Life cover comes in a few forms. Firstly, we have the distinction between term insurance which lasts for a fixed period of time and whole of life insurance which, unsurprisingly, lasts for your whole life. Term insurance only pays out if you die within the term of the policy. So, if it’s a 20-year term and you unfortunately die the day after the policy expires, tough luck.
Because the insurance companies know the odds of a person of your age, gender and health dying within a fixed period of time, they can price it easily and so term insurance is usually fairly low cost.
As everyone dies eventually, whole of life insurance is expensive, even though the insurers know that not all policies will be kept until they pay out – plenty of people will just stop paying for their policies and will let them lapse.
So, most people in the wealth-building stage have term life insurance because it’s cheaper. That kind of insurance can pay out in two ways: a lump sum or a regular amount, which is called a family income benefit policy or an FIB.
With an FIB you set the amount of income you would like paid out if you die, let’s say it’s £30,000 per year, and you choose a 25-year term for the plan. If you die after ten years, the £30,000 will be paid to your family for the remaining 15 years of the plan. It’s not 25 years from the date of death, but from the start of the plan.
So that’s life insurance. You die, it pays out – simple.
Other Types of Insurance
Next up is critical illness insurance. This is almost always a term insurance, so for a fixed period of time, and is usually paid out as a lump sum. There is a list of specified illnesses for each policy, and if you are diagnosed with one of these, and if you survive for a period, usually 14 days after diagnosis, the policy will pay out the sum insured.
The list of illness includes things like cancer, heart attack, stroke, multiple sclerosis, motor neurone disease, loss of limb, paralysis and others. As you can imagine, there are precise definitions, especially with something like cancer, where there are lots of different types and degrees of severity.
Critical illness cover is quite expensive. You’re more likely to get cancer and survive these days, than you are to die of it, so you’re more likely to claim on a critical illness policy than a life insurance policy.
You can also get policies which cover both life and critical illness, usually whichever comes first. It’s rare these days that I come across someone with a standalone critical illness policy – usually it’s attached to life insurance.
Finally, we have income protection insurance or IP. These policies work so that if you are unable to work, for medical reasons, then the policy will pay out the amount you have chosen from that point until the end of the policy. There are a couple of other things you need to know about these plans.
Firstly, the definition of being unable to work can be tightly defined and it might depend on what you do for a living. Some policies will cover on an ‘any occupation’ basis which means that if you can’t do your job, but could do another job, which is say, less physically demanding, or requires a lower level of qualification, then it may be that the policy won’t pay out or would pay out a reduced amount to make up the difference. An ‘own occupation’ basis means it will pay out if you can’t do your job, full stop. This is obviously a better class of policy.
There’s also a deferment period, which is a waiting period between you being unable to work and the policy paying out. This is where your emergency fund comes in handy. A longer deferment period means you’re less likely to claim, which means the premiums are lower.
Having six months’ worth of emergency fund might mean a considerable saving on the cost of your income protection insurance. If you have sick benefits from work, you could set your deferment period to start after that and after your emergency fund is likely to be mostly spent down, making the insurance even cheaper again.
You can’t insure 100% of your pre-illness income, unfortunately. You’re limited to about 65%-70% depending on the insurer. But income protection policy benefits are not taxed, so 65% of your old gross income will probably be about 90% of your net income, if you’re a basic rate taxpayer.
Knowing what you can insure for, and knowing the benefits you currently have from work and from currently owned policies, you can start to fill the gaps. So, how much would you like to have paid out to your family if you die? A lot will depend on how much you owe and how much you want to provide. And a lot will depend on your budget.
If you’re thinking that this is a lot of work, then I have a calculator that you can use to do the maths for you. You’ll need details of your existing cover, but it’ll help you prioritise and come up with an idea of how much cover you might need. The calculator link can be found here.
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