Insurance: Life Insurance

In essence, the whole idea of life insurance is to pay off your debts and support your dependants by replacing some or all of your income if you die. You pay premiums to an insurance company, usually monthly or annually. In return, the insurance company will stump up an agreed amount - the 'sum assured' - if you die during the life of the policy.

Your life insurance premiums will vary according to a number of factors, including the sum assured and the length of your policy (its 'term'), plus individual lifestyle factors such as your age, occupation, gender, state of health and whether you smoke. (You could save a fortune by giving up smoking, as most insurers will quote lower premiums once you've quit the evil weed for a year or more!)

A life insurance plan is essentially a gamble. Neither you nor your insurer wants you to die while you're covered, but your premiums are priced to reflect the risk of this happening. Of course, if you outlive your life insurance policy, it brings you nothing but 'peace of mind'. Usually, you only stand to gain financially if you die, which is a high price to pay!

Who needs life insurance?

Mortgage lenders encourage all borrowers to take out a life insurance policy, but it's only necessary if you have a partner and/or children. After all, if you're young, free and single, who stands to lose out if you kick the bucket? At the very worst, your mortgage lender will sell your house to pay off your home loan, which is no big deal! Why not consider income protection insurance instead, which pays you an income if you can't work because of sickness, injury or disability.

However, at the very least, you should aim to pay off your debts and leave your wife and kids with something to live on if you've passed away. Amazingly, a quarter of homeowners don't even have enough life cover to pay off their mortgage if a breadwinner dies, which is just crazy!

On the other hand, although it's daft to put your family at risk of financial hardship, it's equally bone-headed to over-insure yourself, aiming to leave your family a lottery jackpot if you die. After all, big life insurance payouts mean big premiums!

Remember that if you have something to lose, you have something to insure. Don't forget to insure non-working partners, as it costs a small fortune to replace a housewife/husband. It's tough getting by when you've no-one to run your home and take care of your kids. Don't make the mistake of insuring yourself up to the hilt and leaving your partner unprotected.

Where can you buy life insurance?

Rule One with life insurance is to shop around.

Another smart move is buying separate 'his' and 'hers' policies, instead of a 'joint life, first death policy', which pays out once and ceases after the first death, leaving the survivor uninsured. By buying two individual policies, you can get two payouts - potentially twice as much cover - for just a few pounds a month more. Also, individual policies make life easier when it comes to inheritance tax, and if you separate or divorce, which is a lot less hassle than dividing up a joint policy!

How much cover do you need?

If you have a partner or children, the first thing you need is enough cover to pay off your mortgage and other debts. After that, you need life insurance cover to replace at least some of your income. Realistically, cover of ten times your gross income (your salary before deductions) should give your dependants a reasonable standard of living and keep the wolf from the door.

Of course, how much money a family needs will vary from household to household so, ultimately, it's up to you to decide how much money should leave your family with a reasonable standard of living. Perhaps a better question is 'How much cover can I afford?'

For how long should you be covered?

It makes sense to cover yourself until your normal retirement age, usually sixty or sixty-five. However, if you have young children, you should cover yourself until they are financially independent, which usually comes after they have left school or university and are earning their own money. There's no point in buying a policy that lasts until you reach, say, eighty, because your children will have fled the nest and, all being well, you'll be enjoying life as a pensioner.

Keeping the taxman at bay!

Although a payout from a life insurance policy is tax free, it could form part of your estate and be liable to Inheritance Tax (IHT), which could gobble up to two-fifths (40%) of your payment. Ouch!

The simple way to avoid IHT is to place your policy 'in trust', which enables any payout to be made directly to your dependants, neatly avoiding the taxman, your estate and any Will. Certain kinds of trusts allow you to control what happens to your payout after death and speeds up payment. However, they cannot be used for life insurance policies that are assigned to (earmarked for) your mortgage lender. Your insurer or broker will often set up the trust for you at no extra cost.

An alternative to consider: Family income benefit (FIB)

If you're looking to cover your mortgage or other debt, you need to buy a life insurance policy that pays out a lump sum if you die, so that your entire debt is paid off. However, if you're protecting your partner or family, you don't need to buy a policy that delivers a lottery-sized payout. After all, how many people have the skill to invest this money wisely to replace the income of a deceased partner or parent? Furthermore, big payouts mean big monthly premiums!

If you want to provide your partner or dependants with an income if you die before collecting your pension, family income benefit (FIB) may be the right policy for you.

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The comments above are the opinions of the author only and do not represent advice specific to your circumstances.

This article has been approved and issued by Direct Life & Pension Services Ltd who are authorised and regulated by the Financial Services Authority.

The Motley Fool Insurance Service and The Motley Fool Life Insurance is a trading style of The Motley Fool Limited. The Motley Fool Life Insurance is provided and administered by Direct Life & Pensions Services Limited. The Motley Fool Limited is an introducer appointed representative of Direct Life & Pension Services Limited, who are authorised and regulated by the Financial Services Authority. Registered Office: The Bailey, Skipton, North Yorkshire, BD23 1DN. Registered in England No 2467691.

Published on December 7, 2006