Vincent O'Connor: Terminal illness benefit - give it away or keep it for yourself?

If you think about all the many protection product features and benefits; arguably the easiest thing to understand is how life assurance works. Life assurance pays an amount of money if you die during the term of the plan - simple!

But if you think about all the many things we buy and pay for in our lives; life assurance is a strange commodity because even though you pay for it and you own it; you'll never benefit from it. That's because you have to die first before a claim can be made.

That's almost always true apart from the situation where you become terminally ill.

Terminal illness benefit (TIB) is a feature of many life assurance contracts on the protection market today. It allows you to make a claim on your life assurance policy in the event you are diagnosed with a terminal illness that gives you a life expectancy of (typically) less than 12 months. Claiming the life assurance benefit in this situation gives you the opportunity to get your financial affairs in order - which sounds like a good idea?

But is it a good idea from a financial point of view to have a potentially large lump sum entering your estate just before you are about to die? 

Maybe your intention is to spend the money but is there enough time? How would your terminal illness affect this? Or would it be your intention to make gifts to loved ones?

I think the answer as to whether or not you're going to have a future financial headache (by having proceeds from your life policy entering your estate) is going to be based on the value of your estate at a point in time in the future when you die. 

Could you potentially be putting ‘fuel on the fire' by way of increasing the amount of inheritance tax that your family will have to pay by having the pay-out from your life assurance included within the inheritance tax (IHT) calculation?

Using a trust?

We know that using a trust for a life assurance policy is a great way of tackling the problem of inheritance tax. This is because when you write a life policy into trust, you're actually moving it outside of your estate, and only assets held within your estate are calculated for IHT purposes.

You can't spend the benefit from your life assurance policy because you have to die first before it returns a value, so it makes sense to gift it. 

So in simple terms, life policies written into trust or assigned will not inflate the value of your estate any further and there won't be any inheritance tax to pay on the proceeds from your life assurance plan which means it won't exacerbate the problem any further.

So using trusts for protection policies seem like a good solution?

What if you write your life assurance policy into trust and you are diagnosed with a terminal illness.  You're the life assured but you're not dead - not yet - and you're in a position to claim on your policy whilst you're alive. 

Is it possible to claim the proceeds from your life policy if you've written it into trust?

Gifted and retained benefits

The straightforward answer to this question depends on how the Trust was set up.

Discretionary trusts are most commonly used for life assurance protection policies. The word ‘discretion' means these types of trusts come with a degree of flexibility for the trustees whereby the donor/settlor can change their mind about who they choose to benefit from the proceeds of their policy. 

Discretionary trusts used for protection plans define various protection benefits into two categories: gifted benefits and retained benefits.

Life assurance cover is a ‘gifted' benefit. That means the donor/settlor cannot benefit from these plan proceeds. Instead, these benefits would be ‘gifted' to your chosen beneficiaries. This does make sense because you'd have to die before a claim can be made which means you're not in a position to benefit.

But under a discretionary trust, ‘retained' benefits will be benefits that you need to keep for yourself.  These will be benefits such as critical illness benefit or total permanent and disability benefit. The list of ‘retained' benefits could even include income protection with certain life offices and it makes sense that you retain these benefits. 

You're still alive, you can make a claim and you need the money.

But if you write your life assurance policy into Trust; how is terminal illness benefit defined on trusts used for protection policies?

A common misconception is that terminal illness benefit is treated the same as critical illness benefit. 

However, that's not true for the vast majority of trusts used in the protection market. 

Terminal illness benefit is a life cover benefit and that means the default position is that it's a ‘gifted' benefit under the terms of a trust used for protection policies. 

The trustees don't have the power to award payment back to a donor/settlor which means you won't be able to benefit from Terminal Illness benefit yourself - not unless you had chosen a special option when you first set up the trust.

What if I want to keep my TIB?

Trust forms provided by life offices are designed to be used with their own protection policies and some trust forms do have an option to retain terminal illness benefits. This is usually a simple tick box.

However some life offices have deliberately decided not to include an option to retain TIBs on their trust forms which means TIBs on those trusts will always be ‘gifted'.

For a client taking out a life policy and then writing it into trust; it might seem quite tempting to tick that box to opt to retain terminal illness benefit.  But remember: if you opt to retain terminal illness benefit when you set the trust up; that is an irrevocable decision and it can't be reversed. That simple action could be the cause of an increased inheritance tax bill later on into the future.

Knowing which trusts do and don't have this option would be important for the donor/settlor and it should be a very important advice consideration.

But is this actually a problem worth worrying about?

Well, we know that many people do get diagnosed with terminal illnesses within the UK each year and life offices pay significant amounts of claims each year.

Royal London's claims data published in June 2020 (looking back at calendar year 2019) reported that 21.5% of claims paid on term assurance policies were for terminal illnesses.

The amount paid out was just over £31m just for terminal illness benefit claims with the average amount paid just over £145,000 per claim.

So is it a good idea to have a potentially large lump sum entering your estate when you are terminally ill and the prognosis is that you will die in the not too distant future?

Even for clients who have modest estates right now and calculate at less than the nil rate band for inheritance tax; how can anyone know what the future state of their finances will be?

So the question of using trusts and whether to give away or keep terminal illness benefit for yourself is actually a much more important advice consideration for life cover protection than it appears at face value - it could end up being a very costly decision!

Vincent O'Connor is senior intermediary development and technical manager for Royal London