Income protection insurance pays you a benefit in the event you cannot work to earn your regular income due to sickness or injury. Is this insurance worth having, what do you need to look out for and how can you get the best value for money?
Insuring your million-dollar asset
Without a doubt, most people’s most valuable asset is their ability to earn an income. The aggregate present value of an average professional’s after-tax earnings from age 25 through to age 60 is estimated to be over $3.5 million (i.e. add up all after tax earnings and express it in today’s dollars which excludes inflation)! I’m sure you agree that this is an extremely valuable asset.
The interesting thing is that although the clear majority of people insure their car against loss or damage, significantly fewer people insure their income. If your uninsured car were destroyed, it might take you a couple of years to recover financially. However, compare this to losing your income for an extended period. Perhaps you would never fully recover financially from such a loss.
Unlikely but the consequences are significant
While we hope the likelihood of losing our ability to earn an income for an extended period is extremely low, the financial impact of it occurring is massive.
The predominant concern or risk is long-term incapacity. That is, if you broke your leg and couldn’t work for eight weeks, financially, you would probably recover in a relatively short period of time – you hopefully have some savings, sick leave, annual leave and family to help. However, if you were involved in a car accident and couldn’t work for the next seven years, it’s very likely that such an event would put a big dent in your financial plans. Long-term incapacity has a severe financial impact – we don’t need to be too concerned about short-term incapacity.
Most financial strategies are dependent upon our ability to contribute a regular amount from income towards our investments. In the absence of these regular contributions, most financial strategies would fail. Therefore, this is a key and fundamental risk that must be considered.
Key features of income protection insurance to be aware of
Income protection provides cover in case you cannot perform your usual occupation as a result of sickness or injury. Income protection policies usually pay a monthly benefit for a specific period of time – called the ‘benefit period’ – usually until age 65 (although cover inside super often only pays a two-year benefit). Importantly, income protection does not cover you for involuntary unemployment (such as loss of job or redundancy).
The payment of an income protection benefit allows you to continue to afford to pay for living expenses and financial commitments, and you are able to insure up to 75 per cent of your gross income. (Providers restrict coverage to this level to provide a financial incentive for people to recover and return to work.)
Most income protection policies will have a ‘waiting period’, which is the amount of time you need to be incapacitated for until you can claim a benefit. Waiting periods usually range from 30 days to 280 days – so this is an important aspect to check before signing up.
Income protection insurance premiums are almost always tax-deductible.
Two contract types… make sure you get what you’ve paid for
Insurers typically offer two types of insurance contracts: indemnity or agreed value:
- Indemnity contracts require you to prove the amount of income you were earning before you became incapacitated at the time of claiming a benefit.
- Agreed value contracts are financially underwritten when the insurance contract is established – and, therefore, you don’t need to prove your income when you make a claim.
I recommend agreed value contracts because at least you will get what you pay for. For example, if you have an agreed value contract that provides for a $10,000 per month benefit payment but your pre-disability income had gone to, say, $5,000 per month, you will still receive the full $10,000. However, under an indemnity value contract, you would only receive a benefit of $5,000 per month – even though your past premiums may have been based on a much higher level of cover.
Cover inside super is NOT recommended
A lot of people have income protection insurance inside their super fund, but this is not recommended (unless it’s a split policy). The problems with cover inside super include:
- agreed value contracts are not available by law (as they don’t comply with the superannuation laws);
- superannuation polices rely on a ‘duties’ definition only (more about the benefit of a three-tiered definition below); and
- Partial incapacity and rehabilitation benefits are severely limited inside super which can leave people unprotected under certain events.
In short, income protection policies held inside super provide very basic cover.
Selecting an insurance provider
When it comes to comparing and selecting insurance products the following three considerations need to be balanced:
- the cost of cover (that is, the annual premium net of any tax deduction)
- the quality of cover (more about this below)
- the quantum of cover (the amount of benefit insured).
Two of the three considerations (cost and quantum) are self-explanatory. The quality of cover, however, is a very important consideration – arguably, the most important of the three. The quality of an insurance product essentially refers to a product’s depth of cover. This means that if you need to make a benefit claim, a high-quality product will maximise your chances of having your claim approved by the insurer.
The quality of the policy is critical to understand
Perhaps this is best explained using an example. All income protection insurance policies will include a definition of what constitutes ‘partial incapacity’ (that is, if you are still able to work but not at 100 per cent). A very basic income protection product will typically have a one-tier definition (duties only – see the following list). However, a good quality income protection policy will have a three-tier definition.
A three-tier definition is important
A three-tier definition means that you can prove that you are partially incapacitated by fulfilling any one (or all) of three tests, which typically include:
- Duties definition: You can claim a benefit if you become unable to perform one or more income-earning duties due to sickness or injury.
- An hours worked test: You can claim a benefit if you are unable to work your usual hours. If you are unable to work more than 10 hours per week, an insurer will normally consider you totally incapacitated. However, if you are returning from injury or sickness, you might not be able to work a full week but might want a staged return to work where you work more than 10 hours per week. A good quality policy will provide for this.
- Loss of income test: If due to sickness or injury your income has dropped by 20 per cent or more, you can claim a benefit. This will suit people who are paid on commission or are self-employed. They might still be able to perform their duties and work 40 hours per week, for example, but their volume of work has diminished. Therefore, this test will be handy.
This is only one example of how the quality of a product influences its value. Of course, insurance products are complex and include many different clauses and tests. Therefore, it is important to get professional advice to ensure you know what you are paying for. The good thing is that, unlike with most other things in life, the better-quality products are often the lower cost options, and you rarely need to pay more to get more when it comes to insurance. This is because insurance providers target certain occupations.
Tips to reduce the cost of cover
Insurance is relatively cheap when you are young. Not only are premiums low, but the amount of cover is substantial because you are many decades away from the contract end date – which is typically age 60 or 65. Obviously, as you get older, particularly in your forties and fifties, the cost of insurance begins to escalate, and it might become important to look for ways to reduce this cost. Reducing cover is often a better response than cancelling cover in totality. Here are a few tips:
- The premium for a 90-day waiting period can be often half the cost of a premium with a 30- or 60-day wait period. Therefore, if your income protection insurance is costing too much, increasing the wait period might be a good way of reducing the cost of cover.
- Having some cover is better than none at all, so another way to reduce the cost of insurance is by reducing the benefit amount. Insuring your full income, for example, is not always economical or appropriate. Therefore, some compromises need to be made in order to achieve a more sustainable cost of cover.
- It is possible to establish comprehensive cover as a split policy which means that most of the premium is paid from your super fund and then a smaller proportion, say 15% to 40% of the premium is paid personally. This minimises the impact on your personal cash flow.
- Seek advice from a reputable, non-aligned adviser – that is, one who is not owned by a bank or insurance company. A non-aligned adviser should be able to compare all risk insurance providers in Australia and identify the most appropriate provider for you, at the best price.
Let us help
If you need assistance with reviewing your insurance cover and understanding if it is appropriate, please contact us here. You will quickly appreciate that we employ a very balanced approach toward insurance advice – a consultative process to help you discover how much cover you feel comfortable with.
