Why you should treat whole-life insurance policies with extreme caution

The vast majority of life insurance sold in the UK is term-life, which runs for a fixed period. In essence, you are betting the insurer that you will die before the end of the policy term; the insurer is betting that you won’t and that it will get to keep your premiums. Morbid as all of this is, term-life cover is a must if you have dependants.

Whole-life policies, by contrast, last until you die. The bet is about when that happens. If you die younger than expected, then the insurer pays out much more than you paid in premiums (it loses the bet). If you live a long time it gets to keep collecting your premiums (it wins).

Premiums are higher as the insurer is certain to pay out at some point. “Maximum cover” whole-life policies offer lower premiums at the outset but these can rise steeply, while “balanced-cover” policies’ premiums start higher but are fixed.

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Whole-life policies are often marketed to people in their 50s and over (term life cover is less relevant once offspring have flown the nest and the mortgage is paid off). A big attraction is that it is possible to write the policy in trust, which is not subject to inheritance tax (IHT). Relatives get ready access to some cash when you die, sparing them some of the heartache of the probate process. They can then use the money to settle the IHT bill on your estate (if you are above the threshold). If you die early then one consolation is that the payout is much larger than the premiums, making for a very high return.

Locked in for life

Yet there are significant drawbacks. The key problem with whole-life policies is that you can effectively get locked in. This is an insurance product, not an investment. If you cancel or miss payments then the cover lapses – even if you have already paid tens of thousands of pounds in premiums.

An elderly person in poor health will find switching too expensive. That can leave them stuck paying burdensome premiums on a policy they took out decades before for fear of losing their cover. There is also no guarantee that the rules about trusts won’t be changed in the future.

Maximum-cover policies try to build up a pot of money through investment that can then be cashed in, but returns can be derisory after fees and premiums for the insurance element are deducted. Some whole-life policies don’t even invest the premiums during the first three years, instead using them to pay “sales commission to the broker or financial adviser”. To see what a terrible tangle people can get into with these policies, consider a case highlighted by Ali Hussain in The Sunday Times last month. In 2001 a man took out a policy costing £158 a month. It was supposed to pay £150,000 to his family when he died. But the investment returns have been so poor and the charges so high that he has now ended up paying £1,500 a month to give him a total payout of £371,000. What’s more, he has topped himself up with 29 additional policies rather than pay higher premiums, an option holders of these policies have to cover shortfalls and offset inflation. If he decided to cash in the original plan today, “he would get about £4”.

He cannot switch providers because of poor health and when he tried to “lower the costs by switching off an automatic commission paid to the financial adviser who originally sold him the product, he was told that this would end up costing him more”. It’s better to keep investments and insurance separate.