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.
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 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.
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.
- Original Holloway £14.77 per month*
- Legal & General £27.24 per month
- LV= £29.17 per month
- 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.
- 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. [↩]