How Does Life Insurance Work?

You probably know that it is a good idea to take out life insurance, but have you been wondering how it actually works and how it protects your family? In this article, we provide an overview of life insurance and the different types of policies that are available, so you can decide whether you need insurance and which type policy best suits your circumstances.

What is life insurance?

Life insurance involves paying a monthly payment each month for an insurance policy so that your beneficiaries will receive financial payments in the event of your death. You can arrange for their payment to be a lump sum, or regular payments, whichever option will be most beneficial to them and the financial situation.

If you have children, or a spouse who would financially struggle if you die, taking out life insurance can help to ensure that they have financial support after you are no longer able to provide an income.

There are two main types of life insurance:

Term life insurance policies

With this type of life insurance, the policy runs over a set term, which could be 5, 10 or 25 years, for example. The payout will only be payable if you die within the term of the policy.

There are two different types of term life insurance:

Level term life insurance

If you choose level term life insurance, the amount of the sum assured remains the same throughout the policy. As an example, you could agree a sum assured for £150,000 and this would not change. This type of policy normally provides a surplus for the beneficiaries to enjoy after any mortgage balance is paid off. This is because the mortgage balance will reduce over time but the life cover sum will remain the same.

Decreasing term life insurance

With this type of cover, the further into the term you die, the lower the pay out will be. This type of policy is usually selected to provide protection to redeem your mortgage balance alone upon death. However, unlike level term insurance, there is unlikely to be any surplus leftover after the mortgage has been redeemed.

Taking this type of policy out should mean that there are no concerns about your family losing the house, as the mortgage payments would still get paid off.

Whole-of-life policy

With this type of policy, it is a guaranteed pay out regardless of what date you die, as long as you continue to make the payments for the policy. This type of policy will usually cost significantly more than a term policy.

How much does life insurance cost?

The cost of life insurance depends on a number of different factors, including:

Age

One of the most significant factors is the age of the life insurance policy holder, with premiums being higher for older people. If you start paying for life insurance at the age of 40, the premiums will usually be less than for the same policy if you start paying when you are 45.

Health and family medical history

Insurers will also take into account any pre-existing medical conditions that could deem you to be at higher risk of death. You may also be asked whether there are any members of your family who have a history of a serious medical condition, as this can increase the risk that you will also be affected by the same condition.

Lifestyle

When you apply for life insurance, you will be asked a number of questions related to your lifestyle, such as how much alcohol you drink, whether you smoke (and how much) and your weight. Drinking more alcohol, smoking and being overweight will all affect the price of your policy.

Occupation

People with jobs that are in the higher risk category will also usually need to pay a higher premium for their life insurance. A high-risk job in the construction sector would usually increase premiums, compared to a low-risk job such as office-based roles. If you have any high-risk hobbies, this can also push your premium up.

Amount and length of cover

Longer term and whole-of-life policies will usually cost more than the shorter-term policies, as there is a greater chance of the insurance company being required to pay out and for paying more money out.

How much cover should you take out?

Deciding how much cover to take out is a very important consideration that needs to be carefully calculated. You should spend time to list all of the financial commitments that your family will have and the period of time those commitments will exist for. For example, the number of years left to pay the mortgage off on the house, any loans that have been taken out, financial support for children’s education and the general living expenses including bills.

If your main priority is to ensure the mortgage is paid off for your partner and that there is adequate financial support for your children until they are 21, you then calculate how much will cover all of the relevant costs to cover those.

You would also look at the full financial picture for your family, such as whether your partner has a stable job and their income level, how many years your children are away from full-time employment, as well as any savings and pensions that could be used.

Another consideration that you might want to cover is paying off funeral costs, so that your family are not faced with the financial burden of that, in addition to the grief of losing you.

If you want to keep your premiums to a minimum, taking out the shortest length of term that will work for you will keep the costs down, so you might just want to work out the best option to ensure your family has the minimum financial help that they need, rather than paying more.

Can I name who the money goes to when I pass away?

Yes, when you take out a life insurance policy, you can name the beneficiary who you want the money to go to. If you take out a joint life insurance policy that pays out on 1st death, the money will go to the other policyholder.

How to choose a life insurance policy

There are a lot of different factors to consider when you are choosing a life insurance policy. Firstly, deciding on the right length of term to suit your family’s financial circumstances is the starting point. If you have any pre-existing medical conditions, then you should be looking for insurers that specialise in policies for people with medical conditions.

Before you take out any life insurance, you should check whether your employer provides a death in service policy. You are usually able to name a beneficiary to receive a pay out that is a multiple of your salary, if you die while you are still employed by them.

Affordability is another big influence in the type of insurance that you take out. In an ideal world, you take out the most comprehensive insurance to pay out the biggest sum of money possible. However, the more cover you have, the more you are going to be paying for it, so you will need to decide how much you are prepared to pay for your policy premium.

Who does not need life insurance?

Generally, people who have no dependents would not take out life insurance. If a person’s partner could afford to pay the mortgage on their own, then there is also less reason to take out life insurance but it is entirely up to individual whether they want to protect someone they love by taking out life insurance.

Putting your insurance in trust

Another idea that you might want to consider is whether to put your life insurance in trust, which is the way that will be easiest for your family to deal with when you die. Putting it in trust means your insurance is ring-fenced outside of your other assets. It also means that the payments should be excluded from inheritance tax.

For many people, taking out life insurance provides them with the peace of mind that their family will not face financial difficulty in the event of their death. The policy may never need to get paid out because the policyholder lives longer than the term of the insurance policy but having that safety net means they do not have to worry about how their family would cope without them.

When a parent of a young family passes away and they are the main earner, if they do not have an insurance policy in place, their family will have to face financial struggles in addition to the emotional stress of losing their loved one. So, taking out life insurance, even if it may never be required, is the best way to prevent that situation from happening.

If you would like any advice on life insurance and the different options that would be most suitable for your family’s circumstances, contact our team for a free consultation.