How Does Life Insurance Work? – Forbes Advisor UK

Life insurance works by providing a financial safety net for your loved ones if you died and were no longer able to provide for them.

But before you can decide what type of cover, and how much of it you will need, it’s important to understand the basics of how life insurance works.

What is life insurance?

Life insurance is a contract between you and an insurance company. In exchange for your monthly premium payments, the life insurance company will pay a tax-free lump sum –  known as a death benefit, to your beneficiaries if you die during the policy term.

What is the purpose of life insurance?

For consumers, life insurance policy offers financial protection – and the peace of mind that comes with it.  It can be reassuring to know that your family will not face financial hardship when you’re gone. Life insurance companies offer a range of policy options and the best one for you will depend on your needs and circumstances.

What is life insurance used for?

The money from a life insurance payout can be used by the beneficiaries in whatever way is most helpful. This often includes:

• Paying for funeral costs
• Paying off the mortgage
• Paying off credit card balances, car loans or other debts
• Covering day-to-day living expenses that were previously met by the insured person’s income
• Funding children’s school fees or university costs.

Families who have life insurance in place can often save their family the distress of having to sell a property and move house in the event of a parent’s death, for example. This is because the life insurance payout can cover all or part of the mortgage debt.

Many life insurance policies also have other benefits, such as paying out if you’re diagnosed with a terminal illness. In this case, it means the policy will pay out just once, on terminal illness or death, whichever happens first.

How does life insurance work?

Life insurance works by providing your beneficiaries with a tax-free lump sum payout if you die within the term of the policy. A typical policy term might run for 10 years, for example, or up to even 30 years. If the policyholder outlives the term of the policy there is no cash payout.

You’ll pay a fixed monthly premium for the cover during the policy term. The cost of the premium will depend on a wide range of factors including:

• Your age: The younger you are the lower your risk of a claim and the cheaper the premium
• Your state of health and lifestyle: If you have a health body mass index (BMI) and no pre-existing health conditions, such as high blood pressure, your premium will be lower
• If you’re a smoker or vaper: Life insurance for smokers tends to cost more than for non smokers, due to the increased health risks
• Family medical history: If there is a family history of early death from strokes, heart conditions or cancer, this can impact on the premium you pay
• The amount of life cover you need (the size of payout): Premiums are higher the bigger the payout you require
• The type of life insurance policy: There are different types of life insurance to choose from. For example, level term insurance, where the payout remains the same throughout the policy’s life will cost more than decreasing cover, where the payout falls in size for each year you hold the cover.

Gender makes no difference to the cost of cover as insurers are not legally allowed to use gender in their risk pricing for insurance. Comparing life insurance quotes across a range of providers is a good way to start finding the right life protection for you and your family at the most competitive price.

Level term vs decreasing term life insurance

Two of the most popular types of life insurance are level term life cover and decreasing term cover.

With level term life insurance, the payout remains fixed for the duration of the cover.

This is different to decreasing term life insurance where the sum insured falls with each year of the policy term. This type of cover is therefore often taken out to run alongside a repayment mortgage, and is sometimes known as mortgage life insurance. The payout matches the outstanding mortgage debt as it reduces over time.

As the benefits reduce over time with decreasing term life cover, this type of policy is usually cheaper compared to level term life insurance.

The table below illustrates the difference in cost and as well as how premiums start to rise as you get older. As monthly premium costs are fixed during the term of the cover, this also highlights the benefit of buying life insurance as early as possible.

What does life insurance cover?

Life insurance typically covers all causes of death, including heart attacks, strokes and other illness such as cancer – as well as death due to old age and natural causes.

You’ll be covered for death due to accident, such as a road traffic accident. Most policies will also payout in the sad circumstances that the policyholder has taken their own life (but not in the first 12 months of the cover).

Best life insurance companies

Which life insurer is best for you and your family’s needs will depend on a broad range of factors. While some companies might be the cheapest for a healthy non-smoker, for example, another insurer might offer the lowest premium for those with pre-existing health conditions, such as diabetes.

This is why it is essential to shop around and compare cover before you buy life insurance. In our pick of the best life insurance companies you can see which insurers fare well for term life cover, based on our searches.

What does life insurance exclude?

Most life insurance policies don’t pay out in the event that the policyholder has taken their own life within the first year of the policy.

And, although there tend to be few exclusions to life cover, an insurer can still refuse to pay a claim if it believes the policyholder was not fully open and honest when they took out the cover. For example, if they have failed to disclose a pre-existing health condition or past diagnosis.

It is imperative to be honest with your insurer about your state of health, any conditions you have suffered from (either now or in the past). If you withhold any important information of this kind you run the risk of rendering your life insurance policy invalid, leaving your loved ones without a payout if you die.

Life insurers pay out for around 97% of all claims, according to our research.

Main types of life insurance

There are a number of different types of term life insurance, which all work in slightly different ways.

Term life insurance

• Level term: The sum insured (the payout) stays the same and is fixed (level) for the duration of the policy

• Decreasing term: The sum insured reduces gradually each year, often in line with a repayment mortgage, where the debt will reduce over time as it is paid off.

• Index-linked (or increasing) term: The sum insured rises over time, typically in line with inflation. But your monthly premiums will also be reviewed and are likely to rise each year so it tends to be expensive

Whole life insurance: This is different to the term life insurance policies described above. This is because, as the name suggests, whole life policies remain in force until the policyholder dies (there is no fixed term or end date) and it means there is always a payout to beneficiaries. The downside is this type of life insurance can be expensive and premiums are reviewable and can increase dramatically over time.

Over-50s life insurance: This is a specific type of lower cost life insurance that is designed to help older people meet funeral costs. They are sometimes called funeral savings plans and are available to those over the age of 50 and up to age 85, with no medical screening and guaranteed acceptance. Typically you’ll pay a low monthly premium for a guaranteed payout, which tends to be around £2,000 or £3,000, when you die.

Life insurance payout options

Term life insurance cover will almost always pay out a lump sum to beneficiaries if the policyholder dies during the policy. 

If you are looking for a monthly income instead, to support a young family for example, then it may be worth comparing term life cover with a family income benefit policy.

Family income benefit

Family income benefit is a form of life cover that pays out out a regular fixed income, tax free, to beneficiaries instead of a lump sum on death of the policyholder during the fixed term of the plan.

In some cases this may be a cheaper option than level term life insurance. But be aware it is a form of decreasing life cover. That’s because the monthly income payments are only made until the end of the policy term. So if you die towards the end of the cover there may only be a payout for a short time, which might not equate to much money compared to an equivalent lump sum through term life cover.

How to choose the right life insurance policy type

With all of the life insurance options available, it can seem complicated and a bit daunting to choose the right one.

Consider a level term life insurance policy if you need life insurance for a specific amount of time. For instance, you may want life insurance to cover your working years as a possible ‘income replacement’ for your family if you pass away.

Decreasing term life insurance could be a good choice if your budget is limited. As it is a decreasing benefit the fixed premiums you’ll pay will usually be lower than for level term cover. This type of cover can offer peace of mind that a mortgage debt would be cleared if you died, for example.

Bear in mind that as you enter different stages of life, your life insurance needs may change. Many insurers will allow you to increase the amount of cover on your plan, for example if you move to a bigger home and have a larger mortgage, or if you have more children. But this is likely to lead to a bigger monthly premium.

How much does life insurance cost?

The cost of life insurance varies significantly depending on several factors. One of the biggest cost factors will be the type of life insurance you buy. For example, a level term life insurance policy is likely to be more expensive than decreasing term cover.

Here are some of the factors that will impact on the cost of your cover:

• Age. The younger you are when you buy a policy the less you’ll pay. That’s because your risk of death is lower
• Health. Your health has a major impact on your life insurance rates. The insurer will evaluate your past and current medical conditions in order to calculate your life expectancy. Family history of certain illnesses may also be taken into account
• Lifestyle and occupation. If you’re a smoker, if you’re overweight or regularly drink alcohol, or if you work in a ‘risky’ job, such as at heights, offshore or in the armed forces, then you’ll tend to be viewed as at greater risk of a claim.

Different insurers will place different risk weighting on each of these factors, which is why it can pay to shop around. You may be perceived to be a high risk with one insurer, for example, but to others they view the risk differently.

How to choose a life insurance coverage amount

A good rule of thumb for estimating how much coverage you need is to use the following:

• Add up all the expenses you want to cover, such as paying off a mortgage, loans and other bills and potentially having some money left over for other costs and day-to-day expenses
• From this figure, subtract the amount that your family could use to cover those expenses, such as from savings, other protection policies, any potential death in service benefit and other family member’s income
• The resulting number is how much life cover you’ll need. The amount may look high, especially if you’ve factored in income replacement for many years. But life insurance quotes are free, so it doesn’t hurt to price out the coverage you need.

If it turns out to be unaffordable, you can buy what you can afford now to lock in a good rate. You can buy more later, just be aware that several years from now your rate will be based on your older age and any health conditions you’ve developed, and it could be much more expensive.

Use our handy life insurance calculator to get a better idea of the amount of cover you might need.

How to get life insurance quotes

Many people don’t get life insurance because they think it’s going to be too expensive. But many consumers overestimate the cost.

The only way to know what you will pay is to get life insurance quotes from a few companies. You can do this through our life insurance partner LifeSearch. Quotes are quick and free.

Expect to be asked about your age, health, cigarette or vape use, your family health history and any dangerous occupations or hobbies.

When you have a quote that you like, you can start the application online. You answer more questions in detail and apply for a specific policy type (level or decreasing), amount of coverage and policy length and whether or not you want a joint policy.

Once you’ve submitted the application, occasionally some insurers may require additional medical information or records from your doctor. It will always ask for your permission for this first.

How to choose a beneficiary

A life insurance beneficiary is the person who can claim the lump sum payout (the death benefit) after you pass away.

You can name multiple beneficiaries and decide what percentage they each will receive when you die. Additionally, you should add contingent beneficiaries who will receive the death benefit if your primary beneficiaries have died.

You can also opt to put the policy in trust, sometimes referred to as being ‘written in trust’. This means any payout is ring-fenced from the deceased’s estate (so no inheritance tax – IHT – will be due on the sum) and it can be paid directly, and more quickly to your beneficiaries, without going through the process of probate.

It’s crucial to update and review your beneficiary selections regularly. For example, life events such as a marriage or a divorce or a new baby can impact your choices. To update your beneficiaries, contact your life insurer and submit a change of beneficiary form.

How does a beneficiary make a claim?

Claims will usually be paid out quickly, which can be extremely helpful for your loved ones, particularly if they need to cover funeral costs.

Try to contact the insurance company as soon as possible. While you may have a lot on your plate after a loved one passes away, the sooner you contact the insurer, the sooner you can get the money.

There is likely to be some paperwork involved. You will need to send the death certificate, or a certified copy, to the insurer to start the claim process.

Many life policies include a funeral pledge as standard in their cover. This will typically be an immediate payment of at least £5,000, which can bridge any gap in costs between the funeral and getting the full life insurance payout.

Under normal circumstances life insurance claims will be paid out within 30 days from the insurer receiving all the necessary documents.

You don’t need an original copy of the life insurance policy to make a claim. You only need to know the name of the insurance company and contact them to initiate the claim.

That’s why it’s important to let your beneficiaries know that you have a policy and tell them the name of the insurer. The Insurer is contractually obligated to pay only the people listed on the policy.

As mentioned above, life insurance beneficiaries don’t have any restrictions on how they can use a life insurance payout.