A major part of a financial picture is insurance, whether it be on yourself, your car, your business or anything else. Almost anything is insurable and the scope of things we can insure has grown rapidly over the past 25 years. It is even possible, as a farmer or vintner, to buy insurance against poor weather conditions! For the sake of the blog, however, I'll try to limit the insurance discussion to things that Canadians might (or should) think about as they grow old.
I think the best way to view insurance of any kind is as a hedge, or a form of protection. Yes, it is possible that insurance could be looked on as an investment as well, depending on your definition. If you think of it though, insurance is a way of keeping the odds in your favour, at a price.
For this article, I will keep the discussion to life insurance only, of which there are two main types:
1) Term insurance. This is normally the least expensive type of insurance, meant to pay you if you die during a specific term. A good example of this would be someone who buys a policy that would expire when they retire. If they were 40 and planned to retire when they were 60, then they would buy 20-year term insurance. That way, if they died unexpectedly during their 'earning' years (while their family depends on having an income), their loved ones would have something to help them get by until retirement. Because the odds of us dieing (touch wood) are much lower before we retire, this type of insurance is normally very cheap. With any term insurance policy, it expires at the end of the term with no value. It is possible to renew a policy, however, for another term. You might do this to avoid having to go through another medical examination (normally a requirement to get life insurance in the first place).
2) Whole Life or permanent insurance. As the name suggests, this policy is good for your whole life, meaning that your beneficiaries get paid when you die, regardless of the timing of your death. In my opinion, this type of insurance is good for protecting an asset that might otherwise be difficult to keep if you die. For some families, their cottage is a very important part of their lives and may have been in the family for multiple generations. The problem then becomes the tax that is going to be owed when the parents die and the kids inherit the place. By estimating the amount of tax we might have to pay on the cottage when it gets passed to the next generation (there is no tax to leave something to your spouse), we could buy a Whole Life insurance policy for that amount. Then the beneficiaries would have the money set aside to pay the tax on the cottage and keep the legacy alive. The best way to think of permanent insurance is that it is there to take care of a permanent problem, normally tax-related, that isn't likely to go away. There are types of permanent insurance that have an investment component as well (Universal Life) but I think that gets a bit complicated for today.
When should I buy insurance?
All situations are different of course but there are a few instances where I think insurance is a must. Remember, insurance is a hedge. It is meant to be there in case we die so that our loved ones can continue to lead as normal a life as possible. That's why in my opinion, the first time we should really think about insurance is when we have kids. Should anything happen to us, we would like our kids to have exactly the upbringing we had imagined for them. Insurance makes this possible.
I mentioned the cottage example. The same would apply for a second house, farm house or anything that you would like kept in the family but don't have the cash available to pay the capital gains tax.
There is the business example as well. If you owned a business with a partner and your partner died, would you have the money available to buy out their portion or would you want to risk being in business with someone new that you might not know? Or even worse, your partner's heirs have no interest in maintaining the business, you don't find a buyer and have to wind up the whole thing. You and your business partner can buy insurance on each other's lives to protect against this scenario.
Insurance as an investment
Insurance comes at a cost. Many people choose to avoid buying insurance for this reason - they would rather invest their savings themselves in order to leave something for their heirs. I don't have a problem with this logic, unless you die unexpectedly. Then you will need that money right away, leaving it no time to grow through investment. That's why I think it makes sense to look at insurance as an investment.
Let's say you want a Whole Life policy that has a death benefit of $1 million and you are 50 years old. The insurance company has looked at the results of your medical and deemed that to insure you for this policy, it will cost you $25,000/year over the next ten years, or $200,000 today to pay it in full (these are total ballpark numbers, by the way), if you prefer to get it over with. The insurance company is betting that you will live until the average life expectancy; let's say 85 years old. If you do, this policy would be in force for 35 years. That means if you invested the $200,000 yourself over 35 years, the rate of return to get it to $1 million would be about 4.7%; not a bad risk-free rate of return, but we could probably do better.
However, if something happened unexpectedly and you got hit by a bus one year after the policy went in force, you just invested $200,000 to get $1,000,000 in a year. That's a 400% return on your investment. THAT is the benefit of insurance. If you had chosen to invest the money yourself and got even 8%, you would have all of $216,000 when your heirs needed it.
A counter-argument might be that as we get older, our tax liability on something like a cottage would increase. So if anything happened to us earlier, we would pay less tax. That's a fair point. But keep in mind that an insurance policy is risk-free, as long as you make your payments (called premiums), regardless of what happens in the stock market, bond market, etc.
In conclusion, when thinking about insurance, think about the need and try to match the policy. If you need insurance only for while you're working, then buy it for only that long. Yes, the policy will expire worthless but guess what? That means you're still alive. Maybe it's a small price to pay to have the piece of mind that your heirs will be taken care of.
If the math works for you, then why take the chance?
Cheers.
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