How does life insurance work?

Life insurance is based on the principle that most of us would want to protect our family and loved ones if, for some reason, we were to die prematurely. It recognises that of course death will come to us all at some stage, but that it is possible to pay a regular premium to secure financial protection for the family against an untimely death. So, how does life insurance work?

Life insurance does this in one of two ways: The first involves setting a specific period of time – a term, with a commencement date and a closing date – during which a benefit becomes payable in the event of the insured’s death. If the insured person dies at any time between the commencement date and the final date, the assured benefits become payable; if the insured dies at any time after the terminal date, however, no benefit is payable. Monthly premiums are payable throughout the term of the life insurance cover but cease beyond the terminal date. At no time does such a life insurance policy have a cash-in value; it pays out only in the event of the death of the insured.

An alternative form of life insurance is called whole of life insurance – because it does just that; it covers the insured person for the whole of his or her life and pays out a benefit whenever death occurs. So if you die within three years of the commencement of the cover, or after 30 years, the whole of life insurance policy still pays out an assured sum. Indeed, with the majority of whole of life policies, the insurer will have been investing the money paid in premiums and a proportion of the earnings from those investments will be credited to the policy in the form of a cash value. The cash value part of the policy can then be used in later life as part of a retirement investment plan, while some of the cash value is also used to maintain payments on the life policy until your death and the payout of the death benefit to your family or loved ones. It will be appreciated, therefore, that premiums for a whole of life insurance policy cost considerably more than those for a term life insurance.

Standard term life insurance can work in more flexible ways, too. For example, one of the most popular purposes of life insurance is to ensure that a mortgage is completely repaid in the event of the premature death of the principal breadwinner. If the mortgage is a standard repayment mortgage, of course, the balance of the mortgage will be decreasing over the years. A decreasing term life insurance policy takes into account this reducing commitment by steadily reducing the amount of death benefit that would be paid over the term of the policy. In this way, the risk to the insurer is reduced and premiums can be made correspondingly cheaper.

Alternatively, term life insurance can be made to work in a way that ensures that any benefits payable increase by incremental amounts each year or that they keep pace with the prevailing rate of inflation. In this case, the policies to choose will be increasing term life insurance (where the benefits increase by a certain proportion each year) or an index-linked term life insurance (where the amount of the benefit increases in line with the prevailing index of retail prices).