What is life insurance?

Life cover can be used to help pay off the mortgage and support the family in case either the key earner or homemaker passes away. Joint policies can be taken out to protect you and your partner to help the ones you leave behind cope financially should the worst happen. Depending on the type of policy you have, it can pay out a lump sum or provide a regular income. The key is to identify what you want life insurance cover for, because that will help determine the best life insurance policy for you – term insurance or whole of life, for example. Remember that the first life insurance quote you get may not be the best for your circumstances.

Some things to check

Don't ignore the small print. This will spell out what's covered and what's not covered. It's normally included in a Key Facts or Key Features document, and you should compare various policies' features to determine which one is best for you.

Always read the terms and conditions of the policy so you understand what you’re agreeing to.

1. Think about the exclusions. Your policy may not pay out if you take part in dangerous sports, die from drug or alcohol abuse or have an existing medical condition.
2. Confirm the age limits on your life insurance quote. Some policies will stop providing cover once you reach a certain age.
3. Terminal illness. Some term insurance policies may pay a lump sum if you’re diagnosed with a terminal illness during the policy.
4. Consider the tax implications. Inheritance Tax may be payable on any sum paid out, unless you put your plan in a suitable trust. This can be a complicated area and tax policy can change from 1 year to the next so it’s important to get financial advice if you’re considering this.
5. Flexibility. Does your life insurance policy allow you to skip a payment or two without penalty? And what happens if you want to cancel altogether?
6. Cash-in value. Check whether your policy has one or not. Not all do and you may decide that you don’t want one.
7. Extra benefits. Some policies may offer additional benefits such as critical illness cover.

What are the benefits of life insurance?

Whole-of-life insurance is designed to last as long as you do. You pay in a premium every month and when you die, the policy pays out a lump sum to your loved ones.

That sounds simple enough, and a valuable benefit to have. Yet only a small minority of people take out whole-of-life cover – the vast majority opt for term insurance instead (and are probably right to do so).

How life insurance policies work

The difference between whole-of-life insurance and term insurance is that term insurance only runs for a set period, typically 25 years. If you die in that time, it pays a tax-free cash lump sum to your loved ones, but if you live beyond the term, your plan has no cash-in value. You won’t get any return on your premiums.

As you will see when you compare life-insurance quotes, term insurance is a lot cheaper than whole-of-life cover, which is why so many more people take it out. Plus you don’t have to keep paying premiums into your 60s, 70s or even 80s, when you may no longer need life cover to protect your loved ones.

Use life cover to cut your tax bill

The main reason people still take out whole-life cover is to help cut their family’s tax bill, particularly inheritance tax (IHT). When you die, IHT is charged at 40 per cent on all your assets worth more than £325,000 (in the 2010-11 tax year). This includes the family home, which means that millions now pay this unpopular tax.

If you take out a whole of life policy and write it under trust, your beneficiaries should receive a cash free lump sum, which they can use to pay the IHT bill. Tax planning is a complex area, and the rules are changing all the time, so you should consider taking specialist advice aboutputting life insurance in trust.

What to watch out for when buying a life policy

Many insurers guarantee they won’t increase your premiums and sum insured for the first 10 years of the policy. At this point, they will review your plan and may hike your life insurance premiums. Make sure you understand how this guarantee works. The biggest complaint about whole of life cover is that people didn’t know their premiums would be reviewed, according to the Financial Ombudsman.

You also have to compare investment performance. The insurer invests your payments into a life fund containing a mixture of stocks and shares, cash, bonds and property, and the proceeds go to paying your sum insured. If these investments perform poorly, the insurer may increase your premium to ensure you still have the same level of cover.

How the plan performs is therefore very important. Unfortunately, this is hard to predict, all you can do is check the historic performance of the insurer’s life funds. This is no guide to how they will perform in future.

What else affects your premiums?

How much you pay will also depend on the sum insured, your age, sex and health, and how much you drink or smoke. The higher the risk, the higher the premium. Women pay slightly less because they typically live longer. You need to be in reasonably good health to take out a plan, as the insurer doesn’t want to have to make a payout after just a few months. You can take out a plan for one or two people, although it will only pay out once, on the death of the second person.

You should consider taking out waiver of premium with your policy, because this will cover your monthly premiums if you fall ill and can’t make the payments. Some plans also include sickness or disability benefits.

With some plans, you keep paying in until you die, which can be expensive if you live to 105. But with others, payments stop once you reach a set age, even though cover continues until you die.