Soaring inflation has affected many aspects of everyday life over the past 12 months, from grocery bills to mortgage rates.
A less obvious but potentially damaging consequence is the gap between current asset valuations and the sum assured on insurance policies taken out by clients for inheritance tax (IHT). Policyholders who do not opt for indexation-linking on their contracts could find that insurance payouts have not kept pace with their rising IHT liabilities.
Even though the effects of inflation are well-understood, many clients and their advisers fail to account for them when arranging cover.
So, how can you encourage your clients to take indexation more seriously and help them work out if it’s right for them? Here are three factors that make indexation a prudent choice for clients.
- It protects their sum assured from the effects of inflation
Simply put, indexation means that the sum assured on a policy is able keep pace with inflating asset values, protecting the policy from the effects of inflation. Without it, a payout could fall far short of the amount needed if a claim is made many years after the policy started.
Consider, for example, the effect inflation could have on an IHT liability, given that the nil-rate band has remained at £325,000 since 2009 and has recently been frozen until 2028.
If a client with an estate worth £500,000 in 2009 had taken out a level term policy with no indexation, their IHT liability, and by extension their sum assured, would have been £70,000.
Fast forward to 2023 and soaring house prices and asset values, plus the accumulation of additional wealth over that 14-year period, could easily see the value of a client’s estate having doubled to a £1,000,000.
Let’s say that the client left their home to their child, allowing them to utilise a further £175,000 of relief via the residence nil rate band, they’d still be left with an IHT liability of £200,000. Suddenly, receiving a £70,000 payout from their existing level term policy leaves the client’s family £130,000 short of the sum they need to settle the IHT bill.
However, if the client had added indexation to their policy at the point of application, the sum assured would have risen in line with inflation and, by 2023, it’s likely the payout would be much closer to the value of the IHT bill.
In light of the inflationary increases of 2022 in particular, an example like this one very clearly shows the benefits of adding indexation to a policy.
- It’s much cheaper to add indexation from the outset than to take out a new policy
When a client adds indexation to their policy from the outset at a younger age, they take advantage of two things:
- Premiums tend to be lower for younger people
- The sum assured will rise with inflation, meaning that no matter how much asset values rise, their payout is likely to remain appropriate for their needs
For clients who opt for level term cover, the realisation that their estate is underinsured once its value increases could lead to them needing to take out a new policy much later in life.
This will mean paying vastly higher premiums than they would have needed to, had they opted for indexation at the outset.
- The indexation option is often a flexible addition so clients can decline it in a given year
Although premiums will rise each time your client accepts an inflation linked increase to their sum assured, their initial premium for the policy will not be affected by choosing to include indexation as an option. In other words, the option is free at outset and clients will only be charged each year that they accept an increase to their policy’s value.
Additionally, many providers allow clients to decline the indexation increase in a given year without losing the option in future years. Typically, insurers allow policyholders to decline indexation twice in a row before the option is lost. So as long as an increase to the sum assured is accepted once in every three years, the option will remain on the policy.
Since indexation doesn’t increase the initial cost of cover, it certainly makes financial sense to include it as a policy option from the outset – especially as you can never add it later on.
Overall, with inflationary-pressures mounting, and given that the option can be added at no extra cost, including indexation on life insurance policies should always be strongly considered. It can be accessed flexibly and will provide peace of mind to client’s long term planning.
Holly Hill, specialist Broker for landed estate clients at John Lamb Hill Oldridge
Article published in IFA Magazine in February 2023. View the full article here.