We buy life insurance to provide money for our loved ones in the event of our death.
The idea is to pay off debts, such as the mortgage, other loans and credit card balances, and to make sure there are funds available to meet the family’s other living expenses, both now and in the future.
There are different types of life insurance policy from which to choose. Perhaps the most straightforward is level term insurance: you select the amount of cover you need (the ‘sum insured’) and length of time the policy will run for (say, 20 years).
The policy will then pay out the sum insured if you die before the end of the term.
An alternative is decreasing term insurance. Here, the sum insured reduces over the term of the policy – which means the premiums can be less than for a level term policy (all other things being equal).
Unlike with level term cover, the amount of cover then falls –monthly or annually – over the term
This guide explains how decreasing term insurance works and runs through the benefits and possible drawbacks of opting for this form of cover.
What is decreasing term life insurance?
Decreasing term insurance is often bought to clear a specific debt (normally a repayment mortgage) that is itself reducing over time, with the policy paying out in the event of the death of the borrower or his or her partner.
The term is usually selected to align with the associated debt.
Clearing the mortgage after death is a priority, of course. Indeed, many mortgage lenders will insist life insurance is in place.
The pay-out will mean the family can remain in the property, and the burden of meeting the monthly mortgage repayments will be removed (note that decreasing term insurance is not appropriate for someone with an interest-only mortgage, where the capital debt is only repayed at the end of the mortgage term).
Not all decreasing term insurance is taken out to cover mortgages, though.
Some people also choose this type of life cover because they do not feel such a big payout will be necessary if they die in, say, 20 years rather than within the next 10.
How does it differ from level term insurance?
With level term insurance, it is up to you to decide how long the policy runs for and how much would be paid out if you were to die within the term.
You also choose the length of the term and the size of the sum insured when you arrange decreasing term insurance – but your decisions will be influenced by the term and size of the debt you are looking to repay if worst comes to worst.
Unlike with level term cover, the amount of cover then falls –monthly or annually – over the term.
As noted, decreasing term policy can be cheaper than level term insurance because the sum insured goes down rather than staying the same throughout, reducing the risk of the insurer having to make a big pay-out.
So is decreasing term life insurance right for me?
Decreasing term life insurance is popular with people on a tight budget as the monthly payments are lower than those you would pay with level term cover.
But many people prefer to pay for level term insurance, even though they have a repayment mortgage.
The logic is that, if they set a sum insured that matches their debt but which stays at the same level as the debt falls, then they will create additional insurance that could be used for other purposes following a claim.
Others choose a level sum insured that is greater than their mortgage debt anyway, so they know their loved ones will have additional provision to take care of other living expenses.
Have you got death-in-service benefit through work?
Remember, before taking out any kind of life insurance, you should also check whether your employment contract includes a death-in-service benefit that will go to your family should you die.
This is usually set at four times your annual salary – which is probably insufficient for most families.
To work out how much cover you need in total, you should add up all your debts and the family’s annual living expenses and then take a view about the length of time you need insurance protection to be in place.
For example, if you have children at home, your annual expenditure is likely to fall substantially once they become financially independent.
Mulling over these points should help you determine the size of your sum insured.
Once you reach this stage, you can add to any existing life insurance policies you have, such as a death-in-service benefit, to reach the desired amount.
So if, for example, you decided on a sum insured of £300,000 and had a £100,000 death-in-service benefit, you would need £200,000 from a separate life insurance policy.
Family income benefit and monthly payments
Another type of term insurance is designed to pay an income rather than a lump sum. This is generally known as a family income benefit policy.
Again, you choose the term of the policy, but instead of nominating a lump sum as your sum insured, you choose an amount to be paid as a monthly income, payable from the date of your death (or that of your partner) to the end of the agreed policy term.
You could pay less for family income benefit insurance than for level term insurance because the insurance company, on balance, stands to pay out less. For example, if you died 15 years into a 20 year term, a level term policy would pay out the full amount, but the family income benefit policy would only pay the monthly income for five years.
A family income benefit policy might be attractive to someone who does not have debts to clear – although you could set the monthly amount sufficiently high to take care of the mortgage payments as well as other financial needs and commitments.
Again, in setting the sum insured, you would have to calculate how much you need to provide for your family’s outgoings. You can arrange for the income paid following a claim to increase each year in line with inflation – but the premiums would be higher than for a policy where the monthly payments remain the same.