Why Does Life Insurance Allow Tax-sheltered Growth?

by Kerri-Lynn McAllister November 12, 2016 / No Comments

Well before the launch of the TFSA and even the RRSP, life insurance allowed tax-sheltered growth. What’s more, life insurance can allow larger deposits, even after the changes in 2017.

Why such generosity from the government?

Life and death

Life insurance premiums are based on the probability of people like you dying (same age, gender, health). The risk increases annually. Suppose you buy term life insurance for one year, renew coverage for another year, and repeat. You have yearly renewable term (YRT). The protection becomes less affordable each year.

The rates could be levelized by taking the average. For example, term 10 has rates which are level for 10 years. Coverage renews at a higher level rate for the next 10 years until a maximum age. The underlying problem with YRT rates remains.

Pre-funding

If annually increasing premiums aren’t viable as time passes, another approach is needed. That’s for you to set aside money in the early years to cover the charges in the later years. These funds would be invested to take advantage of the power of compound growth. If the investment earnings were taxed, you’d have to invest even more.

To encourage pre-funding, the government allows the investment income to grow tax-sheltered. This model has since been copied for RRSPs and TFSAs. The investment income—never taxed—helps pay for future insurance charges. You can’t get this advantage if you “buy term and invest the difference.”

Who does the investing?

In the old days, whole life insurance was the mechanism used. The insurance company did the investing and their clients got the gains or losses. Buyers had no say in the investments, which could be an advantage or disadvantage. Whole life was also opaque. You couldn’t tell how well your money was being managed or what you were paying for the investment services.

Buyers got a choice when modern universal life insurance was introduced in the 1990s. Now you could pick your investments (generally fixed interest investments or mutual funds) and see the associated expenses.

Term 100

With term 100—invented in the 1990s—the rates are level for life. That means you pay more in the early years compared to term 10 but far less in later years. What happens to your early “overpayments”? The insurance company invests them to cover the “underpayments” in later years. Since premium rates are often guaranteed, the insurance company bears the investment risk.

Whole life is built on insurance rates which increase every year (also known as yearly renewable term). Universal life started with YRT and now offers term 100 rates (generally called a Level Cost of Insurance or LCOI).

Everyone wins

Making life insurance affordable for life benefits:

  • Your beneficiaries: You’re more likely to buy and keep enough coverage.
  • Society: if we don’t take care of our beneficiaries, taxpayers face a larger burden.
  • You: if your need for insurance lessens or ends, you can access the savings in your policy via withdrawals (which may be taxable) or loans (which are tax-free).

Get a life insurance quote now.

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Flickr: Got Credit