Income Protection (IP) Insurance also known as sick pay insurance has received a lot of headlines recently given the emphasis on sustaining an income during periods of incapacity to work. 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 personal 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 £74.70 per week (if you are over 25), 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 formerly 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.
You can read more about this in our article, 'Sick pay insurance - occupation incapacity definitions explained'
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 examination. But one thing to bear in mind is that pre-existing medical conditions, depending on their severity and impact on your ability to work, 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 percent. Payouts are usually turned down because the customer didn't read the small print or they weren't honest on their application. 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 percent of your pre-tax personal income it generally makes sense to consider your essential monthly outgoings and base the amount of cover on expenses rather than earnings. With income protection for directors of a company it is also possible to cover dividends as well as salary
- Length of cover – it is typical to set the policy term to cover you for the number of years left until you will retire, thus protecting lifetime earnings. The most common termination age is 68 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 enough savings to cover your expenditure and, if appropriate, the period of time your employer's sick pay would suffice.
What 'occupation definition' means
Your occupation definition is based on the type of work that you do and the risks associated with it. This is two-pronged - the insurance company looks at the extra risks that your work environment presents such as the risk of falling objects or using heavy machinery as well as how easily you would be unable to carry out your job if you became ill or incapacitated.
Own occupation – the policy will pay out if you are unable to do the main aspects of your own job
Suited occupation - a claim will be paid if you are unable to do your own occupation or an occupation to which you are suited through education, experience or training
Any occupation – means that the insurer would only pay out if you could not do any occupation
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 upstairs, getting in and out of a car, walking a certain distance or getting yourself dressed
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 policies can be tailored to suit your budget and policies that pay out as soon as you become unable to work will be the most expensive so be realistic about how long you can survive without claiming to keep your costs down. Also, shop around for the best deal but make sure the policies are comparable.
- Non-permanent contracts and introductory periods - some policies 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 you are being paid by your employer whilst you are unable to work, this will reduce any claim you can make so do factor this into your policy so that you're not paying for cover that you won't be able to claim.
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