B1.02: LIFE POLICY TYPES

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1 B1.02: LIFE POLICY TYPES SYLLABUS Term assurance Increasing, decreasing, renewal and conversion options Family Income Benefit policies Whole of life policies With profit whole of life Unit-linked whole of life Joint life policies Other life policies Uses of policies Inter vivos policies Relative costs of policies Qualifying status Surrender values Term assurance Term Assurance is the simplest form of life assurance and provides a sum assured payable on death during the term fixed at outset There is no investment element, and therefore no surrender value nor maturity value The life cover lapses at the end of the policy term There is no tax relief on premiums for new term assurance policies In the past, there has been relief for term assurance taken out under pension rules, but this is no longer available for new policies, though some existing policies continue to benefit from it The details of this continuing relief are outside this syllabus area There is no income tax liability on benefits Increasing, decreasing, renewal and conversion options Increases in the sum assured can be provided for, either as an automatic feature, or as an option for the policyholder The basis of increase is a matter of policy design and may, for example, be a fixed percentage, eg 5% pa, or be linked to an index such as the Retail Prices Index (RPI) Some policies allow increases at the greater of a fixed rate or the increase in the RPI, others at the lesser of the two A higher premium (greater for more extensive increase options) is charged from outset compared with that for a level term assurance The increases do not require the provision of any further medical evidence Premiums increase each year as cover increases, sometimes in direct proportion, sometimes on a precise actuarial basis reflecting the age of the life insured and the increase in sum assured

2 Decreasing term assurance policies are also available, with the cover decreasing on a predetermined basis They are generally used to cover a specific need such as to protect a repayment mortgage or provide for the possible inheritance tax (IHT) on a Potentially Exempt Transfer if the donor dies within 7 years (see Inter vivos policies below) The cover is very inexpensive, because as the age of the insured increases and the risk of death increases, the sum assured decreases Family Income Benefit policies are also available (see below) and are a form of decreasing term assurance Premiums under decreasing term assurance policies are generally level, though this is a matter of policy design Renewable term assurance allows the policyholder to take out a new term assurance policy at the end of the original term, with premiums based on his or her then age, but with no requirement for further medical evidence Because of the increase in age, premiums are likely to be greater at the point the renewal option is exercised The new policy is also generally a renewable term assurance, so this process can be repeated several times, until a maximum age set by the insurer is reached (often around 70) Convertible term assurance allows the cover to be converted to a whole of life or endowment basis, with premiums based on age at conversion, but with no requirement for medical evidence Conversion is usually allowed during the policy term or at the end of the term, and can be carried out for part of the sum assured, with the remainder continuing on a term basis An increased premium is charged for the inclusion of the renewable or convertible options, and they are often both included in a single policy Family Income Benefit policies Family Income Benefit is a form of decreasing term assurance, specifically aimed at families, and is intended to provide cheap, basic cover Benefits are in the form of regular payments ( income ) payable from death until the end of the policy term Cover is therefore substantial in the early years, but its value gradually reduces as the potential payment period of benefits reduces as the end of the term approaches Although described as income, the benefits are treated for tax purposes as instalments of sum assured and are not subject to income tax Most policies allow the benefits to be exchanged for a discounted lump sum This is calculated at the discretion of the insurer, taking into account economic conditions at the time, in particular, interest rates It is possible to arrange cover on the basis that the level of income increases to counteract inflation, at least to an extent There is no investment element, and so no surrender value nor maturity value

3 Although aimed largely at family protection, the cover can also be useful to meet any need for regular income, for example, payment of school fees after the death of a breadwinner This will often be the cheapest method of covering such a liability Whole of life policies Whole of Life (WoL) policies are a mix of protection and investment, but with the emphasis on protection Charging structures tend to make these policies inappropriate for significant levels of investment WoL policies pay a sum assured on death, whenever this occurs They generally develop a surrender value, but this is likely to be little or nothing in the early years of the policy Various styles of policy exist, including non-profit and with profit policies Unit-linked (flexible) whole of life policies are also available (see below) A non-profit WoL policy has a fixed premium and a fixed sum assured With profit whole of life A with profit WoL policy has a fixed premium, but the Guaranteed Sum Assured (GSA) payable on death increases with the addition of bonuses (usually annually) A Terminal Bonus may also be paid on death A low cost whole of life policy is a combination of with profit WoL with decreasing term assurance The intention is to provide a higher sum assured initially than would apply under the normal whole of life basis However, it will not increase until the with profit sum assured plus bonuses exceeds the combined WoL and term assurance cover level set at outset Premiums are usually payable throughout life, but limited payment policies are available where premiums cease at a certain age, perhaps 60 or 65, with cover continuing throughout life This basis can be useful in providing for IHT liabilities which arise whenever death occurs, but recognising that income, and therefore the ability to fund premiums, may reduce after retirement With profit WoL policies are usually qualifying policies, and if so, provided premiums are still being paid, there will be no income tax charge on death If premiums have been stopped before they have been paid for ten years, there could be a tax charge at higher rate(s) on any investment gain on surrender However, the nature of these policies means that a substantial gain is unlikely If premiums cease but the policy is left in paid up form, a tax charge could arise on death, if premiums have been paid for less than ten years Any such tax charge would only be in respect of any investment gain, calculated as if the policy had been surrendered immediately before death A similar tax charge arises in the case of a non-qualifying policy, irrespective of whether premiums are being paid or not, or for how long they have been paid

4 Again any tax charge is based only on any investment gain, not on the sum assured No tax relief is available on premiums (unless the policy is qualifying and was started before Life Assurance Premium Relief or LAPR ceased in 1984) Unit-linked whole of life Unit-linked Whole of Life policies allow considerable flexibility of premiums and sum assured and are often referred to as Flexible Whole of Life policies Generally, premiums purchase units in a fund or fund, so the investment element is visible and identifiable Charges and risk costs are taken by unit cancellation and/or by deduction from premiums (in addition the funds will usually bear an annual management charge) This design approach allows the sum assured for any given level of premium to be set within a wide range at outset and it can subsequently be varied in which case the insurer would simply adjust the amount taken to cover the cost of risk Note that medical evidence is likely to be required for any increase in cover unless there is an increasing cover option built into the policy The insurer usually has the ability to vary the basis of the risk costs, and other charges at any time Although this means that the policyholder has little by way of guarantee, it also allows the insurer to be less conservative in the assumptions made in designing the policy (which results in lower premiums) Premiums can be set at a level expected to be adequate to support the required level of life cover throughout life (often known as standard cover) The adequacy of standard cover premiums is not guaranteed however, and premiums may need to be increased if the assumptions underlying their calculation are not fulfilled Premiums can be paid at a level below the standard cover level The minimum premium level (often known as the maxi-cover or maximum cover basis) is calculated to support cover through a certain period (often ten years) known as the review period At the end of the review period, the policy is reviewed by the insurer This will result in a new minimum premium level being set for the next review period The new premium will reflect the age of the life insured, and will therefore be higher, but no new medical evidence is required Although strong investment performance could reduce the need for an increase, because of the limited investment aspect of such a policy, an increase is likely and indeed is virtually inevitable if the policy is on a maxi-cover basis Review periods often become shorter as the life insured gets older, in order to reduce the extent of premium increases at the review point Unit-linked WoL policies develop a surrender value, but this is usually small or non-existent in the early years and will always be so if the maxi-cover basis is used These policies are often non-qualifying, to allow the greatest possible degree of premium and cover flexibility

5 Any tax charge would be based only any investment gain, either on surrender, or where a death claim arises In the case of a death claim, the gain (if any) is calculated based on the surrender value as if the policy had been surrendered immediately before death The sum assured itself would not be subject to income tax No tax relief is available on premiums (unless the policy is qualifying and was started before LAPR ceased in 1984) Joint life policies Joint life policies can be written on two (or occasionally more) lives Policies are available which pay out on the first death amongst the lives insured (Joint life first death policies) or on the last death (Joint life second death or Joint life last survivor policies) The lives do not need to be related Other life policies Endowment policies are regular premium life policies which include life assurance protection, but are intended primarily as savings vehicles (these are covered in a separate section of notes) Investment bonds are also life policies, designed to accept a single contribution, often with the option to pay top-up amounts later The emphasis of investment bonds is almost entirely on investment, with little or no death benefit in excess of the value of the investment Uses of policies Term assurance is a highly cost effective method of providing protection against the financial consequences of death where the term can be identified Renewal and conversion options create flexibility if needs change They also deal with the risk that health could decline, making a new policy difficult or impossible to obtain on standard terms other than through these options A convertible term policy may be cheaper than a whole of life policy initially, but with the option to convert to permanent cover later, perhaps as income increases, making a higher premium affordable Decreasing term policies are particularly useful for protecting a repayment mortgage, since the amount outstanding reduces through the mortgage term They can also protect any other borrowing where the capital is being paid off gradually Family Income Benefit is an inexpensive method of covering the need for continuing income after the death of the insured and is often used to provide cover whilst children are dependent Family Income Benefit policies can also be used to provide for other circumstances where a regular source of money is required, including the provision of school fees as mentioned above Whole of life insurance is preferable if the period for which cover is needed is indefinite, for example to protect a spouse or partner

6 It is also an appropriate way of providing for an IHT liability which will arise on death whenever that occurs Joint life first death policies may be used for family protection purposes to give cover when either of the lives insured dies Joint life second death policies are often used by married couples and registered civil partners to provide for the IHT liability arising on the second death This reflects the fact that if the surviving spouse/partner inherits on the first death, there will be no IHT liability at that time Inter vivos policies Inter vivos policies are decreasing term assurance policies They are specifically designed to meet the anticipated IHT liability on potentially exempt transfers (PETs) in excess of the nil rate band where the donor dies within 7 years The policy is generally taken out by the donee (recipient) on the life of the donor The potential liability of the donee for the IHT payable creates an insurable interest The sum assured is constant for 3 years, then reduces by 20% of the original sum assured each year in line with the IHT taper relief scale The policy term is seven years Relative costs of policies Term assurance policies are the cheapest form of life assurance cover available The shorter the term, the lower the cost Decreasing term assurance is the cheapest form of policy of all for any given level of initial sum assured Renewal and conversion options increase costs slightly Increase options also increase cost Whole of life policies are more expensive than term assurance policies With profit policies are more expensive than non-profit policies (for the same sum assured) because of the potential for the addition of bonuses to the with profit policy Unit-linked policies are more flexible, and premiums may vary (within limits) according to the requirements of the policyholder, as described above The maximum cover option minimises initial costs, but premiums will increase at each review Joint life first death policies are less expensive than two separate policies on each life (but only one sum assured is payable) Joint life second death policies are considerably cheaper, because the sum assured is likely to be payable later than under a first death policy For life assurance generally, premiums are greater for males than females of the same age and state of health, because male mortality is heavier Premiums are greater for older people rather than younger, for the same reason

7 Many insurers now offer cheaper premiums for non-smokers, particularly under term assurance policies, reflecting the heavier mortality of smokers Non-smoking status requires the individual not to have smoked for a lengthy period Qualifying status Qualifying status is largely irrelevant for term assurance policies because of the absence of any investment element It could be relevant if the policy was sold under a viatical settlement (where the insured is terminally ill) because the proceeds of the settlement would be treated in the same way as a surrender value; however, these settlements are rare in the UK In order to be a qualifying policy, a term assurance with a term of less than ten years must: - have a term of at least one year - provide a lump sum on death or disability, but no other benefits - not pay a surrender value in excess of the premiums paid (though in practice there is generally no surrender value at all) If the term is ten years or more, the term assurance must: - provide a lump sum on death or disability, but no other benefits - require premiums no less frequently than annually through a period of at least 10 years or if less, three-quarters of the term - limit flexibility of premiums so that the premiums in any one year cannot be more than twice those in any other year, nor be more than 12.5% of total premiums - have a sum assured of at least 75% of total premiums payable by the 75th birthday of the life insured For a whole of life policy to be qualifying, the conditions are largely the same as for term assurance policies and are that the policy must: - provide a lump sum on death or disability, but no other benefits - require premiums no less frequently than annually through a period of at least 10 years - limit flexibility of premiums so that the premiums in any one year cannot be more than twice those in any other year, nor be more than 12.5% of total premiums (or, if premiums are payable for life, 12.5% of those payable in the first ten years) - have a sum assured of at least 75% of total premiums payable by the 75th birthday of the life insured Although whole of life policies do include an investment element, this is generally small, and the potential for a large tax liability to arise is usually relatively slight On death or surrender, the excess of the surrender value over premiums paid under a nonqualifying policy is potentially liable to income tax at higher rate(s) but not basic rate (ie 40% - 20% = 20% or 50% - 20% = 30% or a combination of the two, depending on the individual s tax position) A basic rate taxpayer has no liability unless the excess carries him into higher rate(s) after allowing for top-slicing relief The sum assured if paid is not subject to income tax In general, non-profit and with profit whole of life policies are often qualifying Unit-linked whole of life policies are usually non-qualifying because the flexibility gained is felt to outweigh the potential disadvantage from a tax point of view Surrender values Term assurance policies generally do not have a surrender value at any time

8 Whole of life policies do develop a surrender value, though this is normally little or nothing in the early years Surrender values may be subject to penalties and are often not good value In general, whole of life policies should not be used for investment purposes