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?
- Term life insurance policies
- Level term life insurance
- Decreasing term life insurance
- Whole-of-life policy
- How much does life insurance cost?
- How long should the cover last?
- What does life insurance cover? What isn't covered?
- How much cover should you take out?
- Can I name who the money goes to when I pass away?
- How to choose a life insurance policy
- Other types of insurance
- Who does not need life insurance?
- Putting your insurance in trust
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.
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.
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How much does life insurance cost?
The cost of life insurance depends on a number of different factors, including:
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.
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.
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 long should the cover last?
Again, this should be calculated based around the important costs that you want to make sure are going to be covered. For some people, taking out insurance for a 10-year term will ensure that the outstanding mortgage is paid off and after that, there should not be many other large costs to pay out for, so a 10-term will suit their family’s financial situation.
However, if there are lots of financial dependencies, for example, you have young children and want to make sure that they have financial support, even as they get older, you would be better taking out a whole-of-life policy. You will need to weigh up whether paying the higher insurance premiums is a better option than starting up a savings account for your children or helping to get them set up with a property.
What does life insurance cover? What isn’t covered?
Life insurance will usually only cover death, although there are some types of policy that cover being diagnosed with a terminal illness. Certain types of causes of death can be excluded in life insurance policies, for example, deaths that have resulted from drugs or alcohol abuse. High risk sports may also be excluded.
When you initially take out the policy, if you have any medical conditions that could mean you are at higher risk of a premature death, the insurer may decide that death from this health condition is excluded in the terms and conditions of your policy.
It is very important that you answer all of the insurer’s questions accurately and correctly, as any mistruth could be investigated and your insurance could be invalidated as a consequence, meaning that your family could be in a position where they do not get any financial support from your life insurance.
The types of questions you will be asked when you are getting a policy quote include:
- Date of birth
- How much alcohol you drink
- Whether you smoke and how many cigarettes per day
- Medical history
- Family medical history
- How much exercise you do
- Financial information such as annual income.
Most life insurance providers will request that you have a medical examination to check for any existing medical conditions that could affect your life expectancy. Some conditions may result in the insurer declining to offer you a policy, or they could exclude the condition in the terms of your policy, so your family would not receive the money if that is your cause of death.
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.
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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.
Other types of insurance
Life insurance can provide financial security for your family but there are other types of insurance that you might want to consider taking out:
Critical illness cover
If you were to get ill and were unable to work, your life insurance policy will generally not provide you with a payout in this situation.
If you are ill for numerous years, with no income then this is likely to cause you significant financial problems, so if you have a young family and a mortgage, taking out critical illness insurance will ensure that you can pay your mortgage if you were to get a serious illness. However, be cautious of Critical Illness policies as they may not cover all types of critical illnesses.
Accident, sickness & unemployment insurance (ASU)
Another risk for you and your family is that you could lose your job through redundancy and would not be able to afford your mortgage payments until you were able to find another job. ASU insurance will cover you in the event that you lose your job through redundancy or accident/sickness covers either 1 or 2 years of each claim up to a maximum of £1,500 per month.
Income protection benefit
Income protection benefit will provide a monthly benefit amount, normally until retirement, in the event of a loss of earnings through accident or illness. The maximum cover allowed is 80% of the net income. The premium cost will largely depend on age, amount of benefit, deferred period and occupation.
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.