The difference between life assurance and life insurance and why it matters to you
Did you know there are basically two types of life protection policies? Life insurance and life assurance.
The main difference between life assurance and life insurance is that life insurance covers you for a set period of time or term, whereas life assurance covers you for your whole life. If you die outside the term of the policy, you won’t receive any pay out, even though you might have paid premiums for many years. Term insurance contains no investment element so you never get any money back unless there is a claim, much like home or car insurance.
So term insurance covers you for a fixed term of years and/or months whereas whole of life assurance covers you for the rest of your life usually as long as you continue to pay the premiums. Simples? Well as ever, nothing is quite as simple as it seems at first sight.
Confusingly term insurance is often called term assurance whereas whole of life assurance is frequently referred to as whole of life insurance! As a former linguist during my school A level days, I have observed throughout my adult life that English isn’t spoken properly by most people who don’t really understand the language. Not their fault of course as most people are not linguists. So even insurance companies get it wrong and confuse the names of both types of life protection.
Over the years a number of our clients have set up what are known as unit linked whole of life assurance policies to pay Inheritance Tax (IHT). They have proven to be simple yet very effective ways to save IHT. Let me explain by way of an example.
A husband and wife in their sixties have an Inheritance Tax liability of, say, £250,000. So they decide to take out a whole of life assurance policy which costs them £6,000 per annum.* The policy is arranged on a joint life, second death basis which means that the life assurance payout is on the second death. The premiums are payable until the second of the lives assured dies.
The policy is written into trust and the beneficiaries are their two adult children. The premiums are classed as gifts known as PETs for Inheritance Tax purposes. Now don’t confuse your household pets such as dogs, cats and rabbits with these types of PETs! A PET is a potentially exempt transfer, or a gift, for IHT purposes. Each adult has a £3,000 a year annual IHT exemption for gifts so in this example the gifts, the premiums, are exempt from IHT immediately assuming no other gifts are made each tax year.
When the second of the parents dies the policy pays £250,000 into trust. The payout completely avoids probate and the money is paid to HMRC by the children to settle any IHT liability. Once the tax is paid probate may be granted meaning the parents’ estate can now be distributed to the beneficiaries who are the two adult children in this example. This is classic whole of life assurance IHT planning for married couples especially those with children.
Whilst this is one of the simplest ways to settle an IHT liability it is not the only way and it doesn’t suit everyone.
The main problem with the unit linked whole of life policy is that its structure has flaws. Firstly the policies are reviewable meaning that on 10 year anniversaries they are assessed by the insurer and premiums may be increased and/or the sum assured reduced. In later years the reviews may increase to 5 yearly. It may reach the stage that the policies become no longer fit for purpose under the worst case scenarios.
A by-product of such policies is that they can generate a cash sum because there is an investment element to these policies. They aren’t designed to produce a surplus of cash above the amounts paid in premiums. Rather the cash element is used as part of the policy structure to subsidise premiums in later years. Hence the problem. You see such policies not only have relatively high charges but they also depend on investment performance in order to build the cash element of the policies. If investment performance is poor, an unfavourable review is likely to result, meaning the premiums may be increased. In addition to this the insurance company may experience higher than average claims which could lead to an increase in premiums too.
Fortunately, in recent years a new breed of whole of life assurance policy has emerged known as guaranteed whole of life assurance. So what is this type of policy?
Well it does have the main characteristics of a traditional whole of life assurance policy but it differs in a few critical ways which I believe make it a better policy.
Firstly, it isn’t a hybrid investment/life assurance policy. There is no investment element to it.
Secondly, it is guaranteed not reviewable. This means that the premiums are guaranteed to never increase nor decrease. They are fixed for the duration of the policy i.e. until the policyholder dies or, in the case of a joint life second death policy, when the second of the lives assured dies.
Lastly there are no policy reviews so no surprises.
The downside is that the premiums tend to be higher. Let’s face it you always have to pay extra for a guarantee.
So, if this IHT solution is so simple why don’t more people use it? Well that’s a really good question. I think the main reason why is because most people do not know about it. If they did I am sure more people would use it especially married couples with children. A second reason could be because one or more of the applicants is uninsurable or in poor health meaning the premiums would either be rated (increased) or the application would be declined. Another reason may be because the premiums are considered to be too high.
However, as long as the applicant/s has/have a high enough income and/or income can be taken from an existing investment or pension then the premiums could be easily affordable. The way to prove this of course is to forecast income and expenditure using a lifetime cashflow forecast such as Money Forecast which is our cashflow system.**
So if you have an Inheritance Tax liability and you are considering ways to mitigate it why not consider whole of life assurance as one possible solution of the many that could solve your problem? You know it makes sense.
*The premium quoted is an estimate only and that the actual premium will depend on individual circumstances.
** This communication is for general information only and is not intended to be individual advice. You are recommended to seek competent professional advice before taking any action. Tax planning and cashflow modelling are not regulated by the Financial Conduct Authority.