Understanding the different types of life insurance
Last reviewed on 08 June 2016
There are several types of life insurance. Here we look at the options.
What is life insurance?
Life insurance pays out either a lump sum or an income if you die. You might want it to provide your family with an income to live on or to cover a specific regular expense. Or you might want them to receive a lump sum which they can then invest/use for income or to pay for something specific such as an outstanding mortgage or Inheritance Tax bill.
As with all insurance there are exclusions so you need to read policy documents carefully. Life insurers prefer to refuse cover rather than have lots of exclusions. So providing you have been truthful on the application form, once you have cover most policies will pay out whatever the cause of death. However, there are some exceptions. For example, there is usually a qualifying period before death from suicide is covered.
Single and joint policies
Life policies can cover a single life or joint lives. With a joint-life policy, decide if you want the policy to pay out on the first death (this could be useful if you want it to pay off a mortgage or protect dependants) or the second death (which can be useful for inheritance planning).
However, think carefully before taking out a joint-life policy. Two single life policies are often not much more expensive and can work out better if different levels of cover are required. For example, if one partner earns a lot more than the other, that partner may need a higher level of cover.
Life insurance policies can also be written 'in trust'. This means the benefits can be paid direct to whoever you want to receive the pay-out without it becoming part of your estate. This is useful because your survivors receive the pay-out more quickly and it is not subject to Inheritance Tax.
You can take out life insurance for a specific period or term (known as term insurance) or until you die (known as whole-of-life insurance).
This is the simplest and cheapest type of life insurance. You take out cover for a set period which might be 10, 15 or 20 years. If you die within the term then the policy pays out a tax-free lump sum. If you live beyond the term, the insurer pays out nothing.
The premiums are usually fixed for the term of the policy although with some policies they may be reviewed after say five years.
There are various types of term insurance (also known as term assurance).
- Family income benefit - this pays out a regular tax-free income on death.
- Level cover - this is where the amount of cover remains the same for the term of the policy.
- Increasing cover - this is where the amount of cover and the premiums increase over the term.
- Decreasing or reducing term - this is where the amount of cover/total pay-out decreases over the term. This is often taken out alongside a mortgage (see mortgage protection insurance below). Family income benefit is also a form of this.
- Renewable policy - this allows you to extend the original term of the policy.
These policies do not have a set term but carry on for as long as you pay the premiums. This means there is always a lump sum pay-out on death. Some policies have an investment element and this cash-in value can be taken before death. These investment-type policies might only have a small amount of life cover in the early years.
Whole-of-life policies can be expensive but they are useful if you want a guarantee that your policy will pay out no matter when you die. They are used mainly to pay an Inheritance Tax bill or for passing on money after death. If you take out a whole-of-life policy with someone else, it should pay out when the second person dies. If these policies are written in trust, the proceeds won't be included in your estate for Inheritance Tax purposes. Be careful with these policies as sometimes the premiums aren't guaranteed and might increase as you get older.
Other types of life cover
- Endowment insurance - this is term life insurance with an investment element. The investment builds up during the term of the policy and can be cashed in during the term or taken as a lump sum when the term ends. Often the amount of life cover is small. However, when used as part of an endowment mortgage, this type of insurance is designed to pay off the outstanding mortgage either at the end of the term or if you die before this. In reality, these policies are rarely sold alongside new mortgages and are usually sold more as investments.
- Mortgage protection insurance - this pays off your outstanding repayment mortgage if you die within the term. Because the amount you owe on a repayment mortgage decreases over time, so does the level of cover offered by this insurance which means it's usually cheaper than level term insurance. This type of insurance is called decreasing term insurance.
- Travel insurance - often includes some life cover.