The big three
There are three main types of protection policies:
- Life insurance: This provides a financial safety net for your loved ones in the event of your death. It typically pays out a lump-sum to your beneficiaries, helping cover expenses like funeral costs, pay down debts, or ongoing living expenses. Policies are normally written in trust such that the monies do not enter the estate of the deceased (where they would be liable to inheritance tax) and are available immediately post-death (and tax-free) without the need to wait on probate.
- Income protection: Income protection ‘IP’ replaces a portion of your income if you’re unable to work due to illness or injury. This type of insurance ensures you can maintain your lifestyle and meet financial obligations during recovery. The three most common types of illness, resulting in an income protection claim are musculoskeletal issues (25% claims according to ABI), cancer (20%) and mental health (12%).
- Critical illness cover: Critical illness cover ‘CIC’ pays a lump-sum if you’re diagnosed with a serious illness that is covered by the policy, such as cancer or heart disease. The payout is intended to be used for medical expenses, lifestyle adjustments (e.g. modifications to the home), or any other needs during treatment. The three most common reasons for aclaim are cancer; heart attacks and strokes.
There is a lot of optionality within each of the above. For example, in the case of life insurance, do you opt for a decreasing, level or increasing payout. And do you opt for a lump-sum or a regular monthly income (Family Income Benefit – see previous blog).
We’ll be delving deeper into each of the above policy types with future blogs over the coming months.
Our approach to protection
Rather than relying on outdated rules-of-thumb, we use cashflow modelling to estimate whether there’s a potential shortfall in the event of death or severe illness – i.e. your family would potentially run out of liquid capital in such a scenario. And what level of insurance would be required to close that shortfall.
Here’s a worked example:
Harry and Ginny are 35 years-old and have three young children.
- Harry is currently earning £200k a year in an employed role; Ginny is a stay-at-home parent but plans to return to work once their youngest starts secondary school.
- They each have pension savings worth £150k, into which Harry is contributing 10% salary via his work.
- They also have ISA savings of £50k each and joint cash savings of £50k.
- Harry’s employment contract includes a 4x Death-in-Service benefit – this would be paid to Ginny in the event of hisdeath. They have no other protection policies in place.
- They have a main residence worth £750k, with a £500k 30-year repayment mortgage.
- Their spending needs are estimated at £8,500 a month, comprising base ‘lifestyle’ spending of £6k pm plus mortgage costs of £2.5k pm. Lifestyle costs are assumed to rise with inflation.
Having established their current financial position, the next step is to combine this with some assumptions (retirement date, Ginny earnings, future spending, investment returns, inflation, etc.) to project that position forward.
The chart below illustrates their projected liquid assets (everything except property):
As you can see, under the ‘baseline scenario’, they’re on track to comfortably have ‘enough’ income and liquid capital to meet desired spending needs and therefore maintain their desired lifestyle, for the rest of their days.
However, the objective here is to assess whether they’d still have enough in the event of ‘catastrophe’, namely the death or severe illness of Harry or Ginny.
Focussing on the first of these scenarios – death of Harry, the chart below shows revised projected liquid capital in the event of Harry’s imminent demise:
A shortfall now exists. That is, in the event of Harry’s death, based on our assumptions, Ginny would no longer have sufficient income and capital to maintain spending needs for life.
This would indicate a need for additional life insurance.
In terms of how much, we estimate that a £750k lump-sum life insurance policy would be sufficient to close said shortfall. Alternatively, Harry and Ginny might consider a Family Income Benefit, which is a form of decreasing term assurance and pays a monthly income from the date of death to the end of a pre-set period.
The impact on projected liquid capital is shown below:
Ginny would now have enough to sustain spending needs well into her 90’s and even if she did run out at that point, she’d be able to release additional capital from property.
As a side note here, there is some debate as to whether we should include the existing workplace ‘death-in-service’ benefits. Some say yes – it’s a tangible benefit that would pay out if Harry were run over by the proverbial tomorrow; others argue not – Harry could leave his current role at any point, and this cannot therefore be relief upon. My approach is to consider the potential shortfall both with and without the workplace cover, and let clients draw their own conclusions.
We would then repeat the above analysis for the remaining catastrophe scenarios – death of Ginny, and that either Harry or Ginny suffer a severe illness, such that they’re unable to work again.
I appreciate that’s a rather miserable topic, but the positive aspect is getting peace of mind that you have sufficient cover in place, such that your loved ones would be able to maintain a good standard of living, if the worst were to happen.
Coming up
We’ve got some more protection blogs coming over the next few blogs:
- Different types of life insurance – level vs increasing; Family Income Benefits; Relevant Life Plans
- Income Protection vs Critical Illness Cover
- Business Protection – Key Person Insurance and Shareholder Protection.
As always, please let us know if you have any follow-up questions or if there are any particular topics you’d like us to cover.
If you’d like to discuss protection needs for your family I invite you to book a Teams call via the following link: Book Teams call.
Disclaimer: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only. Since I don’t know your specific situation, none of this information should be construed as tax or financial advice. It is not an offer to purchase or sell any particular asset and it does not contain all the information which an investor may require in order to make an investment decision. Although endeavours have been made to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. We cannot accept responsibility for any loss as a result of acts or omissions taken in respect of any articles.
