Historical article note: This article was originally published on 2019-02-14. Rates, policies, home prices, statistics, product names and qualification standards reflect the environment at that time and may have changed. This archive is for historical record and general education only. It is not mortgage approval, investment, legal or tax advice.
Canada is a country with high welfare. Because there is no need to worry about medical issues, achieving financial freedom is very simple. Couples can buy life insurance of 1 million each, own a home, and if their financial assets reach 2 million, they can live out their later years comfortably. Many people know that insurance is the foundation of family finances. The reasoning is what Chinese people often say: before seeking advancement, first consider safety; before pursuing wealth, first arrange how to handle unexpected situations. How much insurance each person should buy has many formulas and opinions, and there is much debate. When a borrower signs a mortgage loan contract, according to commercial banking law, the bank must disclose to the borrower that taking on new debt will lead to new risk exposures and must have the borrower sign a document stating that they have been informed. The bank also takes the opportunity to introduce its various insurance services. It's not just the bank’s insurance services, but the products of major insurance companies. For many Chinese people, it seems like a topic to be avoided at all costs. It seems that Chinese people really have not come to terms with life and death; they do not understand Canada’s tax issues, have not calculated how much insurance they should buy, and do not know what kind of insurance they should get.
Insurance is broadly divided into property insurance, liability insurance, and personal insurance. The characteristic of property insurance is that it insures the value of a specific property. For example, if the property is worth 1 million yuan, and it burns down, even if you have purchased five policies of 1 million yuan each, the maximum compensation you can receive is 1 million yuan. For property insurance, the policyholder must maintain utmost good faith; otherwise, the premiums paid are wasted. For instance, for the same house, if it is for personal use, the premium is lower than if it is for rental purposes. If the policyholder falsely claims that the house is for personal use when it is actually rented out, and a fire caused by the tenant occurs, the insurance company will not compensate, making the premium payments wasted. Liability insurance is primarily related to ordinary people through the third-party liability insurance for motor vehicles. The amounts for property insurance and liability insurance are relatively easy to determine, but how much life insurance to buy is a matter of debate. Personal insurance, which is the main topic of this article, includes life insurance, disability insurance, critical illness insurance, and unemployment insurance.
In my personal opinion, the amount of life insurance coverage should first be related to the tax laws and tax rates of the country you live in. In Canada, when misfortune occurs, the government's tax authorities come first among the heirs of an individual's property. Therefore, regardless of how much property you leave to your family, you must be able to pay the government first. Canada does not have an estate tax, but income tax must be reported after death, and assets under your name are treated as if sold, so capital gains tax is heavy. Mr. A's assets left to his adult daughter are as follows: the market value of a primary residence is 1 million, treated as sold, no capital gains tax; an investment property bought for 200,000, market value 500,000, treated as sold, taxable income 150,000; RRIF retirement account 500,000, treated as sold, fully taxable; investment portfolio, purchase price 300,000, market value 500,000, treated as sold, taxable income 100,000; private company shares, cost 0, market value 1 million, treated as sold, taxable income 500,000; cash 100,000, TFSA tax-free account balance 100,000, no tax required. Mr. A's total estate value after death is 3.7 million, taxable income 1.25 million, Ontario tax rate 53.53%, total tax 669,000. If the daughter cannot pay this tax, assets must first be auctioned to pay it. Mr. A is not extremely wealthy, and the estate is not large, but the tax is almost 18% of the total estate and must be paid in cash. The tax authorities are supreme, and the tax paid at the end by the heirs is paid on their behalf. For the sake of your poor family, buy a life insurance policy with an amount of about 20% of your assets, which is also the minimum coverage amount.
One more point, if you buy property in the United States, you also need to buy more life insurance. When a U.S. property owner dies, not only do they have to pay the aforementioned income tax, but also estate tax, whereas Canada does not have an estate tax. One last point, if a Canadian couple jointly owns property in the U.S., the death of one spouse can potentially trigger estate tax and capital gains tax. In contrast, under Ontario law in Canada, when one spouse dies, jointly owned property is not considered sold and does not trigger capital gains tax.
If you want to smoothly pass on an inheritance to the beneficiaries, after getting through the government tax office, you need to consider how to ensure your family's life is not affected after you pass away. Ideally, you want to leave more cash or assets to your family. Manulife has a worksheet to calculate how much life insurance you need. The logic on it is very clear and fairly comprehensive, and you can use it as a reference. I am not an insurance advisor, but I can try to explain my understanding of this worksheet.
(1) Final expenses = funeral costs + final taxes + lawyer fees + estate management fees
(2) + (3) = (4) = annual expenses (5) = all assets Among these, the final taxes = capital gains on asset sale × corresponding tax bracket, as mentioned above. Since the investment return rate is 3%, after death when all assets are handled, the annual income = remaining assets × 3%. Therefore, the complete equation for posthumous beneficiary income and expenses is: (Insurance + Assets - Liabilities - Final Expenses) × 3% = annual income for family after death (Beneficiary annual living expenses × number of beneficiaries - beneficiary annual income) = annual income for family after death (Insurance + Assets - Liabilities - Final Expenses) × 3% = (beneficiary annual living expense × number of beneficiaries - beneficiary annual income) = annual family annual expenses after death
From the two equations above, we can finally derive: Insurance amount = Liabilities + Final Expenses + 33 times annual posthumous expenses - Assets. According to note 5 in the worksheet, “Assets” in the formula should exclude fixed assets, such as real estate. From this formula, you can see that the size of the insurance coverage relates to three things: amount of debt, investment return rate, and asset amount, especially the amount of liquid assets. This is why banks remind borrowers to reconsider whether life insurance coverage is sufficient before granting a mortgage. Using the example of Mr. A above, Insurance amount = Debts 0 + Final Expenses about 800,000 + 33 years of posthumous annual support of 30,000 for daughter totaling 990,000 - liquid assets 2,100,000 = -300,000. That is, if there is no debt, the minimum insurance coverage only needs to reach 669,000. If there are debts, the insurance coverage should be increased accordingly.
For banks, as long as the borrower is able to make full and timely payments, they will not require the borrower to pay off the mortgage debt in a lump sum. If the borrower unexpectedly dies or suffers from a serious illness, the loan principal may become difficult to repay because of the inherent illiquidity of real estate, and the family may also find it difficult to immediately take over the property and sell it due to tax issues. The bank's insurance products provide life insurance and critical illness coverage for the outstanding loan balance, with premiums determined based on the age at underwriting. The premiums remain unchanged during the coverage period, but the loan balance gradually decreases. The insurance beneficiary is the bank, meaning that in the event of a claim, the bank receives the payout, while the borrower is responsible for paying the premiums. The bank also offers insurance products for the risk of payment default, such as disability insurance and unemployment insurance, where the insurance company covers monthly payments if the borrower becomes disabled or unemployed. Both types of insurance provided by the bank are term insurance; the policy ends once the loan is fully repaid. The main advantages of the bank's insurance products are: no medical examination required; no difference in premiums between smokers and non-smokers; and unemployment insurance, where the insurance company pays the loan monthly while receiving Employment Insurance (EI) benefits.
Insurance companies can provide more insurance products than banks. Not only do they offer term insurance, but also whole life insurance, such as universal life and participating whole life insurance. There are even more types of insurance for special needs, such as travel insurance, long-term care insurance, annuities, critical illness insurance, disability insurance, and so on. In terms of affordability, term insurance is the cheapest—the younger you are, the lower the premium. Young people can purchase a mix of term and whole life insurance, gradually transitioning to whole life. Self-employed individuals without a corporate pension might consider annuities to prevent outliving their savings. Deciding which insurance to buy and how to combine them requires consulting an insurance advisor. In the financial books I have read, a more balanced suggestion comes from Burton Malkiel in 'A Random Walk Down Wall Street': insurance is insurance, investing is investing. He personally recommends 'renewable term insurance'.
Whether to buy insurance and how much to buy does not have an exact calculation formula; it is decided by the scale in your heart: how deeply we love our family. The cost of living in Toronto, as well as government tax policies and rates, basically determine that couples should have at least $500,000 of life insurance for each other. If you want your partner and children to maintain their current standard of living in case of an accident, you need to buy more life insurance. There are only two kinds of people who buy not a cent of insurance: 1. Those who have nothing to live for; 2. Admirers of Madame Pompidou, who, like her, think, 'Even if I die, let the floods come.' Also, a reminder: friends who buy vacation homes in the U.S. need to purchase more life insurance.
Last year at the Niagara Financial Intelligence Forum, I proposed three financial freedom goals, one of which was for spouses to insure each other with life insurance of 500,000 to 1 million. Since then, readers have been asking me how this number was determined. If the company provides group life insurance, is a coverage of 500,000 sufficient? I believe the beneficiary should at least receive cash (insurance payout) before the estate is transferred, to pay the final income tax. With an estate of 2.5 million, 20% amounts to 500,000 in life insurance. If you want the beneficiary to live better or have more time to liquidate the estate, it’s best to insure 1 million. If you don’t own much in the way of assets, it’s even more necessary to buy insurance of 500,000 to 1 million because Canada’s inflation rate is 2%, and the purchasing power of the Canadian dollar halves every 36 years. The 100 dollars today will only have a purchasing power of 50 dollars after 36 years. If you want your beneficiaries, especially minor children, to live and study decently, these insurances are worth purchasing. Life insurance is the cost of love. One weakness of human nature is underestimating the likelihood of events we don’t like to face, and insurance is the only way to strengthen this weakness. Whenever debt increases, the corresponding insurance coverage should also increase.