The problem with mortgage protection for unmarried couples

Vincent O’Connor is senior intermediary development and technical manager at Royal London

Each year within the UK protection industry, we can expect to see a significant amount of life cover purchased by consumers.  Many of these policies are for mortgage protection.

Swiss Re’s Health and Term Watch reported that for the calendar year of 2019, 315,034 Decreasing Term Assurance policies and 216,230 Decreasing Term & Critical Illness policies were taken out.

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It’s fair to say virtually all of these could be described as ‘Mortgage Protection’ and these numbers suggest a buoyant and active market.

According to data from the Yorkshire Building Society there were 353,436 first-time buyers in the UK in 2019.  This was the highest annual total since 2007.

Many of these homebuyers will be young couples who are not yet married or in a civil partnership.

The stepping stone to setting up a mortgage protection plan is usually to have a mortgage debt which needs to be protected.

Isn’t mortgage protection really straightforward?

At face value, mortgage protection is just about the easiest protection concept for a couple of first-time buyers to understand.

Residential mortgages are very typically taken out by couples because pooling resources together increases the scope of affordability and ultimately the type of property they can afford to buy.

People understand that mortgage loans are taken out over long periods of time. Mortgages are usually the biggest debts they will ever have. They also understand that mortgages are secured against the property and the loan does need to be paid back.

So a protection policy that allows each mortgagor the ability to repay the mortgage in the event of death or serious illness is an easy concept to understand.

However, the design of a mortgage protection solution for an unmarried couple requires a little bit of extra thought because it’s not quite as straightforward as you might imagine.

Designing the solution

Let’s consider a life assurance mortgage protection solution. How do we achieve a good customer outcome by way of what needs to happen if a claim is ever registered?

A good customer outcome for a jointly held mortgage might look like this…

If one partner dies during the mortgage term; the surviving partner needs to be in a position to pay off the mortgage so they can keep the home.

The default protection solution for joint mortgage borrowers is typically a joint life first death life assurance policy.  It would typically be ‘decreasing’ to run in line with a capital & interest mortgage, or, ‘level’ to run in line with interest only mortgages.

The term should match the term of the mortgage and the sum assured should match the amount of the mortgage balance.

But for unmarried couples, there is a sting in the tail with this type of solution. The problem concerns tax!

A sting in the tail!

Let’s say an unmarried couple take out a joint life mortgage protection policy for a property they owned jointly. At some point in the future, one of them dies so the other makes a claim on the policy.

When the claim is paid, the surviving partner would receive the full sum assured. This would put them in a position to fully repay the mortgage debt. This sounds like a good customer outcome, surely?

But the problem could potentially arise when looking at the estate of the deceased.

The probate process requires disclosure of all assets held by the deceased. This is to ascertain whether there will be any inheritance tax to pay or not.

Included within the assets of the deceased will be the property. The value of the deceased’s share of the property will form part of their taxable estate (even though it actually passes to their partner). Typically, a discount of between 10% and 15% will usually be available on the full market value of the property.

But another asset which will form part of their taxable estate will be the protection policy.

For an unmarried couple, HMRC will count half of the joint life policy sum assured in the estate of the deceased. This is again, a paper exercise because the reality is the survivor would have already claimed the full sum assured. The funds from the life assurance policy will never actually enter the estate of the deceased but they could be taxed.

By including half of the sum assured (which could be considerable), within the estate of the deceased, this could increase or even give rise to an Inheritance Tax charge.

So it’s quite likely that if this scenario ever arose, it could be an inevitability that the family of the deceased could look to take legal action against the adviser who first recommended what was, a very simple and straightforward protection solution.

What’s the solution then?

Advisers can’t possibly predict the future wealth of their client’s estates, or whether they ever actually make a claim on an insurance policy.

And there is no way of knowing whether the recommendation of a joint life protection solution to an unmarried couple is ever going to cause a problem.

But what we do need to do is make sure these types of scenarios are taken into account during the advice and recommendation process.

For unmarried couples the best solution would be for each partner to take out individual protection cover.

These policies would need to be written into Trust. Beneficiaries can be nominated and for this type of scenario, the beneficiary would be the other partner.

As an alternative solution, the individual protection cover could be written on a life of another basis but that is a lot less flexible. For example, what would happen if they split up or wish to change their beneficiary at some point in the future?

With a Trust, beneficiaries can easily be changed if there is a need to change them. This can be accommodated in a Letter of Wishes, which is usually a good idea to review from time to time because amendments and updates can be made where necessary.

So, a good customer outcome for a couple of unmarried partners would be to make sure that should either of them die during the mortgage term, the other partner is in a position to repay the mortgage debt.

But also, make sure we don’t add to or increase any possible inheritance tax on the estate of the deceased.