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Life insurance and protection: A primer (or why you should buy renewable term life cover, most of the time)

This guest post is by Mark Meldon, an independent financial advisor (and Monevator reader) who we’ve noticed talking a lot of sense over the years.

There remains a great deal of confusion about life insurance, so I thought I’d put together a guide to what life insurance is, who should consider purchasing it, the kinds of policies that are useful in the real world, how such policies are best purchased and set up, and when to review any cover you might have in place.

Too many people:

It’s not actually terribly difficult to get matters right when considering life insurance, especially if you hire a suitably experienced independent financial adviser (IFA), or one of the on-line brokers like Lifesearch [1] with whom I have no connection whatsoever, but who have an excellent reputation.

By using a combination of commonly available policies, you can minimise your costs and maintain flexibility and important long-term guarantees.

I believe:

Let’s get back to basics and have a think about this fascinating subject.

(Well, it’s fascinating to me, anyway.)

Life insurance and protection

Families purchase life insurance for protection; that is, they buy financial protection for themselves if the breadwinner – who brings in most or all of the household income – dies before the children have grown up.

Some families also buy financial protection for the years that follow the breadwinner’s retirement.

Even in the 21st century I find the father is usually the main breadwinner in most families, and so most of the life insurance purchased by a family is on the father. Of course, more and more families have two breadwinners, and the loss of income of either one could seriously affect the family’s financial security. Families with two breadwinners, therefore, may need to consider insuring both individuals.

Life insurance is based on the law of large numbers. Many families share the common risk of losing the breadwinner, and pay a small amount of money (called a premium) each year. In the event of the insured life dying during that year, the dependents/beneficiaries receive a much larger amount of money than the annual premiums that were paid.

A life insurance company uses mortality tables to calculate the risk of the insured dying during that year, collects premiums from all the persons sharing the risk, and handles the payment of the sum assured.

The type of financial protection a family needs varies with family income, resources, goals, composition, and stage in the family life cycle.

Used unwisely, life insurance can be an excessive drain on family finances and, indirectly, on family happiness and satisfaction.

Incidentally, many employers set up group life insurance schemes for their employees. This usually costs the members nothing and can be very helpful should disaster strike. I have a group life insurance plan for my small firm and the cost (tax deductible) is very modest. Do check if such a plan is available to you.

Types and uses of life insurance policies

Today, life insurance can be purchased in three basic types – term, whole of life, and endowment. The latter is quite rarely arranged nowadays, but I still come across policies of the so-called low-cost variety which were often arranged alongside interest-only mortgages up until 15 years or so ago.

There are many different names for policies, such as family income benefit, mortgage protection, gift inter-vivos, ‘flexible life’, and so on. They are all just combinations or variations of the three basic types of policy mentioned above.

Term

A term insurance policy protects the policyholder’s beneficiaries so long as the policyholder dies within the ‘term’, or period of time, specified in the policy.

Protection expires at the end of this period unless the policyholder has purchased a renewable policy; an option that allows him or her to renew the cover, regardless of any changes in health or occupation, until the age specified in the policy.

The premium for renewable term insurance rises at the beginning of each new term, or as death becomes more probable.

For the amount of protection it gives, term insurance is less expensive than any other type of protection up to about age 55. Most term policies can be renewed only up to age 65. A few can be renewed up to around age 100, but the premium for a term policy past age 65 will be extremely high.

Term insurance policies are seldom taken out past 65 because most families no longer need to protect against the loss of the breadwinner’s income. By this time, they may have pension or retirement benefits adequate to cover living expenses for the surviving spouse.

Term insurance is especially useful to young families that have only a small amount of money to budget for insurance but that need a large amount of protection.

In my experience, when money is tight, insurance can be forgotten. That’s potentially disastrous. If you choose ‘five-year renewable term insurance’, for example, a lot of protection can be arranged for a small outlay.

Longer-term policies cost more, and I’m not convinced that they are the best option for most families.

Decreasing term – often called mortgage protection – is a form of term insurance that is bought for a specific purpose. This policy insures the life of the mortgagor(s) for the amount of the mortgage at the time of the mortgagor(s) death. If the breadwinner(s) dies, the home will be paid for in full. The premium for decreasing term insurance is fixed, and the amount of cover decreases over time.

Always arrange life insurance to pay off a mortgage on your family home! (It’s maybe different for ‘buy-to-let’ mortgages where you might decide not to insure your life, preferring the property to be sold instead.)

There are other advantageous uses for term insurance. For example, a family that depends on current income to keep a child in school, college, or university can take out insurance on the breadwinner’s life for the amount needed to complete the child’s education. Commercial debt and leases can also be covered by life insurance, something many prudent businesses do as a matter of course.

Term insurance is often called ‘pure’ insurance because it does not include a savings element. That is, it provides for no cash build-up, as does, for example, endowment assurance.

A convertible clause gives the policyholder the right to convert a term insurance plan to whole life or some other permanent plan, and sometimes families take this option when they can pay higher premiums.

But this is anachronistic in today’s world of Individual Savings Accounts (ISAs) and pensions. There are nearly always better options for savings than life insurance!

Whole of life

Generally speaking, a whole of life policy furnishes the maximum amount of permanent death protection at the lowest annual premium.

Provided that all premiums due are paid, whole life policies will pay out whenever death occurs, hence their name. They are sometimes known as permanent policies.

Whole of life provides death protection throughout life, with premiums payable continuously until the policyholder dies.

Such policies used to contain a savings element, but this type ceased to be available some years ago. Whole life policies available today are pure insurance, akin to term insurance with no term.

Today, whole life policies are mainly used for specialist applications, such as inheritance tax mitigation planning and for those with long-term dependency issues.

Whole of life is much more expensive to purchase and, generally, of limited use for those wishing to insure the family breadwinner(s).

Endowment

The endowment policy is like a savings fund protected by term insurance. It offers insurance protection against death for a specified period of time. The policyholder decides that he or she wants to build up a certain amount of money by the end of a given number of years.

In a sense, the insurance company establishes a savings fund to which the policyholder contributes regularly and on which interest is compounded, usually annually.

If the policyholder lives to the end of the period, he or she will have accumulated – and can obtain – the face value of the policy.

What is face value? Let’s say a £50 per month endowment has a ‘sum assured’ of £25,000. The latter is the face value. If you pay all the premiums to the end of the agreed term, or die during it, the face value – here £25,000 – will be paid. (Perhaps more, if investment-linked or with profits.)

If the policyholder dies before the end of that period, the beneficiary will again receive the face value of the policy.

The limitations of the endowment policy arise from its incorrect use. The prospect of having a large sum of cash at the end of a relatively short period of time once led many families to purchase this plan, when their real need was for premature death protection.

Mainstream life offices withdrew endowments from the market some years ago – mainly due to the mortgage endowment scandal [2]. Restrictions were placed on premium limits (£3,600 per annum) more recently.

The policies are still available from a handful of Friendly Societies who offer what they call ‘tax-exempt savings plans’ with premiums of £25 per month, such as Healthy Investment and Sheffield Mutual.

I believe endowments are an anachronism, and best avoided.

Special policy features

Regardless of the type of policy or policies your family decides to buy, it is important that you keep your plan flexible. To help keep it flexible, you can add special clauses, what I like to call ‘riders’ in the American fashion, to your policy.

Two of these clauses – the renewable and convertible clauses available with term insurance – were mentioned above.

Two additional clauses – which will add to the cost, but which may help you keep your plan flexible – are the disability clause and the guaranteed insurability clause.

The disability waiver clause allows for a waiver of premiums if the policyholder becomes permanently disabled or unable to work through ill-health. This is very useful as it means cover can be maintained should illness strike.

The guaranteed insurability clause (often provided free of any explicit charge) guarantees the policyholder the right to purchase stated amounts of additional insurance at specified times – such as the birth of a child or increasing a mortgage – in the future without providing any heath information. Often forgotten about, this clause can be helpful to those whose health has deteriorated.

Payment of premiums

The premium is the amount of money you pay to keep your policy in force.

The annual premium is almost always less when paid once a year and paying twice or four times a year usually costs less than paying once a month.

However the vast majority of premiums are paid monthly nowadays – as most people never consider the other payment frequencies – by direct debit mandate.

Life insurance needs across the Life Cycle

Life insurance needs of families change as different family members grow older. The amount of protection needed will also vary with the number of members in the family, the current and anticipated income of the family, the earning potential of the family members, other financial resources, and the goals of the various family members.

The single person

In general a single person needn’t bother with life insurance. They may purchase it if they choose to leave any other financial assets, such as their house, to someone else and they don’t want the tab for what are euphemistically called final expenses (funeral and legal bills) to be left to a family member or friends

Sometimes a young single person will be encouraged to buy insurance early in order to get lower premiums.

It is generally true that, the younger the insured, the lower the premiums for a given type of insurance. The younger the person, the lower the risk of death.

However the individual may be paying for protection that he or she does not need, just to get lower premiums throughout life. That’s a waste of money in the majority of circumstances.

Single persons may also want to take out insurance against their own death if they have dependent aged parents. This need for protection could apply during any stage of the life cycle.

Establishment of the family stage (no children)

The insurance needs of a newly settled couple (married or otherwise) with no dependents are likely to be the same as for the single person.

The businessman/woman, the professional person, or the farmer who borrows money to become established – for example, to purchase equipment, supplies or livestock – should cover loans with insurance to protect his or her spouse/partner as well as his or her creditors. Term insurance should be considered to fill these needs.

Decreasing term insurance should be arranged to cover mortgages and something like family income benefit [3] could be considered to protect rent payments.

In this stage of the family life cycle, the couple should try to save for the future. Often both of the couple are working. Building up cash reserves and establishing longer-term investments using tax-efficient things like ISAs and pensions should be a priority, especially if the plan is to have children in due course.

The arrival of children

Without wishing to be accused of gender bias, even today it remains true in my experience that while the children are very young, the death of the father is usually the greatest hazard faced by the family.

Of course if the father is a ‘house husband’ while the mother works, the gender roles and risks I describe here and below are switched.

Though a young mother may be working or may be able to provide income for the family if the father dies, it is more difficult for her to leave home during the preschool and first school stages than at any other time during the family life cycle.

Even if she was working before the death of the father, her income will not be sufficient for the family to maintain the same level of living it did on two incomes. And if she was not working but now goes to work, her income may not be sufficient to maintain the standard of living it had with the husband’s or partner’s income.

Therefore, young families usually need a great deal of income protection from life insurance. At the same time, they typically have relatively little spare cash to provide this protection.

If your family fits into the early life cycle staged, here are some suggestions for getting the major protection you need with minimum expenditures.

What protection should you buy? The most important insurance need for most families is to insure the life of the sole or principal earner. Take care of this need before you buy insurance for any other family member.

The next important consideration, as ghastly as it sounds, should be burial expenses for the mother. If these expenses cannot be met out of current income or savings, consider buying a small whole life policy for, say, £10,000 to cover such ‘final expenses’.

If the mother works, your family might want to consider insuring against the loss of her income as well as against her death. Your family should also consider whether it would be able to meet the cost of caring for the children out of current income if the mother were to die. If you feel you would have difficulty meeting this cost, consider taking out a decreasing term insurance or family income benefit [3] policy on her life. The family’s income needs for child care will decrease as the children mature.

Look ahead to the protection you will want for the possible widow(er) between the time the last child reaches 18 and the time when the widow(er) is eligible for a pension or other retirement benefits. The amount needed will depend on the ability of the non-breadwinner to support him or herself during this period.

What forms or types to buy? To keep the cost of your insurance at a minimum, buy term insurance with a renewable clause. Renewable term insurance should serve your family quite well during this period, particularly if the need for income protection is quite large in relation to what you can pay. If you qualify for group life insurance at work, be sure to join the scheme at the earliest opportunity.

Five-year renewable term price comparison
£250,000 lump-sum cover for a male accountant, non-smoker, born 12/01/1986

Insurer Monthly premium
Royal London £10.87
Zurich £11.35
Aviva £12.42

Source: Source: iress/The Exchange 12 June 2018.

Sixth Form/College and university stages

The years when the children are in sixth form or college or off at university are a good time to re-examine your family’s needs for life insurance. Since the children will not be dependent for many more years, you may want to change the kind or amount of protection you are carrying.

By the time the children are in sixth form or college, the former primary caregiver will probably be back working outside the house. He or she may be in a better position to provide income for the family if the main breadwinner should die unexpectedly.

Any family’s life insurance programme should be re-examined whenever there is an employment change in order to keep the family’s economic security programme up to date.

Recovery stage

The recovery stage of the family life cycle is characterised by the financial independence of the children. The non-main breadwinner is usually the only dependent during this stage, and he or she is probably in the work force, too. If not, be sure that he or she is provided for in the period between the possible death of their partner and the time that he or she is eligible for pension or other retirement benefits.

Your family should make a special effort to build up savings for retirement during the recovery period. Put aside regular amounts for saving.

Retirement stage

When you reach retirement, your family’s need for life insurance is usually much less than in former stages, especially if the couple are nearly the same age.

The widow or widower may be eligible for limited state benefits or other retirement benefits if his or her spouse or partner were to die. He or she may also have money from an ISA or pension plan, or some other form of retirement savings.

During this period, some families purchase annuities [4]. Annuities are the opposite of life insurance – they are used to insure against dying too late and thus outliving your savings.

One time life insurance might be used in the retirement stage is to help set up a fund to help pay for any inheritance tax on the estate. This is a specialist area requiring detailed advice.

Setting up life insurance and using trusts

Apart from the application process – which an IFA can certainly help with – you need to consider the way in which you arrange your life insurance policies.

In most cases, you buy a life insurance policy for someone else: your spouse, partner, children or creditor. It’s best to ensure this plan comes to fruition by arranging the policy correctly.

Sometimes, a life of another policy is arranged. A good example is a wife owning a policy written on her husband’s life. But this is less common nowadays as trusts have become easier to arrange thanks to on-line functionality and simplified documentation.

Simply put, placing a policy into a suitable trust means that the life insured (the ‘settlor’) fills in a form appointing trustees (often a spouse or partner) who would control the sum insured should he or she die whilst the policy is in force. The trustees then deal with the money, following the wide range of potential beneficiaries set out on the trust form. (Most trust forms have a box for specified beneficiaries.)

The big advantage here is that the life insurance payout is not part of the deceased’s estate and won’t be counted as part of his or her estate for inheritance tax purposes. The trustees can usually obtain payment quickly, too, and not wait for the estate to be dealt with in the usual legal way.

Most life insurers offer very good trust forms, which are free to use. It’s unusual to find a situation where a trust shouldn’t be used but, again, an IFA will be able to help.

The bottom line on life insurance.

Mark Meldon is an Independent Financial Advisor based in Cheddar, Somerset. You can find out more at his company website [5]. You can also read his other articles [6] on Monevator. Let us know in the comments if there’s a topic you’d like Mark to cover.