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Life insurance 101: How it works, and why you should buy it

Confused about life insurance? This 5-minute guide will get you up to speed.

28 January 2020Andre Spiteri 3 min read

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Confused about life insurance? This 5-minute guide will get you up to speed.

Your death can leave a lasting financial impact on your loved ones, but only 30% of UK households have life insurance. Worse, 79% of those who do have a policy have never switched, meaning they may be paying more money than they need to.

But before you get started, here’s a quick round up of everything you need to know about life insurance:

  • What it is
  • What it covers
  • Different types of life policy
  • When you should consider buying it

Read on.

What is life insurance?

Life insurance pays out if you die. Like other insurance policies, you pay a monthly fee called a premium. If you die, the person or people you’ve named in your policy, called beneficiaries, receive a lump sum.

What does life insurance cover?

As the name suggests, life insurance covers death.

Some life policies also pay out if you’re terminally ill. But don’t confuse this with critical illness cover or income protection insurance.

Critical illness cover pays out a lump sum if you’re diagnosed with a life-threatening illness. You’ll get the payout regardless of whether the illness results in your death. Similarly, income protection insurance replaces part of your income if you can’t work because you’re sick or disabled.

In comparison, a life policy only pays out if you die or have an illness that will lead to your death. That said, it’s worth noting that life insurance doesn’t cover all causes of death.

Terms and conditions vary from one insurer to another. But, as a rule, life policies won’t pay out if you die from alcohol or drug abuse. If you’re seriously ill when you buy life insurance and die from that illness, your policy might also not pay out (unless this is stated otherwise in the policy).

Why buy life insurance?

Life insurance not only gives you peace of mind, it provides vital support to your loved ones after you're gone. A life insurance policy provides your dependents with money to clear debts, pay for your funeral, pay school fees, or more simply maintain their standard of living.

You may want to consider buying life insurance if you:

  • Are your household's main breadwinner
  • Have dependents who rely on your income, such as school-age children or a sick relative
  • Have a mortgage and think your partner would struggle to pay it off on their own, for example because their income is lower than yours

Unlike other insurance, it's not always necessary to switch your life insurance policy every year. There are a few reasons for this, one of which is that life insurance tends to get more expensive as you get older, so you might end up paying more if you switch. But it's still a good idea to review your policy regularly to make sure you're getting the best cover for your needs. You might find the best method is to add extra cover to your existing policy, or take out a separate policy for the extra cover you need.

Types of life insurance: which one would work best for you?

There are two main types of life insurance:

  • Term
  • Whole-of-life

Term life insurance

This is the most common type of life insurance. It pays out if you die within the term of the policy. Let’s say you buy life insurance with a 20-year term. If you die at any point during those 20 years, the policy pays out. If those 20 years pass and you’re still alive, the policy expires.

There are three main types of term life insurance:

  • Level term Here, the sum you’re covered for stays the same the whole term. So if you insure your life for £1 million for 20 years, your family gets £1 million whether you die now or in 19 years’ time. Level term policies are great for covering fixed debts, such as the principal on an interest-only mortgage

  • Decreasing term In this type of policy, the payout decreases over time. So, your family gets £1 million if you die in 2020, for instance, but £500,000 if you die in 2030. Most people use decreasing term life insurance to cover debts that decrease over time, such as a repayment mortgage

  • Increasing term This is the opposite of a decreasing term policy — the payout increases over time. Increasing term policies are a good option if you want to make sure your family can keep up with the cost of living after you die.

  • Whole- of-life insurance Unlike term life policies, whole-of-life policies don’t expire. They pay out whenever you die, whether that’s tomorrow or when you’re 85.

The catch is that they’re more expensive than term life policies. This is because it’s guaranteed you’ll die at some point, which means the policy will definitely pay out.

Andre Spiteri Image

Written by Andre Spiteri

Financial Writer

Andre is a former lawyer turned award-winning finance writer.