What kind of insurance?

Don’t worry, we will get to the more exciting investing stuff in a couple more issues, in the meantime, carrying on from insurance economics …

You have made your best guess of the amount of insurance you need, and for how long, and padded it a bit for uncertainties. What kind should you buy? There are only two choices. Your vehicle can be leased or bought. Your house can be bought or rented. Same with insurance, you can rent it or buy it.

Term insurance is renting an amount of insurance coverage for a specified time. Permanent insurance, the most common form being “whole life”, is buying coverage that will be permanently in place. You may hear debates about which is better, for example, “buy term and invest the difference”. One kind of insurance is no better than another, there is only the right insurance for you: which product gives you the best value for your money in meeting your need, for the period that you have defined. The permanent needs are most cost-effectively covered by permanent insurance products. A defined period need, like a mortgage, is more cost-effectively covered by renting term insurance.

You define the insurance portion of your financial plan based on your risk management needs, in terms of amounts and the term of coverage, and to rent or buy. It is time to go shopping.

Shopping for insurance

Let’s compare to shopping for a car. You have defined your need as a four door sedan for the family and a panel van for your business. You visit a number of car dealers. They will all have different names for their sedans, and perhaps several models from compact to full size, all with a range of engine, transmission and trim options. So will the insurance companies. This is why you need to know how much of which size of sedan you actually need, or length of lease you want on the van. Some of the options offered may sound of value to you. But like the better trim levels of a mid-sized sedan, there is a cost. Carefully evaluate if the marginal cost of a feature will give you more marginal utility, better value for your money, or is it just so much snake oil from the salesman?

I have a beef with insurance salesmen who sell “double indemnity”, where the policy pays double the face value if you die accidentally. Everyone expects if they die prematurely, it will likely be in an accident, and the extra premium is not much. Reality check! Insurance companies are not charities. Double indemnity is only cheap because the odds are ten to one you will die from natural causes, even in your 30s, than from an accident. Secondly, remember you have defined the need, say for $500,000 of coverage. Buying a $250,000 policy with a double indemnity rider is not good risk protection. On the other hand, buying $500,000, then adding double indemnity is a waste of money. Buy a lottery ticket instead of double indemnity!

Term insurance is less open to product differentiation by the companies when they are trying to establish greater “value” in their brand names. The most common variants are ten year term or twenty year term. The shorter term costs less. It is covering less risk for younger ages when the cost per thousand is less than it is in the later years of the twenty year term. Insurance companies use T10 products as a bit of a loss leader to get clients signed up to their brand. However, if you have defined the need period as twenty years, say to pay off the mortgage and get the kids through college, then the higher premium T20 will be more cost effective over your defined term need than renewing, at a much higher premium, after the first ten.

Like everything, there is an exception. The first need is to provide for the amount of coverage needed. You and your spouse might determine $500,000 coverage is the minimum need if one of you were lost now. But in your early thirties, in a new job, with two pre-schoolers and a new home, scarce resources are even scarcer. Even if the ideal plan says you should use $100,000 permanent and $400,000 term, it may be better at this point to use a ten year term for $500,000. That would cost $68.85/month for two thirty year old non-smokers, versus $231.48/month for the “better” combination. But build it into your plan to convert $100,000 of the term to permanent in five years.

There is one more thing you can do to reduce your cost of insurance: quit smoking. Even a social puff at a party in the last twelve months can classify you as a smoker, and the premiums are close to double. A smoker may be better off with a Term 10 and a financial plan to quit so that they could convert to a longer term at non-smoker rates later. This is managing a risk by reducing your risk factors. Insurance companies may not be charities but they are competitive businesses and will give you a better rate if you can give them a better risk.

A common need for term insurance is when buying a home and signing up for a mortgage. As an aside, my first insurance advice is to get a twenty percent down payment by hook or crook. You can only buy a home with 5% down by paying a huge up front insurance premium to Central Mortgage and Housing Corporation – and it only protects the lender. This cost is almost hidden when you are looking at whether you can afford the PIT payments. But in fact it eats up most of the 5% minimum down payment so your down payment “equity” is almost nil when you begin your mortgage payments.

Whatever financial institution you have applied to will also try to sell you “Mortgage” insurance, often giving the impression that you “have to” for the mortgage to be approved. This is called “tied-selling” and is a violation of regulations. It is also a bad deal. While you make the payments, the bank owns the insurance and makes itself the beneficiary. In some cases, an insurance contract is not even issued (very few bank officials are licensed to sell insurance). It is only “underwritten” when a claim is made and if there were any reason for denial of the original application, such as a medical condition, no insurance payout is made. CBC’s Market Place did an expose of this racket a few years ago; it is still on the net at:
https://www.youtube.com/watch?v=qe61HVGIwUo. Rob Garrick of the Globe & Mail recently did a column calling this insurance as a “junk product”. And the financial industry wonders why it has a bad reputation!

Insurance related to mortgages is another example of regulation not doing anything for you. All of the regulated requirements, from CMHC to title insurance and property insurance and traditional “mortgage” insurance only protect the lender. There is no regulation of any insurance requirement that protects the borrower!

More people are using mortgage brokers who deal with a variety of lenders and can advocate for you as the borrower. Benesure created Mortgage Protection Plan marketed through mortgage brokers. Coverage is underwritten by Manulife (who also bought Benesure a couple of years ago, it’s an incestuous business.) Mortgage brokers are regulated by securities commissions and are not licensed to sell insurance. They just print the form, have you accept or waive, and fax it to Benesure. Your business relationship will be with Benesure, who will pay your broker a referral fee. MPP is an improvement over bank insurance in that you “own” it and can transfer the coverage between lenders if you want to renew your mortgage later with a different lender, but it has its own limitations in that the lender is still the beneficiary, and benefits are tied to and limited to the mortgage. Most financial planners today recommend covering a mortgage liability risk with independent term insurance that you own and designate the beneficiary, who can use the proceeds as most needed at that time.

There are other variations of term that an insurance broker, who also deals with multiple companies, can recommend to fully match your needs. Decreasing term products reduce to 50% of the face value over the first two thirds of the term, then level off at 50% for the rest of the term. This can better match a decreasing insurance amount need, as the kids get closer to independence and the mortgage gets paid down, while still giving adequate coverage for the rest of the term. Better matching the coverage to the need will reduce the cost. If a “mortgage” protection plan were maintained as it approached zero face value, one would be paying a lot for not much insurance.

There are three choices for insuring permanent needs. One is Term to 100, which always pays off but does not accumulate any investment as a cash value. The most common permanent insurance is Whole Life which accumulates an investment. The investment portion is controlled by the insurance company and it is invested very conservatively, partly because of regulations. Nevertheless, Whole Life can play a role in many financial plans at the conservative end of the portfolio.

The “new” form of permanent insurance is called Universal Life, again marketed by insurance companies under various brand names like Innovision or Genesis. Manulife recently updated its UL product line calling it “Manulife UL” – how innovative, calling something what it is! UL is the most flexible form of insurance offered today. It is effectively “buy term and invest the difference”, but this strategy is combined into one contract, with legal and tax advantages. It gives you choices how you pay for the insurance (e.g. yearly renewable term or level cost of insurance) and whether you want the insurance to decline as the investment increases (level face value). You choose how you want the investments handled from fixed income to equities. The best feature is provided by CRA as the investment earnings are tax sheltered, like a TFSA. Yes, insurance should be part of your tax management strategy too.

In a complete financial plan, Universal Life can create your own insurance company for self-insuring risks in your last trimester, from critical illness to long term care to a pension supplement to legacy bequests, to paying off Revenue Canada to preserve your estate.

Fredrick Petrie, author of “THE END OF WORK: financial planning for people with better things to do”, practices financial planning at Mortgage Logic, 1793 Portage Ave., Winnipeg, MB.  (204) 298-2900