Updated 03 December 2020
One of the reasons why you might save up is to safeguard your family against misfortune. But a rainy-day fund can only do so much. For a truly adequate level of protection, life insurance is often a better solution – and it’s more versatile than you might think. Article by Nick Green.
On the financial planning Scale of Excitement (bear with us), up at the sexier end we have investments – because everyone likes the idea of turning money into more money. Ordinary saving is somewhere in the middle – but way down at the dull end of the scale, there’s protection. Somehow, no-one can get excited about paying monthly premiums to a life insurance policy.
But it’s time to see life insurance in a new light. A common reason why people build up savings is to provide a fall-back fund if the unexpected happens. However, few can build up savings large enough to meet one of the biggest challenges of all: the death of one of the family’s main earners.
For most people, only life insurance can hope to fill an income gap like that. Although a life insurance policy is not actually a fund (rather, it’s a contract between you and the provider), it may help to think of it as a special kind of ‘crisis fund’ that only becomes accessible if the worst happens. The big advantage is that if you do need it, it will pay out to you far more than you paid into it – making it a dramatically better solution than an emergency savings fund.
A premature death may seem unlikely if you’re in good health, but the consequences are severe enough to make it qualify as a serious risk. This is why mortgage lenders insist on you taking out life insurance.
Unfortunately, most people tend to take out the first life insurance they’re offered – which is usually the one recommended by their mortgage lender. But it’s possible to arrange a policy that is precisely tailored to fit your needs. Here are just some of the things your life insurance can do for your family.
There are two main categories of life insurance: term insurance and whole-of-life cover. The most popular kind is term insurance. It will cover you for a set period of time (for instance, the term of a mortgage, or until you reach an age when you can access your pension), so that if you die within that time, a lump sum (or a regular income – see below) is paid out. After that, no money can be paid out.
With different kinds of term insurance, you can arrange for the following:
Level term insurance pays the same lump sum to you no matter when you die (within the period of cover).
Increasing term insurance will pay out more if you die later, to take account of the rising cost of living. The downside is that premiums will also increase over time. You can also get a policy that is linked to the Retail Prices Index, to ensure that the lump sum paid out retains the same value in real terms.
You can also opt for decreasing term insurance. Why might you want this? Well, if the insurance is to cover an expense that will reduce over time (such as mortgage repayment), this approach can give you the necessary cover at lower premiums.
Some people prefer the security of a guaranteed income rather than a lump sum that can run out. Similar to term insurance is family income benefit (FIB), which kicks in if the insured person dies within a particular time period. The difference is, instead of paying out a lump sum, it will pay out a regular income until a specific date. For instance, it may be set up to pay for household expenses until the children reach adulthood (e.g. 21).
Though a guaranteed income has its advantages, there is also a downside. If you die close to the end of the insured period (the termination date), your family won’t get much payout – whereas if you had term insurance, they would still receive the full lump sum.
Term insurance only covers you within a set period of time. If you want a guaranteed payout whenever you die, you will need whole-of-life cover. The premiums on this are of course much higher, as you are insuring against an event that will definitely happen one day.
A popular reason for taking out whole-of-life cover is to cover future inheritance tax (IHT) bills. This enables the tax to be paid before the estate is settled (IHT bills must be paid within 6 months of a person’s death, but it may take much longer to settle the estate). Another reason for this kind of cover is to pay for funeral costs.
If you take out convertible term insurance, you can change it to whole-of-life cover at a later date, regardless of any change in your health. However, your premiums will rise.
You can cover both yourself and your partner / spouse under the same policy – it’s usually cheaper. However, most joint life policies work on a ‘first death’ basis, so they only pay out when one of the policyholders dies. If you want both of you to remain insured, then you will need to have separate policies. This will of course be more costly – but it’s also simpler if the relationship fails and the partners separate.
Most life insurance policies will pay out if you develop a terminal illness, and some also cover critical illness (where the illness is severely debilitating but not necessarily terminal). You can often add critical illness cover with a small increase in premiums. However, bear in mind that the industry has a poorer record of paying out on this kind of cover, with one in 12 claims declined.
As you can see, there are many different ways in which life insurance policies can protect against the financial consequences of bereavement. Finding the right policy for you will involve taking all your other circumstances into account. A financial adviser can help you do this, and can also search the whole of the market for you, in order to find the best value policy available.
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