The following guest post is by Mark Meldon, an independent financial advisor (and Monevator reader!) who we’ve noticed talking a lot of sense over the years. We thought we’d ask him to explain some of the more obscure or technical corners of personal finance.
Unfortunately income protection insurance is the least popular by sales volume of the three key kinds of personal insurance – life cover and critical insurance cover being the other two. Whether you need it is an important subject for serious consideration and debate.
In this article I’ll try and demystify this important personal protection policy, explain the features that you need to look out for, and offer two real-life stories to illustrate the potential importance of income protection insurance.
Your top financial asset: You
We all go to work for two reasons:
1. We love our job
2. We need the pay cheque
If I’m wrong about you loving your job then you should consider changing it. I’m sure I’m right about needing the pay cheque!
People forget how entirely reliant they are on being able to do their job. Yet this depends to a very great extent on our health – physical and mental. Lose one or both and you are quickly in trouble.
If you are 30 and earn £30,000 a year, you might bring home £1,050,000 in total between now and age 65, ignoring things like pay rises and inflation.
But what would happen if you couldn’t work because you were long-term sick?
If you have wealthy relatives and friends ready and willing to help financially then that’s great.
Most of us don’t though. We need to think about the risk of something unpleasant happening, and whether or not to offload that risk to an insurer.
What happens if it all goes wrong?
You might be lucky in that your benevolent employer has set up a ‘group’ long-term disability insurance policy. However only a small proportion of the population are so covered (around 11%, according to Canada Life).
Meanwhile you should know state benefits are meagre and ever harder to qualify for. Many people are surprised how quickly they can fall into a financial abyss should a problem arise.
For example, did you know that for most of its employees, the National Health Service pays full salary for six months, half for six months, and then nothing?
A private income protection insurance policy will provide you with a guaranteed source of tax-free replacement income should disaster strike. That’s got to be a good idea!
Back in the 1870s, so-called friendly societies sprang up to address this problem by organising sickness insurance policies, and mainstream life insurance companies soon joined them in doing the same.
Both types of providers are still around but there are important differences. I’ll return to these later.
Plan features
It’s very hard to compare policies as they can be quite complex and you have to consider other important factors like the financial strength of your chosen insurer and their claims paying history.
However there are several basic common features:
- Sum insured – This is the amount of income you’d receive monthly should you suffer from a condition or illness that triggers the policy benefits. Most policies will not go higher than 55%-60% of your pre-disability income. This is to incentivise you to return to work in the fullness of time.
- Payment period – The maximum length of time the claim would be paid. This should be throughout your working life to, say, age 65. Short-term policies with payment periods of two to five years are available but I rarely arrange them. I don’t think that they really provide adequate cover.
- Proportionate benefit – This feature means that your insurer will pay part of the sum insured if you are able to return to work on a part-time basis. If you relapse, the full benefit would be reinstated.
- Deferred period – The period that your illness or disability must last for before you’ll begin to receive the sum insured. This can be anything from one day to two years, but three or six months are the most common choices. The longer the deferred period the lower your premium will be. The period chosen should fit in with your employers sick pay arrangements. You can also arrange ‘split deferred’ policies, with some cover starting after six months with the full sum insured falling due after twelve.
- Indexation – This means the sum insured and premiums are automatically increased each year by either a fixed percentage or by reference to an index such as the RPI. Some policies do this both before and after a claim, others one or the other. An essential ingredient, I think.
- Guaranteed insurability – This refers to two things. Firstly, the ability to purchase further cover without providing health information (within strict limits). Secondly, the policy cannot be taken away from you once it has been issued, ever, unless you cease paying the premiums. This feature was reflected in the old name for this policy – ‘permanent health insurance’.
- Guaranteed or reviewable premiums – Most mainstream insurers offer you a choice of guaranteed premiums where the ‘rate’ is locked in at outset or, for slightly lower initial cost, reviewable premiums where the premiums can be reviewed, up or down, depending on the overall claims experience of the company. I have a reviewable premium policy myself that I set up years ago and the ‘rate’ really did go down one time. My preference today is for guaranteed premiums, as you know where you are.
- State benefits deduction – Some policies reduce the sum insured by any state benefits you might end up receiving. Less common, nowadays, but worth watching out for.
Definition of disability
Arguably the most important thing to look out for is the definition of the word disability.
The primary distinction is whether your policy covers ‘own-occupation’ or ‘any-occupation’ disabilities.
An any-occupation policy requires that to receive your benefits you must be unable to perform the material duties of any occupation. That’s pretty hopeless – the emphasis is on any. Perhaps uncharitably, this has been referred to as the ‘vegetable clause’.
I would say that the whole point of these policies is to help you protect your income, not someone else’s. So, unless you do something very unusual or risky, you need an own occupation definition of disability.
So, serious consideration should be given to buy a full-term policy with as long a deferred period you can afford by reference to your savings to age 65 or so. Make it indexed and seek the own occupation definition of disability.
Underwriting
Underwriting is the work your chosen insurer undertakes when assessing your proposal.
Although the process of looking at income protection insurance has a number of similarities to life assurance risk assessment – for example height, weight, blood pressure, and daily habits – there are a number of important differences, too. Occupation and hobbies are just as important considerations as your physical details.
I have noticed of late an increased interest in alcohol consumption. There is, apparently, a significant cohort in the UK who drink far too much and they are now in their thirties and forties when the risk of alcohol-related mental health and physical diseases suddenly increases. You might get a lot of questions about your booze intake!
Several insurers offer telephone-based underwriting, which I find very convenient for clients.
Often the insurer will request a medical report from your GP and can ask for a medical screening or other medical tests. They pay for these so you could say they are a free health check.
These can turn out to be lifesavers. I have seen two diagnoses of diabetes in recent years and one of life-threatening high blood pressure following insurance medicals.
Claims
In common with many peers, AEGON recently published their 2016 claims experience. Its split showed 61% of claims were by men, 39% women.
The biggest reason for a claim was mental health at 27%, with cancer, musculoskeletal and cerebrovascular claims taking 19% each, cardiovascular 12% and ‘other’ 19%. The latter includes Huntingdon’s disease, diabetes, and multiple sclerosis.
Some 85% of claims were paid totalling £343,000 a year with the average claim value £15,589 a year. The biggest claim was for £68,196 a year and the average age at claim was 48-years old. The average age of the policy at claim was eleven years and six months (Source: AEGON March 2017).
All insurers will want you to get well as soon as possible. They offer a great deal of help and support to genuine claimants.
Fraudulent claims will not be tolerated and the 15% of claims not paid were either due to non-disclosure at the outset of the policy (you must be honest when applying for any kind of insurance, it goes without saying) or the reason for a potential claim falling outside of the policy benefits.
Providers of individual income protection insurance
Policies come from a variety of well-known insurers such as AEGON, Aviva, and LV=, to name but three. They offer excellent contracts for most people in low-risk occupations.
However, we shouldn’t forget the ‘Holloway’ societies, named after the MP for Stroud who brought about their founding legislation in 1870.
These are friendly societies and, whilst they underwrite your health and lifestyle just like the life offices, they are rather more lenient as far as occupations are concerned as they were originally set up to insure the working man.
How much will it cost?
Costs are hard to estimate. It depends on your age when you apply, your benefit choices, expiry age of the plan, and your health, lifestyle, and occupation.
Mainstream insurers will have standard premiums, nowadays on a unisex basis1, but these are often only the starting point. Some 40% of proposals attract non-standard premiums in one way or another in my experience.
Friendly societies have age-banded policies – due to their legal constitution – so their premiums will rise with age every now and again.
Office workers tend to pay significantly less than teachers who in turn would pay rather less than an HGV driver. Some occupations are just too hazardous to cover, such as miners and oilrig workers.
The younger you are when you apply, the lower will be the cost if you qualify for standard terms.
The best thing to do is to ask an independent financial advisor to run some quotes. They will also draw upon their experience of the market for these policies when making recommendations.
Here are some example quotes for a 36 year old office clerk (gender immaterial) insuring for £1,000 per month benefit, linked to RPI, with a three month deferred period to age 68. Guaranteed premium rates. This is, of course, a low-risk occupation.
Non-smoker rates
- Original Holloway £14.77 per month*
- Legal & General £27.24 per month
- LV= £29.17 per month
Smoker rates
- Original Holloway £14.77 per month*
- LV= £29.71 per month
- Legal & General £43.88 per month
* Age-banded premiums so might be more expensive in the long-run.
Quotations are available from several providers – these are just representative (Source: Iress/Exchange 10 October 2017). It very much pays to shop-around or to use an IFA when comparing quotes, ancillary benefits, and policy provisions.
A couple of case studies
With names and other details changed, here are two true stories from my recent experience.
A few years ago I was asked to look after the private pension funding of a legal professional. When I first became involved he was in remission from cancer and explained that, being a prudent individual, he had arranged life cover, critical illness insurance, and an income protection policy some years before my involvement.
The critical illness insurance policy had paid him a lump sum and enabled him to pay off his mortgage in full. His income protection insurance policy had also been claimed. It was paid proportionately as his health improved and he was able to work part time, then suspended when he returned to work full time. The policy remained fully ‘in force’.
Sadly, he became unwell again. The income protection insurer reinstated the full benefits under his policy without quibbling. Unfortunately, he died a few years ago after having been on claim, on and off, for six or seven years. But he was very grateful for the help and advice his provider had given him in those years.
More recently I arranged a friendly society income protection policy for another one of my clients. Michael is a self-employed tree surgeon and gardener; a lovely man, with a ready smile, but of modest financial means. He realised his occupation was risky and we set up a policy with The Original Holloway Friendly Society up to state pension age.
You guessed it! Michael fell out of a tree and badly damaged his back.
“They won’t pay out, will they”, his wife said when she gave me the news. “Yes they will” I answered and they did after just eight weeks deferment period, just as savings were running out.
Michael thought the Original Holloway were great in that he was given every practical help to get better as they paid for specialist consultation and “the policy kept the roof over our heads”.
He did get better after a few months and the claim was reduced and then came to an end. Then there was a (thankfully brief) relapse, and the policy kicked back in.
Michael is confident that he has made a full recovery. But you never know, so he has maintained the premium payments on the policy and will do until it finishes at age 67.
The bottom line on income protection insurance
If you earn any money, in my opinion you should insure your ability to receive an income if you are incapacitated, period.
You can only do this through the too-often overlooked income protection insurance policy.
Choose carefully, tailor the policy to your personal financial circumstances, and never bin it unless your employer offers adequate cover. (Even then what if you subsequently leave and your health is not as good as it was?)
Be prepared to pay up, as the premiums for these policies can seem expensive.
Mark Meldon is an Independent Financial Advisor based in Cheddar, Somerset. If you need an IFA closer to home, try the directory at Unbiased. You can also read Mark’s other articles on Monevator.
- Women tend to make twice the number of income protection insurance claims as men but pay the same premiums – or rather men pay more since gender-based premium equalisation – Source UNUM 2012. [↩]
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Very interesting article – my take had been that these were expensive policies that weren’t worth it as they rarely pay out – so good to have that idea challenged
I’d be interested to know if folk here typically hold these sorts of insurances
I am slightly jealous of ermine now being within IFA distance of Mr Meldon. I would like a financial check up but am a bit to far away for it to make sense..
Claims are indeed paid, averaging 90% across the main providers. I should just mention that I have only covered “self-funded” policies in the article. There are policies available, for example, for those running small limited companies. This quite rare contract is often called “executive income protection”. The difference? Well, the Company pays the premium instead of the life insured. Corporation tax relief is usually granted on these premiums but if a claim is paid the benefit will be taxable in the insured’s hands. On top of this, if you employ a few people, excellent “group” schemes are available from several insurers – these tend to have straightforward underwriting but the premiums are reviewed with age increases – excellent value in my opinion.
Not sure we need this with the benefit sytem we have in this country. Its rediculous! Do you realise the bulk of passengers reported on PO ventura cruise ship are the dissability benefit brigade with their walking sticks and wheelchairs. Annoys the hell out of me who works damn hard saving 60% of my money to get to FI.
FI in 19 months. Need an operation but not life threatening so can wait till then. We would be a very rich country if there were more people like us.
I looked into permanent health insurance when I first went self-employed but decided it was too expensive. Now I am financially independent, I wouldn’t have thought I needed it. (I don’t have any dependants or debts to worry about.)
I run my own Limited Company and never bothered with this type of insurance. Being in the process of saving for FI we had a big cash buffer and lots of investments if worse came to worse.
Then it did.
Two years ago I was suddenly diagnosed with a malignant brain tumour. After weeks in hospital after an operation, I underwent a regime of radio- and chemo-therapy. I went for around a year without any income.
Fortunately we had the savings to cover that because of our FI goal, and I’m lucky enough to have recovered enough to now be earning again and adding to our savings rather than drawing on them, but it could easily be the case that I would be still be unable to work. These types of illnesses really can strike anybody (I am in my early 40s) and I got a lot of criticism for not having insurance to cover something like this (I have a young family)
My point being, consider taking up something like this because the “it won’t happen to me” attitude is simply dangerous!! I’ve been relatively lucky but it could have been much worse…
Just a guess, but I suspect many people buy insurance they shouldn’t and fail to buy insurance they should. I invite you, Mr Meldon, to write about the first type some day.
It would be useful to see a reference for the 90% claim. I’m highly sceptical of it.
I’ve looked at Relevant Life insurance a few times but decided not to fund the marketing, administration and ‘independent advice’ market surrounding it.
Here’s a link to L&G’s stats on their percentage of claims paid, on Life policies for individuals.
http://www.legalandgeneral.com/advisercentre/protection/why-choose-us/our-claims-payment-record/
I think some people will be surprised!
Yes, I used to work for several insurance companies.
B
Ps have a read of the misrepresentation link too.
Ah, So the 90% is for amount of claims made that are paid. I’d read it as the Claims Ratio: the amount of money paid out (claims) vs paid in (premiums).
Monevators own Lars kroijer explains it here http://monevator.com/when-to-buy-insurance/
As that article concludes “there is a tangible financial cost to that intangible peace of mind from insurance that many people cherish. Insurance is expensive. Make sure it is worth it.”
Hi TT
The 90% or 98.6% is by number of claims made by customers in the calendar year, not by amount of money, or by proportion of premium received.
The claims ratio is mostly a General insurance measure and rarely in Life insurance.
Lars investment articles are great, but I’m not sure I’d follow the is insurance advice. Eg it’s often cheaper to buy a fully comp motor policy in the U.K. than it is to buy a Third Party Only policy.
@dearieme. You are right, many buy insurance they don’t need. Such as life (death) cover when there would be no ill-effects, financially speaking, from their early demise. This is all about risk. If you don’t perceive there is a financial risk to something terrible happening to you then don’t buy insurance.
Most people, however, seriously underestimate their vulnerability and, as @ Andrew says above, something horrid and unexpected can mean other plans quickly turn to dust. Most people are very light on savings and state benefits are hard to get and meagre. I could reel off lots of cases, but you have to relate these to your own situation.
Because of what I do, I meet and help claimants and/or their survivors and I can honestly say that no one has ever sent the cheque back!
Pay what you have to for what you need, no more.
Both my wife and I have this as our future plans are utterly dependent on our current and future income streams. Take those income streams away and we would be sunk. We both have a significant income to insure but now have this covered until retirement age if anything should go wrong for less than £100 a month. Seems quite a good and cost-effective trade-off given this low probability high impact risk isn’t one I want or could afford to self-insure.
Worth checking your pension small print. The NHS pension and other generous schemes such as USS offer incapacity retirement that covers permanent disablement. These vary but can cover both partial and total incapacity and are generally awarded on whether, on the balance of probabilities, you will be unable to perform your duties for a certain number of years.
@ James Wilson. Whilst this is true to a certain extent, income protection insurance will cover “temporary” illness and incapacity in, I think, a better way. It is terribly difficult to qualify for ill-health early retirement nowadays as it just costs the pension scheme too much. “Permanent” disability would be covered by an IP policy but is generally a specific feature of critical illness insurance policies and these commonly produce a lump-sum rather than a tax-free income stream.
Look at the claims statistics (all in the public domain) to see what has actually triggered claims.
Hi Mark
You mention that most policies will not go higher than 55%-60% of your pre-disability income. Does that mean at the point you purchase the policy you disclose your current salary and then you keep the same insurance even if a later job pays less? And also do you know if they look at total remuneration or just PAYE? I’m considering a large salary sacrifice arrangement to save NI and boost my pension pot, but this will lower my “salary” and I’m worried this would prevent me from taking out this type of insurance at a high enough level.
Thanks
Is there a disadvantage for FIRE people taking out these policies as they are costed against the general population who expect to work to 67, not 55, so their payout periods go beyond what an early retiree needs. Of can you tailor a policy that only covers X years payout, after which you will live on pensions. If not they will be poor value
@David. Whilst it can vary from one insurer to another, the whole point of this kind of insurance is to cover a large proportion of your earned income at the point disability strikes. For the self-employed, for instance, an average of the last 3 year’s might be used. For the employed, it is often P60 earnings – most insurers write regularly to ask if the level of cover is right as under-insurance or over-insurance can cause problems which they wish to avoid. My own insurer, LV=, writes every year and offers the chance to increase cover, free of underwriting within certain limits, every 12 months.
@John B. There are short-term policies available, with benefits payable for a restricted period, often 2 or 5 years. I’m not a big fan of these as “things happen” that can throw all long-term plans in the bin. Aside from a relationship breakup, ill-health, is the obvious trigger. I nearly always, then, recommend long-term policies as once set up the insurer can’t take it away; if you reach FI, you just bin the thing by ceasing payments.
Now that I’ve read this article again and had time to think about it … I say thank you, MM. Very helpful.
L&G get a mention above. Many years ago I took out ill health cover with them – £100K for £59 per month. I’m not sure if that made sense at the time but it turned out to be possibly the best financial decision I’ve made to date, since I was diagnosed with bowel cancer aged 54. With only requests for medical confirmation, they paid up without difficulty.
Odd thing about cancer is that you may be very ill without even realising it, I felt fine before and even after some major operations, but the side effects of chemo put paid to me being able to do my job after a while, and I can’t thank them enough!
When you need the insurance is not the time to wish you’d started the policy – and your FIRE plan really ought to include some ‘what if’ planning.
I have been a member of pgmutual since 2006.The insurance premiums have increased with age .I do agree that premiums are expensive (30 pounds p.m./ 1000 pounds approx) .But this small amount covers a lot of uncertainty for the family .I am not relying only on the income protection but have covered critical illness as well.The insurance broker guided me on the aspects of critical illness and his own experience( byepass surgery) persuaded me to buy this cover.
I just read this new https://www.thesun.co.uk/news/4739815/dad-sepsis-legs-hands-amputated-wales/
Also,Andrew has made a good point in the comments above and this link to the news article proves the same that no one is immune to the diseases/uncertainties.
@Stuart Brown. I hope you have now made a full recovery. I was pleased to hear that you had a positive experience when making a claim as most do. You had the presence of mind to voluntarily purchase this kind of insurance as you “can’t see into the future” and I’m glad you did.
Just as a “heads up”, I don’t mind disclosing that I purchased my IPI policy with LV= back in the late 1990s when the children came along. I have never, thankfully, had to make a claim, but I’m jolly glad to have purchased the policy (and a critical illness policy – a subject for another day) when I did. That’s because I’m now, at 54, “out of the market” following the diagnosis of type two diabetes five or so years ago. I presented to my GP as an “atypical” diagnosis as I’m not overweight and I happen not to drink(confession time: I’m a smoker) and it was initially thought something far worse was going on.
Today, I’m stable and well-controlled with medication, but these can have very long-term side-effects, but I can’t buy most protection insurance policies, period.
So, if you earn any money, have debts or dependants, get you insurance young and while it is cheap! There is no-one who wants insurance more than someone who can’t get it!
This might be a naive question, but why would you need critical illness cover in addition to income protection insurance? It seems logical that any critical illness you suffer would automatically cause the income protection to kick in, as you’d be unable to work. Or is it about needing extra money to fund care on top of replacing your income?
@david. This is a good question, and I’ll do my best to explain. IPI was “invented” back in the late 19th century in a form where workers pooled funds to provide sickness insurance on a mutual basis. These became the Friendly Societies such as Cirencester, Holloway and Wiltshire still around today. Later, the “mainstream” insurers entered the marketplace.
IPI protects your ability to earn an income if you are ill. The policy will pay out for mental health problems, bad backs and joints – you don’t have to be in a situation where your life is threatened.
Critical illness insurance first came about in 1986 in South Africa and was introduced into the UK shortly afterwards by Abbey Life. This kind of insurance is designed to pay out a one-off lump sum (although there are FIB types around – see an earlier article) upon the diagnosis of something really nasty like cancer, major organ failure, stroke, heart attack, etc. Policies are often arranged to cover, say, mortgages or school fees liabilities. CI does not cover non life threatening problems that IPI does.
They are complimentary, with, in my opinion, IPI always the first thing to do.
I hope that helps.