There are many different types of life insurance designed to meet different needs. In this article, I look at the most common types of life insurance and the scenarios when they are most commonly used. I then provide a checklist of considerations that will help you to decide which life insurance is best for you.
We would always suggest speaking to a life insurance adviser who can provide a personalised recommendation on the best life insurance solution for your circumstances. If you don't already know an adviser you can trust then we have vetted the services of a specialist life insurance adviser*.
Types of life insurance and common uses
Level Term Assurance
Arguably, the simplest type of life insurance. It provides a lump sum of money if you die within a chosen period of time, called the policy term. The amount of money that will be paid out, remains the same throughout the years of the policy so it pays out the same amount whether you die the day after buying it or the day before it expires.
Most common uses - to pay off debts; provide capital for financial security to dependents or fund a possible inheritance tax bill after making a gift.
Increasing Term Assurance
This type of life insurance is the same as a level term assurance policy but the value of the lump sum you are insured for increases each year. Some insurers decide the percentage amount that your lump sum of money will increase each year, while others let you choose. The increase is usually around the rate of the retail price index (RPI) which measures the percentage increase in the cost of a group of products and services commonly bought in the UK. Usually, you can also choose a flat rate of between 5% and 10% each year. Bear in mind that the cost of the policy increases each year too. It is designed to keep track of inflation so that the real value of the lump sum of money isn't eroded over time. £100,000 today won't have the same buying power 20 years down the road as it does currently.
Most common use - to provide some capital that will offer financial security to those left behind should you die whilst they are reliant on you.
Decreasing Term Assurance
This is a life insurance policy that pays out a lump sum, called the sum assured, if you die within a set period of time. This type of policy is sometimes called Mortgage Protection Assurance. The size of the lump sum you receive reduces over time, mimicking the way that the balance on a repayment mortgage reduces. In the early years of the insurance policy, when you're paying back more interest than capital on your repayment mortgage, the sum assured reduces more slowly than in later years.
You will normally choose a sum assured based on what the balance of your mortgage is. You don't have to match the exact amount of your repayment mortgage. Some people choose to insure half of it if they feel that their partner could continue paying the other half. However, if you choose a policy length that is shorter than the number of years left on your mortgage, the policy will reduce faster than your mortgage balance, so it's best to avoid doing this. Decreasing term assurance is cheaper than level or increasing term assurance due to the fact that the sum assured reduces over time but the cost remains the same throughout the term of the policy.
Most common use - to pay off all or part of a repayment mortgage if you die before it is repaid.
Family Income Benefit
This policy allows you to choose an annual amount of income that will be paid to your beneficiaries if you die. It starts paying the income to them from the point of claim until the policy expires. This means the longer you live the smaller the overall potential payout from this policy. Again, the cost of the policy reflects this. Pound for pound it provides a higher level of insurance cover at the start of the policy than a level term assurance policy does. Although this policy is designed with families in mind, it can be used to provide an income to fund any regular cost that will continue for a finite number of years.
Consider the fact that if you die at the beginning of a 20-year financial commitment such as raising children, the impact is much greater than if you die when they are only a few years away from becoming independent. Two of the appealing features of this type of life insurance is that it can accurately match how much money is needed and the recipient may feel more able to manage the money if it is paid as an income rather than as a lump sum.
Most common uses - to fund the everyday costs of your household; raising children until they are adults and educational fees.
Whole of Life Insurance
Contrary to the above types of life insurance policies, this policy has no end date. It can provide either a level or an increasing lump sum when you die. The policy continues to insure you until you die, whenever that happens. The cost of this type of policy is usually higher than for a 'term' policy because it will eventually pay out rather than 'might' pay out. There are now far more whole of life policies available with fixed premiums than there used to be. This means that you don't have to worry about the cost of the policy becoming unaffordable. However, there are still policies that you can buy where the cost is reviewed periodically throughout your life. These are often cheaper to begin with but the reviews could end up making the policy too expensive to maintain as you get older.
Most common uses - to pay fund an inheritance tax bill; funeral costs or to leave a gift/nest egg for someone when you die.
Things to consider...
When deciding which life insurance policy is best for you (or indeed policies) here are some important things to consider:
How your death will affect your partner or spouse
- What do you provide for your partner? Consider the loss of your income to the household as well as the jobs that you do such as caring for children, housekeeping etc.
- Would your partner's lifestyle stay the same? Consider whether your partner would continue to live in the same home and what their expenses would look like on their own.
- What would change about your partner's work/income? Consider whether your partner would work more or less. Caring for children by themselves might mean they're less able to put in the hours. On the other hand, they may choose to work more if they were to become reliant on themselves and did not have to care for others.
How your death will affect your children
- What are the current costs you associate with your children? Consider the basics like food and clothing as well as the extras like clubs, hobbies, tuition, going out and birthdays.
- What costs do you anticipate for the future? Think about further education, weddings, help to buy their first homes.
- Who cares for your children? If you provide the childcare then consider whether someone else will step in and what impact that will have on any income they generate or whether you'll have to pay for childcare to keep things as they are.
- Do you pay maintenance for children who don't live with you? Consider how much you pay, how long this would need to continue for and how this would need to increase over the years. You may want to include other provisions that you want to make for your children that would require a lump sum of money such as weddings, further education or just getting started in life.
How your death will affect your parents, family or friends
- What support and care do you provide for parents, family or friends? Consider who will replace your duties and what this may cost.
Repaying debts if you die
What loans, credit cards, overdrafts do you pay for? You should consider which debts will need to be paid. Will the people in your life continue to make payments or will they prefer to pay these off? Paying off debts can free up the money they earn and lessen the need to work to earn giving them more flexibility to arrange their lives around a different situation.
Repaying a mortgage if you die
- Will your residential mortgage need to be paid off? If you share your home then you should consider whether others would be able to afford to continue to make repayments. If you live on your own, you may still want to leave enough money to pay off the outstanding mortgage on your home so that it can be gifted. However some people are happy for the home to be sold to repay the mortgage.
- Do you have a buy-to-let mortgage? There is value in considering the increased rental income that could be created for people in your life if the mortgage can be repaid. Additionally, it maintains the asset that could grow in value offering more financial security. Of course, you may choose not to prioritise this especially if the rental income derived from the property is stable and sufficiently supplements the mortgage payment. You might even agree that the property should be sold to repay the mortgage taking away the need to manage it and the cost of adding the mortgage to the amount of life insurance you will need to pay for. Think about what will be manageable as well as financially sensible.
Funding everyday bills and living costs if you die
- Which bills and costs will continue? List out the bills that will continue after your death. It's not a nice thought but your living costs will die with you - your car, insurance, food, hobbies and pursuits - remember to remove these. If you're the home-maker or care for children, will your partner need to pay for someone else to carry out your duties?
- How will the bills and costs be paid? If your household can be maintained by your partner's income or any other income then this might not be a concern. However, don't assume that just because your partner earns enough to pay all the bills, they'll be able to continue to work after your death. At the very least, there is likely to be a period of hardship immediately after you die. Would they want the option to spend more time at home, reduce working hours or give it up altogether?
Funding an inheritance tax bill if you die
- Will the value of your estate trigger an inheritance tax bill? There is no inheritance tax between spouses but if you leave behind an estate that is valued at more than the threshold (£325,000 for one person in 2020/21) the excess could be taxable. Will your beneficiaries be able to fund this? If not then it will need to be paid from the proceeds of your estate.
- Will the payout from my life insurance increase my estate and trigger an inheritance tax bill? Any life insurance payout could potentially increase the value of your estate. It's often good practice to arrange a trust with your life insurance so that any claim is paid out to your beneficiaries through trustees - both would be nominated by you. This means the money doesn't add to the value of your estate because the money bypasses this and the probate process. The trust ensures that the money is paid via your nominated trustees to benefit the people you selected.
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