Income Protection Insurance: Things You Should Know

Posted on July 29, 2020

Whether you are employed or self-employed, Income Protection Insurance is a smart move if you want to protect your standard of living throughout temporary or extended illness.

This piece aims to answer some of the more frequently-asked questions about how these polices work: how your premium payments are set by the insurance underwriters and how the choices you make can affect the amount you pay into the scheme and the amount you would receive in the event of incapacity.

It’s a top up to an agreed level, rather than a set amount

It’s important to understand that income protection policies are intended to replace or top up lost income, rather than pay out at a set rate no matter what.

Monthly payments made to you under your policy will be adjusted according to the other financial support you receive from your employer or from the government. Let’s say you’re covered to 60% of your salary. If you’re in PAYE employment then you might have a comprehensive sickness benefits package already in place: depending on how generous your employer has been you might be covered to retirement. Your IP income will top you up to 60% after your other monthly receipts are taken into account.

There might be state benefits that you are entitled to. If you claim and receive these, you’re expected to declare this as you would any employer sickness benefit: your cover is there to top you up to an agreed level of income. However,  it is likely that your receiving an income from a personal income protection policy would affect your entitlement to any means-tested benefits.

How your income is calculated if you’re self employed

For the self-employed, a common method used for calculating the monthly support offered by the policy would be a year’s pre-tax profit (i.e. after trading expense deduction), with the date of your illness or injury being used to work backwards from to arrive at the 12 months to be assessed. However it is also not unusual for this assessment period to run over three years, in recognition of the fact that self-employed earnings can vary quite a bit from year to year.

Factors insurance underwriters take into account

The final contribution you’ll be asked to make monthly to maintain your cover depends on quite a few things, but there are four main initial considerations:

  • your occupation (some are more ‘risky’ than others);
  • your age (a general indicator for health prospects);
  • your actual health (and whether you have any existing conditions or ailments);
  • whether you smoke or not (tobacco use is the second biggest mortality risk globally according to WHO).

Policy modifiers

However, there are a number of policy modifiers, and the choices you make on each of these modifiers will not just change the level of cover but also your monthly payments towards the scheme.

Occupation class

Probably the most important policy modifier is the ‘occupation class’ which determines the circumstances under which you are covered with reference to your employment prospects.

The lowest level of cover provided would be ‘any occupation’, meaning that you would have to be incapable of doing any type of work before making a successful claim. A slightly better level of cover is provided by ‘suited occupation’, where the insurer has to take your skills, qualifications and experience into account when deciding whether or not you could find other work. Note that these two levels of cover mean that a diminished potential earnings factor is not taken into account when considering your claim.

The best level of protection is afforded by ‘own occupation’, which means that you are covered if you are unable to continue to work in any circumstances other than exactly what you normally do, for the business you normally work in, and therefore at the rate you normally get.

Level cover vs inflation-linked cover

You can decide whether payments made to you from the insurers would be adjusted for inflation or not: this is referred to as ‘level’ or ‘inflation-linked’ cover. Level cover involves setting the potential payment amounts to you – and then freezing them – at the start of the policy.

Given that income protection insurance can potentially provide cover for decades (until retirement or death in some cases), level cover will see the real-term value of your monthly income slowly eaten away by inflation. Inflation-linked cover means that, in the event of a successful claim, your monthly income will be adjusted according to the Retail Price Index or RPI.

Do check that your policy allows you to adjust the level of cover to reflect increases in your income (such as a raise or promotion), especially if this is accompanied by any increase in your outgoings.

Guaranteed vs reviewable premiums

Policies will usually offer you the choice of either ‘guaranteed’ or ‘reviewable’ premium payments. Guaranteed premium policies mean that your contributions to the scheme are at a fixed rate determined at the outset – unless you have chosen inflation-linked cover, in which case they will be adjusted by the RPI. Reviewable premiums are usually locked for the first five years of your policy, but can be adjusted upwards or downwards on an annual basis.

Choosing a guaranteed premium might be wise if you are younger and taking out a long-term policy, although this can mean that your monthly payments are higher from the outset. Reviewable premiums often appear attractive because the initial payments are low, but premiums can often rise significantly as you age (increases of up to 300% are not unheard of). A policy with reviewable premiums should come with a table that sets out the likely increases over time, although these are only indications and cannot be relied on to the pound.

The waiting period

Once you have chosen the type of cover and the type of premium, you do have some further control over the monthly premiums you will pay, via a modifier called the ‘waiting period’. As the name suggests, this is the number of months you will have to wait (N.B. whilst continuing to make your premium payments) before you receive your monthly income from the policy. Typical options are 1, 2, 3, 6, 12 or 24 months. The longer the waiting period you agree to, the lower your monthly premium payments.

MOST INCOME PROTECTION PLANS HAVE NO CASH VALUE UNLESS A VALID CLAIM IS MADE.

No guarantee can be given that the information provided is accurate in the present or the future. It is not intended to constitute either a statement of applicable law or financial advice, and responsibility cannot be accepted for any subsequent loss following activity or inactivity by any individual or organisation. Indeed, such information should NOT be acted upon without first receiving appropriate and specific professional advice.