Defaqto

Who needs income protection insurance?

No one can guarantee that they will not be the victim of an accident or be diagnosed with a serious illness, however much attention they pay to diet and exercise.

Indeed, research by Munich Re shows there is at least a one in four chance of needing to claim on an income protection insurance policy during one’s working life.

You are also more likely to suffer a serious illness before age 65, than to die.

But falling ill or having an accident will not stop the bills from arriving or the mortgage payments being deducted from your bank account, so going without income protection insurance could be unwise.

Those in very good jobs will usually receive generous income replacement cover through their employee benefits and these may extend right up when they retire.

But the majority of employees with long-term illness will find themselves having to rely on the state after three to six months.

The exact amount of state help that will be available will vary according to factors such as your age, level of savings, number of dependants and housing needs, but you can be sure that it will never allow you to do anything more than to subsist.

Income protection insurance, however, can enable you to receive benefit payments of up to around half your income while you are unable to work. These payments will continue until you recover or, if you fail to do so, until the end of the policy term - which is typically your intended retirement date.

Widespread confusion

There is considerable confusion among consumers about income protection – possibly because of the various names used to refer to it. These include ‘income replacement insurance’ and in the 1990s it was known as ‘permanent health insurance (PHI).

Income protection insurance should also not be confused with ‘payment protection insurance’ (PPI) which is sold when you take out a mortgage, credit cards and personal loans. (see our guide to Payment Protection Insurance in the credit card section).

How does income protection insurance work?

Income protection insurance is frequently better value than any kind of PPI. However its main downsides are that it is more complex to understand and can take longer to arrange.

This is because with income protection insurance, you have to complete a detailed form about your health and you may have to undergo an independent medical examination so that the underwriter at the insurance company can assess the likelihood of you falling ill. This is known as individual underwriting.

The underwriter may also write to your GP. In some cases, therefore, the whole process can take several weeks.

This detailed underwriting can also mean that you have exclusions imposed for medical conditions that you have already suffered from. If you have a history of back pain or stress-related disorders, you are likely to find that these are excluded.

Rating factors

Individual underwriting means you may find the premiums you are eventually quoted are considerably higher than the prices you originally saw advertised.

Factors that can have a major impact on premiums include your age, gender, smoking, obesity and - most importantly of all – your occupation and even where you live.

Underwriters know that those in certain jobs are far more likely to claim than those in others. Roofers, for example, may be required to pay four times the standard headline rate to reflect the fact they are exposed to a greater than average risk of personal injury.

Even teachers may be charged at least twice the standard rate to reflect the fact that their profession is unusually susceptible to stress.

Cover Issues

Premiums will also be affected by the chosen level of cover, the duration of cover, and the length of the initial ‘deferred period’ - the amount of time that must elapse between when you make a claim and when benefit payments will commence.

Clearly, the shorter the deferred period the greater the cost.  It can be possible to have a deferred period of anything between one month and one year, but in practice most people opt for either three or six months.

Most people opt for a deferred period that dovetails with the sickness pay they are entitled to under their contract of employment which is typically 3-6 months. 

Premiums vary considerably across the different insurers. However, one thing to remember is that cheapest is not necessarily the best.

Issues such as the payment record of the insurer, how quickly it will pay out and its claims record generally are also important. In a recent study by Lifesearch, it was found that some insurers were declining up to 20 per cent of claims.

The small print

Different providers can have significant differences in the small print of their policies, and if you are not aware of these, it will be like comparing apples with pears. Areas to watch out for include the fact that:

• some policies have lower than average maximum benefit limits;
• some insurers insist on making significant deductions for other income you receive while making a claim;
• some insurers quote on a fixed amount of cover throughout the term, whilst others quote for escalating cover that keeps up with inflation;
• some quotes will refer to premiums that remain ‘fixed’ or 'guaranteed' throughout the term, whilst others will be for premiums that are subject to regular pricing reviews which can result in steep rises in premiums.

Premiums which are reviewable (ie not fixed) may cost less than those which are fixed (ie guaranteed to stay the same throughout the term of the policy) at the outset, but choosing the lowest premium could prove to be a false economy if premiums soar at a later stage.

That said, there may be some individuals for whom reviewable premiums are better than guaranteed rates, but you should seek independent financial advice to ensure that you pick whatever is appropriate for your circumstances.

Also watch out for whether the insurer will pay out if you are unable to do your  ‘own occupation’ or ‘any occupation.’

It is clearly best to go for a policy which pays if you are unable to do your ‘own’ occupation. Some policies only pay out if you are unable to carry out particular 'functions of daily living,' and others only shell out  if you are unable to do ‘any occupation’ to which you are suited by experience, education and training.

The importance of advice

Because income protection can be quite complex, it is worth seeking professional advice from an independent Financial Adviser (IFA).

Most IFAs earn their remuneration from commission paid by insurers, but some will work on a fee basis, or by offsetting commissions against fees.

IFAs can save you money by shopping around the market to ensure that you get the most appropriate and competitively priced cover for your needs.

Before you consult an IFA, however, you will need to establish exactly what cover you have from your employment. If in doubt, ask you HR manager.

In particular, you need to know the length of the 'deferred period' under your employer's scheme so that your IFA can take this into account when advising you.

Specialist insurers

IFAs will  also consider how insurers compare when it comes to paying out on claims. Some of the more specialist insurers are likely to give policyholders the greatest benefit of the doubt in the case of borderline claims and provide more comprehensive rehabilitation facilities for claimants who wish to get back to work as soon as possible.

A good IFA will also be aware of which insurers are likely to grant the most lenient terms for those with poor medical histories and risky occupations.

Although PPI typically only pays out for one year, it charges all policyholders the same flat rate, regardless of age, gender, occupation and smoking habits.

This can therefore sometimes make PPI better value than income protection insurance for individuals that income protection insurers will not cover at standard rates or would reject altogether.

Constantly changing market

A little knowledge can certainly be a dangerous thing with income protection insurance and even those who pride themselves on being clued up should be aware that this market is subject to constant change in terms of the innovative new products that are being developed.

In view of the amount of initial and ongoing research that needs to be conducted to select a suitable policy, buying via an IFA is likely to prove the most cost-effective and safest route, as well asproviding a means for help and redress if things go wrong.

Key points

• Just because you are ill or made redundant, the bills will still keep coming
• State benefits will not enable you to do more than subsist
• The cheapest policy is not necessarily the best value
• Don’t confuse income protection insurance with payment protection insurance
• It is a highly recommended that you consult an IFA.