One of the most important decisions you can make when you buy life insurance is how long you want the cover to last. To some, this may seem an odd idea: surely any life policy should cover the holder until their death? But this is not necessarily the right approach.
Why we take out life insurance
The most common reasons for taking out life cover concern family circumstances and making sure that your dependants do not suffer too much in financial terms if you die.
So you may consider taking out a policy when you get married, buy a house with a partner, or have children. But the extent to which your family relies on your income will change over time.
For example, you may take out a life policy when you buy a house with your partner, to ensure they can afford to remain in the home in the event of your death. In this case the life insurance could be set up to match the mortgage.
But typically mortgages last 25 years – so you may decide you only want your life insurance policy to remain in force for this long, as if you died after the mortgage was paid off, the financial implications for your partner would be much less drastic. Alternatively, you may only want your life cover to last as long as your children are at home, or in full-time education.
Life insurance policies which last for a fixed period of time are know as term insurance or term assurance. (Whole-of-life policies, on the other hand, last indefinitely, until the holder’s death.)
Because there is no guarantee that the insurer will have to pay out, term insurance is likely to be cheaper than a whole-of-life policy. You can set the term at any length: it could be five, 10, 15 or 25 years for example. These are your options when it comes to term insurance:
Level term insurance
When you take out a term insurance policy, you need to decide what happens to the amount of cover as time passes. If you want the potential payout to remain the same irrespective of when during the term a claim might be made, your policy will be for level term insurance because the cover remains at the same level throughout the duration of the insurance.
Decreasing term insurance
Alternatively you may be happy for the potential payout to fall year after year, as is the case with decreasing term insurance. For example, if your life insurance is designed solely to cover your mortgage, it may be appropriate for potential payouts to fall as you pay off the loan. (Provided you have a repayment rather than an interest-only mortgage, the amount you owe in year 15, say, will be much lower than in year one.)
This kind of cover may also be known as mortgage life insurance. Cover that falls in value over time will be less expensive than insurance which remains the same or rises.
Increasing term insurance
If you want the possible payment from a life policy to increase over time – to reflect inflation and the rising cost of living, for example – then consider increasing (or index-linked) term insurance.
You can decide how much it will increase every year (for example 3 per cent or 5 per cent), or tie it to a specific inflation measure such as the Consumer Prices Index (CPI) or Retail Prices Index (RPI). Of course, you will have to pay higher premiums than with level term insurance for this extra benefit.
Renewable term insurance
Another option is to take out a policy for a shorter term with the option to renew when the term finishes. The difference between a policy like this and simply shopping around for new cover at the end of the term is that the renewable insurance will not take into account any deterioration in your health and use this information to increase premiums.
Your age at the renewal date will be taken into account, however, so costs could rise. An insurer is only likely to offer you a renewable term policy if you are in relatively good health at the outset.
Cut your family’s tax bill
When you take out a term life insurance policy, it is also worth thinking about how to make sure your dependants can get hold of any payout with the least hassle and the lowest possible tax charge if the worst does happen. Writing your life insurance policy in trust means the cover is ring-fenced outside the rest of your assets, such as savings, investments and property.
This means that payments from the policy are not included in your estate for inheritance tax purposes.
At the moment, inheritance tax is charged at 40 per cent on any bequeathed assets above the £325,000 threshold. So depending on the value of any property or investments you have, up to 40 per cent of a life insurance payment could end up in the taxman’s hands if the policy is not written in trust.
And because the life policy is not included in your estate, the payout does not have to go through the probate process with the rest of your assets, which means your family will probably get the money much more quickly.
A trust is normally simple and cheap (or even free) to set up: talk to your insurer when you take out your policy, but bear in mind that a trust is not appropriate in all circumstances.