Income Protection, 7 things you should know
Income Protection (IP) can be a minefield for financial planners, employee benefit consultants and clients alike so lets try understand it a bit better. Income Protection is a broad term used to describe income disability benefits provided by insurance companies.
Disability policies are derived from the need to protect one's biggest asset, one's ability to earn an income. A benefit of Income Protection vs Capital (Lump-Sum) Disability is that Income Protection provides more certainty around the question of 'how long will my money last?' as the insured amount is based on a percentage of your income.
In simple terms, if you become disabled and meet the claim criteria, you could receive a portion of your income (with potential increases) until you retire (reach the benefit expiry date) thus protecting your income. This differs from Capital Disability where an estimate must be made of the capital amount required to replace your income if you were to become disabled. Often, income protection policies are capped at 75% of net income and in practice some take out capital disability cover in addition to the income protection to supplement the shortfall and to provide capital for lifestyle adjustment costs in the event of disability.
So here are 7 of the things you should know about Income Protection (IP):
1 - Temporary vs Permanent Income Protection
Income Protection payments are paid tax free and most companies offer a Temporary Income Protector and a Permanent Income Protector. Often the Temporary Income Protector allows one to insure 100% of net income and lasts for a maximum of 24 months where the Permanent Income Protector would only allow up to 75% of net income but the benefit lasts much longer (for example, until age 70 when you retire).
There are also other IP benefits available such as Monthly Business Overheads Protector, often payable for 24 months or until permanence of disability is established.
2 - Claim events
When do you qualify for income protection payouts? Well the short answer is that every insurance company and income protection benefit is different with specific terms and conditions, however we can define occupational disability and functional impairment based disability claim events.
With occupational disability, the definitions could either be 'own occupation' or 'own and similar occupation' based definitions with Own Occupation being more expensive and more specific. To elaborate in simple terms, if you are disabled and can't do your job but could do a similar job, you would be paid out on the own occupational income protection benefit but not on the own and similar occupational income protection benefit.
Functional Impairment relates to a medical impairment such as losing both your legs or being paralyzed in a motor accident. Some income protection policies also include payments for critical illness events.
You need to know what you are covered for, is it occupational disability, functional impairment, critical illnesses or a combination.
3 - Reduction of payouts
Most insurers follow a strict aggregation principle whereby they cap income protection payouts. What does this mean? Well in simple terms, if you over-insure yourself (take out more income protection than your actual net income) and you claim, the payout will be limited to a maximum of 100% of your net income (or less depending on the income protection policy). In this instance you would have paid premiums for a benefit you will not receive.
Proof of Loss of Income is an important concept to understand because for you to receive the income protection payouts, certain insurance companies require proof that your disability has caused loss of income. It becomes particularly important for business owners whose businesses may be relatively self sustaining. For example, if such a business owner became disabled and qualified for a claim, it is very possible that the income protection payout could be reduced because of dividends such owner received from the company.
Just a head's up, check the definitions for what classifies as income and remember that some companies waive the proof of loss of income but only for the first two years.
4 - Waiting Periods
Waiting Periods are important. These are the periods of time for which you need to be disabled before you receive benefits and are typically 1 or 3 months. Several companies have also introduced 7 Day waiting periods designed for professionals and self-employed individuals. The shorter the waiting period the more expensive the cost of cover.
Different waiting periods are suitable to different people in different situations. For example, a self employed professional attorney may prefer a 7 day waiting period because he/she works on a hours billed to client basis and by not being able to work, he/she does not earn any income. This would be different to a salaried person with sick leave for example. Such a person may prefer a 1 month waiting period because he/she has a month's paid sick leave.
5 - Premium & Cover Growth Patterns
A Premium Growth Pattern is the rate at which your premium automatically increases each year and can be divided into three main categories. Level Premium Patterns (where there is no automatic premium escalation), Fixed Rate Premium Patterns (where the automatic premium escalation is based on a fixed variable such as a fixed percentage or the inflation rate), and Age Rated/Related Premium Patterns (where the automatic premium escalation is based set percentages which are determined by your age so as you get older premium increase rate changes and often increases).
A Cover Growth Pattern is the rate at which the initial cover selected automatically increases each year. we can separate it into a Level Rate (where the cover amount does not increase) or a Fixed Rate (where the cover amount increases each year based on a fixed variable such as a fixed percentage or the inflation rate).
Your final annual increase in premium amount is a combination of your selected Premium Growth Pattern and selected Cover Growth Pattern.
Premium & Cover Patterns are a very important and in particular when comparing benefit costs. The choice will determine your current premium, rate of increases, future premiums and the overall cost of the cover over the term.
A tip to help you assess benefits is to look for the Break-Even Year (the year at which point the premium of the one premium growth pattern becomes cheaper than the premium growth pattern of the other).
So just because it is cheaper now does not mean it will always be cheaper nor that it is cheaper over the lifetime of the policy. If you save money on the premium now you may end up paying much more later. This is where it is crucial to understand the total increase levied on your income protection policy and to have an approximation of your future premiums so that you can make a more informed decision. Remember different insurers have different increases so different patterns will have different break-even years. However the quotations should provided future premium estimates and if you get confused, get in touch with an accredited financial advisor, they should be able to help you decipher all of this.
6 - If you Smoke, you Pay More.
With Income Protection as with other long term insurance benefits, if you are a smoker, you will automatically pay much more for cover than your non-smoker counterparts. And don't try to hide it from the insurer, in most cases you will have to have blood tests done when taking out cover (they can pick it up in your blood) and some insurers require you to advise them as soon as you start smoking. So if you smoke, you pay more.
Other factors that determine your basic cost of cover are factors such as your Age (the younger you are the cheaper the cover), your Occupation, your Gender (women tend to receive cheaper pricing to men), your Annual Income and your Qualification (the more qualified you are the better the pricing on your income protection policy tends to be). Also, if you are married, your spouse's basic risk details could allow for better pricing of your income protection policy.
7 - The Bells & Whistles
Some insurance companies offer additional 'rider' benefits (the bells & whistles) for their Income Protection benefits. Sometimes the IP benefit may not be comprehensive enough for what you need or sometimes the additional benefits are unnecessary. You pay more for additional benefits and it is important evaluate appropriateness of what is being offer.
In conclusion, Cheaper doesn't always mean better. Different benefits from different insurers have many different nuances and premium/cover growth patterns that affect premium and quality of cover. So understand what you need and why, then consult an accredited financial advisor before taking out income protection cover.
Want to discuss income protection and other financial planning aspects, then give me a call, Warren Basel on 082 490 5182 or email warrenb@oraclebrokers.com to schedule a no obligation, no cost consultation.
