Why income protection makes good financial sense

Why income protection makes good financial sense

Attitudes towards income protection vary from a subconscious denial of the need to an appreciation for the safety net that it provides. Income protection, also known as permanent health insurance, is designed to provide a monthly income in the event you’re not able to work due to sickness or injury. According to the Association of British Insurers about 1 million workers, each year will find themselves unable to work due to sickness or disability[1]. A UK Government report from February 2014 also stated that 960,000 workers took sick leave for a month or more during the period October 2010 to September 2013.[2]

Even though many adults have very little savings and certainly don’t have the recommended savings safety net of 3 months’ outgoings[3], the uptake of income protection insurance is very low. According to a research report by the Chartered Institute of Insurers (CII), only one in ten have some form of income protection insurance[4]. The reasons for this are a complex interaction of behavioral and psychological factors combined with an expectation (perhaps misplaced) that The State will provide.

Income protection provided by an employer (group income protection) can help alleviate the protection gap and at a reasonable cost. A recent green paper by the Department of Work & Pensions states that the average cost of group income protection was approximately £250 to £450 per annum.[5] However, with the increase in short-term contracts and part-time work, many workers may be left exposed in the event of sickness or injury. Also, those with group income protection often do not know the extent of the cover – what the timeframe for payouts is and when they can begin to claim. Consequently, individuals may find that to maintain their lifestyles, additional individual income protection may be required.

Do you need income protection?

Income protection insurance is a vital form of protection particularly for the self-employed. If you wouldn’t be able to pay your bills in the event of illness or disability, then income protection would be suitable for you. However, many people mistakenly believe that they won’t get ill. The table below highlights the likelihood of certain events happening before the retirement age of 67.

 

Probability table 

It is striking the impact smoking has on the different risks. Risk of death more than doubles for both males and females. What is surprising are the scale of the risks for women in terms of being ill for 2 months or more while men have a higher risk of a serious illness. Finally, across the board, the risk of illness prior to age 67 is much higher than the risk of dying.

We underestimate the chances of needing protection hence there is a significant income protection gap which is far greater than for life insurance. This is likely because we know for a fact that we will die but we downplay the likelihood of illness especially during our working lives.

A top UK insurer recently issued their latest (Deadline to the Breadline) report which indicated that the average household, if dependent on savings and state benefits, would only be able to financially survive for 32 days. Yet only 9.3% of workers have any income protection insurance.[6]

In view of these numbers, it is worrying that the take up of income protection is so low.

How does individual income protection work?

In the event of a claim following an illness or injury, the insurer will continue to pay the benefit (after the deferral period) until the earlier of recovery, retirement, death or the end of the contract. Often the payment of the premium is waived during the claim period.

An income protection policy has some important features that require careful consideration to ensure that the right level of benefit is achieved at a fair price. The premium paid will be a function of age, health, and earnings as well as the relevant features selected by the insured.

Key features big

Most insurers will limit the amount of the benefit to a certain percentage of earnings, typically 50% to 60%. The benefit is paid tax-free, but the insurer will reduce the payout by the amount of any benefits received from other insurers and The State. Therefore, it’s important to do a proper needs analysis otherwise, you will end up paying for something that you may not receive. We recommend that clients review these policies regularly as circumstances may change.

Incapacity is defined as follows:

  • Own occupation – you are incapacitated if you are unable, due to illness or accident, to perform the duties of your own occupation and you are not working in another role.
  • Suited occupation – following an illness or injury, you are unable to perform a job suitable to you given your skills and education level.
  • Any occupation – you are incapacitated if you are unable to carry out the duties of any occupation following an accident or sickness.
  • Activities of daily living – following an injury or illness, the policyholder is unable to perform certain defined functions of daily living (e.g. washing, eating, climbing stairs etc.) as stipulated in the policy document.

Own occupation is the most expensive option while activities of daily living is the cheapest.

If you expect to receive certain benefits from your employer or The State, or indeed you have sufficient short-term savings, you may choose to delay receipt of the benefit until a certain time after the onset of an illness or injury. The longer the deferral period, the cheaper the premium. Typical deferral periods include 13 weeks, 26 weeks or even a year.

Inflation will tend to reduce the real value of any benefits received and all providers offer an indexation option with the benefit linked to the Retail Prices Index (RPI) or a fixed percentage. The benefit will increase annually in accordance with RPI and the premium will likewise increase but at a higher rate, for example. 1.5 times RPI. Some providers will allow policyholders to opt in and out of indexation, but most will place a limit on the frequency and some will even withdraw the option if it is not being used regularly.

Most providers now offer incentives to encourage workers to return to work, such as providing a proportionate benefit in the event the employee returns to work on a part-time basis. Other ancillary benefits include counseling, rehabilitation, death benefit, support services, care assistance, and fracture cover.

How much does it cost?

There is a general perception that income protection insurance is expensive which is another reason accounting for the low take-up rates.[7]  However, the average monthly premium in 2017 was £56.[8]  A properly constructed individual income protection policy based on appropriate advice, provides a valuable benefit and the typical pay-out is more than 4 years.[9]

Based on current rates, a 30-year-old individual in good health would be able to purchase an individual income protection policy (own occupation definition plus indexation) with a monthly tax free benefit of £4,000 until a retirement age of 67 for about £50 per month.

 

Age table

In the event of a claim, the potential benefit can be significant. If a permanent disability occurred at age 35, the policy would pay out a monthly benefit for 32 years totalling £1,536,000 over the period (ignoring indexation).

However, most people don’t recognise the need for individual income protection until much later in life leading to much higher premiums; the rate for a 50 year is more than 3 times higher at £156.11 per month. Clearly, it pays to take out a plan early but even at age 50, the annual cost is under £2k – less than what the average family pays for a holiday.

In the end, we are defined by our choices. If you opt not to take out income protection, think carefully about the likely impact on you and your family and their financial security if you were unable to work due to sickness or injury. A useful insight into the challenges faced by disabled workers and their families can be gleaned from the 7 Families project[10]. The important question for those without income protection is, can you afford not to have this protection benefit?