As a business owner, life insurance is one of the best ways to financially protect your family and loved ones.
But it becomes even more important when you take on a large commitment like a mortgage. Especially as self-employed borrowers don't benefit from death-in-service benefits.
Read on to learn about the different types of life insurance available, how they work, the potential costs, and the benefits of writing the policy in trust.
What is life insurance?
Life insurance provides your dependents with a one-time tax-free lump sum payment if you die during the policy term.
It ensures your spouse (or partner) and children are looked after financially. Getting cover is particularly important to consider if the loss of your income would otherwise result in financial hardship for them. For example, if they'd be unable to pay the mortgage or bills.
This article covers what's known as term assurance, where the life insurance is taken out for a pre-agreed period. Often, though not always, for the same duration as your mortgage term.
Unlike whole-of-life insurance, term assurance only pays out if the policyholder passes away (or is diagnosed with a terminal illness and given less than 12 months to live) during the term. Making it much more affordable.
What are the different types of term life insurance?
The three main types of term life assurance are Decreasing, Level, and Increasing.
Decreasing term assurance (DTA)
Decreasing term assurance is the cheapest form of cover, and acts as mortgage protection for borrowers with a capital repayment mortgage.
The policy term is aligned with the mortgage term, and the lump sum paid on death decreases in line with the outstanding mortgage balance. So if the worst happened, there would be sufficient funds for your spouse or partner to pay off the mortgage.
Level term assurance (LTA)
Level Term Assurance pays out to your beneficiaries a fixed pre-agreed lump sum benefit on death.
Because the payout remains the same during the policy term, it's more expensive than decreasing term assurance. That said, it can often be very affordable.
LTA is often used to repay the original loan amount on an interest-only mortgage should the policyholder die early.
But it's also popular with borrowers on a capital repayment mortgage, allowing for both the mortgage to be cleared and a tax-free lump sum to be left over for loved ones.
Increasing term assurance (ITA)
ITA is the most expensive of the three but provides the most comprehensive cover. It's like Level Term Assurance but index-linked to maintain the real value of the benefit amount.
The policyholder can specify whether to adjust the benefit level for inflation using the Retail Price Index (RPI) or use a fixed percentage such as 3 or 5 percent instead The premium you pay increases each year to account for the indexation level specified.
How does life insurance work?
Life insurance can be taken out on a single or joint-life basis. A joint-life policy insures both partners but pays out only once, usually to the survivor on the first death.
Joint-life, first-death term assurance
If you die during the policy term, a joint-life, first-death plan ensures your spouse or partner isn't left financially burdened. They'll be able to pay off the mortgage and possibly have a lump sum left over to pay the bills or use as they see fit.
The benefit amount is determined by the level of coverage you purchase.
Joint-life, second-death term assurance
Joint-life, second-death payouts are another possibility. They payout just the once, and are mainly used by High Net Worth (HNW) individuals for estate planning purposes.
Single-life term assurance
Another option is to take out a single policy for each partner. It's more expensive than joint-life, but if both partners die, the trustees or beneficiaries will receive two payouts.
Who benefits from a life insurance payout?
If the policy is written in trust, the trustees will distribute the benefit amount to your named beneficiaries. Setting up a trust, which is free and simple to complete online at the point of application, has two key advantages:
- There's no need to wait for probate to be granted, so your beneficiaries can receive the payout more quickly.
- The insurance benefit amount falls outside the deceased's estate for inheritance tax purposes.
Without a trust, the payout will form part of the deceased's estate, and distributed by the executors in line with the wishes expressed in the deceased's will.
If there's no will, intestacy rules apply and the estate will be distributed to your spouse, children or relatives accordingly.