Life insurance could be the most important financial product you ever buy.
If you die while you still have dependants, being able to claim on a life insurance policy could be the difference between your loved ones struggling to make ends meet, and their financial security.
Despite this, many of us simply don’t have any life insurance cover in place.
But it’s not hard to see why we put it off. After all, most of us have enough money worries in our everyday lives without also having to think about what will happen when we pass away.
Even if you don’t work – you might be a stay-at-home parent, for example – the cover could still prove invaluable, as childcare and other housekeeping costs will need to be paid if you’re no longer around.
There are several different kinds of life insurance policy to choose from, so it’s important to understand exactly what’s available before buying.
This is our guide to all the various kinds of plan, so you can decide which policy is right for you.
What is term insurance?
Term insurance pays out when the policyholder dies within a period of time set by the insurer. Most policies run for between 10 or 25 years, but you specify how long you want the term to be.
If you die during the term, the policy will pay out the amount agreed at the start, which is known as the ‘sum assured’. Some policies will also pay out if you are diagnosed with a terminal illness, though you usually have to ask for this.
If you live beyond the term of the policy, the cover simply comes to an end – there is no investment element or any return of premiums.
The policy might not pay out if you die too soon after taking out cover, so always read the small print carefully before buying.
The different types of term insurance
There are three main kinds of term insurance:
With level term insurance, the sum assured is the same in the final year of the policy as it is in the first.
Decreasing term insurance is cheaper to take out, but the potential pay-out will fall over the term.
This sort of cover is often taken out to back a repayment mortgage, so the sum assured shrinks along with the outstanding mortgage debt.
Mortgage providers will often try to sell you life cover when you apply for your mortgage, but always get quotes from other providers before buying to ensure you find the best possible deal.
Under increasing term insurance, the pay-out increases over time to keep pace with the rising cost of living. The sum assured either increases by a fixed amount each year, typically 5%, or is pegged to the Retail Prices Index (RPI) measure of inflation.
As the amount of cover increases over time, premiums for this sort of policy are more expensive than for level or decreasing cover.
How long will I need life cover for?
There are several factors to take into consideration when calculating how long you need life insurance for.
First, you should think about any debts you have, such as your mortgage, credit card and any personal loans. These will need to be paid off when you die, so look at your current repayment terms.
For example, if you have a mortgage and it has 18 years left to run, you may want to only take out cover for this 18-year period, so you can be certain that it will be paid off when you die.
You might want to take out cover for longer, so as to leave a lump sum when you die once your mortgage is paid off.
It’s also vital to consider how your dependents will be provided for if you are no longer there. If you have young children for example, it’s a good idea to take out cover that will last until they become financially independent.
How much cover do I need?
When deciding how much life cover you need, you will need to add up any debts that need repaying, as well as how much your partner and children would need to maintain their lifestyle if you die.
Once you’ve established what sort of financial support they would need, you should look at whether you already have any life cover in place.
Many employers include what is known as ‘death-in-service’ benefit, which will pay out a lump sum if you die. This is typically worth around four times’ your salary, but it’s worth checking your contract.
If you have limited debts or few dependants you may be satisfied with this cover, but you may want to supplement it.
The older you are when you take out cover, the more expensive it will be, so don’t leave sorting out cover until later on in life, when premiums could be unaffordable for the amount of cover you require.
How much does life insurance cost?
The price of life insurance has fallen considerably over the past few years, so premiums shouldn’t break the bank.
If you have a policy which you took out several years ago, you might be able to find cover at a cheaper price, even though you are older. It’s certainly worth running a comparison quote to see if a better deal is available.
Don’t, however, cancel your existing policy until you’ve definitely got other cover in place.
Previously, women could expect to pay lower premiums than men for life cover, as they have a longer life expectancy. However under European legislation introduced in 2012 insurers can no longer take gender into account when determining premiums, so this differential between women and men has disappeared.
Insurers will still look at your age, health and occupation. For example, if your work is very physical or dangerous, premiums will be higher than if you sit behind a desk all day.
Similarly, if you have always been in the peak of health, your premiums will be much lower than if you have suffered from a serious medical condition at any point, as your life expectancy will be considered longer.
You will also pay less for cover if you are a non-smoker. However, don’t assume you can kick the habit and then take out cover as a non-smoker. You will need to have given up nicotine products, including e-cigarettes, for at least 12 months, and not be using any nicotine replacement products to qualify as a non-smoker.
Let your insurer know if you already have life cover in place and you stop smoking, as they might be able to reduce your premiums.
What’s the difference between guaranteed and reviewable premiums?
When buying cover, find out whether your premiums are reviewable or guaranteed.
If they are guaranteed they won’t change over time, giving you certainty when budgeting. However, reviewable premiums can and probably will change over time.
Guaranteed premiums are more expensive at the outset, but could prove more cost-efficient in the long-term, as premiums cannot rise over time.
Be honest with your insurer
Don’t be tempted to be economical with the truth when applying for life insurance in order to reduce the cost.
You should always declare it if, for example, you have been seriously ill in the past or are currently receiving medical treatment, or you are a smoker.
Even though it will push up your premiums, if your insurer discovers after your death that you didn’t tell the truth, your policy will be invalidated and won’t pay out.
Joint or single life cover – which is better?
It’s natural for couples to think it’s better to take out a joint policy, but this might not be the case.
For a start, a joint policy is not significantly cheaper than two separate single life policies. But more importantly, a joint policy only pays out once on the first death, leaving the second person without cover.
Since they are likely to be older by this time, it will cost the surviving partner more to buy life insurance a second time.
Buying two single life policies gives you more flexibility. You might want to insure yourselves for different amounts, depending on your income, and you may want to buy cover for different lengths of time.
What other types of life insurance are there?
Although term insurance is by far the most popular form of life insurance, there are other types of cover available.
Family income benefit
Standard term insurance pays out a lump sum. This can be useful but it brings with it decisions about how the money should be managed once immediate debts and other obligations have been settled.
Some families especially might prefer a regular income after the death of the breadwinner, which is where family income benefit policies come in.
This sort of policy provides a monthly tax-free income which will be paid until the end of the term agreed in the policy. You can even choose to have the payment increase over the term to mimic would-be pay rises and increases in the cost of living.
The biggest disadvantage of this type of cover is that the income stops once the policy term finishes. So if you take out a 25-year policy and die two years before it expires, your dependents will only receive an income for the final two years.
If you would prefer your life insurance to last for your whole lifetime rather than a set term, you want whole-of-life cover, which is also known as life assurance.
Insurers tend to use the word ‘insurance’ if there is a risk that something might happen within a given time frame, and ‘assurance’ when something is certain to happen.
This type of policy doesn’t have an end date, so you pay your premiums until you die, at which point the policy will pay out some policies ask that premiums are paid only until you achieve an advanced age – perhaps 85.
As a pay-out is certain, life assurance is much more expensive than term insurance.
It is also more complicated, as some of your premiums will go into investment funds and some towards buying life cover. This means that the amount your dependants will receive when you die will be vary depending on how well the underlying investment has performed.
Because of the way it is designed, whole-of-life insurance is not intended to provide for the unexpected and premature loss of an individual, and is more commonly used for complex financial and tax-planning needs.
Some term insurance policies can be converted to whole-of-life policies, known as convertible term insurance. Premiums for this type of policy are higher than for conventional term insurance policies, and once the policy converts they will increase.
Over-50s life insurance
The main appeal of over-50s life insurance is that anyone over the age of 50 will be accepted, without the need for a medical, even if you’ve had medical problems in the past or are currently suffering from ill health.
However, policies usually have a maximum age limit, which is typically 75. The policy might have to run for 12 or 24 months before a claim will be considered. If you die within this period, your premiums may however be refunded to your estate, minus a consideration for the insurer.
The cover works in a similar way to whole-of-life insurance as there is no end date, so the policy will pay out whenever you die. Premiums are usually relatively inexpensive, but the level of cover offered is also relatively low, in the region of a couple of thousand pounds. Many people use these policies specifically to cover their funeral expenses.
The biggest drawback is that you could end up paying premiums for a very long time. If you take out a policy when you are relatively young, you may end up paying much more into the plan than is paid out when you die.
Some providers will allow you to stop paying premiums when you reach a certain age, often 90 or 95, but if you cease paying before then the policy will lapse and you won’t receive anything.
Putting life insurance in trust
If the total value of your estate – what you leave when you die – is more than £325,000, the government levies inheritance tax at 40% on anything above that threshold, including life insurance pay-outs. In fact, a large sum paid out after an untimely death might be what puts the value of your estate over the line.
There is a perfectly legal way to prevent this from happening, however: ask your insurer to write the plan in trust. This stops the money being added to your estate – so none of it will be liable for inheritance tax (IHT).
Under current tax rules, the IHT threshold is £325,000 for a single person or £650,000 for married couples and registered civil partners. IHT is charged at 40% on anything you leave over this threshold when you die.
Putting your life insurance ‘in trust’ not only means any pay-out is excluded from your estate for IHT purposes, but also that your dependents will receive the money faster. If the policy isn’t written in trust, the executors of your will must apply for a grant of probate, which can take several months.
Can I insure against falling critically ill?
Critical illness cover is an optional extra you can add to a life insurance policy. It pays out a tax-free lump sum in the event you are diagnosed with a serious illness like cancer, have stroke or heart attack, or if you are incapacitated following an accident.
You can use the pay-out for whatever you want, perhaps to pay off your mortgage, or to cover the cost of private medical treatment, refurbish and adapt your house, or pay for a convalescent holiday.
Although all critical illness policies normally cover a range of core conditions, some are more comprehensive than overs. For example, the average policy typically pays out for 30 to 40 illnesses, while others list 160 conditions