Income protection insurance is designed to replace your income in the event that you are unable to work through illness or injury, by paying you a regular tax-free income.
There are a number of income protection policies available, offering a range of options over varying periods of time. So if you are interested in taking out an income protection policy, what do you need to know?
What does an income protection policy cover you for?
Income protection policies fall into three different categories:
- Policies to replace a proportion of your lost earnings
- Policies designed to meet specific financial commitments, such as a mortgage and loans
- Policies which provide cover for housepersons
All policies will contain different types and varying levels of cover, so it is important you read the small print and fully understand what you are covered for before buying a policy:
- Own occupation (you can claim if your incapacity prevents you from fulfilling your own occupation)
- Any suited occupation (you can claim if your incapacity prevents you from fulfilling your own occupation, or any other occupation to which you are suited, or defined within your policy)
- Any occupation (you can claim if your incapacity prevents you from fulfilling any occupation whatsoever)
- Activities of daily living (you can only claim if you are prevented from carrying out basic tasks associated with daily living, such as dressing yourself or washing)
- Activities of daily working (you can only claim if your incapacity prevents you from carrying out a selection of work-related tasks, such as walking, communicating, and exercising manual dexterity).
How does the policy work?
As with most insurance policies, you pay your premiums to the insurer and, subject to the conditions of the policy, the insurer will make regular payments to you in the event of a loss of income. Your insurer will usually pay only a proportion of your total income as their payments are tax-free and, of course, they want to encourage you to return to work as soon as possible.
The major issue with any income protection policy is the definition of "incapacity". This term essentially defines the agreement between you and the insurer. A number of definitions of incapacity are used and this varies from insurer to insurer. The Association of British Insurers lists some of the more common definitions.
Whichever definition applies to you will have a bearing on how much you pay in premiums. The difference can be substantial, so check out all your options before committing to a policy.
Types of income protection premiums
There are three types of income protection premiums available: reviewable, renewable and guaranteed.
A reviewable premium means that premiums may start off relatively low, but will be reviewed in the future and may go up every few years or so. In some cases, the premium may be reviewable every year, or every five years, to take into account your changing circumstances.
Renewable premiums are similar to reviewable premiums, but every time the policy comes up for renewal, the premium is reviewed and the amount you pay to the insurer may change.
The nature of guaranteed premiums means that these tend to be more expensive than the other two options, but the premiums are guaranteed for the life of the policy, which may be as long as 25 years. Always check how many years the guarantee is for.
Think about which option is best for you, both now and in the long run. For example, your money may be tight right now, but you may expect your income to rise substantially over the coming years, so it might make sense to go for the reviewable premium option. Similarly, a cheap reviewable rate now might actually end up costing you more in the long-term than a guaranteed premium.
Your insurer or broker should clearly explain to you why a certain premium type might be more appropriate to you than the other options.
Getting the right cover
Getting the right cover is essential. Do not only think about the cost of the policy, but consider how long you want cover for and when you would expect to receive a payout should the worst happen.
Remember, it is not always about getting the cheapest cover. Cheap cover is likely to have many limitations and restrictions on the policy, meaning that when you really need it, the insurer may not pay out. On the other hand, make sure that you build in enough cover to make the policy worthwhile should you need it. Factor in elements such as overtime, bonus payments, or whatever income you receive that leads to the quality of life you currently have. This will give you the best chance of minimising the impact of your loss of earnings for you and for those around you.
Length of cover
Consider the length of cover you require, too. Some cheaper policies can cover you for as little as 12 or 24 months. Others tend to offer five or 10 year fixed cover. Most policies can be periodically renewed until you reach retirement age if you wish.
Type of cover
Think about when you would need the insurer to start paying out in the event of your loss of income as this varies depending on the type of cover you choose. For example, if you are self-employed and your lifestyle will be affected almost immediately if your income stops, you should opt for Day One cover, which tends to pay out weekly as opposed to monthly.
You should also decide whether you want level or increasing cover. Some insurers offer the insurance cover linked to an inflationary index, meaning your cover will rise with inflation. However, most insurers will allow you to renegotiate your cover at any time throughout the policy, while others may want proof that certain outgoings have increased, such as mortgage payments. Regardless of whether you keep your cover at the same level throughout the term, or link it to inflation, it is always worth reviewing every year or so to make sure you are adequately covered.
Don not confuse income protection with other types of insurance
The whole area of income protection and other similar insurance policies can be very confusing, particularly as there are hundreds of different policies available, all claiming to cover a host of similar unforeseen circumstances.
For example, a payment protection policy for a mortgage or a loan is not sufficient for anyone looking for wider income protection. Payment protection policies only cover payments on the product(s) in question and are usually for a more limited period.
Similarly, a critical illness policy, which pays out a tax-free lump sum in the event a listed illness is diagnosed during the term of the policy, does not pay out for every illness like an income protection policy. Issues such as depression or stress-related illnesses would not be covered by critical illness, but would be covered by an income protection policy.
If in doubt, seek professional advice
Whatever your objectives are, make sure you get the right cover for you. If you are in any doubt at all, seek advice from an independent financial adviser.
Some information contained herein may have changed since it was first published. PrimeLocation strongly advises you to seek current legal and/or financial advice from a qualified professional. If you have any queries relating to the content, please email firstname.lastname@example.org.