A guide to Income Protection Insurance (IP)
Income Protection (IP) Insurance has received a lot of headlines recently, both good and bad. So I thought it would be a good idea to produce a guide to this product and help you find the best income protection policy:
What do I need to know about income protection insurance?
Income protection cover is one of the most underutilised types of insurance around. Most of us take out insurance to cover our home, car and even our mobile phone these days, but often overlook protecting our income.
If you had to stop working for a few months, a few years or even longer due to illness or injury what finances would you have in place to keep up with all your monthly outgoings? The reality is that most people would drain their savings within the first year and then have no choice but to rely on state benefits.
With state support, in the form of the Employment and Support Allowance (ESA), standing at only £99.85 per week, long-term incapacity would mean a significant change in living standards for most households. It is also worth noting that to get ESA you would need to go through a fairly strict Work Capability Assessment - so it is not guaranteed.
For most individuals the only real way of protecting earnings (other than saving), in the long-term, is to take out income protection insurance (which was formally called permanent health insurance or PHI). This type of cover pays out a monthly income if you have to take time off work due to sickness or injury and can payout either until you are well enough to return to work or you reach the end of the policy term.
How does this cover work?
For all but the most risky jobs it is usually possible to take out a plan with an ‘own occupation’ definition of incapacity. This essentially means that the plan would payout if you are unable to perform the duties of your own job due to illness or injury.
The plan would continue paying out each month (tax-free if it is a personal policy, or under PAYE if taken out via your employer) until you are fit to return to work, or you reach the policy end date, which is usually set at the age you expect to retire. Thus, if you were off work for five years whilst recovering from cancer the plan could cover your earnings for five years.
It is important to note that you would need to be off work for a certain period of time before the plan would start paying out, which is called the deferred period. Deferred periods can be as short as 4 weeks or as long as 52 weeks.
While there aren't usually many automatic exclusions from the policy , besides self-inflicted injuries, like any other personal insurance policy, it will need to underwritten by the insurer. Underwriting is the process whereby an insurer assesses an insurance application. Depending on the level and type of cover you are after this may require you to undergo a medical . But one thing to bear in mind is that pre-existing medical conditions will likely be excluded from any policy, or at best lead to your premium being increased.
But I heard insurers don't often pay out on this type of policy, is this true?
The most common claims are for conditions such as stress, back pain, cancer and heart disease. Leading insurers usually report claim payout rates of over 90 per cent. Payouts are usually turned down because the customer didn't read the small print. For more on what to look out for in a policy see the next two sections.
Key policy options
Listed below are policy options that need some consideration when taking out a new plan:
- Amount of cover – although it is usually possible to insure up to 65 per cent of your pre-tax personal income it generally makes sense to consider your essential monthly outgoings and thus base the amount of cover on expenses rather than earnings. With income protection for directors it is also possible to cover dividends as well as salary;
- Length of cover – it is typical to set the term length of the plan at the age you expect to retire, thus protecting lifetime earnings. The most common termination age is 65 years old but some insurers can provide cover up until age 70;
- Deferred period – it usually makes sense to align the deferred period with the length of time you would have savings sufficient enough to cover your expenditure and, if appropriate, the period of time your employer would pay full sick pay.
- Incapacity definition – different policies have different definitions of what it means to be incapacitated.
1) Own occupation – is as described earlier.
2) Any occupation – means that the insurer will only pay out if you could not do any occupation, and not necessarily your own occupation.
3) Work tasks/ activities of daily living - This is the least generous of the incapacity definitions. Basically the insurer will only pay out if you can't complete a set number of tasks, such as walking up stairs or holding a pen.
Naturally, the most appropriate policy options will vary from person-to-person based on their specific circumstances so it is worth speaking to a financial adviser to find a plan with the most favourable terms.
What should I watch out for in an income protection policy?
- Incapacity definition – as shown above, definitions vary considerably and often people will take out income protection policies thinking they are covered should they be unable to do their own job. But this may not necessarily be the case, especially if they have a work task definition.
- Sick pay – if your employer provides long term sick pay then this will restrict the amount of cover you can have under an income protection policy.
- Cost – Income protection is expensive so shop around for the best deal. But make sure the policies are comparable.
- Non-permanent contracts and introductory periods – some polices may stipulate that you can't claim within a certain time period from the date you started a job or took out the policy.
- Over insuring – as stated, there are limits to the amount of income protection you will be able to take out. If other types of insurance you have, such as health care cover, provide some salary replacement in the event of illness this will be offset against your income protection policy. So don't over insure yourself as you will be wasting money
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This guide was written in conjunction with Tom Conner from Drewberry Insurance.