Guide to term insurance

Term insurance is one of the simplest and cheapest forms of life insurance. It is also one of the most important because it provides basic life cover to your dependants if you die. For many people, it is the first type of life insurance they buy, often when they take out a mortgage for the first time.

Premiums are relatively cheap, partly due to a highly competitive market, but also because of increasing life expectancy, due to healthier lifestyles and medical advances.

Use the links below to move to the section you want to read:

• What options are available?
• How much will it cost?
• How do I buy term insurance?
• Putting your policy in trust

Why do I need it?

Term insurance is designed to pay either a lump sum or an income, in the event of the death of the person covered during the period of cover (the term). Policies can be arranged to cover just one person or, in many cases, spouses or partners. But you need to remember that if you die outside the term of the policy, there is no payout.

The death of a loved one has an enormous emotional impact on your dependants, but there are major financial consequences as well. If this is of concern to you, you should consider life insurance.

If you were to die your income would be lost, but the bills would still need to be paid. The level of life insurance you buy should be enough for your loved ones to pay off your debts (in particular your mortgage) and to provide sufficient money to allow them to pay for other essential outgoings, such as council tax, food, gas, electricity, child care and so on.

What types of term insurance are there?

There are four main types of term insurance:

Level term

The amount of cover remains the same throughout the term of the policy. This type of term assurance is normally used to cover an interest-only mortgage or to provide family protection.

Decreasing term

The sum insured reduces each year, decreasing to nil at the end of the term. The cover can reduce by a fixed amount each year, or in line with a repayment mortgage to match the reducing debt.

Family Income Benefit

This type of policy is ideally suited to providing your family with a replacement income. If you die during the term of the policy, a regular income is paid to your dependants for the remainder of the policy’s term.

The income can be paid monthly, quarterly or yearly. Some policies provide an income which increases each year at a fixed rate, such as 3 per cent or 5 per cent.

Gifts inter vivos

These policies are designed to cover the potential inheritance tax liability that can arise if you make a large gift to someone from your estate while you are alive.

Such a gift is called a Potentially Exempt Transfer or PET. If you die within seven years of making a gift, it is possible that a liability for inheritance tax (IHT) could arise. A Gift Inter Vivos policy lasts for 7 years and the cover decreases in line with the potential IHT liability.

What options are available?

Some term insurance polices offer other options at extra cost which provide added protection for you and your family.

Inflation protection

Term insurance policies are designed to provide long term protection. Over time inflation can erode the value of what was once an adequate level of benefit. This is particularly important if your insurance has been taken out to protect your family.

Many term insurance and family income benefit policies include a valuable option whereby the amount of cover increases automatically in line with inflation each year. You should bear in mind that as the amount of cover increases, the premium will go up as well.

Waiver of premium

Some policies include ‘waiver of premium’ as an option. This benefit will ensure that the premiums for your policy are maintained if you are unable to work due to long term sickness or disability.

The benefit is equal to the premium due to your term insurance policy and will become payable after a certain period of time (known as the deferred period) following your incapacity. This can be 1, 3, 6 or 12 months depending on your circumstances and the particular policy you choose.

Conversion options

A small number of policies allow you to convert the policy into a different type of life insurance policy without the need for you to provide fresh evidence of your state of health.

Insurability options

Marriage, birth of a child, divorce and moving house all bring with them additional expense and the need for additional life cover.

In this event, you can take out a top-up policy. However, if your health has deteriorated, this may prove time-consuming and expensive. That said, some policies include insurability options that allow you to increase the cover within a set period following a major life event, such as marriage, birth of a child or increasing your mortgage without fresh medical evidence.

Renewal options

Some term assurance policies can be arranged on a renewable basis, which means that at the end of the policy term, usually either 5 or 10 years, you have the right to take out a further policy for the same term as the original policy, without the need to provide further information about your health.

Buying a renewable policy is cheaper at the outset than a normal term assurance policy because the period of insurance is shorter. This makes it an ideal policy for those on a limited budget.

However, you should bear in mind that the cost of the ‘renewed’ cover will be based on your age at that time, which means that the long term cost of this cover will be higher than with a standard term assurance policy.

Critical illness

Some term insurance policies allow you to include critical illness cover. This provides cover against the risk of death or you having a serious illness, such as a heart attack, stroke or cancer.

If you develop one of the illnesses covered by the policy, a lump sum (or a regular income in the case of family income benefit) will be paid and the life cover will cease. Likewise, if you die before contracting a critical illness, the policy will pay out the life insurance benefit and the critical illness cover will cease.

Critical illness benefit can also be purchased on its own. For more information, see our Guide to Critical Illness:

How much will it cost?

It is important to remember that taking out life insurance gets more expensive as you get older. This is because premiums for term insurance policies are based on a number of factors, including your age when the policy starts, so the younger are when you take a policy out the better.

Under most term insurance policies, the premium is guaranteed to remain the same for the term of the policy.

The cost of the premiums you have to pay will depend on a number of other factors, such as your gender, state of health and lifestyle, whether you smoke, how long you want the cover for and, of course, the amount of cover you need.

Prices vary widely from insurer to insurer and the market is extremely competitive, so it is important to check the whole market to find the company that offers the best terms for you. The figures in the table below provide an example of the costs of some of the different types of policy we discussed earlier.

Source – Defaqto– 1 August 2007

As with any purchase, price should not be the overriding factor to determine which policy you buy. It is essential to find a policy that is suitable for your current needs and that can adapt to meet your future needs.

How do I buy term insurance?

We recommend that you seek advice before buying any insurance product so that you end up with a policy that is fit for purpose. Preferably you should seek this advice from an independent financial adviser who is able to recommend from the whole market. You will also have the protection of the Financial Ombudsman Service if something goes wrong, which is not always the case if you buy a financial product without taking advice from an adviser registered with the Financial Services Authority.

Once you and your adviser have selected a policy, you will need to complete a proposal form. This will ask you about the cover you want and about your health and lifestyle.

The adviser will then pass this to the insurance company who will then consider the information you have provided. If you are applying for an especially large amount of cover (usually over £500,000), or you have history of ill health, the insurer may write to your GP for more details. In some circumstances, they may also ask you to attend a medical examination with an independent doctor.

Once they have all the information required, the insurer issue an acceptance letter which will confirm the basis of the cover and the premium.

Occasionally, where the individual has a history of ill-health, the insurer may charge a higher premium to reflect the increased risk. High blood pressure, obesity and diabetes are examples of conditions that could give rise to a higher premium. If the ill health is very serious, the insurer may decline to offer cover.

Once you have accepted the terms offered, the policy can then be put ‘on-risk’ which means it goes live.

Putting your policy in trust

Although life insurance benefits are paid tax free, in the event of your death, the proceeds, which could be considerable, could form part of your estate and be liable to inheritance tax, if it is not placed in a trust.

Setting up your policy in trust will mean that the benefits are paid to the trust and not to your estate. This means that the money will go to the right person at the right time and will not be delayed by probate or end up in the hands of the taxman.

Taking out a life insurance policy should be treated as an investment, rather than an expense. Once you have taken it out, you and your loved ones can relax in the knowledge that if the worst happens, at least their financial future is secure.

Last edited August 2007

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