How you would your family or partner manage if your income suddenly stopped in its tracks? Life insurance is a type of protection designed to help your loved ones coverage mortgages, debts, and day-to-day expenses when you are no longer around.
How does the coverage work?
With this type of insurance, you pay regular monthly or annual premium to a life insurance company. If you die during the term of the policy, a lump sum is paid out to your family – or other dependents – known as ‘beneficiaries’.
While the beneficiaries can do what they like with the funds paid out, the money is commonly used to clear the mortgage and other outstanding debts, as well as to coverage household bills, living costs – and to fund childcare.
Why should you take out life insurance?
Given that none of us knows what’s around the corner, it’s very important to have financial protection in place. And, of course, COVID-19 has been a timely reminder of this.
Simply put, life insurance offers peace of mind that your family would be financially protected if you were no longer around to provide for them. Without this safety net in place, they may struggle to keep financially afloat, causing even further anguish and upheaval.
When should you take out life insurance?
Certain key life events trigger the need for life insurance, such as buying a house, getting married or having a baby. You should then think about increasing your level of coverageage when things change – for example, you have more children, or take on a bigger mortgage if you’ve upsized your home.
While a greater level of coverageage is likely to result in a higher premium, this is likely to pale into insignificance for the peace of mind it offers – and, of course, what it might one day provide.
How much coverageage do you need?
As a minimum, you should opt for enough coverageage to pay your debts – including what’s outstanding on the mortgage, credit cards, and loans – pay the bills, keep your car, and maintain your current standard of living.
However, some experts say that around 10 times your gross annual salary should be a starting point, rising to 15 or even 20 times if you have large commitments.
How much will it cost?
Competition among life insurance companies, as well as simplicity of the outcome (alive or dead), means premiums are relatively cheap – literally starting from as little as $5 a month.
The exact premium you are quoted however, will depend on a range of factors, including your age, health and lifestyle (such as if you exercise and whether you smoke). It will also hinge on the amount of coverageage you want, and the length of the term you want the coverageage for.
You can expect to pay lower premiums if you take out life insurance when you are young and healthy, while premiums will gradually increase as you get older.
Premiums tend to be higher also if you suffer from a health condition that could mean you are more likely to die sooner than the projected average age.
What are the different kinds of coverageage?
There are various kinds of life insurance available and the one you choose will depend on your circumstances. Here’s an outline of how each one works.
Term life insurance
In broad terms, the most common form of life insurance, ‘term insurance’ is the cheapest option as it only pays if you die within the specified term of the policy.
This is opposed to ‘whole life’ coverageage (more details on this below) which pays out whenever you die.
Term life insurance falls into three different types: decreasing term, level term and increasing term. Here’s an outline of each.
Decreasing term insurance
With a decreasing term policy – the most common type of ‘term’ coverage – the amount that will be paid out in the event of death becomes lower over time, so it’s most suitable if your own financial commitments will also reduce over time.
The most notable example of this is a repayment mortgage – the life insurance pay out decreases in line with the projected fall in your mortgage balance as you chip it away.
Decreasing term insurance is cheaper than level term insurance, and often the most cost-effective option. That said, if you have children who depend on you financially, level term coverage may be a better option.
Level term insurance
A level term policy pays out a fixed amount if the policyholder passes away within a pre-selected period of time – known as the policy ‘term’. No matter how many years into the policy you pass away, your beneficiaries will receive the same pay out – known as the ‘benefit amount’.
This makes level term coverage well-suited to an interest-only mortgage, where only the interest is paid off but the capital debt does not decrease. While premiums remain the same during the term, they tend to be more expensive to those attached to decreasing term coverage.
If you survive the ‘term,’ your coverage will end, and you will need to purchase a new life insurance policy.
Increasing term insurance
With an increasing term policy, the amount insured goes up every year by a fixed amount for the length of the policy. This is designed to protect your policy’s value against inflation. Because the amount of coverage becomes greater over time, premiums tend to be more costly than other types of life insurance.
Whole-of-life coverage
Unlike term insurance (which only pays out if you die within a specified period), a whole-of-life policy is designed to run for the remainder of your life.
So, provided you keep paying your monthly or annual premiums, your loved ones are guaranteed to receive a payment when you die.
For this reason – and because whole-of-life coverage does not require a medical exam or take into account your pre-existing medical conditions – premiums for whole-of-life insurance tend to be more expensive than term insurance.
Furthermore, as this type of policy is typically linked to a specific investment, your premiums may also increase if that investment does not perform well.
Usually, you will need to pay premiums for the rest of your life, although there are some types of whole-of-life coverage (such as over-50s) that allow you to stop paying, but still be coverageed once you reach a certain age, 90 for example.
Pay outs for whole-of-life coverage are often used to offset any inheritance tax bill that your loved ones may receive in the event of your death.
Single life insurance
This type of policy coverages just one person, opposed to joint life insurance (see below) which is used to coverage a couple.
That said, if you’re in a couple, you might consider taking out two single policies so your dependents could potentially receive two pay outs.
However, this approach tends to be more expensive than a joint policy as you will also have to pay two lots of premiums, rather than one.
Joint life insurance
A joint life insurance policy coverages two people, usually who are married or in a civil partnership. (It’s possible to buy joint life insurance just as a couple, although some insurers may stipulate you must live in the same household.)
Joint life insurance means you pay just one premium which will provide coverage for you both. However, the policy only pays out once – on the first person to die within the term.
Before taking a joint policy, it’s worth checking whether two single policies could be better. While it means two sets of premiums, it also means two potential pay outs.
Have your policy ‘written in trust’
It could be worth getting your life insurance policy ‘written in trust’ as money in a trust is no longer your asset, so not liable to inheritance tax.
If you do this, the pay out from the life policy goes directly to the beneficiaries, rather than your estate, meaning it won’t be taken into account when inheritance tax is calculated.
Neither income tax or capital gains tax is charged on life insurance pay outs.
Mortgage life insurance
This type of life insurance – also known as ‘decreasing term insurance’ – pays out if you pass away before you have paid off your mortgage. As this coverage is tied to your mortgage, the amount coverageed decreases as you continue to pay it off.
Note that if you bought this coverage from your lender when you took out your mortgage, you could be paying over the odds, so it could pay to switch (ensuring, of course, you leave no gaps in coverage).
Critical illness coverage
Many life insurance policies allow you to add on critical illness coverage for an additional cost. It pays out a tax-free lump sum if you are diagnosed with a specific illness or medical condition listed on your policy – such as cancer, heart attack, stroke or loss of limb – during the term.
Its purpose is to offer a financial buffer at a highly stressful time of life, and support if you have to stop working. The funds paid out can be used to ensure your mortgage and other major financial commitments are paid. The money can also be used to make any required adjustments to your home that make life more comfortable.
Critical illness coverage is considerably more expensive than life insurance. So, while you should look to take out enough coverage for your mortgage, debts and monthly bills, in reality, it may be a case of seeing how much you can afford.
Also be sure to read the small print carefully, as insurance companies have a finite list of conditions they will coverage. This can run to more than 100, but if your illness isn’t included, you won’t get a pay out.
You may also be declined if you have withheld information about your medical history or if the illness you contract isn’t advanced enough.
Income protection
Income protection will pay out a regular income if you are unable to work due to illness or injury, thus enabling you to continue to meet your monthly outgoings.
Many policies come with a ‘deferral period’ where you won’t receive a pay out for, say, the first six months of being unable to work. But the best policies will continue to pay over a long period of time until you are fit enough to return to work – or reach retirement age.
The amount you take out is usually based on your salary. Premiums can be guaranteed or reviewable.
And look for policies that pay out if you cannot carry out your ‘own occupation’ rather than ‘any occupation’ at all as, in reality, this would make a big difference to the value of the policy.
If you don’t have dependents, income protection is likely to be the most important type of coverage. It can also be crucial if you are the main breadwinner or sole earner in your household.
Equally, income protection can be especially important for the self-employed who are not entitled to sick leave or pay from an employer.
