Cost of Insurance and Death Benefit: Level vs Increasing

As mentioned in one of my first few posts, insurance is a very critical part of solidifying your financial foundation. Using the UL (Universal Life -- Permanent Insurance) can be a very beneficial strategy for you, if used properly.

However, a couple of the things that usually don't get talked about much are, how the insurance cost is actually broken down, and how the death benefit is calculated.

Cost of Insurance

Essentially, there are 2 ways cost of insurance is calculated; you can have Level Cost of Insurance or Increasing Cost of Insurance.

Level - Pretty straight forward; means that the cost of insurance will remain the same over the entire life of the policy

Increasing - Also pretty straight forward; means that the cost of insurance will rise every year over the life of the policy. Originally, cost of insurance will be a lot lower during the earlier years, to allow for more money to go towards the investment portion of the policy. However, over time the cost of insurance will surpass that of "level cost of insurance" and the policy will cost more to maintain.

Both strategies have their pros and cons and you should crunch the numbers for both strategies to see which one works best for you for the amount that you are contributing to your policy.

Death Benefit

Just as there is Increasing and Level Cost of insurance, there is also Increasing and Level Death Benefit.

With an Increasing Death Benefit, your insured amount stays fixed, while your death benefit increases with the accumlated savings.

Using an example of $500,000 Insured amount, plus $100,000 in the savings component, with an Increasing Death Benefit, the total payout would be $600,000 upon death. This is advantageous because you can increase your tax-free benefit to your heirs.

With a Level Death Benefit, the death benefit stays fixed and the insured amount decreases as your savings increase (thus decreasing the cost of insurance). Using the above example, the death benefit would be a total of $500,000 ($400,000 that the insurance company is giving you, and $100,000 of your own investments).

The benefit is that the overall cost of insurance is going to be lower, because as your investment amount increase, proportionally that's how much less coverage you will be paying for; therefore allowing more of your premium to go towards the investment amount.

However, once the investment amount has surpassed the face amount, the death benefit paid to your beneficiaries increases. For example, if you originally bought a policy with a face amount of $500,000, and later on in life your investment portion grows to $750,000, your beneficiary would actually receive the full $750,000, not $500,000.

Here's a great visual example that I got from the sunlife.ca website:

Level death benefit For fixed insurance needs, the level death benefit is the less expensive option. With this option, the amount of the death benefit paid to your beneficiary remains level. Here’s how it works: as the policy fund grows through contributions and earned interest, the difference between the death benefit and the policy fund value decreases. The difference is called the “net amount at risk.” The cost of insurance (COI) you must pay each month for the base insurance portion of your policy is based on the net amount at risk. By lowering the net amount at risk, you can lower the monthly COI withdrawal.		Death benefit plus policy fund With the increasing death benefit option, any amount in the policy fund is added to the death benefit and paid tax-free to the beneficiary. The policy fund is not used to reduce the net amount of risk. Because the net amount of risk stays constant, you will know at purchase exactly what the COI withdrawal for your base insurance will be over the lifetime of your policy.

(source: http://www.sunlife.ca/plan/v/index.jsp?vgnextoid=ea9775b5e1856110VgnVCM1000002dd2d09fRCRD&vgnextfmt=default&vgnLocale=en_CA)

Essentially, these graphs can also be used to show how increasing vs level cost of insurance works.

As mentioned before, both strategies have their pros and cons, and much of depends on time horizon and how much you will be contributing to the policy over that time. Make sure your advisor always crunches the numbers for both strategies and shows you how each one would work for you.

I hope this has helped! If you have any questions please do not hesitate to contact me. Please consult your financial advisor before making any decisions.

Mutual Funds vs Segregated Funds

In an earlier post, I had discussed the main differences between Stocks and Mutual Funds, as well as the pros and cons of each strategy (http://financialhealthblog.blogspot.com/2009/06/stocks-vs-mutual-funds.html). In this post I will discuss another type of investment strategy called Segregated Funds (Seg Funds) and compare that strategy with Mutual Funds.

To restate what my explanation of Mutual Funds is I'll copy and paste what I wrote in my previous post:

Let's take a step back and examine what a mutual fund really is. Generally, this is how I explain to someone what a mutual fund is:

There are a group of people who all are investing into a pool of money, which is then invested into a company. That company has Professional Money Managers who then go and buy and sell certain investments (stocks, bonds, cash etc..). The sole purpose of these managers is to buy and sell investments and to get the best returns they can; they look over the balance sheets, income statements, research companies, look at executive statements etc... They are managing all the money that is invested with them, and the fund will earn a rate of return (either positive or negative -- hopefully positive). For doing this service, they charge an MER (Management Expense Ratio), which is like the 'service fee' so to speak for doing all that work.

And some of the points about mutual funds:

Mutual Funds:

- Professionally Managed
- Can get a diversified portfolio
- Can have up to 100+ stocks
- Also may contain some bonds/cash/t-bills etc...
- Lower risk then just stock picking
- Management Fee charged
- Less control then individual stock picking
- If a few of the companies within the mutual fund tank, it will not affect your investments as much as an individual stock portfolio

Now, I think most people are familiar with, or at least have heard of Mutual Funds. Seg Funds, however, are often foreign to the average investor and have not been explained by some advisors (usually because many advisors are not licensed to deal with them). Some investors, however, are already invested in Seg Funds, but they don't even know it. They think it is just a regular Mutual Funds and don't know the difference. That being said, it can be difficult for the average investor to always distinguish between the two.

When giving an explanation of Seg Funds, I start by giving the explanation of Mutual Funds, and then give the differences. To better illustrate the differences, I usually draw it/write it out on paper so it is easier to understand; something similar to whats below:

	Segregated Funds	Mutual Funds
Overview	Your net premiums are invested in the segregated funds of an insurer which, in turn, invests in securities such as stocks, bonds and money market investments. Segregated Funds are insurance products.	Money is pooled and invested on behalf of unit holders in securities such as stocks, bonds and money market investments.
Regulated by	Provincial Life Insurance Acts	Securities Legislation
Capital Growth Potential	Yes	Yes
Track unit value in the newspaper	Yes	Yes
Diversify investments	Yes	Yes
Financial Protection	At death and maturity, premiums minus withdrawals are usually guaranteed, between 75% and 100%.	No guarantees on investment performance. Theoretically, you could lose everything.
Death Benefit	Beneficiaries receive either the guaranteed death benefit or the market value depending on which is greater.	The estate or beneficiaries 2 will get the market value only – there are no guaranteed minimums.
Probate Protection	At death, proceeds can be paid directly to a named beneficiary, avoiding the estate administration process, and the cost of probate fees.	At death, proceeds are an asset of the estate and are subject to the estate, administration process and legal fees. It could be some time before the estate can distribute the mutual funds. Proceeds could bypass probe if held in an RRSP and has designated beneficiary.
Creditor Protection	Designations in favour of a parent, spouse, child or grandchild may result in the insurance money being exempt from seizure. This is sometimes referred to as "creditor protection". The money cannot have been deposited as: Part of a fraudulent conveyance (transferring money to keep it out of reach of existing creditors). Within a specific time period before bankruptcy	Potential of creditor protection if in an RRSP.
RRSP Eligible	Yes	Yes
RESP Eligible	Yes	Yes
Taxation Implications for non-registered investments	You are only taxed on the income you actually receive. Taxation is based on how long you own the Segregated Fund units within the income period. E.g. if you buy units one day before the fixed date, you are only assessed for one day's income. The unit seller is assessed for income made before the end date. You can use capital losses to offset capital gains from other sources. For accounting purposes, acquisition fees are excluded from the adjusted cost base and treated separately .	You could be taxed on income you never received. Taxation is based on who owns the mutual fund units on a given date at the end of the income period. E.g. if you buy units one day before the end date, you are assessed for all income earned in that period, even though you did not benefit from that income. Capital losses must be carried forward by the fund and are not allocated to you, the unit holders. Acquisition fees are included in the adjusted cost base.
Under what circumstances might these be more suitable?	Non-registered or registered funds. Investors approaching retirement. Investors who like the security of guarantees. Business owners who want creditor protection.	Non-registered and registered funds. Investors who want a wide variety of specialized fund choices in their investments. Investors willing to give up guarantees for potential increased returns.

(Source: http://www.segfundscanada.ca/seg_funds_comparison.asp)

Another thing to note, Seg Funds have the ability to 'Lock-In' market gains with a feature called "aut0-resets" (some also have Manual Resets). This can be very beneficial to your bottom line and can guarantee you a minimum return of more then what you started with (principal).

Please note, that since there are some added benefits to Segregated funds, they also charge higher fees (MER's) as well; usually about 1% more then a regular mutual fund. So before using the Seg Fund Strategy, you must determine if you really want to pay the extra for some added features.

Each strategy is only suitable for certain investors so there should always be a proper discussion between the advisor and client before one is chosen. As you can see, both strategies have their pros and cons and there must be careful considering before choosing either one.

I hope this has been helpful, and if you have any more questions, please do not hesitate to ask me. Please consult your financial advisor before making any decisions. If you require any more information please do not hesitate to contact me.