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Guide to Income Protection

Introduction

All of us worry about different things. In some cases it may be about death, or dreadful diseases like cancer, that cause suffering.

Quite rightly, we want to protect ourselves against such events happening – or at least ensure that should they happen our loved ones will be OK.

Oddly enough, the one thing we rarely think about is how WE would survive financially if something happened, but we carried on living – not just for a year or two but quite possibly indefinitely.

That’s where permanent health insurance, or PHI, comes in. PHI is a bizarrely-named type of insurance. It sounds like some form of medical insurance, but actually pays out an income in the event of an illness that prevents you from working.

It will pay up to 60 per cent of your salary free of tax (or 75 per cent if it is an employer’s policy – but you are taxed on the income) either until you are able to resume work again, or until the plan expires, typically at 50, 55, 60 or 65 years of age.

Like other types of insurance, PHI contracts are agreed for a certain number of years, usually until retirement, or earlier by agreement.

Do you need PHI?

• Almost two million people are sick and disabled and have been unable to work for over a year

• Over 2,900 people begin claiming sickness benefits every day – that is, they go long-term sick

• A working adult is 10 times more likely to be unable to work through ill health than to die before retirement

• One in five people has a chance of being off work for at least three months

• There is a one in six chance of an adult being incapacitated for longer than six months

Before you buy PHI

Check whether you have some form of PHI cover through your employer.

If you haven’t, find out what your employer’s sick payment scheme offers. This is because generally, though not always, PHI policies are timed to kick in after a sickness scheme runs out.

Now you have to decide on the following:

• Decide when you want your PHI to start: this can be at any time from 4 weeks to two years after you become ill, depending on the plan. Many people tend to start payouts as soon as their company sickness benefits end. But the longer you hold out, the lower the cost of monthly premiums

• Choose which type of cover you want. There are three types:

1. Level Cover: Benefits and contributions remain level through the plan term. This is cheapest, but the benefits will be eroded by inflation.

2. Increasing Claim: Benefits increase by five per cent during the course of a claim. Premiums will be extremely expensive at the outset.

3. Increasing Cover: Both benefits and contributions increase by five per cent annually. You are trying to match premiums with income, which is a bit cheaper in the long run.

• Decide how much income you want to protect. The most common rule is that the income paid out by the policy, PLUS any other income from sources such as statutory sick pay, state benefits and any other insurance must not equal to more than three-quarters of your PRE-tax earnings over the previous 12 months

In the case of the self-employed, the insurer will calculate assumed annual income by taking an average of three years’ worth of taxable earnings.

However, the income you receive is free of tax, so you are not as badly off as you think. But, if your PHI is arranged by your employer under a group scheme, then benefits ARE taxable.

• Decide if you need “waiver of premium”. This ensures that your premiums continue to be paid while you remain unable to work – yes, you need to keep paying premiums while drawing PHI. Waiver of premium is worthwhile is you are likely to be off work for a long time – but then again, you don’t know how long you will be off work

• Choose whether you want an “own occupation” or “any occupation” clause. The former means that the policy will pay out if you are unable to do your own job. The latter means it pays out if you cannot do ANY job. For example, the insurer might argue that a former steeplejack who is now in a wheelchair can still work in an office and cut benefits accordingly

As before, the better the policy the more you pay. If you take a lower paid job after a period of illness, you may only be entitled to a portion of your PHI benefit, as the amount received would be based on the ratio of your drop in income to your original income.

• Rehab and hospital benefits are sometimes available as extras, but the small print needs to be checked

Things to watch out for

• Medical evidence is always required. Cover may be more expensive for those in poor health and existing medical conditions may be excluded

• Don’t over-insure: if total income after a claim exceeds 60 per cent of pre-claim income, the policy will not pay out the full amount in the event of a claim. The relationship between benefits and earnings are tested at the time of the claim – which means that policyholder only discovers that they have been paying premiums for useless cover at that point

• Many policies are reviewable. This means that if overall claims history, (not your individual ones, but those of all policyholders), are greater than anticipated, premiums can rise across the board

Companies will buy business with low premiums, only to increase them in later years. Cheapest is not always best.

• There may well be restrictions on working or travelling abroad

How much does PHI cost?

A male aged 45, protecting an income of £20,000 a year, would pay upwards of £50 a month.

Premiums are almost always higher for a woman than for a man of the same age and occupation: statistics show that women are more likely on average to suffer ill health during working ages than men.

Certain occupations may be “loaded” – have an increased premium due to particular working conditions – or excluded altogether.

The self-employed may find it difficult to get maximum cover they need. This is because they have to prove their current earnings and this often means providing accounts, difficult when you spend half your life trying to tell the taxman that your earnings are really very low.

One additional point to note is that cover for self-employed people is usually based on earnings after business expenses and other deductions, but before tax.

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