How does life insurance work?

When most Canadians start exploring financial protection, one of the first questions that comes up is, “How does life insurance work?” The answer is straightforward, but the details make all the difference.

Life insurance is designed to provide your loved ones with a tax-free financial cushion when you pass away. This benefit helps meet your loved ones’ financial needs by covering expenses such as funeral costs, debts, and income replacement, ensuring their financial security after your passing. However, the way it functions depends on the policy type you choose, how long you need coverage, and what options you build into your plan.

This guide explains the full process, from application to payout, and answers the most common questions Canadians have about taxation, conversion, and policy types so you can make an informed decision that fits your long-term goals, including planning for your financial future.

What is life insurance?

Life insurance is a financial contract between an individual (the policyholder) and an insurance company. It provides a lump sum, the death benefit, to the chosen beneficiaries, most commonly a family member such as a spouse or child, when the insured person dies. Life insurance guarantees that your beneficiaries will get a tax-free cash payment, typically paid as a tax free lump sum, when you die, provided you meet all requirements in your policy.

How does life insurance work?

At its core, life insurance works as a financial agreement between you and an insurance company. You pay regular premiums, monthly or annually, in exchange for a promise that your beneficiaries will receive a death benefit if you pass away while the policy is active.

When you apply, the insurer reviews your personal information, health history, and lifestyle to assess your risk. This process, known as underwriting, determines your premiums and eligibility. Once the policy is in force, you keep your coverage by paying premiums on time.

If you pass away during the policy term, your beneficiaries file a claim and submit proof of death, usually through a death certificate. The insurer verifies the details, and once approved, the death benefit is paid out to the beneficiaries. Most payouts in Canada are tax-free and can be used for anything, from paying off a mortgage and replacing income to covering final expenses, funeral expenses, or to cover debts such as loans and credit cards, or funding education.

There are two main policy types: term life insurance (also known as term insurance or temporary coverage) and permanent life insurance (also called permanent insurance). Term coverage protects you for a specific period, while permanent coverage lasts for your lifetime and can include a cash value component. Understanding these differences is key to selecting the right plan for your situation.

What does life insurance cover?

Beneficiaries are typically free to use the death benefit amount as they see fit. The money can be used for various purposes, such as funeral and burial costs, outstanding debts, daily living expenses, healthcare, childcare, and education expenses.

It’s important to ensure you have enough coverage to financially protect your beneficiaries, so they can maintain their lifestyle and cover essential expenses after your passing.

Types of life insurance

There are various life insurance plans available to suit different needs.

• Term life insurance: Provides coverage for a specified period, offering a death benefit if the insured passes away during the term. Term life insurance is a type of coverage that is temporary and can last for a specific period of time, usually ranging from 5 to 50 years.
• Permanent life insurance: Offers lifelong protection with guaranteed coverage, providing a guaranteed death benefit and cash value accumulation over time. This type of policy ensures your coverage lasts for your entire lifetime, making it suitable for estate and retirement planning.

How does term life insurance work?

Term life insurance, also known as term insurance, provides temporary coverage for a specific period known as the term. The duration can be one, five, 10, 20, or 30 years. If the policyholder or the insured person passes away within the term, the insurance company pays the death benefit to the beneficiaries. The death benefit is generally tax-free, and beneficiaries use it to cover various expenses as they see fit.

Premiums for term insurance are typically lower than those for permanent life insurance, making it a popular choice for those seeking affordable coverage.

Term insurance does not build cash value, unlike some permanent policies.

What happens when the term policy expires?

If the insured person dies after the term life insurance policy expires, there is no death benefit payout. Term life insurance is designed to provide temporary coverage, which ends when the policy expires. Term life insurance covers only a specific period (the term), and if the insured person passes away outside that period, no benefit is paid to the beneficiaries.

What happens when the insured person outlives the term policy?

If the insured survives beyond the policy term, the coverage expires, and there is no payout.

What options do you have before the expiration of the term?

Before a term life insurance policy expires, policyholders typically have several options. The specific choices available can depend on the terms and features of the individual policy.

• Renew the policy,
• Convert it to a permanent life insurance policy or
• Let it expire.

Be proactive in considering these options well before the term policy expires. Waiting until the last minute may limit your choices and could result in a coverage gap if a decision is not made in time.

• Policy renewal: Most term life insurance policies offer a renewal option. This allows the policyholder to renew and extend the coverage for an additional term without undergoing a new medical exam. However, the premium for the renewed term is often higher since the insured person is older. The policy contract usually specifies the renewal period and the premium for the renewed term.
• Policy conversion: Most term life insurance policies also offer a conversion option. This allows policyholders to convert the term policy into permanent life insurance, such as whole or universal life. Policyholders may convert the term policy into permanent life insurance without additional underwriting or a medical exam.
• Let the policy expire: If you no longer require life insurance coverage or cannot afford the renewal premiums, you may choose to let the policy expire. In this case, coverage ends, and no death benefit is paid upon the policyholder’s death.

How does Permanent life insurance work?

Unlike term life insurance, which provides coverage for a specific term, permanent life insurance remains in force for a lifetime as long as the policyholder continues to pay the premiums. Permanent life insurance provides lifetime coverage and can build cash value. The chosen beneficiaries receive the death benefit regardless of when the insured person dies. The death benefit is generally tax-free, and beneficiaries use it to cover various expenses, such as outstanding debt, mortgage premiums, estate taxes, and funeral costs, as they see fit. Permanent life insurance policies often accumulate cash value over time.

• Cash value: One distinguishing feature of permanent life insurance is cash value. The cash value represents the policy’s savings or investment component. A portion of the premium goes toward the policy’s cash value component, which grows on a tax-deferred savings basis and can be used to supplement retirement income. Whole life insurance has fixed premiums, a guaranteed death benefit, and cash value accumulation.
• Accessing cash value: Accessing the cash value during the insured person’s lifetime is one of the significant advantages of a permanent life insurance policy. A policyholder can access cash value in three ways: policy loans, partial withdrawals, and by surrendering the policy. Exceeding certain cash value limits may create a tax liability.
• Policy loans: Policyholders can borrow money from the insurance company against the cash value. Policy loans typically have a relatively low interest rate, and the policyholder can repay the loan or let the outstanding amount reduce the death benefit.
• Partial withdrawals: Policyholders can withdraw some of the accumulated cash value without affecting the entire policy. However, there may be potential tax implications.
• Surrendering the policy: If a policyholder decides to terminate the policy, they can surrender it in exchange for the cash value. However, surrendering the policy means giving up the life insurance coverage.

When converting term life insurance to permanent coverage, it’s important to note that universal life insurance is a type of permanent insurance with flexible premiums and an investment component. Universal life insurance offers the potential for cash value growth, tax-deferred savings, and can be used for estate planning, wealth transfer, or as a strategy to generate retirement income.

How do insurance companies issue a policy?

Insurance companies use an underwriting process to assess an individual’s eligibility for a life insurance policy. Underwriting assesses the applicant’s overall risk and determines if they meet the insurance company’s criteria for coverage. They take various factors into account when considering risk:

• Age
• Health history
• Lifestyle and habits
• Family medical history
• Occupation and hobbies
• Coverage amount

The underwriting process assigns the applicant a rating class based on the evaluation. This class determines the specific premium rate that reflects the risk associated with providing coverage for the applicant, and premiums can vary based on the applicant’s individual risk profile.

Types of deaths covered by life insurance

Life insurance policies generally cover deaths resulting from various causes, including:

• Natural causes: This includes deaths due to illnesses, diseases, or natural health-related issues, such as heart disease, cancer, stroke, or respiratory conditions.
• Accidental death: This includes accidental deaths resulting from unforeseen accidents, such as vehicle accidents, falls, or other accidental causes.
• Terminal illness: Some policies include provisions for accelerated death benefits. If the insured person is diagnosed with a terminal illness, they can access a portion of the death benefit.

Suppose it is discovered that the insured person withheld or provided false information about a pre-existing illness or medical condition that would have affected the underwriting decision. In that case, the insurance company may have grounds to deny the claim.

How much does life insurance cost?

The average cost of life insurance is based on various factors, including age, gender, coverage amount, smoking status, and other individual factors.

 Methodology: The chart above reflects average life insurance premiums for a female non-smoker in a standard health classification for a 20-year term life insurance policy with $500,000 in coverage. Prices in the table are determined by internal actuarial rate tables for Canada’s top life insurance carriers that offer policies through the marketplace.

How to determine life insurance coverage amount

When determining life insurance coverage, consider your longest financial obligations, such as a mortgage or income replacement needs, to ensure adequate protection for your dependents in the event of your death. Determining how much insurance you need involves considering lost income, education costs, and any existing coverage you may already have. This approach helps address long-term financial responsibilities and provides a more comprehensive coverage safety net.

Also, anticipate future financial needs, such as funding your children’s education and providing for a spouse’s retirement. You can answer a few questions or use online calculators to estimate how much life insurance or how much coverage you need based on your personal situation. A standard guideline is getting coverage worth 5 to 10 times your annual income.

A real-life example

Sarah is a 42-year-old married individual with two young children. She earns an annual income of $80,000 and has a mortgage balance of $200,000. Her outstanding debts, including car loans and credit cards, amount to $30,000. Sarah estimates that it would cost approximately $50,000 per year to cover her family’s living expenses if she were to pass away. She wants to cover her children’s college education expenses, which she estimates are around $100,000 per child. Sarah also wants to provide some additional funds for her spouse’s retirement.

Based on these factors, here’s how Sarah might calculate her life insurance coverage amount:

• Income Replacement: Sarah wants to ensure that her family’s income is replaced in the event of her passing. She decides to aim for coverage that is seven times her annual income ($80,000 x 7 = $560,000).
• Outstanding Debts: Sarah adds her outstanding debts to the coverage amount ($200,000 mortgage + $30,000 other debts = $230,000).
• Living Expenses: Sarah estimates her family’s annual living expenses at $50,000. She multiplies these expenses by ten years ($50,000 x 10 = $500,000) to cover these expenses for a reasonable period.
• Education Expenses: Sarah wants to provide $100,000 for her children’s college education. Since she has two children, she adds $200,000 to the coverage amount.
• Retirement Funds: Sarah wants to provide additional funds for her spouse’s retirement. After considering her spouse’s retirement goals and financial situation, she added $100,000 to the coverage.

Adding up these amounts, Sarah calculates her life insurance coverage amount as follows:

$560,000 (income replacement) + $230,000 (outstanding debts) + $500,000 (living expenses) + $200,000 (education expenses) + $100,000 (retirement funds) = $1,590,000

Based on her evaluation of her financial obligations, income replacement needs, and future goals, Sarah determines that a coverage amount of $1,450,000 would be appropriate for her life insurance policy. 

Choosing a life insurance policy

When choosing between a term life insurance policy and a permanent one, you must evaluate how long you anticipate needing the coverage. There are various life insurance plans available to fit your financial plan, so it’s important to consider which option aligns best with your goals. A term policy may be sufficient if you have specific financial obligations that will diminish over time (e.g., mortgage, education expenses). A permanent policy may be more suitable if you want lifelong coverage for estate planning, legacy goals, or leaving an inheritance.

Term life insurance typically offers more affordable premiums compared to permanent life insurance. If budget is a significant consideration, and you prioritize obtaining the highest coverage amount for a specific period, a term policy may be more cost-effective. Term life insurance is generally the most affordable option and is often used to cover short-term financial needs. Many people choose term life insurance for its affordable coverage, making it easier to protect loved ones without financial strain.

Choosing a life insurance beneficiary

Determining who will receive the death benefit when you pass away is one of the important decisions when getting life insurance. Prioritize those who would be most affected by the loss of your income.

Have open and honest conversations with potential beneficiaries about your life insurance policy and its role in your financial planning. Discuss your intentions and ensure they understand their responsibilities if they become the beneficiary.

Who can be a life insurance beneficiary?

• Individual
  • Spouse: Your husband, wife, or partner can be the primary beneficiary.
  • Children: You can designate your children as beneficiaries to provide for their financial well-being. Consider the age, maturity, and financial knowledge of the beneficiaries.
  • Other family members: Parents, siblings, or relatives can be named beneficiaries.
  • Friends: You may choose to name a close friend as a beneficiary. Think about your relationship with potential beneficiaries and their financial responsibility. Assess their ability to manage the funds responsibly and use them for the intended purpose.
  • Significant others: Unmarried partners or individuals in non-traditional relationships can be designated as beneficiaries.
  • Minors: If you want to name a minor as a beneficiary, you may need to establish a trust or appoint a guardian to manage the funds.
• Trust: You can name a trust the beneficiary, allowing more control over how the funds are managed and distributed. This can be useful for estate planning or ensuring the funds are used for specific purposes, such as education or supporting a loved one with special needs.
• Estate: If you name your estate as the beneficiary, the proceeds will become part of your estate and be distributed according to your will or applicable inheritance laws. However, this may result in probate fees and potential fund distribution delays.
• Charitable Organization: You can name a charitable or nonprofit organization as the beneficiary, allowing the death benefit to support a cause or organization you care about.
• Contingent beneficiaries: Contingent beneficiaries are also known as secondary beneficiaries. There may be situations where the primary beneficiary cannot receive the death benefit or is disqualified. For example, if the primary beneficiary is a minor or is incapacitated, the contingent beneficiary would assume the role. If the primary beneficiary predeceases you or cannot receive the death benefit, naming the contingent beneficiaries ensures the funds go to your chosen alternative beneficiary without delay or complications.

What happens if the insured does not name any beneficiaries?

If the insured person fails to name any beneficiaries on the policy or the primary and contingent beneficiaries are predeceased, the insurance proceeds typically become part of the insured’s estate upon death. The distribution of the proceeds will then follow the rules outlined in the deceased person’s will or the laws of intestacy if there is no valid will. If you don’t designate a beneficiary, the money from the death benefit will go to your estate and may be subject to estate administration tax.

The appointed executor of the estate will oversee the distribution process and ensure that the deceased person’s wishes are carried out as outlined in the will.

Without a valid will, intestacy laws govern how the estate, including the insurance proceeds, is distributed. These laws vary among provinces and territories in Canada. Typically, the estate is distributed among the deceased person’s closest living relatives, such as a spouse, children, parents, or siblings, according to a predetermined order of priority.

How does a beneficiary make a claim?

When the insured person passes away, the beneficiaries must initiate the claims process with the insurance company. Here are the general steps involved:

• Notify the insurance company: The beneficiaries or the policyholder’s representative should inform the insurance company of the insured person’s death as soon as possible. The insurance company will guide them through the claim process and provide the necessary forms.
• Submit required documentation: The beneficiaries must provide documents, such as the death certificate and any additional forms or information requested by the insurance company.
• Claims review and verification: The insurance company will review the claim, verify the provided information and documentation, and assess the eligibility for the death benefit payout.
• Benefit payout: Once the claim is approved, the insurance company will pay the death benefit to the designated beneficiaries. The beneficiaries typically receive the benefit as a tax free lump sum, although some policies offer alternative payout options, such as installments or annuity payments.

How do life insurance payouts work?

When a life insurance claim is approved, the life insurance company typically makes the tax free lump sum death benefit payment to the designated beneficiary or beneficiaries according to the terms of the life policy in one of the following ways:

• Lump sum payment: The most common method is a lump sum payment, where the entire death benefit is paid to the beneficiary in one installment. The beneficiary receives the total amount specified in the insurance policy.
• Annuity or income option: The beneficiary may accept the death benefit as an annuity or regular income payment instead of a lump sum payment. Depending on the policy, this provides a steady income stream over a specified period or for the beneficiary’s lifetime.
• Trust or guardianship: If the beneficiary is a minor or lacks the legal capacity to manage the funds, the insurance company may set up a trust or guardianship account to hold the death benefit until the beneficiary reaches a certain age or gains legal capacity. The funds are then disbursed according to the terms established for the trust or guardianship.

Where to buy life insurance in Canada?

• Direct-to-consumer insurance companies: Many reputable insurance companies in Canada offer life insurance policies directly to consumers. You can visit their websites, contact their customer service, or contact their insurance agents or brokers to inquire about and purchase life insurance policies.
• Insurance agents or brokerage firms: Insurance agents and brokers act as liaisons between the insurance companies and the customers. They usually work with multiple insurance providers, get you numerous quotes, and help you find the most suitable policy for your needs.
• Banks and financial institutions: Some central banks and financial institutions in Canada offer life insurance products. You can visit their branches or contact their representatives to explore the life insurance options they provide.

Group life insurance is often available through employers as part of workplace benefits. While group life insurance can be affordable and convenient, the coverage amount may not be enough to meet your loved ones’ financial needs. You can supplement group life insurance with an individual policy to ensure you have sufficient protection, especially if you leave your job or want more flexible coverage.

Most companies offer the purchase of life insurance through different methods:

1. Via telephone
2. Online, through websites or digital platforms
3. In face-to-face interactions or in-person meetings.

When choosing where to buy life insurance, consider factors such as the company’s reputation and financial stability, the right policy for your unique needs and financial situation, customer service quality, and your preferences regarding online vs. in-person interactions.

To purchase life insurance in Canada, you must be a Canadian resident.

How is life insurance regulated?

In Canada, life insurance is regulated at the federal and provincial levels. Here are some critical aspects of life insurance regulation in Canada:

• Federal Regulation: The Office of the Superintendent of Financial Institutions (OSFI) is the primary federal regulator overseeing federally regulated life insurance companies and other financial institutions. It sets prudential regulations and guidelines to ensure these institutions’ financial stability and solvency.
• Provincial Regulation: Each province and territory in Canada has its insurance regulatory authority or commission.  Provincial regulatory bodies oversee the licensing and regulation of agents, insurers, insurance agencies, and brokers**.** Each province has its own regulatory body that sets standards for agents and agencies, ensuring they are knowledgeable and ethical in their practices. These regulatory bodies supervise agents, insurers, insurance agencies, and brokers operating within their respective jurisdictions. They enforce provincial insurance laws and regulations to protect policyholders’ interests and ensure fair business practices. Examples of provincial insurance regulators include:
• Financial Services Regulatory Authority of Ontario (FSRA)
• Autorité des marchés financiers (AMF) in Quebec
• Alberta Treasury Board and Finance – Superintendent of Insurance
• Insurance Council of British Columbia (ICBC)
• Insurance and Risk Management Board in Manitoba

Licensing and registration: Insurance companies, agents, and brokers must be licensed or registered to operate in Canada (including within each province and territory where they conduct business). They must meet certain qualifications and comply with specific regulatory requirements, including maintaining adequate capital reserves, financial reporting, and consumer protection measures.

Assuris is an independent, not-for-profit, industry-funded organization mandated by the federal government to protect policyholders in the event of an insurance company failure. It protects policyholders by guaranteeing a certain level of protection if an insurance company becomes insolvent. Permanent policies can be used as a tax-advantaged tool to transfer wealth to heirs and cover potential estate taxes. These permanent policies can also be integrated into your overall financial plan for wealth transfer and estate planning.

Canadian Council of Insurance Regulators (CCIR): The CCIR is an inter-jurisdictional association composed of federal, provincial, and territorial insurance regulatory authorities. While it does not have direct regulatory authority itself, it facilitates cooperation and harmonization of insurance regulation across jurisdictions to facilitate and promote an efficient and effective insurance regulatory system in Canada to serve the public interest.

How life insurance works – Conclusion

Life insurance is one of the most reliable tools for protecting the people who depend on you. Understanding how it works, from application to payout, helps you make choices that align with your financial goals.

Whether you choose term for short-term affordability or permanent for lifelong stability, maintaining your policy and reviewing it regularly ensures your family remains financially secure.

If you’re ready to explore your options, get a quote with Oneday to see how affordable customized coverage can be. Policies are underwritten by Humania Assurance and are subject to underwriting and provincial regulation.

Frequently asked questions about life insurance in Canada basics

Sources:

1. FCAC, “Life insurance”
2. CLHIA, “A Guide to Life Insurance”