Complete guide to Life Insurance – and how much you need
You can get insurance to cover just about anything these days. However, while a lot of people understand the importance of certain insurances, such as home insurance, life insurance is often overlooked.
But ask yourself the question ‘how would my family cope financially if I died?’ As morbid as it sounds you need to consider the impact of your own death on those left behind, particularly if you are the main breadwinner. Unless you have left them with sufficient assets the chances are that they may well struggle to cope. What sort of legacy is that to leave behind? In this guide I talk through the types of life insurance available, how premiums are worked out and how much you need.
Types of life insurance
- Level Term - A policy that protects the life assured over a set period of years. This is one of the cheapest forms of life insurance and is often used to cover a mortgage debt
- Increasing Term - A type of term insurance where the sum assured and premiums will increase over the term of the contract to offset the effects of inflation
- Decreasing Term - An even cheaper from of term insurance specifically designed to cover the loan on a repayment mortgage. The sum assured reduces roughly in line with the outstanding debt
- Renewable Term - This is a term insurance policy that has the option to renew, without any medical evidence, after a set period
- Convertible Term - This policy can be converted to a whole of life or endowment policy during the term without any new medical evidence
- Family Income Benefit - With this policy instead of a lump sum payable on death there is a regular annual income paid over a given term
- Whole of Life - This policy will cover you for the remainder of your life so that a lump sum is guaranteed on death. In some instances there may be an investment element in the policy,where the sum assured increases over time, or the premiums may only be paid up to a certain age
- Endowment Policy - This is a combination of life insurance and investment where the policy is taken over a term of years. At the end of the term the policy pays out accumulated returns but in the event of death during the term a lump sum is paid
- Critical Illness - A sum is paid on the diagnosis of a critical illness during the policy term. The critical illnesses covered would normally be life threatening and often this cover is linked in with life insurance cover
- Health history
- Lifestyle - eg participation in extreme sports
- To clear a mortgage, or other debts or pay funeral expenses
- To pay a potential Inheritance Tax (IHT) bill payable on your estate, so ensuring that your dependents receive more of your assets
- To provide an income or capital sum for you dependents in the event of your death
To keep things simple I’m only going to look at the above scenarios. In addition, I’ll assume that in each instance the need is to be met by the receipt of a tax-free lump sum. Consequently I’m only going to consider ‘term assurance protection contracts’ here, which pay out a tax free lump sum in the event of death, within a given period of time – called the term. Term assurance contracts are used to cover most people’s post-death requirements. (- term assurance contracts do not have an investment element to them as they are pure protection contracts).
So going back to the original question – how much life insurance do you need? Well a good starting point is to look at the financial requirements immediately after you die. So let’s crunch some numbers.
The simple 5 step calculation
STEP 1 - Mortgage
Write down the amount of your mortgage that is outstanding. I’ll use the figure of £250,000 as an example.
STEP 2 – Other debts
Write down any additional debts you may have.
I’ll assume the figure of £20,000.
STEP 3 – Inheritance tax bill
Now calculate your rough IHT bill in the event of your death.
Take the value of your worldly assets which you plan to pass on. Now deduct any IHT exemptions (i.e. you don’t pay any IHT on money left to a spouse) and your IHT allowance of £325,000 (for the tax year 2011/12).
Take 40% of this figure and voila you have a rough estimate of the likely IHT bill upon your death.
So let’s assume you have an estate of £1,000,000 (ignoring your house which is jointly owned with your spouse – so they will assume full ownership) and you are leaving half of the estate to your spouse and half to a friend.
Then £1,000,000 - £500,000 (left to your spouse) - £325,000 (your unused IHT allowance) = £175,000 is liable to IHT. Now take 40% of this figure which gives you £70,000.
STEP 4 – Dependents’ income shortfall
Now you need to work out the income requirements of your dependents – over and above their own earnings plus any income their inheritance will provide. I’ll assume your spouse will need an additional £50,000 a year tax free (ignoring inflation) for 10 years after you die.
So that’s the equivalent to a lump sum of £500,000 when you die.
STEP 5 - Existing policies
Note down details of any life insurance policies you already have, including those offered by your employer if applicable.
I’ll assume a death in service sum assured of £200,000
Now carry out the following calculation.
Step 1 + Step 2 + Step 3 + Step 4 – Step 5.
In my example that equals £250,000 + £20,000 +£70,000 + £500,000 - £200,000 = £640,000.
So this is the figure that you would need to insure in order to meet all of the above requirements if you were to die today.
One size doesn’t fit all
Now this may be the figure needed at the date of death but simply taking out one term assurance policy with a sum assured of £640,000 would not only be expensive but would likely be unnecessary. In the above example each need exists at various different times.
For example let’s assume you have a repayment mortgage. In 12 years time the value of your outstanding mortgage will be greatly reduced (as you will have repaid a fair bit by then). So at that point you won’t need life cover of the full £250,000 stated in step 1. Similarly if you were to die in 12 years time your dependents’ extra income requirement will no longer exist. So your life cover need will again be lower.
The answer would be to take out a number of term assurance contracts where the policy type, the sum assured and the term of each reflected each separate need. For example, a decreasing term assurance contract could be taken out with an initial sum assured of £250,000 and a term matching that of your mortgage. A Family Income Benefit plan could be taken out to satisfy your dependents’ income requirements. This would save you money and has the additional benefit that each policy can be assigned or placed in trust for different people (a topic for another day). Also don’t forget to consider the impact of your spouse dying. Could you cope financially on your own? You may want to consider taking out a joint life insurance policy so that your mortgage is cleared should the worst happen to either of you.
But, if you can only afford to take out a minimal amount of insurance I would suggest that you at least try and cover your mortgage.
At least cover your mortgage
In the event of your death your mortgage doesn’t simply disappear, the debt still stands. Obviously the bank will want their money so if your mortgage is jointly held with your spouse then they will become solely liable for the monthly mortgage payments. This could be disastrous if their own income is insufficient to meet the monthly bill. This might lead to your home having to be sold in order to pay the outstanding debt so rendering your family homeless. (for more information on what happens to debts on when someone dies click here)
This can all be avoided by taking out life insurance which matches any outstanding mortgage at the date of death. That way in the event of your death the insurance policy pays out and clears the outstanding mortgage – leaving your family with a house to live in mortgage free.
So if you have:
- A repayment mortgage – you should look into taking out a decreasing term assurance policy with a term that matches that left on your mortgage, and a sum assured matching the debt outstanding at the time of taking out the insurance. A decreasing term assurance policy is one where the sum assured decrease over time at a similar rate to which you are paying off your mortgage.
- An interest only mortgage - you should look into taking out a level term assurance policy with a term that matches that left on your mortgage, and a sum assured matching the mortgage amount initially borrowed. A level term assurance policy is one where the sum assured remains the same throughout – which will reflect the fact that you are not repaying your mortgage but simply paying off the monthly interest.
Often your mortgage lender will require you to take out a life assurance policy as a condition of their lending, but in reality this is seldom enforced and a lot of people have mortgages in place with no life cover.
If you are at all unsure speak to a financial adviser who should recommend the most suitable protection solution to meet your needs.
There are a number of other types of protection policies such as Critical Illness cover which pays out a lump sum in the event of you being diagnosed with a specified illness (such as breast cancer). Similarly there are income protection arrangements which will replace a certain percentage of your income should you become unable to work through accident and ill-health. (see my guide to Income Protection)
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