event or circumstance that is not covered under your policy

Living benefit (also known as critical illness insurance) – This is a ‘rider’ you can sometimes tack onto  a life insurance policy for an additional cost that allows you to collect part of the death benefit early if you’re diagnosed with a terminal illness. You can also buy this separately from life insurance in some cases.

Permanent life insurance – Also simply called permanent life, this is life insurance that covers you for your entire life, with no set term

Premium – This is the amount that you pay (usually monthly) for a life insurance policy

Term – the period of time during which a policy is in force

Term life insurance – Also simply called term life, this is life insurance that covers you for a set period of time

The basics

All life insurance includes a death benefit. This is the amount paid to your beneficiary when you pass away, and the main reason most people get life insurance. When you buy a life insurance policy, most brokers will ask “how much coverage” you want. They mean how much would you like the death benefit to be.

Common benefit levels are $250,000, $500,000 and $750,000. Your premium will depend on the benefit level you select Many people choose a benefit level that corresponds to approximately 10 to 15 years of their salary. Some opt for an amount that is sufficient to pay off their mortgage and other debts.

When you come to Mitch for life insurance, your broker will walk you through what we call a life needs analysis. This takes into account your income, assets, debts, goals (like trips, purchases, kids’ education and inheritance) and any other obligations, like perhaps a court order related to a divorce that requires you to have a certain amount of coverage. Based on this analysis, we will help you arrive at an optimal coverage amount and duration, and then find the best policy within your budget.

Beneficiaries

You as the policyholder decide who will be your beneficiary. If you choose multiple people or organizations, your death benefit will be split equally amongst them. Usually your spouse or children are named as beneficiaries, but it can be a friend or even a favourite charity.

In most cases, the policyholder can change their beneficiary at any time during the term of the policy. Some people choose to make their beneficiary irrevocable, meaning both the policyholder and the beneficiary need to agree before a change is made. Changing your will does not change your life insurance beneficiary.

It’s also a good idea to name a contingent beneficiary. This is someone who would receive the death benefit if your primary beneficiary is not alive to receive it. In most cases, the contingent beneficiary would be a close friend or relative who you trust to use the money to care for your children, for example. If you make your minor children contingent beneficiaries, they won’t be able to access the funds until they turn 18. Assuming you have a will, the money will go to whoever you have named as their guardian, in trust.

Cost

Your exact premium will depend on a number of factors. Your broker will go over a number of questions with you to determine the following:

  • Type of policy (Permanent life is more expensive to start, but more affordable in the long run)
  • Term (the shorter the term, the lower the premium)
  • Benefit level (the higher the benefit, the higher the premium)
  • Age (you’ll get a better rate the younger you are at the start of the policy)
  • Gender (women pay less because they typically live longer)
  • Tobacco use (smokers, vapers or chewers of tobacco pay higher premiums)
  • Health and lifestyle (you may pay more if you suffer from certain conditions or undertake risky activities like skydiving)

Just to give you a rough idea of what you might expect to pay for life insurance, a 40-year-old male non smoker in fairly good health with no major risk factors might expect to pay around $45 a month for a 20-year renewable term life policy with a $500,000 death benefit.

Permanent life insurance is more expensive in general than term life, because in addition to a death benefit, the policy also builds cash value during your lifetime, so it is also a way of saving and investing.

Qualifying for coverage

In most cases, you will be approved for coverage based on a questionnaire, your medical records, and possibly some follow-up tests depending on what your records reveal. It’s very rare that you would be declined coverage altogether, but certain health conditions or lifestyle choices (like smoking, skydiving) may impact your premium and the amount of coverage available to you.

What is not covered?

Exclusions are circumstances under which your coverage would not apply and your beneficiary would not receive a death benefit. Exclusions are always listed specifically in your policy, but generally include:

  • Suicide – Some policies remove this exclusion after two years
  • Crime – If you die while committing a crime
  • Pre-existing conditions – If you die from something you already knew you had when you bought the policy
  • Recklessness – If you die while street racing for example

How long does coverage last?

How long you’re covered depends on what kind of life insurance you buy.  If you buy term life, you can choose a term of 10, 20 or 30 years. If you choose permanent life, you’re covered for your entire life. In both cases, you need to continue paying your premiums in order to keep the policy in force.

The only other way that your policy can be cancelled before the end of the term, other than non-payment of premiums, is if your insurance company discovers that you lied on your application. Your insurance will not be cancelled just because you get sick or injured during the policy term.

But keep in mind that if you have a 10-year non-renewable term policy and the term ends, you are back at square one.  So if you have a serious illness at that time, it will probably affect your eligibility for coverage and your premium if you want to sign up for a new term.

That’s why we recommend getting a renewable term policy or permanent life if it fits your budget. With permanent life insurance, whatever life throws at you, as long as you pay your premiums, you’re covered. With a renewable term policy, your premiums will increase on renewal, but only a pre-determined amount. That means that you can extend your coverage without having to requalify.

How to make a claim

We always recommend that you make your beneficiaries aware of your policy and their status as beneficiaries. Ordinarily, should you pass away, your beneficiaries would simply contact Mitch to begin the process of making a claim. There is a certain amount of paperwork required, starting with the death certificate.

Your beneficiaries have up to a year from your passing to start a claim. It can take up to a month for the insurance company to process your claim. This could take longer if there is doubt about whether the claim is valid and further investigation is required.

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Term life insurance

The simplest form of life insurance is called term life, and as the name suggests, you buy it for a set term or period of time. The most common terms are 10, 20 and 30 years. There are also options for terms to age 65, 80 and 100, regardless of how old you are at the start of the term.

Your age when you apply can affect what length of term you are eligible for. So for example, if you apply at age 70, you may be eligible for a 10-year term, but probably not 30. Likewise, your age can also affect the renewal terms for a renewable policy. So a 20-year term bought at age 60 may only be renewable to age 85.

Most term life policies can be converted into permanent life.

Permanent life insurance

Permanent life insurance is life insurance for your entire life, and includes a cash value component that you can use in different ways depending on the specific type of policy you choose. In terms of short-term cost, permanent life can’t compare to term insurance, with monthly premiums for a policy starting at age 30 costing more than eight times as much as you would pay for a 20-year term policy. The advantage of permanent life is that your premiums stay fixed, whereas term premiums keep going up the older you get. Plus the cash value, which is not a feature of term insurance.

  • Whole life – This is the most common type of permanent life insurance. Your premium and benefit never change, and your cash value is almost like a GIC that grows at a set rate, so you know what the cash value will be at a given point in time.
  • Universal life – This is a more flexible policy where you have more choices in terms of investing the cash value. Premiums, coverage and investment returns can vary.
  • Participating life – With this kind of policy, you rely on the insurance company to invest the funds for you. Again, returns vary, but you don’t choose the investments.

With most permanent life insurance policies, if you live past 100, you no longer have to pay premiums and your coverage stays in place for life. There are also options that allow for a higher premium at the start in order to “pay off” the policy, say in 20 or 30 years. After that, your coverage is in place for life and you never have to pay premiums again.

What is layered life insurance?

What you want out of life insurance can and does change over time. A layered approach to life insurance means that you get coverage to match your evolving needs. So for example, if you have young kids, you might want a fairly large death benefit in case something happens to you while they’re growing up. After that, you may not feel compelled to maintain that high a benefit, but you may want to make sure that your funeral expenses are covered. So you could get a 20-year term policy for $500,000, plus a much smaller whole life policy, say for $50,000, that would pay your funeral expenses regardless of when you pass away.

How does cash value work in permanent life insurance?

With permanent life insurance, part of your monthly premium is actually going towards maintaining your coverage (or death benefit), and the other part is going toward building cash value over time. In most cases, you can’t access the cash value for the first five years of the policy. Once the waiting period has passed, you can then use the cash value in a number of ways depending on the type of policy you have.

With participating life, cash value is paid out in dividends that you can use to increase your coverage, reduce your monthly premiums, or in some cases you can just take the money.

With whole life or universal life, as the cash value builds, you can withdraw a certain portion, but that will reduce your death benefit. If you want to maintain your death benefit, you can take out a low-interest loan (better than any bank) against your cash value, and repay it over time.

If you want to access the full cash value all at once, you would cash out the policy. This means that you would get the cash value, and there would no longer be a death benefit.

Reasons to get life insurance

Life insurance comes in many different forms, and can serve different purposes for different people. Here are some of the more common reasons people decide to buy life insurance:

  1. Children – When you have children, it’s common to think about how they would be impacted if something were to happen to you. Life insurance ensures they will continue to have an income if you’re gone.
  2. Home – Many people choose to get life insurance to pay off their mortgage if they die unexpectedly.
  3. Debts – In addition to a mortgage, you may want to pay off other debts so that your spouse or children are not left to pay them.
  4. Education – Again, if you have children, you might want to make sure that their post-secondary education is paid for should something happen to you.
  5. Funeral expenses – Even if you have no debts and your children are grown, you may want to leave behind enough to cover your final expenses.
  6. Divorce – Some divorce agreements include a requirement for each party to maintain a certain amount of life insurance to ensure the financial wellbeing of the children.
  7. Business – If you are a vital contributor to a business, particularly one that you own, you may want to leave something behind if you pass unexpectedly, to help the business survive the transition while they work to fill your various roles.
  8. Legacy – Many of us feel strongly about leaving a lasting legacy after we’re gone. That can be in the form of an inheritance or trust fund for our children, a donation to a favourite charity or something else.
  9. Rainy day – Permanent life insurance is attractive to some people because they know they can tap into the cash value of the policy in an emergency.
  10. Tax planning – Some types of permanent life insurance, like universal life, can be used as a tax shelter.

Tax implications of life insurance

First of all, you cannot write off your life insurance premiums as they are a personal expense. On the flip side, your beneficiaries won’t have to pay tax on the death benefit. So if you have a term policy, the tax implications are non-existent. If you opt for permanent life on the other hand, the cash value in the policy will accumulate tax-free.  But any withdrawals or loans you take on the cash value during your lifetime will likely have tax implications. As mentioned, policies like universal life can sometimes be used as a tax shelter.

Want to know more about life insurance?

Mitch works with some of the best life insurance companies in Canada, so we’re able to set you up with just about any type of policy at a price that works for you. One of our life insurance specialists would be happy to go over your options with you. Give us a call today.

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Mitch Team

The articles you'll find on the Mitch blog are all the result of a team effort, contributed to by one or more of our RIBO licensed insurance brokers and/or other Ontario insurance experts. Contributors to our blog include:

  • Adam Mitchell (RIBO) - President and CEO of Mitch Insurance Brokers
  • Nick Kidd (RIBO) - Chief innovation officer at Mitch, & director of business insurance
  • Alex Gemmiti (BSc, CIP, RIBO) - Service team lead at Mitch Insurance
  • Jesica Ryzynski (RIBO) - Insurance broker, claims specialist, and account manager at Mitch Insurance

Learn more about the Mitch Team


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