The term life insurance is common in the U.S., where the term life assurance is common in the UK. Although these terms are often used interchangeably there is a difference in meaning which is discussed below.
Life based contracts tend to fall into two major categories:
- Protection policies - designed to provide a benefit in the event of specified event, typically a lum sum payment.
- Investment policies - where the main objective is to facilitate the growth of capital by regular or single premiums.
What is life assurance/insurance?
As with all most insurance polices, life assurance is a contract between the insurer and the policy owner (policyholder) whereby a benefit is paid to the designated Beneficiary (or Beneficiaries) if an insured event occurs which is covered by the policy. To be a life policy the insured event must be based upon life (or lives) of the people name in the policy.
Insured events that may be covered include:
- death,
- diagnosis of a terminal illness,
- diagnosis of a critical illness,
- disability due to ill health,
- permanent disability,
- accidental death or
- requirement for long term care. (This list is not exhaustive).
Life policies are typically presented as types legal contracts and the terms of the contract describe the limitations of the insured events. Specific exclusions are often written into the contract to limit the liability of the insurer; for example claims relating to war, riot and civil commotion.
Underwriting
The insurer will collect pertinent information about the life (lives) to be insured and have an underwriter assess the information to establish if the likelihood of a claim for a given individual is above average. The information is typically a series of facts relating to age, lifestyle habits and medical history. The likelihood of death is referred to as mortality the likelihood of ill health is referred to as morbidity.
It is a general principle that life contracts are written on the basis of utmost good faith. That is, the proposer and the insurer both accept that the other is acting in good faith. In practice this means the proposer can assume the contract offers what is shown prima facie without having to fine comb the small print and the insurer assumes the proposer is being honest when providing details to underwriter.
When does insurance become assurance?
When a person insures the contents of their home they do so because of events that might happen; fire, theft, flood etc. Insurance is a way of spending a little money to protect against the risk of having to spend a lot of money. The point is, when a person insures their home contents they do so to provide protection against something that might happen. They hope their home will never be burgled, or burn down but they want to ensure they are financially protected if the worst happens.
When a person insures their life they do so knowing that one day they will die. Therefore a policy that covers death is assured to make a payment. The policy offers assurance on death; even if the policy has prescribed termination date the policy is still assured to pay on death and therefore is an assurance policy. Examples include Term assurance and Whole of life assurance. An accidental death policy is not assured to pay on death as the life insured may not die through an accident, therefore it is an insurance policy.
A policy might also be assured for other reasons. For example an endowment policy is designed to provide a lump sum on maturity. Under certain types of policy the lump sum is guaranteed. Therefore, this may also be called an assurance policy.
The test of whether a policy is assurance or insurance is that with an assurance policy the insured event will definitely occur (at some point) whereas with an insurance policy there is a risk the insured event might occur.
Protection policies
Term assurance
Term assurance is a straightforward protection business. A policy holder insures his life for a specified term. If he dies before that specified term is up, his estate or named beneficiary(ies) receive(s) a payout. If he does not die before the term is up, he receives nothing. Policies typically contain exclusions for where a policy holder has a pre-existing condition of which he later dies. In the past these policies would almost always exclude suicide. However, after a number of court judgments against the industry, payouts do occur on death by suicide (presumably except for in the unlikely case that it can be shown that the suicide was just to benefit from the policy).
Investment policies
With-profits policies
Some policies allow the policyholder to participate in the profits of the insurance company these are with-profits policies. Other policies have no rights to participate in the profits of the company, these are non-profit policies.
With-profits policies are used as a form of collective investment to achieve capital growth. Other policies offer a guaranteed return not dependent on the companies underlying investment performance; these are often referred to as without-profit policies which may be construed as a misnomer.
Pensions
Pensions are a form of life assurance. However, whilst basic life assurance, permanent health insurance and non-pensions annuity business includes an amount of mortality or morbidity risk for the insurer, for pensions there is a longevity risk.
A pension fund will be built up throughout a person's working life. When the person retires, the pension will become in payment, and at some stage the pensioner will buy an annuity contract, which will guarantee a certain pay-out each month until death.
Annuities
An annuity is a policy that, after an initial premium or premiums, pays out a sum at pre-determined intervals. For example, a policy holder may pay £10,000, and in return receive £150 each month until he dies; or £1,000 for each of 14 years or death benefits if he dies before the full term of the annuity has elapsed.
Tax considerations
Taxation of life assurance in the United Kingdom
Premiums are not usually allowable against income tax or corporation tax, however qualifying policies issued prior to 14th March 1984 do still attract LAPR (Life Assurance Premium Relief) at 15% (with the net premium being collected from the policyholder).
Non-investment life policies do not normally attract either income tax or capital gains tax on claim. If the policy has as investment element such as an endowment policy, whole of life policy or an investment bond then the tax treatment is determined by the qualifying status of the policy.
Qualifying status is determined at the outset of the policy if the contract meets certain criteria. Essentially, long term contracts (10 years plus) tend to be qualifying policies and the proceeds are free from income tax and capital gains tax. Single premium contracts and those run for a short term are subject to income tax depending upon your marginal rate in the year you make a gain. All (UK) insurers pay a special rate of corporation tax on the profits form their life book; this is deemed as meeting the basic rate (22% in 2005-06) laibility for policyholders. Therefore if you are a higher rate taxpayer (40% in 2005-06 ),or become one through the transaction, you must pay tax on the gain at the difference between the higher and the basic rate. This gain may be reduced by applying a complicated calculation called top-slicing based on the number of years you have held the policy.
Although this may seem complicated the taxation of life assurance based investment contracts is broadly deemed beneficial compared to alternative equity based collective investment schemes (unit trusts, investment trusts and OEICs). One feature which especially favours investment bonds is the ability to draw 5% of the original investment amount each policy year without being subject to any taxation on the amount withdrawn. The withdrawal is deemed by HMRC (Her Majesties Revenue and Customs) to be a payment of capital and therefore the tax calculation is defered until further encashment above the 5% limit. This is an especially useful tax planning tool for higher rate taxpayers who expect to become basic rate taxpayers at some predictable point in the future (e.g. retirement).
The proceeds of a life policy will be included in the estate for inheritance tax (IHT) purposes. Policies written in trust may fall outside the estate for IHT purposes but it's not always that simple. If in doubt you should seek profession advice from an IFA (Independent Financial Adviser) who is registered with the government regulator: the Financial Services Authority.