Life insurance can be more than insuring your life. Did you know that you can also build wealth via life insurance? Find out how in this article
Life insurance carries several unique features that make it an attractive asset that many high-net-worth families can use to manage their wealth.
Unlike liquid assets – such as stocks, shares, and bonds – whose values fluctuate depending on the market conditions, most types of life insurance policies are immune to market volatility. This form of coverage also has the potential to generate huge savings as the benefits paid out are generally non-taxable.
But these are just a few of the many advantages of using life insurance as a part of a broader wealth management plan. In this article, Wealth Professional discusses the role life insurance plays in helping affluent Canadians grow, preserve, and manage their wealth. We will also explain how the different types of policies work, and which individuals and groups can benefit the most in taking out the right coverage.
Some high-net-worth individuals may be attracted to life insurance because of the tax-free savings and investment opportunities that such policies provide. Life insurance plans can also allow them to keep their wealth in the family. However, regardless of net worth, there are certain types of individuals who can benefit the most from taking out life insurance. These include:
- Married couples with children
- Those who have dependents with special needs
- Those who owe co-signed debts, including mortgage and student loans
- Parties to a divorce
- Business owners and their partners
As a person’s wealth grows, so does their need for lifestyle, business, and estate planning. This is where life insurance comes into play. If utilized strategically, this type of financial instrument can play an important role in helping high-net-worth individuals maximize and protect their wealth.
Here are some of the ways industry experts say affluent Canadians can use life policies to enhance and preserve their financial capital.
1. Asset protection
Because life insurance is designed to benefit the policyholder’s family, policies generally receive legislative protection from creditor claims when they are structured as such.
“Where there is a named family class beneficiary, the insurance proceeds do not fall into the estate of the deceased and are thus not subject to the deceased’s creditors,” explained Joseph Sardo, vice-president and portfolio manager, and Wesley Smith, associate advisor and financial planner, both from RBC Wealth Management, in an asset management guide.
The experts added that if the life insurance policy has a preferred beneficiary or irrevocable designation, it is often beyond the reach of creditors during the policyholder’s lifetime.
2. Estate tax funding
At the time of death, a person is presumed to have disposed of all their assets and an executor or liquidator is expected to pay the associated tax before distributing the estate. These include:
- The total value of a registered retirement savings plan (RRSP)
- The total value of a registered retirement income fund (RRIF)
- Capital gains realized on non-registered investments
And because of the substantial wealth involved in these assets, they are also often subjected to the highest tax rates. This leads to the legacy being significantly smaller than the original assets. A life insurance policy can help pay these taxes to preserve the asset’s value.
“Insurance can provide immediate and tax-free liquidity to satisfy estate obligations, including taxes, probate, and estate settlement costs,” noted the RBC experts. “These obligations can be satisfied on either a single life or joint last-to-die basis, as circumstances may require.”
3. Tax-free death benefit
Death benefit payouts from a life insurance policy are not taxable. This means the beneficiaries will receive the whole amount that the policyholder has left them. In addition, permanent life insurance plans allow the insured to potentially grow the money their loved ones are set to inherit, also exempted from taxes.
4. Diversifying portfolio
Permanent life insurance is considered as a “non-correlated asset,” meaning its value is not affected by market fluctuations, unlike other asset classes, including bonds, stocks, and gold. This allows policyholders to invest in an asset that reacts differently to market conditions. For whole life plans, the cash value is guaranteed and may even increase, depending on how the policy performs.
5. Estate equalization
For business-owner families, life insurance can be used if they want to pass along a business with multiple beneficiaries to a single family member. This likewise allows them to bequeath the entire business to one family member while still leaving something for their other dependents.
According to brokerage firm Life Insurance Canada, estate equalization operates this way: “The business owner takes out a life insurance policy worth the value of the business and names the other dependent (who isn’t inheriting the business) as beneficiary. If there are more children, additional life insurance policies worth the same amount can be purchased. This life insurance strategy also generates more wealth for the next generations, doubling or tripling the business owner’s estate value when they die.”
6. Funding buyout agreements
A buy-sell life insurance agreement is designed to protect a business in the event a co-owner dies. In such an agreement, the death benefit is used to fund buy-sell transactions. Typically, the benefit amount depends on a relative portion of the company’s value. If there are two co-owners, for example, the death benefit will be 50% of the business’s worth. The money is then given to the late owner’s family, while their stake goes to the surviving partner.
A buyout agreement often happens when the remaining owners are not interested in having the deceased’s family stay involved in the business and the family likewise shows no interest in doing so.
There are several ways a buy-sell transaction goes. These include using the proceeds to redeem shares or paying a capital dividend to fund a personal purchase of shares from the deceased’s estate. To avoid confusion and potential conflict later, the buyout process – including the intended use of the life insurance benefits and the capital dividend account – should be documented in the co-owner's agreement.
7. Key employee insurance
This type of protection is essentially a life insurance policy that covers a vital team member and provides financial benefit to the company at the time of the employee’s death. It is particularly useful for businesses that rely on specific workers for critical tasks. The payout is intended to provide monetary support as the company goes through a transition period to find and train a replacement.
8. Charitable giving
Many high-net-worth individuals use permanent life insurance to make a significant charitable donation in two ways:
- Gifting insurance proceeds to charity by designating a charity as the beneficiary of a policy, and receiving a charitable receipt for the year of death to reduce estate tax liabilities
- Gifting an insurance policy to charity and obtaining a receipt for the annual premium payments to reduce ongoing tax liabilities
Either way, the charitable institution will receive a substantial amount at the time of the person’s death.
Here’s a recap of how high-net-worth individuals can use life insurance to grow, manage, and protect their wealth.
Life insurance comes in several variations, with each type offering different levels of protection and wealth accumulation opportunities. But before high-net-worth individuals can make the most out of these investment opportunities, they must first understand how each policy works.
Life insurance plans work by providing a tax-free lump-sum payment to the policyholder’s family after they die. Coverage generally falls into two categories:
1: Term life insurance
As the name suggests, this type of policy covers the policyholder for a set term. It pays out a death benefit if the insured dies within a specified period, meaning they can only access the payment in the years when the plan is active.
Once the term expires, the policyholder has three options:
- Renew the policy for another term
- Convert the policy to permanent coverage
- Terminate the policy
Term life insurance premiums typically increase every time the policy is renewed, often in five, 10, or 20-year “steps,” according to the Canadian Life and Health Insurance Association (CLHIA). If the policyholder chooses to turn their plan into permanent coverage, they can do so without the need for further underwriting but only if it is with the same insurer. This allows them to adjust coverage features to address their long-term needs.
Unlike permanent plans, however, term life policies do not accumulate cash value. This means the insured cannot borrow against their policies or get any cash value back if they cancel.
2: Permanent life insurance
Permanent life insurance plans provide guaranteed lifetime coverage and a cash value element that builds up over time. This value can also be used as collateral if the policyholder decides to borrow. If the policy is voluntarily terminated before maturity or death, the insurance company pays the policyholder the cash surrender value.
Permanent life insurance plans often play a key part in estate planning, allowing businesses to accumulate value long-term and cover estate taxes. Coverage comes in two main types, with each combining the death benefit with a savings component. These are:
1: Whole life insurance
This type of policy offers coverage for the entire lifetime of the insured and the savings can grow at a guaranteed rate. Whole life plans can be non-participating or participating.
- Non-participating whole life insurance: Provides a tax-free death benefit with lifetime coverage and accumulates a guaranteed cash value that policyholders can borrow against.
- Participating whole life insurance: In addition to the guaranteed death benefit, this can generate dividends, depending on how the insurer performs. These dividends are typically issued to the policyholder annually.
2: Universal life insurance
This type of policy uses different premium structures, with the earnings based on how the market performs. Policyholders also have some flexibility in where the funds are invested in, which makes it a riskier option.
Cost is among the biggest drawbacks of permanent life insurance plans. It requires policyholders to pay higher premiums compared to term life coverage. Permanent policies can also have tax implications if the beneficiaries opt to surrender coverage or if the insured dies with outstanding loans. Additionally, borrowing from the cash value or accessing accelerated benefits can reduce the payout amount.
Life insurance policyholders are required to designate a person who will receive the death benefit, also referred to as the beneficiary. This can be the insured’s spouse, immediate family, other relatives, friends, business partners, or even a charitable organization. Policyholders are also allowed to name several beneficiaries for their life insurance plans and assign how much benefit each person or group will receive.
There are two types of beneficiaries:
- Revocable: Those who the policyholder can replace at any time without needing to inform them
- Irrevocable: Those who the policyholder cannot replace unless they secure a written permission from the beneficiaries
What about you? Do you think wealthy people need life insurance, or can anyone benefit? Do you see life insurance as an effective investment tool? Share your thoughts in the comment box below.