What is life insurance and how does it work?

·6-min read
 (Unsplash)
(Unsplash)

Discussing death, or even just the thought of dying, is uncomfortable for many of us. However, taking out a life insurance policy means you can at least protect your nearest and dearest financially if you die unexpectedly and prematurely.

What is life insurance?

The most common type of life insurance is designed to pay out a tax-free sum to your loved ones if you die within a certain period, known as the ‘term’. That’s why you’ll sometimes hear it called ‘term insurance’.

The money that’s paid out is known as the ‘sum assured’. This is the amount of cover you decide to buy when you take out your policy.

If you survive to the full length of the term, your policy comes to an end - it does not have any value at this point. Likewise, if you stop paying premiums, the policy simply ends.

The other main form of life cover is ‘whole life’ insurance, which pays out whenever you die. For this reason, it is more expensive - and it is more of an investment and tax-planning mechanism than a means of providing funds for your loved ones after your sudden demise.

Who needs it?

If you have people who are financially dependent on you, such as a partner, children (or both), then taking out life cover at least means that they would be provided for in the event of your premature death.

You don’t have to be a breadwinner. If you take care of the home and family while your partner works, think of the impact if you weren’t around. The money from a life insurance pay-out would be very handy in paying for the support needed to cover your not being there.

However, if you’re single, have no dependants, and have savings with which to support loved ones, the case for taking out life cover is less obvious.

Beneficiaries can spend the proceeds from a life insurance policy as they see fit. But typically, the money might be used to pay off a mortgage, clear outstanding debts from loans or racked up on credit cards, or to pay bills or other ongoing future expenses.

Should they choose to, an individual is allowed to take out several different life insurance policies at the same time.

Who offers life insurance?

Life cover is available from comparison sites, banks, building societies, insurance companies and brokers, and from some retailers.

The policyholder pays premiums, usually monthly, to obtain the required financial protection.

Depending on your personal circumstances and financial planning needs, there are several types of life insurance to choose from.

For example, ‘term’ insurance is a type of life policy that offers cover for a designated period of time (the term). This sort of plan typically runs for between five and 25 years.

The longer the term, the higher your premiums are likely to be. That’s because the chances of death rise with age, making it increasingly likely there will be a claim on the policy.

Terms of use

Term insurance can be appropriate for those who want to make sure a large loan, such as a mortgage, will be covered after their death. Or it can provide a family with financial protection until children have grown up and become financially independent.

There are three versions of term life insurance, each with a particular characteristic…

In the case of ‘level’ term insurance, the payout stays the same regardless of when a claim is made during the term of the policy. Would-be beneficiaries will know exactly how much they’d be entitled to at any time. Premiums on the policy remain the same for the duration as well.

With ‘decreasing’ term insurance, the pay out reduces over the term of the policy. This makes sense if the main debt to be paid off is a home loan, such as a repayment mortgage, because this, too, reduces over time.

The premiums on decreasing term insurance will stay the same over the life of the policy, but they should be cheaper overall than those for comparable level term cover.

In contrast, ‘increasing’ term insurance is a type of policy where the payout increases over time. The thinking behind this is to protect your policy’s value against inflation. The amount of cover can be set to rise with an inflation measure such as the Retail Prices Index, or by a fixed amount each year.

Policyholders pay for this benefit via increased premiums over time, making it the costliest of the three forms of term cover.

Joint decision

A couple may decide to buy two separate term insurance policies to protect each other as well as, say, their children.

Another option is for them to buy a ‘joint life’ policy which can be cheaper, in terms of the cost of overall premiums, but only because it pays out on the first death.

With a joint policy, if the survivor wanted to take out a new life policy, it would be dearer for them to do so. This is because they would be older than when they took out the original plan.

How long should the term be?

When choosing the length of term on a life insurance policy, the key fact revolves around for what purpose you might need the cover. If the aim is to pay off the mortgage, the term needs to last as long as the time that’s left on the home loan in question.

By contrast, you may decide you only need cover for the time your children, or other loved ones, will be financially dependent on you. Alternatively, you may be looking for cover up until the time of your retirement.

What does term life insurance cost?

The premiums charged by life insurers depend on a range of factors to do with the would-be policyholder. These include:

  • Age

  • Health (along with that of immediate blood relatives)

  • Smoker/non-smoker

  • Occupation

  • Term of the policy

  • Amount of cover chosen

The older you are, the more expensive your premiums will be. The same applies if you have health problems or if you are a heavy smoker. When taking out life insurance you may be asked to fill in a medical questionnaire or undergo a health check.

From an insurer’s perspective, each of these variables nudges up the likelihood of a policyholder making a claim. With this in mind, and assuming you need it, it can pay to take out insurance while you’re young.

Renewable option

The older you are when you take out life insurance, the greater the chance you’ll have health issues and the more expensive your cover will be. If your term insurance came to an end and you wanted to take out a new policy, your premiums would probably cost a whole lot more.

Some insurers, therefore, offer so-called ‘renewable’ term policies that allow you to renew your cover without an updated health check. For example, this would allow you to take out a 15-year term policy and, at the end of the period, renew your cover at the same level.

Life insurance alternative

Those looking for a different means of supporting loved ones financially might also consider taking out family income benefit. Instead of providing a cash lump sum on death, this pays out a monthly tax-free income to your family if you die within the policy term.

If the cost of life insurance is a concern, family income benefit can be a more affordable option. Dealing with a regular income can also be easier than trying to manage a one-off lump sum.

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