Protection against the financial consequences of death

- This Guide was written by Lewis Greenwood 11th September 2019

Many individuals have insufficient savings required to continue to meet their own or their dependents financial obligations, should the main source of income from the ‘breadwinner’ pause or stop.

Insurance is a necessity, and if selected correctly, protection products and there subsequent premiums are a small price to pay to cover your family or business.

Throughout this guide we will discuss how these arrangements work and how they can be used in everyday life.

Type 1 – Term Assurance

Cover is provided for selected period of time = ‘term’.
Ceases at the end of the term or if the policy lapses = premiums aren’t paid (within 30 days).
Premiums – monthly/ annually or sometimes through a single premium.
Benefits – paid on death within the specified term.
No cash value, no investment element, and no return of premium.

Type 1a – Level Term Assurance

Level of cover stays out throughout the term, as shown in the graph below.

(Study.libf.ac.uk, 2019)

Policyholder’s should therefore consider that the cover will not be line with inflation, so the buying power of the cover in real terms may reduce with time.

Type 1b – Increasing Term Assurance

Sum insured increases by a fixed percentage or amount by the original sum each year – premiums increase in line with this – however no account of health change complications will be considered as the increase occurs.
(Study.libf.ac.uk, 2019)
This type of policy may be used when temporary cover is needed to a fixed degree, but is required to adapt to effects of inflation on purchasing power.

Type 1c – Renewable Term Assurance

Some plans can be reviewed without further medical underwriting at the end of the term – typically this renewable is repeatable until a certain age.

Type 1d – Decreasing Term Assurance

Premiums remain constant and payable throughout term – cover provided throughout the term gradually decreases to nothing – as sum assured reduces to nothing, this equates to a lower premium than level term.
(Study.libf.ac.uk, 2019)
This graph above shows an example of level decreasing term assurance – I.e. cover on outstanding debt that reduces each year by a fixed amount.
(Study.libf.ac.uk, 2019)
This graph above shows an example of how a decreasing term assurance policy could be carried out to cover the outstanding on a repayment mortgage. The sum assured decreases by lesser amounts each month at the start than towards the end of the plan term.

Type 1e – Gift inter vivos term assurance

A gift inter vivos policy is designed to provide an amount sufficient to pay the IHT due when the donor dies within seven years of making a potentially exempt transfer (PET).

(Study.libf.ac.uk, 2019)

As shown in the graph above – the sum assured is set to the amount of IHT tax due.

The cover then reduces to 80% 3rd year, 60% 5th year, 40% 6th year and 20% 7th year.

Cover ceases at the end of the seventh year, at which point liability for IHT ends on the gift that the policy is covering. (Royal London Group, 2019)

Type 1f – Family Income Benefit

Form of decreasing term assurance.

Benefits paid at death as a form of income payments – if death occurs within the term – premiums stop – and income is paid until expiry date of the policy – or alternatively a cash sum called ‘commutation’ of income, this lump sum will be discounted from the sum of income payments due

Benefits Term Assurance Drawbacks Term Assurance
Low cost.
Flexible cover, can adapt to different timescales and GSA requirements.
No investment element plus its fairly simplistic and easy to explain for the average retail based investor, individual or family.
No cash value to policy – if the premiums stop so does the cover.
No investment element – client is purely reliant on the sum assured and keeping up with the premiums.

This case study is for illustrative purposes only and does not constitute advice.

Case Study

Rupert has made a gift with a value of £550k. He has made no other lifetime gifts during the last seven years and has used the annual exemption for gifts of £3,000. Rupert contacts his adviser who explains that the value of this gift exceeds his nil rate band by £225k (£550k – £325k).

He also explains that Rupert will have to pay up to 40% IHT tax on the £225k if he dies within the next 7 years, but this charge will reduce over this time under the taper relief threshold. In order to mitigate this potential IHT tax bill, Rupert’s adviser recommends Rupert take out a ‘Gift inter vivos policy’ for the taxation.

The policy starts with a sum assured of £90k cover which then reduces by £18k each year after year three – (40% of £225k = £90k, and after year three the IHT liability will reduce by 20%, 20% of £90k = £18k).

As long as the premiums are paid – this policy will ensure Rupert is covered for the IHT liability at any stage of his life within the next 7 years until the gift is out of his estate.

The adviser has also realised that there is still a certain liability on the remains of Rupert’s estate. Rupert has used his nil rate band entirely, meaning his beneficiaries for the rest of estate have an increased liability until the gift he has made falls outside of his estate and the full nil rate band is available again in seven years.

Rupert’s estate is not being left to a spouse/ civil partner, so his adviser explains this means it’s not exempt from IHT tax, so Rupert’s adviser recommended covering this liability by means of a level term assurance policy, as taper relief does not apply to this sum.

The cover required for Rupert would be £130k equivalent to the 40% tax liability on his nil rate band. The policy term for this also needs to be set at 7 years to ensure his liability is accounted for throughout the time the gift is passing out of his estate.

Type 2 – Whole of life Assurance (WOL)

No term – if premiums are paid continuously, benefits are paid upon death.

WOL policies can provide an element of investment – these are increasingly rare now.

Normally WOL policies are ‘universal’ in that they have additional benefits added, i.e. Income Protection Insurance or Critical illness cover – naturally the more benefits added – the higher the premium/ cashing of more units.

Type 2a – WOL With-Profits

Policy premiums are invested in company’s with-profit fund – this is invested in range of assets – selected by a fund manager – when the policy is created a GSA (guaranteed sum assured) is established – fund is assessed each year – the company will declare potential reversionary bonuses – added to the plan – increasing the GSA – when the policyholder dies a terminal bonus may also be applied – calculated as a percentage of the plans value.

Type 2a (i) – WOL With-Profits (Low Cost)

GSA is lower than the required level of life cover to keep the cost down – the difference left between the necessary GSA and actual GSA taken out – is incorporated into the plan as temporary life cover – with every policy anniversary – the temporary GSA reduces by the bonuses declared – eventually meaning the temporary cover is no longer required. (Moneysupermarket.com, 2019)

Benefits Drawbacks
Investment element – fund can grow with the policy.
Revisionary bonuses cannot be taken off the GSA once added.
Premiums are fixed.
90% current cash value potential loan available.
‘Low-cost’ policies – an option for the less well-off.
Premiums can be expensive.
No guarantee of investment growth = no guarantee of any revisionary bonuses.
Expenses are not transparent –charges are not clearly defined.
Not as flexible as competitor policies.

Type 2b – WOL (Unit Linked)

Premiums buy units in the chosen unit-linked fund – premium is set so the fund will sustain the level of charges until a predetermined period – a review will then take place – dependant on the performance of the funds – fund manager makes the alterations necessary – reviews happen between 5-10 year periods – premium is set for a given sum assured. (Anon, 2019)

Benefits Drawbacks
Flexibility – allow the policyholder to easily access and add other products onto their policy plus the premiums are not fixed and nor is the GSA. (see benefits that can be added below)
All expenses are transparent.
Specific client specific funds can be selected.
Investment element – fund can grow with policy.
No ‘low cost’ version. Lots of charges – i.e. bid-offer spread costs which may be as high as 6-6.5%.
Premiums can be expensive.
No guarantee of investment growth and plans should not be treated as investment vehicles.

Key uses of implementing a WOL:

  • Protection for dependants – if the main earner dies, these policies ensure some degree of financial support in the event of their death.
  • The policy enables a tax free legacy for the dependants and the lump sum can be used to pay any expenses i.e. funeral costs.
  • IHT planning – policies can be used to pay IHT bills.

Additional benefits that can be added to life assurance products:

  • Guaranteed Insurability – the GSA can be increased without any further medical underwriting.
  • Indexation of benefits – GSA increases in line with an index i.e. RPI.
  • Waiver of premium (WOP) – an insurance to cover the costs of the premiums if the policyholder is unable to pay. (Financialadvice.net, 2019)

Case Study

James (32) (an only child) and Lisa (30) are married and have 3 children (all under 4) – they live in their house in Tonbridge. James’s mother Patricia (64) has been recently windowed, and lives in the family home. James wishes in the future to retire and move his family into Patricia’s home where he grew up, he also wants to ensure his Mother can continue living in this house for her remaining years.

Patricia owns the family house outright and its current value is £1.4m, she now also has assets equating to a value of £650k, since the recent death of James’s father Ian. Ian did not use any of his nil rate band, as all gifts were made over 7 years ago, meaning now upon his death his remaining assets now form part of Patricia’s estate.

James’s financial adviser recommends a ‘Life of another, WOL with added benefits of guaranteed insurability and indexation of benefits of RPI’.

James will take out the policy on the life of his mother Patricia as soon as possible after the passing of his father. The adviser recommended he take out £450k worth of cover to ensure all the IHT tax can be paid upon Patricia’s death.

Patricia’s Total Assets Value – £2.05m (£650k + £1.4m)
Patricia’s Nil Rate Band Value – £925k ((£475k + £475k) – £25k)

(Patricia’s nil rate band and her RNRB + Ian’s nil rate band and his RNRB)
+
(Her estate is over £2m by £50k, her allowance reduces by £1 for every £2 over this threshold, meaning £25k is subtracted from her original allowance £950k amount leaving £925k)

(£2.05m – £2m = £50k) → (£50k / £2 = £25 x £1 = £25k) → (£950k – £25k = £925k)

RNRB: £150k in 2019/2020
Nil Rate Band: £325k in 2019/2020
(GOV.UK, 2019)
Patricia’s Taxable Estate Value – £1.125m (£2.05m – £925k)
Patricia’s IHT Bill Value – £450k (40% of £1.125m)
Cover needed – £450k

Guaranteed insurability allows James to increase the amount of cover in the future if his Mother’s estate amount increases without further medical tests.

Having the policy run in line with RPI will ensure that as the capital appreciation of property increases, thus increasing the value of the IHT tax bill, the cover will also increase, meaning when the policy pays out, it will still have the required level of cover available.

This example does not require an investment element with the policy, as it’s taken out for a specific reason – IHT planning.

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