FOOL'S EYE VIEW
60-Second Guide To Life Insurance

By James Carlisle
October 2, 2002

Contemplating your own mortality is never going to be great fun, but if you have people that depend on you for their living, then you need to consider how they'd fare if you were to shuffle off a little early. For most people, that's going to mean having some life insurance. But what's it all about? Here's the Motley Fool's 60-Second Guide To Life Insurance to help you on your way.

0:57 What is life insurance?

Life insurance, at its simplest, is just insurance against dying. So you'll pay premiums of a certain each amount each month, depending on how likely the insurance company thinks you are to die within the period of the insurance. In return, they'll cough up an agreed sum (the 'sum assured') to your dependents if you do die whilst covered by the policy. The idea is that your dependents have some money to replace the income that they'll no longer be getting through you.

0:47 Okay, so what's life assurance, then?

'Life insurance' and 'life assurance' tend to be used pretty interchangeably these days. Technically, I think, you have insurance against something that might happen (e.g. dying within a particular number of years) and assurance for something that definitely will happen (like dying).

0:42 Do I need some?

Well what would happen if you died? Would it financially inconvenience someone that's near and dear to you? If so, then you'd want to think very hard about it. If you don't have dependents, then it's hard to see much point. Mortgage lenders generally like you to have some if you take out a mortgage, but that's for their convenience not yours.

0:32 How much should I have?

Again, think about what happens if you die. Assuming you're an earner, then your household will lose that income. On the other side of the equation, the household will also be shot of your monthly expenditure. If your household is dependent on you, then most likely the loss of income is greater than the cost savings, so you need an amount of money to plug the gap.

Think about how big a lump sum would be required to produce enough income to make up the difference. One option would be to invest it in index-linked gilts, or if you're happy for your dependents to take some risk with shares, they might go for some high yield shares. As a safer alternative, they could make a tax-free return equal to your mortgage interest rate just by using a lump sum to pay back the mortgage.

You could also factor in your family using up a little of the lump sum capital each year. Perhaps this would make sense if you expect the financial hardships only to last a certain time, for example until your children leave home. But if you take even just a few per cent of the capital per year, it will start to disappear very quickly.

On any basis, you're unlikely to be able to afford enough insurance to cover every one of your family's whims after you're gone. Remember that it's not designed to be a windfall to help your family get over the emotional impact of your death. It's just to plug some financial holes. But every penny spent on life insurance premiums is a penny that hasn't gone into your savings -- and a penny that therefore won't help you and your family if you do survive. Saving hard for your future is also a priority. You should be aiming to reach a stage eventually where you and your family have enough assets not to need life insurance. In the meantime, you need to strike a sensible balance between saving and insuring.

0:20 What is 'Term Insurance'?

Term insurance promises to pay out a lump sum if you die within the 'term' (i.e. period) of the insurance, hence the name. It's the cheapest type of life insurance and does exactly what it says on the tin. That way, you can get the biggest amount of cover for a given monthly premium, which is basically what you're after.

The simplest type is level term insurance. This means that the level of your premiums and the amount of cover stay level throughout the insurance term. This would be the answer if you want to keep things simple and/or, the gap that your death would leave will remain relatively constant for a period of time.

There are, however, more exotic forms of term insurance. For example Renewable term insurance gives you the option to extend your term without another medical. Decreasing term means that the amount of cover reduces throughout the term (it's handy to go alongside repayment mortgages where the amount of the mortgage is itself decreasing). Increasing term does the opposite (and is intended to increase your cover as your earnings increase). There's also a thing called family income benefit, which actually pays out an income for a fixed period after your death. But really this effectively forces your family to buy a certain type of investment after your death. It makes more sense to give them the flexibility to choose something more suitable, or pay off the mortgage, or whatever.

0:15 What is 'Whole of Life Insurance'?

It's an investment, that's what! Not really insurance at all! It promises to pay a certain amount when you die, whenever that is, so long as you keep paying the premiums. That just means you're making an investment for your heirs and, at the same time, taking a gamble on your life expectancy. It doesn't do the real job of insurance, which is to cover you against the financial hardships of dying at an inconvenient time. Whole of life insurance just pays out some money when you do eventually die, which is a different thing entirely.

0:08 Any other frills?

Yes, lots of them I'm afraid. The good news is, though, that they're almost invariably a bad idea. So as soon as life insurance looks like it's starting to get a little complicated and your eyes start to glaze over, then forget it and ask about level term insurance.

The biggest problem that gets introduced to life insurance is a 'savings element'. Whenever you hear words like 'endowment', 'unit-linked', 'with profits' or 'bond', then you know that someone is trying to sell you an investment product rather than a straightforward insurance policy. And, if you want an investment, then get an investment! Don't get it mixed up with insurance.

Also watch out for products that claim that they pay out after 25 years 'even if you don't die'. It sounds pretty good, but bear in mind that something that pays out after 25 years even if you don't die is an investment, not insurance. You wouldn't get household insurance that pays out 'even if you don't get burgled', so why do it with life insurance?

There it is. Life insurance is an absolute minefield, but it's relatively straightforward to navigate your way through it if you keep your focus on what you need it to do for you and keep things simple!

Got another few minutes? There's more about life and other types of insurance in the Motley Fool's Insurance Centre.