What is life insurance and how does it work?

In simple terms when you take out life insurance you are insuring your life against when you die. In the event of your death your policy will provide your family or loved one's with a cash lump sum and also pay your funeral expenses plus any outstanding debts you may have.

You can spread out your payments out over a period of time. The amount you will need to pay for your life insurance will depend on your personal circumstances and what level of cover you decide to opt for. Factors such as age, gender and health will come into play. Obviously the higher payout will mean a larger premium payment.

There are a number of things that can drive down your insurance premium. If you are a smoker, kicking the weed is a good idea as insurers charge smokers extra for their policy than non-smokers. Also making sure you have a healthy weight and get regular exercise can also reduce your premium. It may seem strange to think about getting some life insurance when you are young but the younger and healthier you are will mean you will pay considerably lower payments than if you take out a policy when you are much older.

Although when most of us think about life insurance we associate it with only paying out when someone dies but there are many different types of policy that come under the ‘life insurance' category.

‘Protection only' or ‘term insurance' are policies that pay out only within a certain period of time. This is usually the cheapest way to provide financial protection for your family in the event of your death.

A ‘whole of life' policy lasts throughout your life so your dependants are guaranteed a payout whenever you die. Because you are certain to die while holding the policy, premiums are substantially higher than for term assurance.

Whole of life policies are often reviewable, usually after 10 years. At this point your insurance company may decide to put up your premiums or reduce the cover it offers.

There are different types of whole of life policy – some offer a set payout from the outset, others are linked to investments, and the payout will depend on performance.

Endowment, pension or other ‘life policies' will pay out in the event of a death during the term of the policy but if a person survives that term they will get a cash payout. This type of policy can be seen more as an investment that can be cashed in during your lifetime while also providing protection in the event of a death or critical illness.

Although a payout from a life insurance policy is tax free, it could form part of your estate and be liable to Inheritance Tax (IHT), which could gobble up to two-fifths (40%) of your payment. Ouch!

The simple way to avoid IHT is to place your policy 'in trust', which enables any payout to be made directly to your dependants, neatly avoiding the taxman, your estate and any Will.

It's also worth looking at mortgage life insurance that will pay off your mortgage if you die.