Chapter 05 – Income protection cover

As the name suggests, income protection insurance allows a person to protect their personal income in the event that they are unable to continue working due to illness or injury. This is sometimes known as a ‘temporary disability.’ The word temporary is important: if the worker is permanently disabled income protection policies may not apply. 

The idea is a simple one: if you become sick or injured and you cannot work, then any income you lose can be compensated for by the insurance. 

What income can I insure?

Insurers will typically only allow individuals to insure income that is related to the insured person’s labour. The general term for this is ‘personal exertion’ income. This is the income that will be lost if the insured person cannot work. So-called ‘passive’ income (income from assets which do not require active management, such as shares or investment properties) is typically not insurable. But this is OK, because this income is typically not lost if the insured person cannot work. 

Income protection can be complex. This is because there is substantial variety in the features offered by different providers, and the same insurer may even offer dfferent features to individuals with different types of income. Talk to your adviser about your specific income protection needs. 

How long are benefits paid for?

One of the ways that policies differ is in the benefit period. The benefit period is the time over which the insurer will pay income protection benefits. The standard periods are 1 year, 2 years, 5 years, to age 60 or to age 65. 

As you might expect, shorter periods lead to smaller premiums. This is because the amount that the insurer may eventually have to pay out is lower if the payment period is shorter. 

Waiting period

All income protection policies impose some form of waiting period. This is a period of time that a person needs to be unable to work before a payment will be made.

The minimum waiting period is typically 14 days. Most income protection policies allow people to extend the waiting period beyond 14 days. For example, a person may take up a policy with a 30 day waiting period. If they are unable to work for a period of less than 30 days, then no benefit is paid. If the period off work exceeds 30 days, then benefits start to be paid on the 31st day.

Longer waiting periods reduce the likelihood that a benefit will be paid. This is because people are less likely to be off work for the longer period of time. This means that insurers are less likely to make a payment on a policy with a longer waiting period.

Limits on benefits paid

Income protection benefits are also typically limited to 75% of the pre-disability income. Many insurers take the average income over the two years prior to the illness or injury to calculate pre-disability income. They will then pay 75% of this amount.

Most insurers also apply an ‘absolute’ upper limit. If the absolute limit is $12,000 per month, for example, then this is the most that a person can receive in a month. 

Agreed value or indemnity

The amount insured can also vary according to whether the policy is an agreed value policy or an indemnity policy. In an agreed value policy, the amount of benefit payable will be established at the time of the policy being written (that is, the policty first being implemented). Such policies typically are favoured by people with variable incomes, such as consultants or casual workers whose income may fluctuate across time.

In the agreed value situation, when the policy is first undertaken, the individual must demonstrate that the amount of insurance is realistic. Once the amount has been established, it becomes the amount that will be payable, even if the individual’s income has fallen during the period of insurance. The main parameter is that the change in the individual’s earning must be considered to be ‘normal.’ You can discuss what this means with your financial adviser.  

The under-writing process is longer for an agreed value policy. This is because the income is verified at the time the policy is taken out. This means that the verification happens for the policy even if no claim is made. This means that the insurer needs to verify the income of all of its policy holders, not just the ones who make a claim. This creates more work for the insurer, and the insurer needs to charge higher premiums to pay for this work. 

Alternatively, for an indemnity policy, the insurer only seeks confirmation of the amount being earned at the time a claim is made. Of course, when making a claim, the insured person must be able to prove that the amount for which they insured their income was accurate. If it was not, then the insurer will only pay out 75% of the actual income. (If the income actual income is higher than the amount that was insured for, the insurer will only pay 75% of the amount that was insured). 

Because the work of establishing the actual income only occurs when a claim is made, and most people do not make claims, indemnity policies offer lowered premiums. Indemnity policies can be useful for people with very stable incomes, such as public servants or other employees with secure employers.

If you use an indemnity policy, and your income situation changes (for example, you change or lose your job), you need to let your adviser know immediately.

Who needs income protection cover?

Anyone whose circumstances would be negatively affected by a loss of income should take out income protection cover. This includes people with financial dependants such as mums or dads. But is also includes people with their own financial commitments such as mortgages and other debt.

Essentially, most people should consider income protection cover. The only people who do not need to at least consider this form of insurance are people whose investment income is such that they would not suffer financially if they were unable to work. 

To learn more about Income Protection Cover, please visit the ASIC website here.

Superannuation and income protection

It is possible to take out some income protection insurance using a super fund. The main potential benefit of doing so is that the money used to pay the premium is taken from the insured person’s super benefits. This means that the insured person’s immediate spending power is not affected.

Whenever a client spends money on insurances, this reduces their ability to spend money elsewhere. This is because once money is spent, it is gone. If a client spends superannuation money on insurances, the negative impact on their spending power is deferred to some later point after which they have access to those benefits. Usually, this is after they turn 55. So, a 35-year old client who uses super to pay for their income protection cover will not experience a reduction in spending power until some point in time that is at least 20 years into the future.

For clients with many current demands on their time (raising a family, paying off a home loan, etc), this can be an attractive option. But there are various ‘negatives’ associated with using super to pay for income protection cover. These negatives include:

Limitations on agreed value policies.

In an agreed value policy, the sum insured is established at the time the policy is commenced. In the event of a claim, the amount of benefit payable is subject to the amount that was agreed.

If the cover is held through super, however, there is also a legal restriction on how much money the super fund can release in the event of temporary incapacity. These limits are contained in the Superannuation Industry (Supervision) Regulations (SISR). SISR states that, in the event of temporary incapacity, the following payment can be made:

A non-commutable income stream cashed from the regulated superannuation fund for:

(a) the purpose of continuing (in whole or part) the gain or reward which the member was receiving before the temporary incapacity; and

(b) a period not exceeding the period of incapacity from employment of the kind engaged in immediately before the temporary incapacity.

The effect of this is that the amount that may be paid out is limited to whatever the client was earning prior to their need to stop work – which may be less than the amount of insurance that has been agreed.

This limitation can be especially harsh for anyone who is not working at all at the time they become incapacitated – they cannot claim any benefit at all, as their income was nil immediately before the incapacity.

Limitations on the release of some benefits

Sometimes, an income protection policy will include some benefit payments that cannot be released from a super fund. This means that the fund receives a benefit payment from the insurer – but cannot then pass the whole payment on to the client.

An example is where the benefit payment received by the fund covers a period greater than the actual time spent off work by the client. The full benefit cannot be released to the client, because (as outlined above) a super fund member can only receive temporary incapacity benefits for the actual period of incapacitation.

Loss of some tax benefits

The premium for an income protection policy is usually deductible in the hands of a person who pays their premium on their own behalf. If a super fund can claim a tax deduction, the deduction is limited to 15%, which is the flat rate of tax payable for a super fund. This generally means that the absolute amount of tax relief is greater if the premium is paid outside of super.

To learn more about using superannuation funds to purchase income protection cover, please visit the ASIC website here.

The Dover Group