How to choose an income protection policy

Income protection insurance pays you an income if you’re unable to work. It offers reassurance you would potentially be covered for any income shortfall due to a serious illness.

It can be contrasted with critical illness insurance, which typically pays out a tax-free lump sum if you’re diagnosed with certain illnesses or disabilities. It can also be contrasted with life insurance, which only pays out on death.

Our ‘Do you need income protection?’ article can help you decide whether this type of insurance is right for you. If you’re considering income protection cover you’ll have to decide which policy best suits your needs, as they can vary significantly. You’ll also have to decide which particular policy features you want, as each has several options.

Unfortunately, trying to understand the broad range of income protection policies and options can be daunting. And trying to then assess which might be right for you can add to the complexity.

In the end, you may find it simplest to speak with a financial adviser who understands the available income protection offerings and how they might dovetail with your protection needs. But at Schroders Personal Wealth we believe it’s important for people to be as informed as possible before discussing financial planning issues with advisers.

What, then, should you consider when choosing an income protection policy?

Income cover

You first need to decide how much of your income you want to cover. Unsurprisingly, you pay higher premiums for higher levels of cover.

You can usually cover a maximum of around 60 percent of pre-tax income (income before income tax and national insurance). But some insurers offer maximum income levels as low as 55 percent. There may also be maximum income limits, such as £240,000 a year.

Income protection payouts are tax-free. So the monthly insurance payouts could be in line with your monthly net income (after income tax and national insurance have been paid). So, if you want to insure yourself for your net income level, then you should be able to find an income protection policy that can do this for you. If you’re unsure of the income cover you require, an adviser can help you decide the proportion of income appropriate for your circumstances.

Some insurers offer a stepped approach to income levels. You may, for example, get 60 percent of cover for the first £50,000 of annual pre-tax income and 50 percent for anything above that.

Levels of cover

You also need to decide the level of cover you require. There are several levels with income protection insurance.

• Own occupation pays out if you’re unable to perform your own occupation

• Suited occupation pays out if you can’t do your own job or a similar one that matches your skills, experience and qualifications

• Any occupation pays out if you’re unable to work at all.

If you’d prefer to stay in your current type of role, then you may want to choose the ‘own occupation’ level of cover. This is the most expensive of the three levels, but it has the highest chance of paying out.

On the other hand, if you’re concerned about the cost of premiums and you’re flexible on the type of work you do, then you may prefer the ‘any occupation’ level. But it has the highest risk of not paying out of the three options because the insurer could, for example, argue you are able to do a less demanding job.

One thing to note: insurers will assess how dangerous your job is and different policies may assess the same role differently. So you need to know which category your job falls into.

Exclusions

If you have a pre-existing medical condition, or other family members have had a particular medical condition, then you may have to make some choices regarding income cover.

Some insurers won’t cover you for pre-existing medical conditions or for medical conditions other family members have had. Other insurers may cover you for these conditions, but could charge you higher premiums for doing so. Meanwhile some insurers may cover you for these conditions without charging higher premiums.

In general, the more serious a pre-existing condition, the greater the likelihood of it being excluded from a policy or the higher the premiums you may have to pay for cover. If you want cover for a more serious pre-existing condition then you might have to look at a range of income protection policies to find one that’s right for you.

If you’re considering choosing a policy that excludes a pre-existing condition because it’s cheaper, then you may want to ask yourself the following question: how would you feel if the excluded condition led you to have to give up work, but you were unable to make a claim because you chose a cheaper policy?

Insurance premiums and inflation

Inflation measures the rise in the cost of living and, as it goes up, our income needs increase along with it. If you claim on a policy that only pays out a proportion of your current salary, the amount you receive will in time be worth less and less in real terms. On the other hand, these so-called ‘non-indexed’ policies often offer fixed premiums, which means the cost of premiums won’t rise.

In contrast, payouts from ‘index-linked’ policies go up as inflation rises. These payouts are matched to well-known inflation indices such as the consumer prices index (CPI) or the retail prices index (RPI). Premiums for inflation-linked policies generally increase each year, in line with the increase in cover.

Premiums can be cheaper for non-indexed policies than for inflation-linked policies and, in time, the differences could become significant. Even so, if the cost of living has risen substantially when you make a claim on a non-indexed policy, you could end up with a much smaller income than envisaged. You might want to ask yourself if you’d consider this a worthwhile trade-off.

Stepped benefit

It may be helpful to find out whether your employer provides sickness benefits. If, for example, your employer pays you in full for a period and then reduces how much it will pay, then ‘stepped’ income protection could be appropriate.

Stepped policies offer two different levels of payment for two different time periods. You could get a lower payment while your employer is still paying you a higher proportion of your income, which then increases when they reduce the payments.

Waiting periods

Most policies have a ‘waiting period’ of at least a month after you stop work before payments start. But such deferred periods can extend to up to two years.

You could pay lower premiums if you’re comfortable with longer waiting periods. But if you don’t want a deferred period, then you could pay for a waiver through higher premiums.

State benefits

Should illness prevent you from working and you claim benefits such as statutory sick pay, then some insurers will reduce your payouts but others won’t. On the other hand, you could become ineligible for some means-tested State benefits if you can’t work due to illness or injury and are receiving income protection payments.

You may benefit from carefully reading through any income protection policies you’re considering, to see how they treat State support. But you might want to be wary of reducing cover on the assumption you’ll receive State benefits if there’s any uncertainty about your eligibility for them.

In addition, you may also want to consider ensuring the policy you take out has the following features:

• The payouts for an inflation-linked policy would increase with inflation both when the policy is in force and while claiming.

• You would get an immediate payment in full on relapse of illness within six months.

• The policy would pay out a proportion of the full benefit if, as a result of the illness, you have to take a lower paid job.

• You wouldn’t need to notify the insurer of a change of your occupation.

• There would be a waiver of premiums, so you wouldn’t have to continue premium payments when you’re claiming monthly benefits.

As stated at the start of this article, income protection insurance policies can vary widely between providers, and they can use different definitions and exclude different things from their cover. So you might want to carefully read and complete the application to ensure you know exactly what is and isn’t included.

One final point: you generally pay higher premiums for greater income protection cover. But you may want to consider the following scenario: you had paid premiums on a cheaper policy with more limited coverage only to find yourself inadequately covered, or not covered at all, when unable to work due to illness. How would you feel if you found yourself in this situation?

We appreciate that choosing an income protection policy can seem daunting, but Schroders Personal Wealth could help select a policy with the right features for your needs when looking at your financial plan. One of our key principles is to have regular reviews with an adviser, to help ensure your protection arrangements match your evolving circumstances.