What You Need To Know About Life Insurance

Choosing a financial product isn't just about comparing price; it's about understanding what you're buying. Life insurance is certainly no different. Here's what you need to know.

Life insurance pays out to your dependants if you die. Well, that seems simple enough. But is it though?

In my view, other than the price, there are several things you need to know. Here are some of the key questions you should consider:

1. How much will I pay?

The premium should be obvious when you get a quote. The one thing to be sure of is whether it's a fixed amount. If it isn't, the insurer is likely to ramp up the premiums significantly as you get older.

Fixed premiums are a good choice for most people. They tend to start off slightly more expensive, but they're cheaper in the long run.

Summary: If you want a fixed premium, make sure that's what you're getting.

2. Oooh! I can invest in the stock market at the same time, can I? That's convenient!..Hang on, what's the catch?

Life insurance policies can be sold with an investment element, such as an endowment. When completely different financial products are combined like this, they are invariably poor value for money. If you want to invest, do it separately, perhaps by increasing your pension payments or investing in an ISA.

Summary: Make sure there's no investment element to your policy. It should be pure life insurance.

3. Do I want the payout amount to remain the same throughout the length of the policy?

You can specify when the policy ends and you can decide whether the payout decreases as the months go by (a 'decreasing term assurance' policy) or whether it remains the same ('level term assurance').

Normally, you only opt for decreasing term assurance if it's for paying off your mortgage should you die. As the amount outstanding on a repayment mortgage decreases over time, your cover should reduce as well.

One alternative that I like is a family income benefit policy, which pays a monthly income to the beneficiary instead of a big lump sum. Not only does this make the money easier to manage, but it's an awful lot cheaper too.

Summary: Select decreasing term assurance for mortgages and, usually, level term assurance for other purposes. Use your common sense when deciding which is appropriate.

4. When my policy pays out, will it be subject to inheritance tax?

You can protect a life insurance payout from inheritance tax by putting it in a trust. Usually, this just involves ticking the relevant box on the application form. This also has the added advantage that it speeds up the payout, as it will be made directly to whoever you name as the beneficiary of your policy, rather than getting paid into your estate and tangled up with any other assets you have.

You can also set up more complex trusts to deal a life insurance payout but, thanks to recent rule changes regarding the taxation of trusts, you could end up paying tax in such cases. In these cases, it's worth taking specialist advice, especially if your assets exceed the Inheritance Tax limit of £285,000.

Summary: Make sure your policy is written into trust by ticking the right boxes when you receive the application forms.

5. Should I get insurance for my life insurance?

If your circumstances force you to stop paying your life insurance premiums, you'll need to take out a new policy when you decide to start up again. But your premiums the second time round could be far higher, particularly if many years have passed since you started the first one. So providers will offer you more insurance to protect your premium payments. This is often called 'waiver of premium' cover.

The thing is, the same rule as for endowments applies, because you're now looking at a combined product: a life insurance policy and a payment protection policy. This protection is likely to be disproportionately expensive. On the other hand, you're likely to find it difficult to get a standalone provider for this, as there's not enough money in it. So it's up to you to decide whether you really feel like you need it.

Personally, I'd rather get the income protection insurance I mentioned in question three, as this will cover all scenarios.

Summary: Think carefully before buying premium payment protection. Is the price worth it to you? Would income protection be more suitable?

6. Should I get a pension term assurance policy?...And what the heck does that actually mean?

'Pension term assurance' (PTA), is basically normal life insurance, except that you pay the premium pre-tax. (Higher-rate tax payers can claim the remainder through their tax returns.)

These policies tend to be more expensive for insurers to set up, but overall they can be significantly cheaper than a regular policy because of the tax savings. You can also index-link these policies to guard against inflation.

You must be aware that any settlement amount counts towards your tax-free pension limit (currently £1.5m). If your pension pot and the insurance settlement amount totals more than this, the excess is subject to 55% tax, payable by your estate.

Summary: Just go for the cheapest policy, unless your pension pot and life insurance payout amount combined is likely to exceed the tax-free limit.

7. This small print thing: is it worth reading?

A life insurance policy pays out when you die. That's pretty much it. Still, you must read the small print. I'm not just saying this because it's some sort of financial industry mantra; the only way to get real peace of mind is to read and understand every sentence in the policy.

If you want another reason, consider this: just to confuse you, insurers use different terminology. For example, 'waiver of premium' cover may be called 'premium payment protection cover', or something else. Therefore you may sign up to something costly without realising it.

Summary: Read the small print. If you don't understand what something means or the affect that it might have on you, take a look at the guidance in ourInsurance centre, post a question on our ever-helpfuldiscussion boards, or simply give the insurer a call and don't let them hang up until they've explained it to you.

> Learn more about life insurance and compare life insurance quotes here at the Fool.