Life insurance: How to choose the best insurance policy?

protect your family with life insurance

Life insurance is a policy that, in return for periodic premiums, pays out upon your death to beneficiaries you have selected. The main objective of life insurance is to ensure that your dependents, such as your spouse, children and ageing relatives, are financially comfortable in the unfortunate event of your passing away.

In addition to this main purpose, it is also sometimes required as part of an arrangement to take out a loan or a mortgage, to ensure that the lender is repaid in case the borrower dies. In some policies, the pay-out can also occur in cases of severe illness and disability, which is more characteristic of critical illness insurance life. Life insurance plans can sometimes provide a mix of investment and retirement elements – so while they do pay out upon death, like normal life insurance, some of the funds can also be withdrawn.

Why is life insurance so important?

Life insurance is regarded by specialists as one of the pillars of personal financial and retirement planning. This is because, except for the very rich, even if you have a good income and are saving carefully according to a retirement plan, if you pass away before you have had the opportunity to build up sufficient savings, your dependents are likely to be financially vulnerable.

This is simply because, even with the trend of professionals marrying and having children later, many of us do so before accumulating most of our savings, or even before reaching our peak earning power.

For more information: Download our Insurance Guide.

Picture yourself as a 35-year-old expat lawyer with an income of $200,000. You are married and have two young children aged 1 and 3, whom your spouse (also a successful lawyer) currently takes care of. You diligently save half your income – $100,000 per year. That saving rate is above average and would be more than sufficient to ensure comfortable retirement if sustained for a few years, especially considering that your income could rise as you move ahead in your career. That’s excellent. But let’s say you suffer a fatal accident, having built up savings of $400,000 so far.

Not only has your family suffered an emotional tragedy, but also a financial one. First of all, they will face medical and funeral expenses. Then your spouse might have to move back to the UK to be able to work and to be closer to family – yet another emotional and financial disruption. That could take time, and in the meantime household expenses eat into your savings. Your estate would also be subject to inheritance tax, if you were UK resident. When your spouse finally settles and finds a job, that means someone has to take care of the children and the home, adding yet more expenses. Keeping your children in a private school, in extra-curricular activities and through university could be much harder.

Most people are willing to trade off a small premium in the positive scenario, in which they are healthy and working, to ensure that in the negative scenario their family only has to deal with the emotional blow, without the added financial troubles.

This is easy to understand, and so many people carry some life insurance, companies offer it as a benefit, and so on. What is sometimes less well-understood is that the amount matters, and that the amount of your insurance plan may not be sufficient for your specific case – especially if you went with the default offer.

Take the example above. A pay-out of $100,000 would have helped, surely. But given that that much was being saved per year by our hypothetical lawyer, it certainly wouldn’t be sufficient to maintain anywhere near the same standard of living as the family was used to.

Am I eligible?

Life insurance is appropriate for anybody who has dependents who would face a financial setback if the policyholder passed away.

Most commonly, that is portrayed as above – the leading income-earner in a newly married couple with young children. But it would also apply to the stay-at-home spouse, in that the working spouse would have to hire help and, if working overseas, might choose to move back so the children can be close to the family. Alternatively, it could apply to those caring for an elderly relative, even if they, themselves, have no children and are retired.

For more information: Download our Insurance Guide.

If you have dependents, the lower your income and net worth, the more seriously you should consider life-insurance. That’s because, even though it will mean a larger cut of your income, it’s more likely that your dependents would be financially vulnerable if you passed away.

Life insurance is available in varying amounts, so some insurance is accessible to virtually anyone with an income, regardless of how much. The amount of life insurance you can take out may be limited by your income, though. It may not be possible to take out a policy that promises to pay more than you could be expected to earn in your lifetime, for instance.

How does it work?

There are three main types of life insurance: term, whole life and universal life, that function slightly differently.

The simplest form of life insurance is Term Life Insurance: you sign a contract for a specific period, such as 25 years. During that time, you pay a regular premium. If you die during that period, your beneficiary receives a contracted sum of money. If you don’t, there is no pay-out. So this is a ‘pure’ insurance product, very similar to property insurance in terms of its mechanisms. There are usually a few restrictions. The pay-out might not be due in case of suicide or war, for instance.

Permanent life insurance, on the other hand, are policies that extend for an individual’s entire life. There are two types: Whole Life and Universal Life. Because death is eventually certain, a permanent life policy must pay out eventually. So these policies are, in a sense, also investment and retirement products: you pay in regularly and in the future you or your beneficiaries receive a pay-out.

Because for many policyholders it is more convenient to receive that pay-out themselves, while still living, rather than have it paid to beneficiaries upon death, permanent life policies include a number of ways in which the policyholders can access funds while still alive, such as:
– By borrowing against the policy
– By surrendering the policy and keeping part of its value.
– By receiving the pay-out when a pre-established maturity date is reached, such as when the policyholder reaches the age of 90 or 100

To allow for this, permanent life policies set premiums to a higher level that covers not only the ‘pure’ insurance premium itself, but also builds up an investment fund, called the ‘Cash Value’. So they are mixtures of insurance and monthly investment schemes. The Cash Value is different from the ‘Face Value’, which is the sum the policy pays upon death, but it is related: insurance companies set premiums and face values so that the expected cumulative premiums and investment returns equal the expected pay-outs plus their profits.

For more information: Download our Insurance Guide.

For example: say a policyholder takes out permanent insurance and passes away very soon. They won’t have built up any Cash Value, but will receive the Face Value – the policy will have functioned as a pure insurance product. On the other hand, if the policyholder lives to 90, their dependents will also receive the Face Value, but given that a Cash Value – possibly of comparable amount – had been built up over all the years, in a sense this functioned as a monthly investment product. All the insurance company is doing is giving to the beneficiaries the money the policyholder saved himself! For an intermediary case of a policyholder that passes away 10 years into the policy, for example, the Face Value payed out will be partly the result of an insurance pay-out, and partly the result of his monthly investment.

Whole life insurance policies have pre-established premiums and pay-outs and do not usually allow for adjustment either in the overall level of coverage or between the investment and insurance components of the product.

Universal life insurance, or adjustable life insurance, on the other hand, seeks to add this flexibility. For example, you can choose to increase your premiums and your face value, which you might want to do if you have another child. On the other hand, if you lose your job, you can use your Cash Value to pay the insurance premiums and maintain coverage.

What type of insurance can I get?

Term life insurance

Overall, financial specialists have a favourable opinion on term life insurance, because it is ‘pure’ insurance, without savings products built in. This means that premiums are lower than for permanent life. It also makes the best term life insurance easy to compare prices and conditions and to make sure you buy the right amount.

Term insurance can have one drawback. Because your risk of death increases as you age, so do the premiums for a given pay-out. If you buy insurance for a given period, once the term of your initial contract is over, if you decide you still need insurance, the premiums are then likely to be higher. Eventually they could become prohibitive.

This is usually a fairly minor issue, because, for most people, as you age you will have built up more retirement savings which you can leave to your beneficiaries in case of untimely death. You will also have fewer years of supporting dependents ahead of you. Your children might be older or fully adult and elderly parents that require support may have passed away or will have fewer years of dependency ahead of them. So as you age you are likely to need less life insurance or no longer need it at all. This is very different from medical insurance: you need more medical care as you age.

Permanent life insurance

Permanent life insurance policies have one significant benefit regarding their investment components: tax efficiency. Because they are treated as insurance for tax purposes, but in practice include investment products, investments can grow free of income tax and can be passed on to beneficiaries free of inheritance tax. Whether they are subject to tax for the various mechanisms to access the funds while still alive depends on the specific mechanism and jurisdiction.

For more information: Download our Insurance Guide.

On the other hand, in some cases these benefits can be obtained through other structures such as ISAs, SIPPs and QROPS, while maintaining better investment flexibility and better access to funds, and without tangling together investment, insurance and tax aspects of your financial plan.

Also, as mentioned above, as most people grow older, their need for life insurance falls. For the lawyer in our case above, having made partner and built up a net-worth of potentially millions of pounds by the age of 65, and having children in their early thirties well into their own careers, maintaining the same coverage from the age of 35 may be less effective. The money going towards premiums could be better invested elsewhere, or spent enjoyably.

Whether you should buy term insurance and keep your investment portfolio separate, or whether, for you, permanent life insurance could be a good wrapper for investments, is best determined together with your financial advisor in light of your personal financial plan.

Can I buy life insurance alone or do I need a financial advisor?

Historically, insurance has been bought via brokers. Brokers have the advantage that they are specialised in insurance, and presumably know the products well. In theory, brokers are expected to work in your best interest and help you choose the most appropriate provider and policy and mediate the purchase. Depending on the jurisdiction, brokers may be legally required to act in their clients’ best interest.

Brokers may not have a comprehensive view of your personal financial situation. They will seek to understand the basics – your age, dependents, income, and so on – in order to offer you products that make sense, but they may not be able to ensure that that fits in perfectly with your personal plan.

For more information: Download our Insurance Guide.

Insurance companies also increasingly offer products directly. For financially sophisticated buyers, or for simple policies, this is appropriate.

It is important to understand, however, that insurance products can be much more complicated than many investment products.. An insurance contract involves long-term commitments on your side, actuarial and legal terms, and can be a mix of investment, insurance and tax-wrapper.

Understanding whether your policy is a bargain or a rip-off can be quite complicated. If you have difficulty understanding the contract, calculating investment returns and making rough life-expectancy calculations, it might be an idea to seek professional advice.

Financial advisors have the most comprehensive view of your overall personal and financial situation and retirement plan, and what kind of insurance policy would be most appropriate in that context. In some cases, financial advisors will also be certified insurance brokers and so will be able to take you through the entire process. In other cases, financial advisors might explain the broad outlines of the policy that is ideal for you, then refer you to brokers for the actual purchase.

What can I invest in?

Some life insurance products that are specifically set up with their tax-efficient investment characteristics in mind may seek to offer flexible investment options. But generally speaking, though, you will have less flexibility than with your overall portfolio – illiquid investments such as in property might not be available, and the fund managers are ultimately selected by the insurance fund.

Who are the main service providers?

Life insurance is a very well-established and consolidated business. The top 20 life insurance companies are in the Fortune 500 and have been in business for over a century. Old Mutual International, Friends Provident International, AXA, Zurich and Generali are some big names. Generally speaking, it is essential to go for solid and reputable firms.

For more information: Download our Insurance Guide.

Discussion of what specific provider is most appropriate for you is best had with your financial advisor or insurance broker.

What are the risks of an insurance policy?

Insurance policies are designed to reduce, rather than increase, your exposure to risk.

Because it is a contractual relationship, you are always subject to credit risk – that is, that the insurer will actually pay you, which was discussed above. For financially solid insurers in jurisdictions with appropriate regulation, this risk is quite small.

The most important risk in insurance is that you, the policyholder, are not able to make premium payments, resulting in penalties or the cancellation of the policy, usually at terms that are disadvantageous to you. If you face financial difficulties, it is essential to determine, if necessary with the assistance of a financial advisor, whether defaulting on your premiums is the best option, or if you should keep making them and take funds from elsewhere.

In the case of policies that have investment components, you are also subject to all of the usual risks of the underlying investments, such as changes in prices, interest rates and so on.

How to buy life insurance? How much cover do I need?

As mentioned above, many people, by opting for the default insurance amount, are actually under-insured, while others are over-insured.

Ideally, you should have enough insurance to ensure that if you pass away, your beneficiaries will have enough to cover:
– Any outstanding financial obligations (such as loans and mortgages);
– One-time expenses such as medical, funeral, moving, etc.;
– Taxes, particularly inheritance tax;
– Living expenses for your dependents, for the entire period they will be dependent;
– Extra recurring expenses resulting from your death, such as a working spouse needing to hire help for cleaning and caring for children.

Life insurance is a key part of personal financial security for anybody with dependents. It can be bought for specific periods (term) or for an entire life-time (whole or universal), in which case it also functions as an investment product. The amount of insurance you need and which type of policy is most appropriate for you depends on your overall financial situation and plan. Because of this, and because insurance products can be very complex, it is recommended you consult your financial advisor on what is ideal for you.

For more information: Download our Insurance Guide.


CHRIS LAND, FINANCIAL ADVISOR

Chris has 9 years’ experience as a UK pension specialist and licensed financial advisor. He specialises in helping clients make balanced financial decisions to grow their personal wealth.

Chris is licensed with Globaleye, an award-winning international financial advisory firm established in 1999, with 10 offices and 15,000 clients worldwide.


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