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Studied by 9 peopleNoteStudied by 226 peopleNoteStudied by 16 peopleNoteStudied by 10 peopleNoteStudied by 71 peopleNoteStudied by 2847 peopleLife Assurance Products - In Depth Notes
Purpose and Key Features of Life Assurance Products
Life assurance provides financial protection in the event of death or critical illness.
Comes in various forms, each with distinct features suited for different needs and circumstances.
Types of Life Assurance Policies
Terminology:
There are some key terms that come up often when talking about life insurance, so it's helpful to understand them from the start:
The proposer is the person who applies for the life insurance policy.
The life assured is the person whose death will trigger the insurance payout.
The assured is the person who takes out the policy and owns it.
Often, the life assured and the assured are the same person. When this happens, it’s called an own life policy.
Sometimes, the life assured and the assured are different people. These are called life of another policies (for example, if you take out a policy on your spouse or business partner).
Most life insurance policies cover just one person. If that person dies during the policy term, the insurance pays out, and the policy ends.
Policies can also cover two people (or more), which is common. These are called joint life policies:
Joint life, first death: Pays out when the first person dies. Often used for family protection.
Joint life, second death: Pays out after both people have died. Often used in whole of life insurance for things like covering inheritance tax.
Term assurance is the simplest and most affordable type of life insurance. It only pays out the agreed amount (sum assured) if the person covered dies during the set time period (the term). If they don't die during that time, nothing is paid out, and the policy usually has no value you can cash in. It simply ends when the term is over.
In this chapter, we'll look at seven types of term assurance policies, explaining how each one works, what it's used for, and what benefits it offers.
Types:
Level Term Assurance:
Let’s start with the most basic type of life insurance: Level Term Assurance. In this policy, the payout amount (sum assured) stays the same throughout the policy term. When the term ends, the policy usually ends with no payout and no cash value. It’s a simple and low-cost option for life cover.
Uses:
It's often used to protect the main income earner in a family. However, since the payout amount doesn’t increase over time, it may not keep up with rising incomes or living costs.
It's also used with interest-only mortgages. Since the mortgage balance doesn’t reduce over time, the level payout is a good match.
It can help with inheritance tax (IHT) planning, especially if a gift has been made and could be taxed within seven years. Even though the tax-free threshold (Nil Rate Band) may rise over time, the value of the estate might also grow—so a fixed payout could still be useful.
Increasing Term Assurance:
This type of policy is like level term assurance, but the payout amount (sum assured) increases over time. Usually, it goes up once a year when the policy renews, but in some cases, the increase might happen every few years (for example, every five years).
The amount it increases by depends on the policy. Some plans increase the sum assured by a fixed percentage, like 3% or 5% each year.
A popular and useful option is to have the sum assured increase based on inflation, measured by the Retail Prices Index (RPI). But keep in mind, as seen in 2009, RPI doesn’t always go up, even when other costs are rising.
Some insurance companies also allow bigger increases (up to 50% of the original amount) during major life events—like getting married, having a baby, or taking out a new mortgage. This is called a "guaranteed insurability option."
The starting premium for this type of policy is a bit more than a standard level term policy. And the premium will increase whenever the sum assured increases.
Uses:
This type of policy is good for protecting your family, especially because it can grow with inflation to keep up with rising living costs.
Renewable Term Assurance:
The "renewable" option lets the person covered by the policy take out a new term life insurance policy when the current one ends—without needing to do another health check. This is called guaranteed insurability. The new policy can only last for a certain number of years, based on the original policy and possibly a maximum age limit. Each new policy can also include the same renewable option, with the same limits.
The first premium is a bit higher than a regular level term policy. When the policy is renewed, the premium will go up because the person is older at that point.
Uses:
This type of policy is useful when you know you need life insurance, but you're not sure how long you'll need it.
It's often used in business situations—like insuring a key employee—when that person is important to the business now, but might not stay in that role forever.
Convertible Term Assurance:
This is a type of term life insurance that gives you the option to switch (convert) it to a whole of life policy or an endowment policy later on. You can make this switch at any time during the term, and you won’t need to go through any health checks again.
The starting premium for this kind of policy is higher than a regular level term policy because it gives you more flexibility. When you do convert it, the new premium will be based on the type of policy you choose—and both whole of life and endowment policies are much more expensive than term insurance.
Uses:
This policy is helpful when you need term insurance now but think you might want a more permanent type of life insurance in the future. Ideally, you’d get the whole of life or endowment policy right away, but those can be too expensive at first. This lets you start with term insurance and switch later without worrying about your health changing.
Decreasing Term Assurance (DTA):
DTA (Decreasing Term Assurance) policies have a payout amount (sum assured) that gets smaller each year, eventually reaching zero by the end of the policy term.
Even though the coverage goes down over time, the monthly payments (premiums) stay the same. Because the insurance company has to pay out less over time, the starting premium is lower than it would be for a level term policy. Sometimes, you don’t have to pay premiums for the whole term—this helps stop people from cancelling the policy near the end when the coverage is small.
Uses:
These are mostly used to cover debts that go down over time, like a repayment mortgage.
A special type called a "gift inter vivos" policy (usually lasting seven years) is used when someone receives a large gift that could be taxed. The tax risk decreases over time due to taper relief, so this kind of policy helps cover that risk.
Family Income Benefit (FIB):
This is a type of decreasing term life insurance that gives regular income payments to the beneficiaries (like your family) instead of a one-time lump sum. If the person covered by the policy dies, the policy starts paying out a set amount of tax-free income each year, until the policy ends. The later the person dies during the policy term, the fewer payments there will be.
The income can usually be paid every month, every three months, or once a year. Sometimes, there's also an option to get all the income as a single lump sum instead.
These policies are usually very cheap because the total payout decreases over time. A slightly more expensive option is an increasing version, where the income amount goes up by a set amount each year.
Uses:
These are often used for affordable family protection. Many people prefer this kind of policy because it gives income regularly—something they’re more familiar with—rather than a large lump sum that would need to be invested to generate income.
Unit-Linked Term Assurance:
These are still regular term life insurance policies, which means they only pay out the insured amount if the person covered dies during the time the policy is active. However, behind the scenes, how well the invested premiums perform can be just as important.
Every month, the money you pay (your premium) is used to buy units in an investment fund. Some of these units are sold each month to cover the cost of your life insurance for that month. The rest stay invested in the fund you’ve chosen. Usually, for this kind of policy, the insurance company provides a default fund or a few standard fund options.
When the policy begins, actuaries (experts who calculate risks and costs) guess how well the investments will do. If their predictions are right, the policy works as expected. If the investments do better than expected, the insured amount might go up without costing you more, or you might build up some cash that you can access at the end of the policy.
If the investments do worse than expected, the insurance company may review the policy. As a result, you might need to pay more to keep the same coverage, or if you want to keep paying the same, your coverage amount might go down.
Uses:
Since this is just a different type of structure, the uses are the same as other term policies—you can have level, convertible, renewable, or increasing coverage.
This type of policy may appeal more to people who are comfortable taking risks because the results depend on how well the investments do. However, for most people looking for life insurance, investment performance isn’t the main concern.
2. Whole of Life Assurance
The name whole of life pretty much explains what these policies are. They pay out the sum assured when the person covered (the life assured) dies, no matter when that happens.
Because this type of insurance is for life and the payout is guaranteed as long as you keep paying the premiums, the premiums are more expensive than for term life insurance. Whole of life policies also build up a cash value over time, but this value can be very low at the start of the policy. Some whole of life policies are more like investment products than just protection, but we’ll focus on their protection side for now.
In this chapter, we will cover four types of whole of life policies, explaining how they work, their uses, and their benefits.
Types:
Non-Profit Whole of Life Policies:
Non-profit whole of life policies have fixed premiums that you pay for life. They pay out a set amount when the person covered (the life assured) dies.
Some versions of this policy stop collecting premiums after a certain age, like 80 or 85. Because of this, the initial premiums will be a little higher.
These types of policies aren’t sold much, but they’ve become more popular recently for Inheritance Tax (IHT) planning.
They are also the kind of policy often advertised directly to people over 50, like the commercials that play during shows like Countdown, where a well-known celebrity talks about the importance of planning ahead. These policies usually have very simple application forms with few medical questions. However, it’s common that the insurance payout is only made if the person dies more than two years after the policy starts. Also, these policies usually don’t have a surrender value (you can’t cash them in early for money).
With-Profit Whole of Life Policies:
With-profit policies give you the chance to increase the payout amount (sum assured) with bonus payments. These bonuses aren't guaranteed, but once they’re added, they can’t be taken away. The amount of the bonus depends on how well the insurance company is doing with its investments and finances.
There are two main types of bonuses:
Reversionary bonuses: These are added regularly, usually as a percentage of the sum assured. They can be either:
Simple: Based only on the original sum assured.
Compound: Based on the original sum assured plus any previous bonuses.
Terminal bonus: This bonus may be added when the policy is paid out (for example, when the person dies, but not if the policy is surrendered). It’s usually a percentage of all the previous bonuses added to the policy.
Once a bonus is added, it can’t be removed. However, if you decide to cancel (surrender) the policy or switch out of the with-profit fund, the insurer can apply a market value reduction (MVR). This means the amount you get back could be reduced to be fair to other policyholders who are still in the fund. MVRs are mostly used when the market isn’t doing well, and they only apply if you cancel or switch (not when the policy ends due to death).
For a with-profit whole of life policy, the payout on death is the sum assured plus any bonuses that have been added up to that point. Since these policies may pay out more, the premiums are usually higher than for non-profit policies.
Uses:
This type of policy is used for standard life cover, like protecting your family or planning for inheritance tax (IHT).
A with-profit policy should be less risky than a unit-linked policy because the bonuses help provide more stable growth.
Low-Cost Whole of Life Policies:
These are products sold as one policy, but, in effect, are a combination of two policies we have already considered:
• a with-profit whole of life policy element.
• a decreasing term assurance element.
The policy will pay out a full sum assured on early death, based on the combined value of these two elements. In the longer term, the bonuses added to the with-profit element will increase pay out from that element, while the DTA sum assured is progressively reducing.
EXAMPLE
A low-cost whole of life policy provides a sum assured of £100,000. This might be made up of £60,000 with-profit whole of life cover and £40,000 DTA. So, if the life assured dies immediately, there is a combined payout of the required £100,000. Over the years, bonuses should be added to the with-profit element, taking it up to, say £70,000, over 10 years. In the same time period, the DTA sum assured will have fallen by the equivalent amount to, say, £30,000. The sum assured payout on death would therefore be the same amount of £100,000.
The attraction of these policies is hinted at in the name – they are significantly cheaper than full with-profit policies. That is because, as we have already seen, DTAs are a very cheap form of life assurance.
The surrender values of these policies, as they are based on just the with-profit element, are even less than those available on a full with-profits policy.
Uses:
• They are used for much the same purposes as full with-profit contracts, but at a much reduced cost.
Unit-Linked Whole of Life Policies:
We previously mentioned unit-linked policies when talking about term assurance, and the same basic idea applies here:
You pay premiums, which buy units.
Each month, enough units are sold to pay for that month’s life coverage.
The remaining units stay invested in a fund of your choice.
The main advantage of unit-linked whole of life policies is their flexibility (often called "flexible whole of life policies"). When you start the policy, you can choose between:
Standard sum assured: This is the amount the insurance company thinks they can maintain for the premium, assuming a certain rate of growth in the fund.
Maximum sum assured: This gives you a higher initial sum assured, but means more units need to be sold each month to pay for the cover, leaving fewer units invested. After some years (usually after 10 years, then every 5 years), the premium may need to be increased to keep this level of cover.
Minimum sum assured: This gives you a lower initial sum assured, so fewer units are sold each month, and more units remain invested. This is a strategy to build up the policy’s surrender value, or to have extra investment in case you don't need a high sum assured in the future.
Uses:
The appeal of this policy is the flexibility in the level of coverage. For example, it allows for higher protection in the early years (when you have children to support) and lower protection with more investment later on (once your children are grown).
The maximum cover option is similar to a convertible term assurance policy, but with fewer units being actively invested.
Most people probably wouldn't choose the minimum cover option at the start, since there are likely better ways to invest money if that’s the goal.
Endowment Assurance
Endowment policies combine life insurance for a set period (like term assurance) with the guarantee of a payout (like whole of life insurance). They offer both protection and investment, making them the most expensive type of life insurance.
Endowments have a bad reputation, mainly because many policies sold in the 1980s and 1990s were used to repay interest-only mortgage debts. Many people didn’t realize that cash-in values (how much money you get if you cancel the policy early) weren’t guaranteed. As a result, many were shocked to find out later that their endowment would not fully cover their mortgage. This led to the endowment mis-selling scandal.
Endowments are still available today, but they are less common because the term "endowment" carries a negative stigma. Instead, names like "Regular Savings Plans" are used to make them seem more appealing.
In this chapter, we will look at five types of endowment assurance policies, how they work, and their pros and cons.
Types:
Non-Profit Endowment Policies:
The most basic form, with level premiums and a payout of only a fixed guaranteed sum assured on maturity or earlier death.
Uses:
• These are now very rarely sold.
With-Profit Endowment Policies:
These policies guarantee that the sum assured will be paid out either when the person dies or when the policy reaches the end of its term. In addition, reversionary bonuses may be added during the policy's term, and there could be a terminal bonus at maturity. So, in theory, the final payout should cover a mortgage requirement (if there is one) and possibly provide extra money.
Uses:
Because these policies guarantee payouts, they tend to be more expensive, and as a result, they are less commonly purchased.
Low-Cost Endowment Policies:
These policies work similarly to low-cost whole of life insurance but have two parts in one policy:
A with-profit endowment part
A decreasing term assurance (DTA) part
They guarantee to pay out the full sum assured upon death, but there's no guarantee for the payout when the policy matures. The payout at maturity depends on the bonuses added to the with-profit endowment part throughout the policy. The final payout is often influenced by a terminal bonus added at maturity.
For example, if a low-cost endowment has a £100,000 sum assured, it might initially be made up of £60,000 with-profit endowment and £40,000 DTA. After 25 years, the with-profit endowment might only have grown to £90,000, falling short of the target. However, a terminal bonus of £20,000 added on maturity could bring the total payout up to the required £100,000.
The key appeal of these policies is that they cost less upfront than full with-profit endowments.
Uses:
These policies were popular in the 1980s and 1990s for repaying interest-only mortgages at a lower cost.
They were often surrendered early, especially when people moved or changed their mortgage, resulting in poor value and low surrender amounts, especially in the early years.
Now, these policies are often sold in the Traded Endowment Policy market, where the original policyholder may receive more money than if they simply canceled the policy.
Low-Start Endowment Policies:
Lower initial premiums, increase over time.
Low-start endowments are similar to low-cost endowments but have a lower initial premium. The reason for this is that the premium increases during the first five years, and then stays higher for the rest of the policy term compared to a low-cost endowment.
Uses:
These policies were originally designed for professionals, like doctors, lawyers, and accountants, who could expect their income to increase over a short period of time.
Unfortunately, because of the lower initial premium, these policies were often sold to people whose income wasn’t likely to grow fast enough to keep up with the rising premiums.
As a result, many of these policies were canceled early, leaving the policyholders with very little return on their payments.
Unit-Linked Endowment Policies:
Similar to unit-linked whole of life, but primarily investment-focused.
These policies work like low-cost whole of life insurance but have two parts:
A with-profit endowment part.
A decreasing term assurance (DTA) part.
They guarantee to pay out the full amount if the person dies, but there’s no guarantee on the amount paid when the policy ends. The final payout depends on the bonuses added to the with-profit part during the term. A terminal bonus at the end can also increase the payout.
For example, if the total sum assured is £100,000, it might be made up of £60,000 for the with-profit endowment and £40,000 for the DTA. After 25 years, the with-profit part might have grown to only £90,000, which is short of the target. However, a terminal bonus of £20,000 might be added at the end to bring the total payout to £100,000.
The advantage of these policies is that they are cheaper to start compared to full with-profit endowment policies.
Uses:
These policies were popular in the 1980s and 1990s for paying off interest-only mortgages at a lower cost.
They were often canceled early, especially when people moved or changed their mortgage, leading to low payouts in the early years.
Now, these policies are often sold in the Traded Endowment Policy market, where the original policyholder can get more money than if they canceled the policy.
Tax Implications of Life Assurance Products
Qualifying Policies: Meet specific criteria for favorable tax treatment:
The main reason endowment policies are appealing is because of their tax benefits. They are sold as ‘qualifying policies’, which means they have special tax advantages. The rules to make a policy qualify can be complicated, but in general, a life assurance policy qualifies if:
The policy term is 10 years or more.
Premiums are paid at least annually.
The sum assured is at least 75% of the total premiums paid over the term.
No premium paid in a year is more than twice the amount paid in any other year.
No premium paid in a year is more than 1/8th of the total premiums over the policy term.
Life assurance policies are taxed within the fund, which can limit growth. Generally, tax within the fund is assumed to be 20%. The big benefit of a qualifying policy is that once it meets the rules, no more tax is due, no matter what the tax situation of the person covered by the policy is, when it matures or if they pass away.
This is why endowment policies are attractive. They are sold as qualifying policies, which means after 10 years (or three-quarters of the term if sooner), there’s no additional tax to pay. For example, a 15-year policy will qualify for the tax benefit after 10 years, and a 12-year policy will qualify after 9 years.
This "no additional tax" benefit applies to both income tax and capital gains tax (like ISAs). But unlike ISAs, these policies can be written in trust. This isn’t as common for endowments where the life assured is usually the beneficiary, but for whole of life policies used for protection, it makes sense to write them in trust.
For joint life second death whole of life plans, which are often used for Inheritance Tax (IHT) planning, it’s very important to have these policies written in trust!
Non-Qualifying Policies: Higher tax liabilities, chargeable events triggered on maturity, assignments, or withdrawals.
To simplify the explanation of how single premium life assurance bonds (SPLABs) work in the UK and the tax implications:
Key Points on SPLABs:
SPLABs are non-qualifying life assurance policies, unlike regular qualifying policies. This means they don’t benefit from the same tax advantages.
Taxation: SPLABs are subject to additional income tax (not capital gains tax) on the gains made within the policy when certain events occur.
Tax within the fund: SPLABs are taxed at a rate of 20% within the policy, similar to qualifying policies. However, non-taxpayers cannot reclaim this tax, and basic-rate taxpayers have no further tax liability.
Higher-rate taxpayers will face additional income tax of 20% on chargeable gains (30% for additional-rate taxpayers). However, this is only assessed when certain events, known as "chargeable events," occur.
Chargeable Events (DAMPS):
The key chargeable events that trigger tax are:
Death
Assignment for money or money’s worth
Maturity
Partial surrender (if above a specified limit)
Surrender
A useful acronym to remember these events is DAMPS.
5% Withdrawal Allowance:
SPLABs allow withdrawals of 5% of the original investment per year without triggering an immediate tax liability. This is called a partial surrender.
These 5% withdrawals are cumulative. For example, if Harry has not withdrawn anything for 9 years, he can withdraw up to £25,000 in the 10th year without tax liability.
Example of Withdrawal:
Harry invests £50,000 into a SPLAB. After 9 years, he can withdraw £25,000 (10 years x 5%) without any immediate tax consequences.
However, if Harry decides to withdraw £35,000, the excess £10,000 will trigger a chargeable event, and Harry will need to pay tax on that amount.
Top-Slicing:
When a chargeable event occurs (e.g., a withdrawal or surrender), the chargeable gain is calculated, and top-slicing can be used to calculate the tax liability based on the number of years the policy has been active.
Example of Top-Slicing with a Partial Surrender:
Harry withdraws £35,000 from his SPLAB in the 10th policy year.
The excess amount is £10,000 over the allowable 5% withdrawal.
Top-slicing: This gain is divided by the number of years the policy has been running, i.e., £10,000 / 10 years = £1,000. This is added to Harry’s taxable income.
If Harry’s taxable income is £36,000, the new income will be £37,000, which is below the basic rate threshold of £37,400 for 2010/11. Therefore, he doesn’t pay any additional tax.
If his taxable income were £37,000:
The extra £1,000 would push him over the threshold by £600, so 20% of £600 = £120 tax.
This is then multiplied by the number of years the policy has been active, in this case, 10 years, so £120 x 10 = £1,200.
Example of Full Surrender:
Harry surrenders the policy after 9 years, and the value of the policy has grown to £62,000 from the original investment of £50,000.
Chargeable gain: £62,000 (value) - £50,000 (original investment) = £12,000.
Top-slicing: £12,000 / 9 years = £1,333.33.
Adding this to Harry’s income, the extra £1,333.33 is added to his taxable income. If Harry’s income is £36,000, it goes to £37,333.33, which is just below the basic rate threshold.
If Harry's taxable income is £37,000, he will pay 20% tax on the excess (the £933.33 above the threshold), which amounts to £186.67.
Then, the £186.67 is multiplied by the number of years the policy has been active, i.e., 9 years, resulting in £1,680.03 tax liability.
Surrender with Previous Withdrawals:
If Harry has previously made a withdrawal (e.g., £25,000 within the 5% limit), that amount is included in the final surrender gain calculation.
£55,000 surrender value + £25,000 of withdrawals = £80,000.
Chargeable gain: £80,000 - £50,000 = £30,000.
Using top-slicing:
£30,000 / 15 years = £2,000 per year.
If Harry’s taxable income is £36,000, his total income becomes £38,000, which is £600 above the basic rate. The £600 excess is taxed at 20% = £120.
The £120 is multiplied by the number of years the policy has been running (15 years) = £1,800 tax liability.
In summary, SPLABs have some attractive features like the 5% annual withdrawals without immediate tax, but they also come with a tax liability when chargeable events occur. Taxation is based on the chargeable gain and can be minimized by using top-slicing to distribute the gain across the policy years. However, if the policyholder is already in the higher-rate tax bracket, the top-slicing might not be as useful.
Using Non-Qualifying Policies as Investments
The debate about using SPLABs (Single Premium Life Assurance Bonds) versus other investment products like unit trusts and OEICs (Open-Ended Investment Companies) is a significant one within the financial services industry. Both types of investments share some similarities in terms of the assets they are invested in (e.g., stocks, bonds, etc.), but they differ markedly in terms of tax treatment and investment strategy. Here are some key points to consider:
Tax Treatment Differences
Tax on Gains in the Fund:
SPLABs pay more tax within the fund compared to unit trusts and OEICs. Specifically, the fund in an SPLAB is taxed at a 20% rate, whereas unit trusts and OEICs are typically more tax-efficient because of how they are structured. For an investor, this means that SPLABs may grow more slowly than unit trusts/OEICs because of the additional tax burden on the fund's gains.
Tax Reclamation:
Non-taxpayers (e.g., people whose income is below the personal allowance) cannot reclaim the tax that is paid inside a SPLAB. This is a key disadvantage because, in contrast, interest-bearing unit trusts and OEICs allow non-taxpayers to reclaim tax paid on their income or gains, making them more attractive to lower-income investors.
Advantages of SPLABs for Higher-Rate Taxpayers
Tax-Efficient Withdrawals:
Withdrawals from SPLABs do not count as income, which makes them very tax-efficient for higher-rate taxpayers and those over 65 years of age. Since the withdrawals are not treated as income, they do not count against age allowances (like the higher personal allowance for pensioners).
Deferral of Tax Liability:
SPLABs offer an opportunity to defer tax liability. A canny investor might choose to invest in a SPLAB while earning a high income (and being taxed at the higher rate). Later, when their income drops (e.g., after retirement and they move to a lower tax bracket), they can surrender the policy or make a partial surrender above the 5% cumulative limit, creating a chargeable event and benefiting from top-slicing. This can allow them to potentially avoid additional tax if their income after retirement is low enough to stay within the basic-rate tax band.
Comparison with Unit Trusts and OEICs
Control Over Taxation (Unit Trusts and OEICs):
Proponents of unit trusts and OEICs argue that these products give the investor more control over their tax situation. For example, investors can use Capital Gains Tax (CGT) allowances and ISA wrappers to minimize tax exposure. In these cases, the tax rate on gains is usually lower than the income tax rate.
CGT is generally taxed at a lower rate (10% or 20%) than income tax (20%, 40%, or 45% depending on the income level), making unit trusts and OEICs potentially more attractive from a tax perspective for investors with significant capital gains.
Exemptions from CGT and Inheritance Tax
Exemption from CGT:
SPLABs, like qualifying life assurance policies, are exempt from CGT in the hands of the original investor. This is a significant advantage for investors who are seeking to avoid CGT on any gains made within the policy. However, when the policy is assigned (sold or transferred to a new owner), there is a risk that it may be subject to CGT in the future.
IHT (Inheritance Tax) Planning:
SPLABs can also be used to help reduce inheritance tax (IHT) liabilities. By writing a SPLAB in trust, it is possible to transfer the value of the policy out of the individual's estate, helping reduce their IHT exposure. This strategy is particularly useful for high-net-worth individuals looking to pass on wealth to their beneficiaries efficiently.
Many policies, especially non-qualifying policies, have been written in trust with the aim of mitigating IHT liabilities. This allows the policyholder to retain some control over the policy while ensuring that the policy’s proceeds are passed on without being taxed as part of the estate.
Summary: SPLABs vs. Unit Trusts/OEICs
SPLABs can be a tax-efficient choice for higher-rate taxpayers or those over 65 due to the non-income tax treatment of withdrawals and the ability to defer tax liability via top-slicing.
They may also offer a strategic advantage in IHT planning by placing policies in trust and avoiding CGT on growth in the policy.
Unit trusts and OEICs, on the other hand, offer greater control over taxation through CGT allowances and ISA wrappers, and they typically have a lower tax burden than SPLABs in terms of the fund's internal tax. These are generally seen as more flexible investment vehicles.
In the end, whether SPLABs or unit trusts/OEICs are better for an investor depends on their tax situation, investment goals, and need for flexibility in how they manage their investments and tax liabilities.
Guaranteed growth Bonds
Guaranteed Growth Bonds (GGBs) are investment products that differ from Guaranteed Income Bonds (GIBs) in that they do not pay regular income to the investor. Instead, the focus is on the guaranteed growth of the investment, which will be paid out as a lump sum at the end of the investment term (typically 3, 4, or 5 years). Here’s an overview of how they work and the key features:
Key Features of Guaranteed Growth Bonds
Single Premium Investment:
The investor makes a one-time payment (a single premium) to invest in the bond. After the initial investment, no further payments are required.
No Income During the Term:
Unlike Guaranteed Income Bonds, which provide periodic income payments, Guaranteed Growth Bonds generate no income throughout the investment term. Instead, the focus is on the capital appreciation of the investment.
Guaranteed Capital Growth:
At the end of the investment term (typically 3, 4, or 5 years), the investor is guaranteed to receive a capital sum. This sum includes the original investment plus any growth that has been guaranteed by the product.
Guaranteed Growth Period:
The bond has a set investment term, and the growth is guaranteed at the time of purchase, meaning the investor is assured of receiving a specific return by the maturity date.
Tax Treatment:
These bonds follow the same tax rules as non-qualifying policies, meaning they are subject to income tax but free of Capital Gains Tax (CGT) and basic-rate income tax during the investment term.
Since no income is generated during the term, there’s no income tax to pay on interest or distributions while the bond is held.
Higher-rate taxpayers will need to account for tax if a chargeable event (such as a full surrender) occurs, and a chargeable gain is calculated. However, the capital appreciation is free from CGT.
No Tax on Capital Appreciation:
One of the significant advantages of Guaranteed Growth Bonds is that the capital growth is free of CGT, which is a benefit for investors who might otherwise be subject to CGT on other types of investments.
Investors who are basic-rate taxpayers will not face additional tax liabilities, as the capital growth is free from basic-rate income tax as well.
Example:
If an investor places £10,000 into a 3-year Guaranteed Growth Bond, the bond may guarantee a 10% growth over the term. After 3 years, the investor would receive the original £10,000 investment plus £1,000 in guaranteed growth, bringing the total payout to £11,000.
Comparison with Other Investment Products:
Guaranteed Income Bonds (GIBs) offer a different structure in that they provide regular income over the term, which might be more suitable for investors who want ongoing income.
Unit trusts, OEICs, and SPLABs are more flexible in terms of growth and withdrawals, but they may come with different tax treatments and more variability in returns. Guaranteed Growth Bonds offer more certainty as the growth is guaranteed.
Conclusion:
Guaranteed Growth Bonds are ideal for investors who are willing to forego income during the investment term in exchange for a guaranteed return at the end of the term. They provide a safe, predictable growth option with a clear end date, and they are tax-efficient in terms of CGT and basic-rate income tax. However, they may not offer the same flexibility as other investment vehicles like unit trusts or OEICs, which can offer income generation and tax advantages through CGT allowances or ISA wrappers.
Guaranteed Income Bonds
Guaranteed Income Bonds (GIBs) are a type of investment product that fall under the category of single premium non-qualifying life assurance policies. The structure of these bonds is designed to offer a guaranteed income to the investor in exchange for a single premium investment. Here are the key features and tax implications associated with Guaranteed Income Bonds:
Key Features of Guaranteed Income Bonds:
Single Premium Investment:
The investor makes a one-time payment (single premium) into the bond at the start of the investment term. This is the total amount the investor will pay into the bond; no further payments are required during the term.
Guaranteed Income Payments:
In return for the single premium investment, the bond guarantees to pay a fixed income to the investor over the term of the bond.
These payments are typically made annually in arrears, meaning the income is paid at the end of each year.
The income payments are guaranteed, meaning the investor will receive the agreed amount, regardless of market conditions or performance.
The term of the income payments typically ranges up to five years.
Capital Return on Maturity:
At the end of the investment term, the investor receives back the original capital invested in the bond.
This capital return is typically the same as the initial single premium paid, meaning there is no capital appreciation over the term.
Non-Qualifying Policy:
As non-qualifying life assurance policies, GIBs are subject to different tax rules compared to qualifying policies (like endowments or whole life policies).
They do not benefit from the same tax advantages that qualifying policies enjoy, particularly with regard to tax-free growth or tax exemptions.
Tax Treatment of Guaranteed Income Bonds:
Income Tax:
The income paid by the bond is subject to income tax. This is one of the main distinctions between GIBs and other types of life assurance policies, like endowments, which might offer more favorable tax treatment.The income you receive from the bond will be taxed as interest income, depending on your tax bracket (basic-rate, higher-rate, or additional-rate taxpayer).
Capital Gains Tax (CGT):
Since these bonds are non-qualifying policies, CGT does not apply to the growth of the investment inside the bond itself. However, the bond does not generate any capital growth in the same way other investment vehicles, such as unit trusts, do.
The capital invested is returned at the end of the term, with no capital gains to tax.
Higher-rate Taxpayer Implications:
Higher-rate taxpayers will be subject to additional tax on the income received, as this is considered taxable income, unlike guaranteed growth bonds where no income is paid during the term.
Example:
Let's say an investor pays a single premium of £50,000 into a Guaranteed Income Bond that promises £3,000 per year in guaranteed income for a term of 5 years. The income would be paid annually in arrears, and at the end of the 5-year term, the £50,000 principal is returned to the investor.
Annual Income: £3,000 each year for five years (total of £15,000 in income).
Capital Return on Maturity: £50,000 (the original investment).
Pros and Cons:
Advantages:
Predictable Income: GIBs offer a guaranteed income, which can be useful for planning or budgeting.
Capital Return: The investor gets the principal amount back at the end of the term, making it a low-risk product.
Disadvantages:
Taxable Income: The guaranteed income is taxed as income, which might be less favorable for higher-rate taxpayers.
No Capital Growth: Unlike other investment vehicles, GIBs do not offer the potential for capital appreciation over the term.
No Flexibility: Once the single premium is paid, the terms are fixed, and the investor cannot adjust the income or capital return.
Conclusion:
Guaranteed Income Bonds can be a useful tool for investors who want a predictable income for a set period, with the return of their principal capital at the end of the term. However, the tax implications on the income can be a drawback, especially for higher-rate taxpayers. These bonds are best suited for those looking for low-risk, income-focused investments and who do not mind the lack of growth potential.
Annuities
An annuity is a financial product that provides regular payments to the annuitant (the individual who holds the annuity contract) for a specified period or for the rest of their life. The amount of the annuity payment is determined by various factors, such as the annuitant’s age, life expectancy, prevailing interest rates, any additional options included in the contract, the health of the annuitant, and even demographic factors like their location (e.g., post code). The goal of an annuity is to provide a stable income stream, often in retirement, ensuring that the annuitant doesn’t outlive their savings.
There are different types of annuities, and their tax treatment can vary depending on their structure. Below is an overview of some of the common types of annuities:
Common Types of Annuities
Life Annuity
A life annuity pays regular payments for the rest of the annuitant’s life.
Factors influencing the payment: Age, life expectancy, and health.
If the annuitant dies prematurely, the payments cease, unless the annuity includes additional features, such as a guaranteed period or a spouse’s benefit.
Fixed Annuity
A fixed annuity guarantees a fixed amount of regular payments to the annuitant for life or for a set period.
The payment amount is predetermined and doesn't change over time, offering stability in income.
Inflation-Linked Annuity (Index-Linked Annuity)
This annuity type adjusts payments over time to keep up with inflation. Payments are typically tied to an inflation index, such as the Consumer Price Index (CPI).
This type of annuity is designed to ensure that the purchasing power of the payments doesn’t erode over time due to inflation.
Joint and Survivor Annuity
This annuity provides income for two people (e.g., spouses or partners) for their lifetimes. The payments continue after the death of one person, often reducing to a percentage of the original amount for the surviving partner.
It’s useful for couples who want to ensure both individuals are supported financially in retirement.
Guaranteed Period Annuity
A guaranteed period annuity ensures that payments will be made for a minimum period, even if the annuitant dies before the end of that period. For example, if the annuitant selects a 10-year guaranteed period, their beneficiaries will continue to receive the annuity payments for the full 10 years, regardless of when the annuitant dies.
This type provides additional security to the annuitant’s heirs.
Immediate Annuity
With an immediate annuity, payments start immediately after the premium is paid, typically within one period (e.g., one month or one year). This type is commonly used by people seeking immediate retirement income.
Deferred Annuity
In a deferred annuity, the annuitant makes a lump-sum premium payment (or series of payments) and the annuity payments do not begin until a later date, often at retirement.
The payments can start years or even decades after the initial premium is paid.
Tax Treatment of Annuities
The tax situation of annuities differs depending on the type of annuity and the country’s tax laws. Below are some general principles:
Income Tax on Annuities:
Taxable Income: The payments from annuities are generally considered taxable income. The portion of the payment that represents a return of principal (the initial premium paid for the annuity) is not taxed, but the income portion is taxed as ordinary income.
The income portion is typically determined using a formula based on the amount invested in the annuity and the expected length of time the annuitant will receive payments.
Non-Qualifying Annuities:
If the annuity is purchased with non-tax-advantaged funds (i.e., it is not part of an IRA, 401(k), or pension), then the full amount of the annuity payment may be subject to income tax, except for the portion that represents the return of the original investment.
Qualifying Annuities:
If the annuity is purchased within a qualified retirement account (e.g., IRA or 401(k)), the entire annuity payment is taxable as income because the funds have already benefited from tax deferral while inside the account. Taxes will apply when distributions begin.
Taxation of Joint Annuities:
In joint and survivor annuities, the income payments are split between the two annuitants. When one annuitant passes away, the survivor continues receiving payments, often at a reduced rate.
The tax treatment of these annuities may differ depending on the income split between the two parties and how the payments are structured.
Tax Relief for Contributions:
In some countries, individuals may receive tax relief on contributions to a retirement account that funds the annuity. However, once the annuity begins paying out, it is subject to tax as income.
Inflation-Linked Annuities:
Payments from inflation-linked annuities may be subject to tax as they increase in value over time. The inflation adjustment is generally taxed as income.
Death Benefits:
Depending on the type of annuity, the death benefit may be paid to beneficiaries if the annuitant passes away before the end of the term. The taxability of death benefits depends on the type of annuity and the jurisdiction.
Tax-Free Annuities (Certain Conditions):
In some cases, tax-free annuities may be available, for example, under certain life insurance policies or pension plans. This is more common in countries with specific tax incentives for retirement products.
Conclusion:
Annuities can be a valuable tool for providing a guaranteed income stream, particularly in retirement. The amount of income from an annuity depends on several factors, such as the annuitant’s age, health, the type of annuity, and any additional options or riders chosen.
The tax treatment of annuities varies depending on the type of annuity and whether the annuity is purchased with pre-tax or after-tax funds. It is essential to understand the tax implications before purchasing an annuity, as they can significantly impact the effective income that the annuitant receives.
If you are considering purchasing an annuity, it’s important to work with a financial advisor or tax professional to ensure you fully understand the potential tax consequences and how they may affect your long-term financial planning.
Protection Products
Critical Illness Cover (CIC):
Critical Illness Cover (CIC) is a relatively modern form of insurance that was first developed in South Africa in the 1980s. It provides a lump sum payment to the policyholder upon the diagnosis of one of a number of specified critical illnesses, often referred to as "dread diseases." The goal of CIC is to offer financial protection in case the insured person contracts a serious illness, such as cancer, a heart attack, or a stroke.
Key Features and Evolution
Origins and Development:
1980s South Africa: CIC was first developed in South Africa and later became widely available in other markets, including the UK. It started as a product attached to life insurance but has since evolved to become a stand-alone policy.
Whole of Life vs. Term-based: Initially, most CIC policies were whole-of-life policies, but over time, term-based policies became more popular. These policies are often sold as stand-alone products, separate from life assurance cover.
Illness Coverage:
The list of illnesses covered by CIC can vary between insurers, but the most common claims are made for illnesses such as:
Cancer
Heart attack
Stroke
These are the "dread diseases" most commonly associated with CIC, though some policies may cover additional conditions.
Survival Period:
Most CIC policies include a survival period, which means the policyholder must survive a certain period (e.g., 14, 28, or 30 days) after being diagnosed with a covered illness before the payout is made. This ensures that the illness is serious enough to warrant a claim and prevents abuse of the policy.
Reviewable Policies:
Today, most CIC policies are reviewable. This means the premium rates are guaranteed only for a fixed period (e.g., the first five years), after which they may increase based on changes in medical advancements. This review helps life insurers manage the risks associated with earlier diagnosis due to improved medical technology.
It is important to note that reviews do not consider the health status of the individual but instead focus on broader medical developments.
Tax Treatment:
CIC payments are generally not considered a chargeable event, meaning there is no income tax liability on the payout. Additionally, because the payout does not involve the transfer of value, there is typically no inheritance tax (IHT) liability on the payout either.
Uses of Critical Illness Cover (CIC)
CIC is a versatile product, and it has a wide range of potential uses. Some common uses include:
Mortgage Protection:
One of the most common uses of CIC is to protect a mortgage or other debt. The lump sum paid out on the diagnosis of a critical illness can help the policyholder pay off their mortgage, either on a level or decreasing basis.
Level basis: The payout remains the same throughout the life of the policy.
Decreasing basis: The payout reduces over time, often in line with the outstanding balance of the mortgage.
Independence for Single People:
CIC can be especially attractive to single individuals who might not need life insurance but want to protect themselves financially against serious illness. The lump sum payout can help them maintain independence by covering costs such as medical treatment, lifestyle adjustments, or home modifications.
Home and Car Alterations:
A critical illness can result in the need for significant home or car modifications (e.g., installing wheelchair ramps or adapting living spaces for mobility). The additional payout from CIC can be used to fund these necessary changes, providing support during recovery.
Retirement Protection:
Some life insurers now market CIC as a form of retirement protection. The idea is that a critical illness could severely affect an individual’s ability to save for retirement, and having CIC in place ensures they have financial support during such a difficult time.
Business Protection Insurance:
CIC is also commonly used in business protection scenarios. For business owners or key employees, a critical illness could disrupt business operations, and CIC can provide the financial resources to cover any gaps, pay off debts, or fund the recruitment of replacements.
Important Considerations
Claim Denials and Small Print: In the past, there were concerns over claims being rejected due to small print in the policy definitions of the covered illnesses. In response, industry bodies such as the Association of British Insurers (ABI) worked to create standard definitions for critical illnesses, which most insurers have adopted. This has helped reduce the instances of claim rejections and increased the overall level of CIC payouts.
Non-Disclosure Issues: Another issue has been non-disclosure, where claims were rejected because the applicant failed to disclose relevant medical information during the application process. However, the ABI’s guidance in 2008 helped address this issue, contributing to a record level of CIC claims being paid out in the years that followed.
Conclusion
Critical Illness Cover provides valuable financial protection in case the policyholder is diagnosed with a severe illness, offering peace of mind that they can cover medical expenses, lifestyle changes, or debts such as a mortgage. It is particularly useful for individuals without significant life insurance needs, such as single people, or those in business who want to protect themselves against the financial impact of serious illness.
While the coverage and terms can vary between insurers, the key advantages of CIC are the lump sum payouts, the absence of income tax on the payout, and the ability to use the payout for a wide range of purposes, from mortgage protection to retirement planning and business continuity.
Given the evolving nature of medical technology, the reviewable premium structure helps insurers adapt to the changing landscape, and the product remains an important tool in personal and business financial planning.
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Income Protection Insurance (IPI):
Income Protection Insurance (IPI) provides valuable financial support by offering a regular income to individuals who are unable to work due to illness or injury. Unlike Critical Illness Cover (CIC), which provides a lump sum payment, IPI offers a more consistent and long-term benefit. The key pricing factors for IPI policies go beyond the basic factors of age, gender, and the amount of cover, and include various aspects of the insured person's circumstances. Below are some of the key pricing factors to consider when assessing or offering IPI:
Key Pricing Factors for Income Protection Insurance (IPI)
Choice of Deferred Period:
Deferred period refers to the waiting period before the policy starts paying out. Common deferred periods are 4, 13, 26, or 52 weeks.
Shorter Deferred Periods: If the insured chooses a shorter waiting period, they will pay higher premiums because the insurer will be expected to pay out sooner.
Longer Deferred Periods: A longer deferred period generally results in lower premiums, as the insured will need to wait longer before receiving the benefit.
The choice should take into account any sick pay the insured might receive from their employer, or their emergency savings to cover this gap.
Occupation Class:
Risk level associated with the insured's occupation plays a significant role in determining premiums. Insurers often categorize occupations into classes:
Class 1: Typically office-based or administrative jobs, which are lower-risk and result in lower premiums.
Class 2-4: Occupations such as skilled labor, manual work, or hazardous jobs, which are higher-risk and lead to higher premiums.
Certain high-risk occupations may be excluded altogether or have a higher premium due to the increased likelihood of injury or incapacity.
Type of Incapacity Cover:
Own occupation cover provides the highest level of protection and typically results in higher premiums. The insured will receive benefits if they cannot perform their specific job.
Suited occupation cover is less favorable. The insured must be unable to perform a suitable alternative occupation (one that they are reasonably qualified to do). This tends to result in lower premiums than own occupation cover.
Any occupation cover is the least favorable option. The insured must be unable to perform any job at all, even if it's unrelated to their previous occupation. This often leads to the lowest premiums.
Term of Cover:
The term of the cover specifies how long the policy will pay out for an insured incapacity. It can vary from a short-term cover (e.g., 5 or 10 years) to a policy that continues until the insured's retirement age.
Shorter-term policies may offer more affordable premiums but will provide a benefit only for a limited time.
Longer-term policies that last until retirement tend to be more expensive because the insurer may have to pay benefits for a longer duration, especially if the insured remains unable to work for an extended period.
Underwriting and Pre-existing Conditions:
Underwriting for IPI is stricter than for life insurance because it requires detailed health and lifestyle assessments. Insurers may exclude pre-existing conditions (such as chronic back or knee problems) from coverage, leading to higher premiums for those with existing health concerns.
The underwriting process often involves medical questionnaires, physical exams, or other forms of assessment to determine the applicant's risk level.
Smoker vs Non-Smoker Status:
Like many other types of insurance, IPI premiums can be higher for smokers compared to non-smokers, due to the increased health risks associated with smoking.
Occupation History & Job Stability:
Insurers may consider the applicant's job stability and history. For example, someone with a history of frequent job changes or periods of unemployment may face higher premiums, as insurers perceive them as potentially higher-risk for long-term incapacity.
State Benefits:
Some insurers consider state benefits when calculating premiums or coverage. For instance, if an individual is eligible for state disability benefits or other forms of government support, the insurer may factor this into the policy, potentially offering lower cover levels or adjusting premiums accordingly.
Benefit Level Relative to Earnings:
The amount of cover chosen relative to the insured's pre-incapacity earnings also affects the premium. Most insurers will offer benefits between 50% and 75% of the insured’s earnings, with the higher percentage typically costing more in premiums.
Indexation:
Many IPI policies include indexation options, where the payout increases annually in line with inflation or a set percentage. While this feature ensures that benefits keep pace with rising living costs, it can result in higher premiums over time.
Tax Situation of IPI Policies
The benefits from IPI policies are generally tax-free, which is a significant advantage. This tax treatment incentivizes individuals to purchase IPI policies as it ensures they receive the full benefit of the income replacement without worrying about taxation.
However, to prevent over-compensation (and encourage a return to work), insurers typically restrict the benefit to 50%-75% of the insured's pre-incapacity earnings. This limit ensures that the policyholder doesn't receive a higher income than they would have if they were working, thus providing an incentive to return to work.
Uses of Income Protection Insurance (IPI)
Employed Individuals: For employees, IPI can complement employer sick pay. It can be customized based on the waiting period that aligns with the sick pay duration and the individual's savings.
Self-employed Individuals: Self-employed people may find IPI particularly valuable, as they do not have access to employer-provided sick pay. The coverage provides a vital income stream if they are unable to work due to illness or injury.
Homemakers: Some insurers now offer IPI policies for homemakers. If the main caregiver becomes ill, the family may face increased costs for child care, household management, or other essential services.
Conclusion
Income Protection Insurance is a crucial product for individuals who rely on their income to support themselves and their families. Key pricing factors such as the choice of deferred period, occupation class, type of incapacity cover, and the term of cover can all significantly affect the premium. By understanding these factors, individuals can make informed decisions to find a policy that provides the right level of protection while balancing the cost of premiums.
For those looking to safeguard their income in case of illness or accident, IPI offers a reliable, tax-free benefit to replace lost earnings and ensure financial stability during times of incapacity.
Private Medical Insurance (PMI):
Private Medical Insurance (PMI) in the UK
The National Health Service (NHS) in the UK offers excellent care, particularly for chronic conditions (long-lasting and often incurable), but for acute conditions (sudden and usually curable conditions), the service can sometimes be less efficient, especially regarding waiting times for procedures like hip replacements. This gap in the provision of services for acute conditions has led to the growth of the Private Medical Insurance (PMI) market. PMI aims to cover the cost of medical treatment, particularly for conditions that require prompt attention.
Types of Private Medical Insurance (PMI)
Budget Plans:
These plans are designed to be affordable but come with high excesses (the amount the policyholder must pay before the insurance kicks in), limits on coverage, and typically lower levels of cover. They are often chosen by people who want to manage costs while having some protection against private healthcare expenses.
Comprehensive Plans:
The most expensive PMI options, offering the fullest coverage. These plans generally provide comprehensive benefits, including private rooms, quicker access to specialists, and a wide range of treatments. The higher premium reflects the broader range of services and minimal limitations on coverage.
Hospital Cash Plans:
These plans provide a fixed cash sum for each day spent in a private hospital. In addition, they may offer fixed cash sums for specific treatments such as optical or dental care. This is generally a more affordable form of private health cover compared to full PMI, offering a more limited scope of services.
Underwriting and Exclusions
PMI policies often involve an underwriting process, but to keep costs down, the initial underwriting may be cursory, meaning the insurer might only ask for limited health information. This typically results in exclusions for pre-existing conditions (medical conditions that the insured person already had before the start of the policy). Some insurers may allow for the coverage of pre-existing conditions after a certain period of being on the plan, typically after two years.
Premiums and Tax
PMI is considered a general insurance contract, and as such, the premiums are subject to insurance premium tax (IPT) at a rate of 5%. This adds an additional cost to the premiums paid for the insurance cover.
Uses of Private Medical Insurance (PMI)
Control over Timing: PMI is particularly beneficial for individuals who want more control over the timing of their treatment for acute conditions, reducing waiting times for surgeries, consultations, or diagnostic tests.
Private Treatment: Some people prefer to avoid NHS hospitals, either due to the environment or the quality of service provided, and instead opt for private healthcare where they can enjoy more comfortable settings, such as private rooms and faster treatment.
Dental Plans: Many PMI policies now offer dental coverage, which is affordable and helps pay for dental care, something that is not typically covered by the NHS except in emergency cases.
Summary
While the NHS provides comprehensive services, PMI can be a valuable addition for those seeking shorter waiting times, private facilities, or expanded treatment options. PMI is flexible, with a range of options available to suit different needs and budgets, from budget plans with higher excesses and limits to comprehensive plans offering the fullest benefits. Whether it's for more rapid treatment or comfort during recovery, PMI helps provide control and peace of mind in managing acute health issues.
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