Life insurance payout: explained

Life insurance is an insurance policy that pays out a tax-free lump sum of money if you die while you're insured. This money is often called the 'payout'. How much this payout is and who it will go to is decided when you take out a policy. In general, a life insurance payout enables your loved ones to pay off debts, keep paying the bills, and generally cope financially without you and your income.

Choosing your life insurance payout

When you buy term life insurance, you choose:

• How much cover you want to buy (the amount)
• How long you want to be insured for (the term)
• Whether your cover is level or decreasing (the type)

These three factors all combine to determine what your life insurance payout would be and when it would be received, in this way:

• The amount of cover you have determines how much the lump sum payout would be
• The term determines how long you're insured for – so your life insurance payout would only be made if you die during this policy term
• The type determines what happens to your payout amount over time – whether it always stays the same (level) or goes down with time (decreasing)

Do all life insurance policies pay out in the same way?

No, there are different types of life insurance – and one of the ways in which they're different is how they pay out if you die. Here we'll explain how term life insurance pays out, but you can find out more about how other types of life insurance pay out here.

For term life cover, the two main types are decreasing and level policies. It’s important to understand the difference between the two as it affects how much money your loved ones will receive once you’re gone.

Decreasing term insurance

Decreasing term life insurance covers you for a fixed amount of time (eg. 10, 20, 30 or 40 years) and leaves your family with a lump sum payout – but, crucially, this payout will gradually decrease over time. If you die in the first few years of your policy, your family will be left with more money than if you die towards the end of your policy.

Term life insurance is a good option if you only need to protect your family for a certain period of time – until you’ve paid off the mortgage, for example, or until your children aren’t so financially dependent. This type of life insurance is one of the most affordable ways to get covered (it's cheaper than level term cover, as well as other alternatives like whole-of-life cover).

Level term insurance

Level term insurance also covers you for a fixed amount of time (eg. 10, 20, 30 or 40 years) and leaves your family a lump sum payout in the event of your death – but in this case the payout amount always stays the same. Your family will always receive the same amount whenever you die (so long as you die during the policy term).

Level term insurance is more expensive than decreasing term insurance, but it is a good option if you know the money your family needs without your income will always stay the same. You might choose it simply because you'd prefer to know that your family will always be left with the same guaranteed amount if the worst happens to you.

What can a life insurance payout actually be used for?

Nobody likes to think about dying, but if you want to be sure your death won’t leave your family with financial worry and debt, a life insurance policy is an easy way to do this. The lump sum your family receive can be used to:

• Pay off the mortgage
• Pay the rent
• Pay off any debts you may have, such as credit-cards or loans
• Pay for your funeral
• Pay for essential monthly living costs
• Pay for any other living costs, so your family can maintain their current lifestyle

The point is to make sure the payout is as useful for your loved ones as possible – meeting the financial needs they have without you and your income, until they reach a point when they can support themselves. Simply speaking: making sure any shortfall that you leave behind is covered.

The other thing you should do to make sure the payout is as useful as possible is review your cover level whenever your circumstances change. Moving house, getting married, having another child – these are all common reasons for reviewing your existing level of cover, as they signal shifts in your financial commitments or dependents.

Some insurers will let you increase the level of cover you already have to make sure you’re not underinsured. In other circumstances, you might be better off taking out a new policy to replace your old one – or in addition to your old policy, to bridge the gap and make sure you're sufficiently protected. If you don't do this, your family might not have enough money to pay for the essentials after you've gone.

When life insurance does (and doesn't) pay out

A lump sum sounds pretty good – but is there a catch? It's natural to think this when you buy any kind of insurance. With life insurance, insurers typically pay over 90% of life insurance claims. Your family will receive your life insurance payout so long as you die while you're insured and you were honest about your health and lifestyle when you applied.

To be really clear, your family won't receive the payout if you aren't insured when you die (i.e. you die after your policy ends) or if you've cancelled your policy. It also won't pay out if you've missed paying your monthly premiums, because this usually leads to the insurer cancelling your policy. And they might not receive it if an exclusion applies. You can read more about the ins-and-outs of when life insurance does and doesn't pay out here.