Asking a financial adviser whether you need life insurance can be a little like asking a barber if you need a haircut. Ninety nine times out of a hundred the answer is going to be yes, and the other time will be when they are shutting up shop to go on holiday.
At the outset, I’d like to make one thing very clear. Nothing in life is free, and this doubly applies to buying insurance.
Insurance policies are one of the few remaining financial products where the recommendation (sale) of one can earn an adviser a commission from the insurance company. It is a similar situation if you buy a policy through a comparison website, that site will be earning a referral fee (commission by another name) for your business.
Please do not fall into the trap of assuming that the advice that you receive to buy one of these policies is free.
Commercial entities are not charities, and someone somewhere is always getting paid. The cost of the commissions paid by the insurance companies will be reflected in the premiums that you, and everyone else, pays.
Moreover the availability of these, potentially chunky, commissions can skew incentives somewhat.
Not only are advisers, and comparison websites, very much incentivised to get you to buy insurance. The cynic might observe that they are also incentivised to get you to buy more than you need - ideally from the insurance companies that pay the highest commissions.
In order to ensure that you can go into battle better informed, this week’s post focusses on giving you the answer to two questions.
Question Number One - Do You Even Need Life Insurance?
A decent place to start in answering this question, is by asking another question.
Do you have any liabilities which will outlive you?
If the answer to this question is yes, then life insurance is likely to be a sensible purchase for you to make.
A liability can be an explicit debt, like a mortgage, or it can be an implicit future cost - like supporting people who are financially dependent on you.
If you are single, without children or any major debts - you can stop reading now and go for a pint or something.
For the rest of us, life insurance is likely to be the best answer to a big question. How are those who are left behind going to cope financially without me around?
I can think of four common scenarios off the top of my head where life insurance can be massively important. Let’s run through them one by one.
1. You have an outstanding mortgage.
Most people first come across life insurance when they buy their first home. Although a mortgage can be cleared on death through the sale of the property, the thought of moving house may not be all that desirable to those that you leave behind.
Therefore even though it isn’t required in order to obtain a mortgage, purchasing life insurance alongside a mortgage is quite common, with the sum assured being sufficient to cover the mortgage liability on death so that the remaining family can continue to live in the property mortgage free.
Most people choose to take out a repayment mortgage when they buy a property, the effect being that over time the amount of mortgage debt owed is paid down.
The sum assured on a decreasing term assurance policy is designed to reduce in line with the amount owed on a repayment mortgage, to ensure that as close as possible, the amount paid out on death is sufficient to cover the mortgage and no more.
2. You have financial dependents.
If you are under the age of 45, it is likely that the biggest asset that you own is your human capital. Human capital simply refers to the value of the future earnings stream that you can generate using your unique set of skills and experience.
When we are young our human capital is bursting at the seams, waiting to be exchanged for financial capital. As we age, we work and receive money in exchange for the work that we do and our human capital reduces.
Source: Ibbotson Associates
Almost every single working household in the country makes financial plans for the future on the basis that the family’s human capital will be able to be turned into financial capital.
In some cases, sadly, life does not turn out as we plan. People fall ill, people die, in some cases far too soon. Unforeseen deaths can throw families into financial, as well as emotional turmoil.
Life insurance protects families against the loss of human capital. These policies ensure that the death of a “provider” within the household does not mean that financial plans need be ripped up.
Term assurance policies which cover individuals, or couples, for a defined period (say up until the age that you expect your youngest child to remain financially dependent) can be relatively cost effective - particularly if you take out the policy when you are young.
Family income benefit is a type of term assurance policy that pays out a regular tax-free income instead of a one off lump sum.
3. You expect your estate to be subject to inheritance tax when you die.
Approximately 1 in 25 estates in the UK end up paying inheritance tax. The vast majority of estates are covered by the various tax free allowances that are currently afforded us by the government.
But for those whose estate is projected to be subject to inheritance tax and who do not wish to gift assets to others just yet - taking out life insurance to cover the projected inheritance tax liability can be a neat solution.
However if you have an inheritance tax liability today, and aren’t going to undertake any further legacy planning, it is likely that this liability is only going to increase as your asset base grows. An increasing whole of life insurance policy will pay out a sum assured that rises (say, in line with inflation) over the time that you continue to pay the policy premiums. This kind of a policy can see your level of cover increase in line with the eventual inheritance tax liability - just be aware that it will never be a perfect 1:1 match.
When a life insurance policy is held for the purpose of covering an inheritance tax liability, it may well make sense to write it into trust. If it isn’t, the sum paid out will fall within the deceased’s estate and be immediately subject to a 40% haircut. Getting a life insurance policy written into trust also means that the pay-out can be accessed much quicker than it would otherwise be through probate.
4. You own a business.
If you own a business, you are likely to represent a large proportion of the value within that business. If you were no longer around, provided the business is still able to function, it would be materially inhibited at the very least.
Key Person Insurance pays out if you or another important individual within your company dies. These funds can be used by the business to find a replacement, or to shore up the company’s balance sheet during a period of disruption.
Shareholder Protection will pay out in the event that a shareholder of a company dies or becomes critically ill. Again, the aim here is to minimise disruption to the business - the sum assured provides funds for the remaining shareholders to buy out the deceased’s holding. These funds can then be used to support the deceased’s family, while ensuring continuity and certainty for the remaining shareholders.
Where the premiums for these kinds of business insurances are paid by the company, they are allowable expenses for purposes of calculating corporation tax. Indeed, premiums due for personal life insurance cover can also be paid via a business - although while doing so can reduce the company’s corporation tax bill, this is categorised as a “benefit in kind” and the amount of premium paid will be taxed at the relevant individual employee’s marginal rate of income tax. So it is worth doing the sums, or asking your accountant to do the sums, to calculate if it is worth it.
Phew…right, onto question two.
Question Number Two - How Much Do You Need?
This is an important question to answer, in order to avoid being over or under-insured i.e. having too much, or not enough cover. It is likely that the amount of cover that you need will change over time, as circumstances change. But the below will hopefully provide a reasonable framework to establish if you are in the right ballpark.
There are two steps to establishing how much life insurance you need to buy.
1. Calculate How Much Cover Is Required.
If you would prefer the quicker, less exact, method of working out how much cover is required you might go choose to use the “income method”.
Calculate your current annual salary, net of tax, and deduct any savings which you make from your net income into savings accounts/ISAs/pensions. Then multiply this figure by the amount of years that you plan to keep working.
What you are left with is a number which represents your projected future financial contribution to your household. A proportion of your future human capital. This is the amount of cover you should buy.
The “expenditure method” offers an alternative method - a more granular, more accurate way of calculating how much insurance you should by. As the name suggests, rather than focussing on income it focusses on outgoings.
It involves calculating what the future costs to the family would be in the scenario that you are no longer around. These costs may include, but not be limited to, the following:
Regular basic household costs - food, clothing, water, gas, electricity, phones, internet.
The future cost of supporting dependent children.
Education costs.
Cost of childcare if your spouse has to go back to work.
The future cost of maintaining your home - home and garden maintenance.
Future support for your children - property deposit, cost of a wedding.
Funeral costs.
The amount required to cover any outstanding debts.
This is by no means an exhaustive list, and there will be further costs which are specific to you and your family.
It is important to highlight that you will inevitably be relying upon assumptions whether you choose the income or expenditure method, and the number that you come up with will never be exactly perfect.
But we aren’t aiming for perfect, we are aiming for good enough. And there will be other factors in play when we determine the amount of cover that you end up with - for example, what level of premiums you can actually afford to pay month to month.
2. Subtract any available assets or existing policies.
Once we have an idea of the total amount of cover that we would like, we can subtract the value of the savings that we already hold to cover future liabilities. These savings can include ISAs, pensions or cash accounts.
It may be that your asset base is so large that it is sufficient to cover all of the future costs identified using the “expenditure method”. In this case, you are able to self-insure, and do not need to buy a policy if you don’t wish to.
However, regardless of your level of assets you may wish to buy cover in any case for reasons of access for your beneficiaries post your death. The probate process can take a long time, and if it drags on an insurance pay-out can be invaluable in providing liquidity for your family or executors. Again, a reminder that a life insurance pay-out will only sit outside of the probate process if it is written into trust.
And finally, without wanting to teach you how to suck eggs, in calculating how much cover you need it is also important to bear in mind any existing life cover that you might have - either personally, or as an employee benefit.
Many employers will offer death in service cover, in many cases up to four times your annual gross salary, which will handily reduce the amount of cover that you need to buy. Of course, any time you change job it is important to review your position.
Running through all of these steps should give you a really good idea of how much cover that you need, but if you ever need a definitive idea of how much insurance you require then a regulated financial adviser can help with this.
Buying insurance is an inherently unglamourous act. But it is a loving act.
Forgoing some pleasure today, so that others can take some comfort in future. I’d say that’s pretty close to the definition of selflessness.
None of the above is intended to constitute advice to any specific individual.
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