Insurance primer: Income protection (Part 1)
- The ability to earn income is many peoples' main asset
- If losing this ‘asset’ would be devastating, IP insurance is critical
- We highlight the features of a good policy
Insurance policies come in all shapes and sizes and can offer many different features, benefits and prices. They can be scaled back to be low cost or scaled up to offer more comprehensive cover, so it’s vital to shop carefully and read the policy documents – especially the exclusions.
A fundamental requirement of any policy is that it meet your needs; don't sign on the dotted line until it does. While we recommend talking to an adviser to ensure you understand the coverage and the long-term costs, this article (and the other articles in this series) guides you on what to look for if you go it alone.
So how do you compare one cover against another and choose a decent policy?
Firstly, you need to focus on the features of each policy. For most types of insurance, there are some essential (core) benefits, which should be non-negotiable, some benefits that are ‘nice to have’ and others that simply add the bells and whistles.
In this article we’ll focus on income protection (IP) insurance and outline the ‘core’ features you should look out for, plus some of the bells and whistles.
Why take out income protection insurance?
When you ask someone what insurance policies they have, the most common answers are home and motor vehicle insurance. Why? Because the bank providing your mortgage insists on the former and the latter is often compulsory. In any event, we’ve become conditioned to taking them out.
But it is your ability to work and earn an income that is your main asset (your human capital) and this enables you to own and maintain those other assets. Without an income, it would be hard for many of us to keep our house and cars while still providing for the other living expenses of our families.
The prospect of long-term disability, causing inability to work, is so unimaginable that many people simply choose to put it in the ‘too hard basket’. It’s human nature to hope that nothing bad will happen.
Unfortunately for some, relying on hope to protect future earning power, won’t stand up to the reality test. Instead, you should consider a decent income protection (IP) or salary continuance policy that provides enough replacement income to enable you and your family to maintain your existing lifestyle if you ever need to recover from injury or illness that keeps you off work.
Remember, there’s a personal choice to be made here. Some people won’t want their current living standards to drop. However, others will accept lower living standards in the event of the unexpected and will simply look to be able to cover the bills. The trade-off is lower premiums.
Below we’ve set out the core features of an IP policy and the standard of features a good one should provide. A good policy will be very clear about what’s covered and you should be careful of those that sound good but are relatively cheap. These often have a sting in the tail with ‘pre-existing illness’ or ‘injury exclusions’ that are so broad the policy becomes next to useless.
What are the ‘core features’ you need to look for?
1. ‘Own occupation’ vs ‘any occupation’
An ‘own occupation’ policy pays out if you’re unable to do your own job. But an ‘any occupation’ policy will only pay out if you can meet a stricter definition: you cannot continue any form of work for which you could reasonably be expected to do based on your education, training and experience.
A good policy will offer an 'own occupation' cover option (although remember that ‘own occupation’ cover isn’t available on policies taken out through your super account).
If you want 'own occupation' cover but the cost of holding it completely outside super is prohibitive, you can consider a 'super link' policy. This approach has you holding 'any occupation' cover inside of super and a linked 'own occupation' policy outside of super. If there's a claim, the insurer will first seek to pay out under the super policy, but if it can't, you get paid under the policy held outside super.
Insurance companies group occupations into classes based on the risk of being unable to work. If you are in a riskier occupation, some insurers may only offer you a less generous definition of any occupation disability. In fact, there are some occupations where there are very few providers who will offer you cover at all. Unless you know which insurer to go to, you may need to involve a specialist broker.
2. Three-tier disability definition
There are a wide range of disabilities, and some policies offer a ‘three-tier’ disability definition. This means you don’t have to fit a particular definition of disability.
A good policy will offer you three pay-out scenarios (and the ability to make a claim under any one).
The three definitions of disability typically used are:
- Duties-based. This is the industry standard and works best for PAYG employees. The criteria used are based on your ability to perform the normal duties of your occupation. Once this criteria is met, the partial or full disability payment is based upon an income-based formula: ([Pre-disability income – Post-disability income] DIVIDED BY [Pre-disability income x Monthly Benefit]).
- Hours-based. The criteria used are based upon the number of hours you can spend at your place of employment. Many definitions include a ’10 hour clause’ that will allow you to return to work for up to 10 hours and still receive a full total disability benefit. This definition typically works best for self-employed individuals. They often have an inconsistent earnings pattern, where income may be received later for a job that was performed prior to the disability.
- Income-based. This definition is often important to self-employed individuals who may be performing some administrative tasks, but are unable to perform more strenuous physical tasks associated with their occupation due to illness or injury, and as such are not earning an income. Under this definition, regardless of how many hours you work or how many duties you can perform, as long as you are still suffering an injury or illness and there has been a reduction in your income, then you are entitled to a benefit. You are often allowed to earn up to 20 per cent of your pre-disability income while on full benefit.
3. Stepped vs level premiums
Level premiums are agreed upon when you start a policy and fixed throughout the term of the policy (unless you change the term or benefits of the policy). Stepped premiums are based on your age and increase substantially over time.
A good policy will offer you the choice between stepped and level premiums.
Stepped premiums are suitable in some circumstances (such as cover for a limited time period when you are managing a large loan) but for those planning on holding a policy over the long term, level is usually the best option. A quote will typically include a comparison of stepped and level premiums over 10 to 20 years and you can see the breakeven point to decide your preference.
4. Agreed value vs indemnity
‘Agreed value’ is where you establish the benefit amount at the outset of the policy. In order to establish the amount of benefit your policy will pay, you need to provide evidence of earnings and any other sources of income up front. An ‘indemnity’ policy will only pay out based on your earnings immediately before your claim.
A good policy will offer you the choice between agreed value and indemnity.
If for any reason you feel you may make a career change that would result in lower earnings (for instance, accountant to farmer) then it may be wiser to lock in the agreed cover now when you can show regular income rather than hope that you haven’t had a bad year before a claim on an indemnity based policy. However, if you are pursuing a steady career then indemnity cover with indexation is likely to be sufficient.
5. Waiver of premium
A waiver of premium ensures that if you have a claim and are unable to work due to illness or injury, your insurance premiums are waived and cover continues without you having to fund them.
A good policy will include a waiver of premium automatically (or, at the least, as an option).
6. Benefit flexibility
Some policies will allow you to increase or decrease the amount of your benefit (cover) if your circumstances change, with minimum additional paperwork.
A good policy will include the ability to increase or decrease the benefit.
If you increase the benefit, you may have to provide additional medical evidence, but a really good policy will allow some basic ‘hassle free’ increases for life events (for example, taking out a mortgage or having kids) without the need for a new underwriting process.
Indexation is the ability to have your cover (benefit amount) increase each year in line with an index (such as the consumer price index) or a fixed percentage, so your benefit maintains its buying power as time passes. This reduces the effects of inflationThe gradual decline in the purchasing power of money over time. Alternatively, the general rate at which prices increase over time. In Australia inflation is typically measure by the Consumer Price Index (CPI). on your cover amount.
A good policy will provide the option to index your benefit.
Ideally, your policy will allow you to decline the indexation for a number of years, but still retain the option to accept it in at a later point. However, some (policies) will only let you decline the option once and then never offer it again.
8. Exclusions and restrictions
Your policy should clearly state what is excluded and what restrictions are on the cover. This enables you to see what is and isn’t covered and enables you to compare alternatives.
A good policy will offer the option to avoid exclusions/restrictions.
Removal of exclusions or restrictions may require you to provide further details or undergo a medical examination or test. Some insurers will offer to review your exclusions and restrictions in 18 to 24 months and if you receive one, (or a loading on your premium) you should ask about the circumstances under which it would be removed.
That’s the core features of a good IP policy. However, there’s a range of ancillary features that should be included or offered as an option within good policies. You can see them in the following table.
Let’s turn now to the tricks and traps when looking at IP policies.
Tricks and traps
Firstly, it’s crucial to choose a policy to suit your occupation and circumstances. ‘Own occupation’ cover may be essential for a mechanic or plumber who dreads the idea of having to take a desk job, but ‘any occupation’ cover may be sufficient for an office administrator.
Circumstances can change, so you want a policy that can be flexible and that is updated to suit your needs as you progress through your career and family life cycle. Some insurers now offer guaranteed upgrades where their existing policies are automatically upgraded with new features as the insurance market develops (so you avoid being left with an inferior policy).
If you’re on an employment package that includes fringe benefits (for instance, a car allowance) make sure they’re included in the benefit calculation. You should also note that if you have other continuing income, or payments from separate insurance, these might reduce the benefit you receive in the event of a claim.
Finally, some cheaper policies on the market use a definition of ‘Total Assessable Income’ when calculating the benefit in the event of a claim. So they may reduce any benefit by the amount of any dividend or rental property income even though this is not income from employment.
This is a sneaky way of charging for higher sums insured but only paying out lower amounts at claim time. The claim benefit should be based on your total employment income package only.
Choosing your insurer
There are many insurance companies offering a range of IP policies in Australia. It’s essential to make sure that whatever policy you purchase has clearly worded and flexible core benefits, as over 90 per cent of claims will be for standard illnesses and injuries.
Good insurers will pay claims quickly while others will look for a reason not to pay. Larger, more established, brands have more to lose with their reputations so they tend to play by the book. Liam tends to stick with the likes of AIA, AMP, Asteron, CommInsure, Macquarie Life, MLC and TAL, for his clients.
Many low-cost policies have pre-existing condition exclusions, some of the traps noted above, and work to deny claims wherever possible. Make sure you’re aware of their limitations before signing on the dotted line.
The next question you’ll face when taking out an IP policy is whether you should do it inside or outside of super? We’ll tackle this in Part 2 (a Premium Member article), to be published shortly.
Liam Shorte is a principal of Verante Financial Planning Pty Ltd (www.verante.com.au), a corporate authorised representative of Magnitude Group Pty Ltd (AFSL 221557). This article is a general information article and to the extent it contains any financial advice it is general advice only. We recommend seeking personal advice on your own circumstances.
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