How to choose which type of life insurance policy to buy

Term life insurance

Term insurance offers cover for a specific period of time – the 'term'. This is generally appropriate if you only need your insurance to protect your earnings for a fixed period of time, most commonly for the duration of your mortgage or until your children are old enough to be financially independent.

The size of your premiums depends on your age when you take out the policy, your state of health at the time, and the level of cover you want.

How long do you really need to keep old paperwork?

Another factor in the cost of cover is what happens to the level of protection over time: decreasing-term insurance, for example, pays out less towards the end of the policy than at the start. This is to reflect the fact that your family’s needs may be decrease as time passes, for example as the mortgage debt is paid off (this kind of policy is often known as mortgage life insurance) or as the period for which your children are likely to be financially dependent on you gets shorter.

Level-term insurance ensures that payouts would be the same whenever the policyholder died, while increasing-term insurance means that payouts are better placed to keep pace with inflation.

If you want your policy to pay out the same or a greater amount over time, your premiums will be higher.

Whole-of-life insurance

This type of policy remains in force until you die instead of for a specific term. Whole-of-life cover is more commonly aimed at older people rather than those with new mortgages or young families. It is typically sold on the basis that it will help the deceased’s relatives cover the likes of funeral expenses or inheritance tax bills, although it can also help to bolster the pension incomes of widows or widowers.

Some whole-of-life cover usually requires premiums to be paid only until a certain age, say 65. At this point, the policy remains in force, but no more premiums are due. Other policies use premiums to make investments that are expected to grow to cover the sum insured: but in some cases, if these investments do not do well, higher premiums may be charged.

Critical illness cover

This type of insurance offers a tax-free payout if you are incapacitated by serious health problems, for example cancer or heart disease, and have to give up work either temporarily or for good.

The cost of health problems

Premiums will depend on your age, state of health and amount of insurance required. Pre-existing medical conditions are unlikely to be covered, and not all illnesses will qualify for claims: when taking out a critical illness policy, it is vital to check the small print and to be completely honest in the application process.

Using life insurance to pay your inheritance tax bill

Many older people take out life insurance to ensure their family has enough money to pay any inheritance tax bills that may be liable upon their death.

How life insurance can help

Life cover is often taken out to protect families or partners in the event of the main breadwinner’s death. But many older people sign up for life insurance so that their relatives have enough money to pay any inheritance tax bills that may be liable upon their death. This can make the difference between being able to keep a family home and having to sell it to cover the tax bill, for example.

Normally, this would be done with a whole-of-life insurance policy, which remains in force until the policyholder’s death, provided their premiums are fully paid.

With term insurance, which only runs for a fixed period of time – until a mortgage is paid off, or until children have left home, say – there is a good chance that the policy will end before the policyholder dies. In this case it would not be able to offset any inheritance tax liability.

Levels of life insurance cover

When you take out life insurance, you can decide how much the policy will pay out upon your death.

If you are signing up for cover to mitigate inheritance tax, you will have to estimate the potential size of your bill. This can be difficult as you don’t know a) when you’ll die, b) what the value of your assets will be at this point and c) whether the government’s current inheritance tax policy is likely to change.

Using a Trust

Under normal circumstances, any payment from a life insurance policy could itself be subject to inheritance tax. However, by writing the policy in Trust, the tax should be avoided. What’s more, the payout will not have to go through the often lengthy probate process, so your relatives will get their money much more quickly.

Trusts can be simple to set up, but it is well worth seeking expert legal advice before doing so to ensure this approach is appropriate to your circumstances.

How can Trusts help?

One of the primary reasons for setting up a life insurance policy in Trust is to avoid inheritance tax. Assets in Trusts will not normally be considered part of a deceased person’s estate for tax purposes. Outside of a Trust, any pay out could be subject to a hefty deduction percentage deduction by the taxman.

There is a further advantage: because the life insurance money is not part of the policyholder’s estate, it does not need to go through the probate process – which can in some cases take weeks and even months – before relatives are paid. This means they should get the pay out much more quickly, which can be very important if it is needed to meet day-to-day expenses.

Potential drawbacks of Trusts

The decision to use a Trust is not always straightforward, however. There are likely to be extra costs involved in setting one up, and it will be harder, or at least more time-consuming, to cancel a policy once it is inside a Trust as the agreement of the trustees is required. However, if you simply stop paying the premiums, the policy will probably lapse and be cancelled by the provider.

Trusts are a complex aspect of the law, and there are different types available. Discretionary Trusts, where the person who set it up has the power to change the beneficiaries, are one of the most common kinds.

In any case, it is a good idea to seek expert legal advice if you are considering this course of action.

Checklist: reasons to update your life insurance cover

Changes in income

If your earnings increase significantly, you may want to increase the amount you are insured for.

If your policy is designed to give your family a lump sum in the event of your death, it makes sense that the amount insured rises in line with your family’s standard of living.

Moving home

Similarly, if your policy has been set up to cover your mortgage commitments, you may need to update it if you take on more debt by moving to a more expensive property or by remortgaging.

A growing family

As you have more children, so the cost of raising your family will grow. New additions should be a key catalyst for a review of life insurance levels.

Changing beneficiaries

One common mistake is failing to change the named beneficiary on a life insurance policy in the event of divorce or separation. When you set up a policy, you will be asked who is to benefit and this can only be changed by your direct instruction.

The inheritance tax threat

Older people often take out life insurance in order to help their families meet any inheritance tax bills that are due on their estates. Extra cover may be required if their assets increase significantly in value, for example as a result of a booming property market, or if the government makes the inheritance tax regime more punitive.

How to update your life insurance policy

Administrative changes, such as replacing a named beneficiary, should be straightforward to carry out.

If you want to increase the level of cover, your insurer may allow this without any further checks in return for a small increase in premiums. In some cases, though, you may need to go through a repeat of the original application process, answering questions about your health and so on.

However, it is rarely a good idea simply to cancel your existing policy and take out a new one with more generous levels of cover. Generally, the younger you are when you take out life insurance, the lower your premiums are. It may, therefore, work out cheaper to keep your old policy and simply buy a top-up policy, either with your existing provider or a rival.