What is Index-Linking in Life Insurance?

• Home
• Resources
• What is Index-Linking in Life Insurance?

There are many things about life insurance which make the subject seem more complicated than it truly is. One of those is index-linking.

Contents:

What is index-linked life insurance?

Why aren’t all policies index linked?

Mortgage-linked decreasing term life insurance

What are the benefits of an index-linked policy?

Examples of index-linked and non-index-linked policies

How can I index-link my life insurance policy?

What is index-linked life insurance? How is it different?

According to the land registry, the average price of a house in London in March 1979 was £14,013.

At the tail end of 2018, 40 years later, the average price for a property in London was £476,752.

While it’s not the scope of this article to go into the rising property market and all the factors that make that growth, it’s easy to see that the number has gone up - a lot. No wonder it’s sensible to have buildings insurance as well as life insurance!

If you had taken out a 40-year level term life insurance policy in 1978, it might have been reasonable for you to make it enough to buy a house. Even if you had thought ‘prices will go up, and I want my child to be able to buy a house, so I’ll double it’, then you’d have taken a life insurance policy out for £30,000 – quite the sum in 1978.

Should you have then passed away in 2018, and your policy paid out in full, your child would not have been able to buy a house. In fact, your child would not have enough to put down a deposit for a mortgage for a similar house in London, let alone buy it outright.

Introducing the consumer price index

The consumer price index (CPI) is a value which dictates through actual data, the level by which the value of money has changed over the years.

CPI works this out by taking a basket of things – for example; chocolate, soap, fuel, milk – and compares how much you’d pay for them this year to how much you would have paid for those identical items the year before. This then allows for an accurate calculation of how much things have gone up in the meantime.

There is another index, the retail price index (RPI) which takes a few more things into account, but when looking for an insurance index definition, most life insurance companies use the CPI rather than the RPI.

By applying the CPI over years, is it possible to see the relative value of money and that £30,000 back in 1978? The CPI says it would be the same as having £168,860 in 2018. Still not enough to buy that London house (the housing market grows at a massive rate above CPI due to a number of other factors), but a lot more significant than £30,000.

So, what is index-linked term life insurance?

Simply put, it’s a policy which pays out a value taking into account CPI, rather than the set sum assured. If you took out a £30,000 index-linked term life insurance policy in 1978 then in 2018, it would have paid out almost £169,000.

Why aren’t all life insurance policies index-linked?

Index-linked insurance policies are an option, rather than the standard. For many, the idea of increasing term insurance is complicated – they see the sum insured and expect it to remain a constant value. There is enough going on with life insurance that can confuse and put someone off purchasing a policy that making it more complicated at the offset can do more damage than good.

Plus, when you index-link your life insurance, it’s not just the end payout that goes up – so do your premiums.

There’s always a catch!

It’s only fair – if you index-link one end of the insurance policy, it makes sense to index-link the other end. Your premiums will rise in accordance with the CPI too, meaning that a policy which was taken out at £20 per month in 2010 would be costing a little over £25 per month in 2018. It’s a small rise, and potentially a very beneficial one in the long run, but (and this is important) it’s your choice to opt for it, not the insurance company’s place to force you into it.

What about mortgage-linked decreasing term life insurance?

DTA (decreasing term assurance) is a type of life insurance usually tied to a mortgage. With DTA, your premiums are low because the final payout decreases over time. They are designed to pay off a mortgage should you die, and as the value of the mortgage goes down, so too does the life insurance payout.

As your mortgage doesn’t increase with the consumer price index, a DTA life insurance policy has no need to be index-linked. It’s a good example of a type of life insurance that would probably suffer from index-linking, especially in terms of the increased complexity.

What are the benefits of an index-linked life insurance policy?

Typically, comparing the different types of life insurance policy would result in a list of pros and cons, but with index-linking there is only one pro, and one con:

Pro: The pay out on your life insurance policy reflects the actual value intended, rather than the exact amount of the initial sum assured.

Con: Annual premiums increase in line with the CPI.

What are some examples of index-linked and non-index-linked policies?

Look at these three examples to see how much of an improvement the end payment would be with an index-linked policy rather than a standard life insurance policy. These show the actual cash value of life insurance in the UK.

1 - Policy taken out in 2000, for £100,000 at a monthly premium of £40

If you index-linked this policy, it would pay out £168,118 in 2019 and the premiums would have become £67 per month by then.

If you didn’t index-link this policy, it would pay out £100,000 and the premiums would remain £40.

There’s a difference over 19 years of £68,118.

2 – Policy taken out in 2005, for £300,000 at a monthly premium of £65

If this policy was index-linked, it would pay out £444,751 in 2019, with a premium of £96 per month.

If this policy wasn’t index-linked, it would pay out £300,000 and the premiums would still be £65.

Here, you have a difference over 14 years of £144,751.

3 – Policy taken out in 1990, for £250,000 at a monthly premium of £50

An index-linked policy would pay out £564,171 in 2019, with a monthly premium of £113 per month.

A standard policy, not index-linked, would pay out £250,000 at a monthly premium of £50.

Here, the difference over 29 years is £314,171.

How can I index-link my life insurance policy?

It is possible to opt to index-link your policy at any time, and for any length of time. Of course, dipping in and out of index-linking can lead to some very confusing maths in order to work out the actual policy value, but the option to do so is there.

For more information about index-linking and to make changes to your policy, give our expert team a call today – or fill out our contact form to have someone call you at a more convenient time.