Income protection insurance

Income Protection Insurance (IPI) is an insurance policy, available principally in Australia, Ireland, New Zealand, South Africa, and the United Kingdom, paying benefits to policyholders who are incapacitated and hence unable to work due to illness or accident. IPI policies were formerly called Permanent Health Insurance (PHI).

History

The original provider for this type of insurance is the Original Holloway Friendly Society, based in Gloucester. It was founded in 1880 by George Holloway.

Relevant concepts

• Incapacity will be defined on one of the following four bases:
  • Own occupation – the policyholder is incapacitated if they are unable, following illness or accident to perform their own occupation and are not working in another job.
  • Suited occupation – the policyholder is incapacitated if they are unable, following illness or accident to perform an occupation suitable to them given their education and training etc.
  • Any occupation – the policyholder is incapacitated if they are unable, following illness or accident to perform any occupation at all.
  • Activities of daily living (ADLs) – the policyholder is incapacitated if they are unable, following illness or accident to perform a number of defined functions such as dressing and undressing, washing, eating, climbing stairs, shopping, cooking etc. The policy will define the number of functions and their definitions.
• Benefit limits – nearly all policies limit the benefit payable to some percentage of the policyholder's normal earnings. The limit is usually around 70% of gross earnings, but could be less for high earners. Any state benefits payable may reduce the maximum benefit and benefits from any other policies may also reduce the maximum.
• Deferred period – the deferred period is the time between a valid claim and the commencement of benefit payments. The deferred period chosen has a significant influence on the cost of a policy (see below).
• Proportionate benefit – to encourage the return to work of a policyholder recovering their health, many life offices offer to pay a reduced benefit if the policyholder takes a part-time or lower-paid job after recovering their health.
• Free limit – the IPI policy will be only be valid while the policyholder is permanently resident in the area defined in the policy. The area will be at least the UK, probably the EU or Western Europe and could include the United States and other developed countries. Most policies will allow holidays and temporary residences outside of these areas.

Product features

Benefits

Income protection insurance policies offer a number of benefits in comparison to other insurance policies such as accident, sickness and unemployment insurance or personal accident and sickness (PAS):

• Benefits are payable when the policyholder becomes incapacitated and after the deferred period has passed and continue until the earliest of death, recovery of health, retirement or the term of the contract.
• Benefits are paid regularly (usually weekly or monthly) and may be free of tax.
• The insurance company cannot cancel or refuse to renew the policy provided that the policyholder continues to pay the premiums.
• A waiver of premium option may be provided whereby premiums for the IPI policy are not required while benefits are being paid from the policy, but the policy cover continues as normal.

Restrictions

There are a number of restrictions that can affect a policyholder's eligibility for income protection insurance:

• The policies do not pay out if the policyholder becomes unemployed for a reason other than illness or accident.
• The deferred period is usually quite long, often a minimum of 4 weeks but perhaps as long as 52 weeks. Premiums decrease as the deferred period increases.
• There are a number of exclusions which apply to most policies, so that no benefits are payable for accidents or illness arising from events such as drug or alcohol abuse, criminal acts, intentional self-harm, wars and pregnancy.
• Due to the benefit limits, the maximum regular payment is usually restricted to prevent moral hazard – if the benefit exceeds the policyholder's income they have a reduced incentive to return to work once their health recovers.
• On change of occupation (or unemployment) of the policyholder the policy may become invalid, or the life office may require the premiums to be changed to reflect the new risk.
• For individual policies, as the benefits paid are not taxable income, the tax relief available to the policyholder may be reduced so, for example, tax relief on pension contributions is no longer available.

Product variations

In addition to standard fixed-premium Income protection insurance policies there are a number of variations available from some life offices:

• Renewable IPI – renewable policies give the policyholder a right to renew the policy, possibly with an increase in cover, at a set period (often 5 years), based on the prevailing premiums for a person of their age and occupation. Premiums will initially be cheaper than a fixed IPI policy but will then increase each renewal as the policyholder gets older.
• Reviewable IPI – the term of a reviewable IPI policy will be the same as a fixed policy, but the premiums will be reviewed (and almost invariably increased) by the life office every few years, based on its general rates (not based on the health or claims of the policyholder). Initial premiums will then be cheaper than for a standard policy.
• Increasing IPI – the value of the benefit payable by a fixed-benefit policy is eroded over time by inflation so policies whose benefits increase are often more suitable. The benefits may increase at an indexed rate (such as the Retail Prices Index), a fixed percentage or by a percentage chosen by the policyholder every few years. For such increasing policies, premiums usually increase as well.
• Unit-linked IPI – other IPI policies have no investment element and hence no surrender value, however a unit-linked policy has an investment element similar to unit-linked life assurance policies. Premiums will normally be more expensive than standard policies due to the investment element, and could be still more expensive if the return on the invested premiums is poor.
• Group IPI – employers may provide a group IPI policy for their employees. For group policies a maximum payout period may apply and the policy will expire if the employee ceases employment with the employer.

Suitability and need

• IPI policies meet the general need of wage earners to protect their income against the inability to work due to accident and illness. The level of state benefits provided (such as statutory sick pay (SSP) and incapacity benefit) usually falls well below the income of average earners, so additional insurance is required to make up the difference. If a policy is purchased it is usual for the term of the policy to last until the retirement age of the policyholder. For those not working such as parents caring for children, a policy paying out based on ADLs is appropriate as the definitions for incapacity based on occupation may not be relevant.
• IPI policies are not suitable insurance against unemployment in general as benefits are only paid if the unemployment arises due to incapacity. An accident, sickness and unemployment insurance policy or Mortgage Payment Protection Insurance may be needed as an alternative or to complement the IPI policy.
• IPI policies do not provide health insurance, death benefits or critical illness cover, so health insurance and/or life assurance and/or critical illness cover may also be needed by the policyholder.

The choices involved and the potential for confusion and buying the incorrect product means it is considered essential that consumers consult an Independent Financial Adviser (IFA).

Pricing

IPI policies are relatively expensive due to the guarantees offered by the policy. However, premiums decrease as the deferred period increases and choosing a 'suited occupation' or 'any occupation' option over an 'own occupation' will likely reduce the cost of the policy. In 2014, some insurers launched a new variant called as "Guaranteed Age Rated". In this option, the pricing will go up as the policy holder gets older, but the pricing term i.e. by how much the premium is guaranteed on basis of a table that is provided at the inception of the policy.

Taxation

Premiums paid by employers to provide cover for their employees are tax-deductible as a business expense and are a taxable benefit to the employee. Benefit payments paid from the policy, following an accident or illness affecting the policyholder, are free of income tax and National Insurance contributions for individual policies. For group policies, benefits are paid as taxable and NIable earnings.

Regulation

IPI policies are classed as long-term insurance and are regulated by the Financial Services Authority (FSA) under its Insurance Conduct of Business Sourcebook (ICOBS) rules.^[1] This requires the issuing insurance company to keep records of the contract for a minimum of six years, and the policyholder has a minimum of 30 days to cancel the contract. If cancelled, the policyholder is entitled to a full refund of any premiums paid.

In Australia

Income Protection in Australia is designed to provide replacement of income to individuals who are unable to work due to illness or injury. Income Protection in Australia will generally replace up to 75% of a person's gross income. The majority of policies offered in Australia will provide benefits if a person is unable to conduct their own occupation, even when a policy is held within superannuation. There are however some high risk occupations where, if policies are available, they are offered on an 'any occupation' basis, either immediately on claim, or after an 'own occupation' claim period. Income Protection is available to employees and the self-employed, with greater importance held on the latter as the self-employed are generally not eligible for Workers' Compensation.^[2]

There are a number of options available under income protection policies and the ability on a person to receive claim payments will depend on the options taken at application. These include:

• Waiting Period - the length of time from date of illness or injury that a person needs to be disabled prior to benefit entitlement. The waiting periods available include, 14 days, 30 days, 60 days, 90 days, 180 days, 1 year and 2 years. The longer the waiting period the cheaper the premium.
• Benefit Period - the maximum length of claim per event. The options include 6 months, 1 year, 2 years, 5 years, until age 65 and until age 70.

Insurers generally offer different levels of policies with varying inclusions and depending on options taken, premiums can vary significantly.

Risk assessment

Income protection is normally underwritten at application. Underwriting includes medical risk and also business and income risk. An application needs to provide medical history along with occupational information and history. An insurer can either increase a premium or apply an exclusion or limitation if an applicant presents a higher insurable risk.

An applicant also needs to substantiate income. When income is substantiated at application, any future benefit is normally 'agreed' with no further medical evidence required at claim. If no financial evidence is provided at application, income needs to be substantiated at application with the possibility of a lower claim benefit being payable if the claimant cannot confirm the income that was originally applied (indemnity).

Taxation

Income protection is generally tax deductible to individuals, however claim payments are considered assessable income for taxation purposes .^[3] Insurers rarely withhold taxation amounts and as such, individuals on claim need to keep funds aside in order to meet future taxation obligations.

In the UK

Deadline to the Breadline

A study by British insurer Legal & General, entitled Deadline to the Breadline Report 2014, found that only 8% of UK households have income protection insurance.^[4] This is despite the 29 days the study reports that it would take before the average UK household, if solely relying on savings and state benefits, would be unable to survive financially. This research aimed to highlight the help income protection insurance can provide, as well as the precarious position many UK households are in financially.

7 Families

Further work to bring the topic into the public domain appears in the 7 Families project.^[5] This charity-led campaign is providing seven people in the UK who have lost their income because of a serious or long-term illness, injury or disability with a tax-free income for one year. The campaign is documenting the effect this income has on their family life as well as the value of independent living support, rehabilitation and counselling, this educational approach receiving backing from groups like Disability Rights UK.^[6] The charity project aims to raise public awareness of the financial impact of a long-term illness or disability and is supported by a number of financial providers including Aviva, Friends Life and Zurich.

References