A Guide Explaining Index-Linked Life Insurance

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The subject of life insurance and obtaining a suitable life cover policy can be tricky at the best of times, but when you introduce things like index-linked insurance into the mix, that’s when things can really start to seem very complicated.

In our guide to index-linked life insurance, we’ll explain what it is and how it works in relation to a life insurance policy.

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What does index-linked mean?

An index-linked life insurance policy sounds much more complicated than it really is.

In short, it’s a policy that pays out a value that takes into account the consumer price index (CPI), rather than the set sum assured.

There is another type of index known as the retail price index (RPI), but when it comes to life insurance indexing, it’s the CPI that you take into account. The consumer price index takes a basket of things, such as food prices, fuel and other things and compares how much you pay for them this year to how much you would have paid for them in previous years. These figures are then used to show examples of inflation, with house prices being one of the biggest increases over the years.

Should I index link my life insurance policy?

It’s safe to say that house prices over the years increase substantially. For example, in March 1979, the average house price in London was £14,013. Forty years later, at the end of 2018, the average price of a house in London was £476,752.

That rate of inflation seems almost unfathomable to comprehend, but if you’d have taken out a life insurance policy worth double the value of your house in 1979, you still wouldn’t have enough money for your child to buy a house in 2018 as according to the CPI, as it would only be worth £168,860.

The choice of whether to index link your life insurance policy is entirely your decision. However, if you want your life insurance policy to maintain its value, it might be a good idea to take out index-linked life insurance.

Can you index link other types of insurance?

It is possible to index link other types of insurance such as buildings insurance and types of income protection.

How is index-linked life insurance calculated?

An index-linked life insurance policy allows the policy to increase on an annual basis as it offsets the effects of inflation. 

Some policies are arranged to increase with the retail price index, some in line with the consumer price index and some are done by a specific percentage per year, such as 5%, for example.

Why are life insurance policies not index-linked automatically?

Not all life insurance policies are automatically index-linked. This is because some of them simply don’t need to be index-linked, such as level term life insurance, for example.

Level term cover is usually suitable for someone who is looking to take out cover to protect a mortgage or loan and as the premiums won’t increase throughout the term of the policy, there might not be any need for an index-linked policy.

Does mortgage life insurance need to be index-linked?

Decreasing term life insurance policies are usually linked with a mortgage and in this instance, the premiums are usually low as the final payout decreases over time. As they are designed to pay off a mortgage when you die, as the value of your mortgage goes down as you pay it off throughout the duration of your life, so does the life insurance payout.

This means that your mortgage doesn’t increase in line with the consumer price index, so this type of policy doesn’t need to be index-linked and doing so could actually cause it to suffer.

Read more: Do you need life insurance for a mortgage?

Pros and cons of index-linked life insurance

While it seems like index-linked life insurance would be a good idea most of the time, there are instances when it’s not always the right option.

Take a look at some of the pros and cons of index-linked life insurance below:

Pros

  • The payout on the life insurance policy reflects the actual intended value, rather than the initial sum assured value.
  • They offer more flexibility as they let you choose the amount of risk you’re willing to take.

Cons

  • It’s not suitable for every type of life insurance policy, such as decreasing term life insurance.
  • Annual premiums increase in line with the consumer price index.

Index-linked life insurance examples

Below, we’ve put together some examples of index-linked policies vs standard life insurance policies to see the expected amount that you would receive.

For example, if you took a life insurance policy out in 2005 at a value of £300,000 with a monthly premium of £65, if the life insurance policy was index-linked, you could expect a payout of £444,751 in 2019 with a premium of £96 a month.

Whereas if you decided not to index-link this policy, it would pay out £300,00 and the premiums would still be £65. Therefore, you would have a difference of £144,751 over 14 years.

In another example of an index-linked life insurance policy that was taken out in 1990, for example, at a cost of £250,000 and a monthly premium of £50, if the policy was index-linked, it would pay out £564,171 in 2019, with a monthly premium of £113 per month.

On the other hand, a standard life insurance policy, that wasn’t index-linked, would pay out £250,000 at a monthly premium of £50. Therefore you would have a difference of £314,171 over the course of 29 years.

When considering whether to take out an index-linked life insurance policy, it’s important to try and determine how much value you’d lose if you didn’t take one out. While the maths can be incredibly complex to figure out, you can seek financial advice from a professional who will be able to give you guidance on the best option for you with regards to index-linked life insurance policies.

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