B1.03: TERM ASSURANCE

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1 B1.03: TERM ASSURANCE SYLLABUS Term assurance Increasing term assurance Decreasing term assurance Mortgage protection Renewable and convertible term assurance Pension term assurance Tax treatment Family Income Benefit policies Uses of term assurance 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 or if premiums cease during the term As a result, term assurance is the cheapest form of life assurance available Increasing term assurance 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 Increasing term assurance reduces the need for an individual to review his cover frequently, but reviews should still occur from time to time as needs change over the years Decreasing term assurance Decreasing term assurance policies are also available, with the cover decreasing on a predetermined basis

2 This is ideal for certain specific needs 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 The cover is very inexpensive, because as the age of the insured increases and the risk of death increases, the sum assured decreases Premiums under decreasing term assurance policies are generally level, though this is a matter of policy design Mortgage Protection Decreasing term assurance linked to a repayment mortgage is also known as a Mortgage Protection Insurance This should not be confused with Mortgage Payment Protection Insurance, which provides a short term income stream to pay mortgage costs in the event of incapacity or compulsory redundancy The cover under a Mortgage Protection Insurance policy reduces through the term, but may not precisely match the reduction in capital outstanding under a repayment mortgage In general, policies are designed to provide cover which is likely to slightly exceed the outstanding loan at any time This is the most cost efficient method of protecting a mortgage against the death of the borrower Joint life policies are available for joint borrowers, usually on a first death basis (ie the policy pays out on the death of the first of the joint lives insured to die) For interest only mortgages (other than endowment mortgages), life assurance is usually required or recommended and level term assurance is likely to be more appropriate than decreasing term assurance because the amount owed to the lender does not reduce Even if an investment product, such as an ISA, is being used to build up capital for repayment, the shortfall is likely to fluctuate, so a decreasing term is not appropriate Renewable and convertible term assurance 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, and can be carried out for part of the sum assured, with the remainder continuing on a term assurance basis An increased premium is charged from outset for the inclusion of the renewable or convertible options, and they are often both included in a single policy Pension term assurance In the past, it has been possible to write term assurance under pension rules with tax relief

3 The policies involved were term assurances designed to pay out a lump sum on death before age 75 However, no relief is available on premiums paid by individuals to new policies applied for on or after 14 December 2006 (when the withdrawal of relief was announced) Policies in force before then continue to benefit from relief, provided the benefits are not increased and the term is not extended There are some transitional rules for policies applied for before 14 December 2006, but not put into force until later, provided this was not after 1 August 2007 (these provisions are beyond this syllabus area) Where available, tax relief is granted at the highest rate(s) paid by the individual, subject to certain limitations on the total contributions being made under pension rules The change in tax treatment has resulted in insurers withdrawing these contracts from the market Tax treatment There is no tax relief on premiums for new term assurance policies In the past, as explained above, 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 The proceeds of a term assurance policy will however fall into the estate of the owner of the policy, so if on an own life basis, this could result in an inheritance tax (IHT) liability This can generally be avoided by writing the policy into a suitable trust 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 to some extent There is no investment element, and so no surrender value nor maturity value

4 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 Uses of term assurance 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, and 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 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 Relative costs of policies A term assurance policy is the cheapest form of life cover The shorter the term, the lower the cost Renewal and conversion options increase costs slightly The inclusion of increase options also increases cost from outset For the same initial level of cover, a decreasing term assurance will be cheaper than a level term assurance As with life assurance generally, premiums (assuming acceptance at standard rates) 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 Many insurers now offer cheaper premiums for non-smokers, reflecting the heavier mortality of smokers Non-smoking status generally 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 however if the policy was sold under a viatical settlement (where the insured is terminally ill) This is because the proceeds of the settlement would be treated as a surrender value and a gain could arise However, these settlements are rare in the UK at the moment

5 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 Surrender values Term assurance policies generally do not have a surrender value at any time