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How does life insurance work?

Understand the different kinds of life insurance and how they work

published: 08 September 2022
Read time: 7 minutes

Getting life insurance is a big decision – so our guide explains everything you need to know about the different types of insurance and how they work

How does a life insurance policy work?

There are several different types of life insurance policy – but they all work in a similar way. When you take out life insurance, you’ll pay a small amount every month to your insurer. These payments are known as premiums. If you die while your insurance is still active, your life insurance will pay out to your family. This payment is called the ‘lump sum,’ and you can choose how big you want the lump sum to be – but a larger lump sum means higher premiums. Some types of life insurance will also pay out while you’re alive, if you develop certain critical illnesses covered by the policy.

Some life insurance policies only last for a certain amount of time, while others will last your entire life. Depending on which type of insurance you decide on, the lump sum can also increase or decrease over time.

You can read more in our guide on what is life insurance.

mother and daughter in a living room looking at a photo album

How does term life insurance work?

Term life insurance only works for a certain period of time – this is called the ‘term.’ You need to keep making payments throughout the term, and if you die during that period your loved ones will get a payment. A typical term is around 20 or 25 years, but different policies will have different ways of working.

Level term

With level term life insurance, the amount of money your family will receive if you die stays the same throughout your term. Your loved ones will get the same amount if you die after one year or ten years, no matter how much you’ve paid into the policy. Your premiums will also stay the same throughout the term. This makes level term insurance a good option for long term planning – the rates insurers charge tend to go up over time due to inflation, but if you get life insurance early you’ll be locked in to a cheaper rate for two decades or more.

Decreasing term

Decreasing term insurance, often referred to as mortgage life insurance, means that the lump sum slowly shrinks over the course of the policy’s term. Most people take out decreasing term life insurance to cover a specific debt – usually a mortgage. With your decreasing term life insurance linked to your mortgage, the lump sum is normally the same as the amount you still have left to pay on your property. This means that if you die during the term, your loved ones won’t have to worry about paying off your debts or even losing their home. Because the lump sum gets smaller every year, decreasing term life insurance is often much cheaper than level term – but it won’t give your loved ones any extra money for any additional debts or to provide ongoing financial support.

Increasing term

Increasing term insurance is designed to protect your family’s lump sum against inflation. Because a life insurance policy lasts for a long time, inflation could make a big difference - £100,000 could pay for a lot more twenty years ago than it does now. With increasing term insurance, the amount your family receives goes up every year – it’s usually tied to a measure of inflation, such as the government’s Retail Price Index. However, your premiums will also go up at the same time. This means that even if you buy increasing term insurance with the same monthly premiums as a level term policy, it’ll still be more expensive in the long run.

Term insurance is often a cheaper life insurance policy for younger people, since it means there’s less of a risk that the provider will need to make a payment. This means it might be harder or more expensive to get term insurance if you’re older than 60.

Your insurer will also want some information about your lifestyle habits, such as drinking and smoking, and they’ll usually ask you to go for a medical checkup so they can get an idea of your overall health. This information will help determine your premiums – if they think you’re less healthy, there’s more risk, so you’ll have to pay more.

It’s possible to get both single and joint life insurance. With joint life insurance, two people are covered by a single policy – if one of them dies, the other gets the lump sum.

How does whole of life insurance work?

Whole of life insurance works differently – there’s no term, and one policy will last you for the rest of your life. You get the peace of mind of knowing that your loved ones will always be covered, but it’s often much more expensive, since insurers know that every whole of life insurance policy is guaranteed to pay out at some point in the future.

Your whole of life insurance will keep working as long as you keep paying premiums, although some insurers will let you stop making payments after a certain age – usually around 85 – while keeping your cover.

Standard cover

With standard whole of life cover, your premiums are determined when you first take out the policy, and they’ll stay the same throughout. Balanced cover can be pricey, since the premiums need to be high enough to stay fixed for the rest of your life. That’s why it’s usually best to take out balanced whole of life insurance when you’re younger – if you’re young and in good health it’s likely you’ll get a cheaper deal.

Maximum cover

With maximum cover, your insurer will occasionally assess your health and change your premiums accordingly. However, with maximum cover you can also include an investment element in your insurance. This means that some of the money you pay for your premiums will be invested in the stock market, and if the markets rise you could get a larger lump sum or cheaper premiums. Just remember that your investments could also go down – if the stock markets fall, you might have to pay higher premiums to make up the difference and avoid shrinking the lump sum.

How does over 50s life insurance work?

Over 50s life insurance is designed for older people who might find it difficult to get an ordinary term life insurance policy. It’s a type of whole of life cover, and premiums are usually fixed for the entire policy. The main difference between over 50s life insurance and other policies is that over 50s cover usually comes with guaranteed acceptance – there’s no medical checkups, and you won’t have to answer any questions about your health or lifestyle.

Most over 50s life insurance policies will only pay out if you die more than a year after taking out insurance. If you die within the first 12 months, your family will receive however much you’ve already paid in premiums – but not the full lump sum.

How does death in service work?

Unlike ordinary life insurance, you don’t take out death in service cover yourself – it’s a workplace benefit offered by some employers, which pays out to your family if you die while you’re on their payroll. The amount you receive is usually a multiple of your annual salary. If your workplace has a death in service policy, your loved ones will receive the money if you pass away at any point while you’re an employee – the payout isn’t dependent on your dying at your workplace or in a work related accident.

If you’re not sure if your workplace has a death in service benefit, it’s worth talking to your HR department. It’s important to know if they do – they’ll need to have the right paperwork showing who you want to receive the money if you pass away.

What’s the difference between critical and terminal illness cover?

Critical and terminal illness cover are both forms of life insurance that can pay out to you while you’re alive to cover the costs that come with a serious illness. Both of these can be added to your ordinary life insurance policy for a little extra each month, although some insurers might include one or both of them as standard. However, while the names might be similar, they cover different situations and work in different ways.

Critical illness cover

Critical illness cover is designed to help protect you against the extra costs that come with a serious illness. It pays out a lump sum if you suffer a serious health problem, such as a heart attack or a stroke. Most policies will cover some forms of cancer, organ failure, or permanent disabilities. The lump sum is there to help cover the costs of medical treatment and any lost income while you recover. If you have a pre existing condition when you take out insurance, it usually won’t be covered by your critical illness cover.

Terminal illness cover

Unlike critical illness cover, terminal illness cover isn’t a separate insurance that’s added on to your main policy. With terminal illness cover, you can get the entire lump sum early if you develop a serious illness that significantly shortens your lifespan. Usually, insurers will pay out the lump sum if a doctor certifies that you have less than 18 months to live. This means that your life insurance can help pay for the care you might need, but there isn’t usually a separate payout to your loved once you’ve passed away.

Which life insurance should I get?

Any of the different types of life insurance might be best for you and your family – it all depends on your circumstances. Before deciding on a policy, it’s best to think about what you want your life insurance to do if the worst happens.

If your income helps support your family, term life insurance might be the best for you – it makes sure your loved ones won’t face extra money problems at an already stressful time if you pass away. If you want to cover a mortgage without paying too much in premiums, decreasing term life insurance is the smart choice – some mortgage lenders will require it before they’ll give you a deal. If you want to leave a legacy to your family through your insurance, whole of life cover might be right for your needs.

As always, it’s important to balance the cost of insurance against the level of cover. Some cheaper options might not provide a big enough payout to protect the people you care about if you’re the primary wage earner in your household. It’s a good idea to work out how much you contribute to the family budget, and how much your family might need if you were gone. This can be a difficult decision – but with the right insurance, you can make sure the people who matter most to you will have the security they need for years to come.

Looking for life insurance deals?

Life insurance is there to protect your family, whatever happens next. Once you’ve decided what type of insurance is right for you, the next step is to find an insurer that meets your needs.

The best way to find a great deal on life insurance is to shop around. With MoneySuperMarket, finding cheap quotes on life insurance couldn’t be easier. Simply tell us a little about yourself, and we’ll put together a list of quotes tailored to your requirements. You’ll be able to sort deals by the overall cost or the level of cover, and once you’ve found the perfect offer simply click through to the provider to finish things up.

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