How does life insurance work?

How does life insurance work?

Life insurance is simple. You pay a monthly amount so that if you die, your loved ones receive financial support, which is usually in the form of a tax-free lump sum. The payout can help them with a number of things:

• Replacing your income, which they may have been reliant on
• Paying off the mortgage or keeping up with rent
• Covering childcare costs and setting them up with a future fund
• Paying for a funeral (if you want one)

Taking out life insurance at a young age means you will normally get a more cost-effective deal, providing you’re fit and healthy. That’s because people on average are expected to live into their late 70s or early 80s, depending on gender. The most common type of life insurance would be ‘term life insurance’, which covers you for an exceedingly long period, such as 20, 25 or 30 years. 

Still, there are different types of insurance you can buy. Sometimes the payout is flat and unchanging throughout the term. Sometimes it decreases over time in line with your outstanding mortgage balance – this version is often a bit cheaper. Another option is whole-of-life policies, which are typically more costly, but they cover you for your entire life and guarantee a payout whenever you pass away.

Is life insurance worth it?

Ask most people if they’re happy with their life insurance policy, and most will say they “don’t know yet.” After all, you never see the tangible benefits of life insurance yourself.  What you’re buying is peace of mind that your loved ones will be okay financially.

Do you have loved ones who would be in a sticky situation financially if you died? Does your partner rely on your income? Would you leave them any debt? If the answer is yes, life insurance is something to seriously consider. Even if you feel fine, physically.

Think you don’t need it? Read this first

If you’re single, you have no dependants and you can’t think of anyone who would need financial support if you passed away, you may decide to pass on life insurance. But it's a common misconception that life insurance is useless for young people with no dependants.

Circumstances change. Life happens. And while you might not have dependants now, who knows about the next few years? It can be shrewd to lock in a rate for the long term.

Other types of insurance worth knowing about

Life insurance is only one type of cover. Here are some other worthwhile policies:

• Income protection

This is such a good one, we’ve done a deep dive on it. 

Check it out here: Income protection insurance explained 

Simply put, income protection insurance is a level of cover to help with living costs if you lose your income because of being unable to work due to illness or injury. 

Income protection is usually worth it for anyone whose financial life would be significantly disrupted were they suddenly unable to work. Sadly, unwelcome news is experienced by all of us through life. And unfortunately, only then do most people realise the value of cover.

• Critical illness

Critical illness cover normally pays a one-off lump sum for specific conditions like cancer, a heart attack, or a stroke. Again, it’s another great way to take pressure off as you recover. It could even pay for private treatment. As with all insurance policies, it’s important to check to small print of the policy to see what is and what isn’t covered.

• Death-in-service benefit 

Many employers pay a lump sum to your loved ones if you die while in the job. This is often a multiple of your annual salary. The main drawback is that unlike having your own private insurance policy, this one’s linked to your job. If you leave your employer, you’ll probably lose a death-in-service benefit, so it isn’t great as your only form of life cover.

Should you have an emergency fund before life insurance?

Treat an emergency fund as a pot of money for things that could happen while you are very much alive. And treat the life insurance policy as a pot for your loved ones if you die. 

Not sure what to prioritise? If money’s tight and you have no dependants, many financial planners would steer you towards building up an emergency fund first. After all, one day, it could be your emergency fund which helps you meet the monthly life insurance payments. However, everybody’s circumstances are different. 

Wondering how much of an emergency fund you should have? The answer is here: How much of an emergency fund should I have? | Charles Stanley

If you want any help getting your head around a big financial decision or doing some financial planning around your future goals, you are more than welcome to contact us. You can speak to one of our qualified financial coaches completely confidentially and free of charge.

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