Chapter 12 – Calculating the Sum to Insure – Income Protection

In terms of the amount to insure, income protection is often quite simple. The figure of 75% of gross employment income is the industry standard. Employment income is the income that is lost when a person becomes unable to work. This does not include passive income like rent or dividends.

Most policies have an upper limit on the amount that can be paid under a claim. This can be as low as $10,000 per month (implying a cap on insurable income of $160,000 – 75% of this is $120,000 a year, or $10,000 a month) or as high as $60,000 per month (implying an insurable income of $960,000).

So, in terms of selecting the amount to insure, most advisers simply select 75% of the client’s gross income, up to the limits for the particular policy.

Affordability

As with life cover and TPD, affordability of the premium is a key factor in determining whether a recommended policy is in the client’s best interests. The premium for an income protection policy is affected by factors other than the amount insured. There are two other major variables that affect the premium: the waiting period before payments will be made and the period over which payments will be made (the benefit period). Lengthening the first period and shortening the second will both reduce the premium.

Typically, income protection is taken out in conjunction with other forms of insurance, especially life cover and TPD. Therefore, when considering affordability, the ability to pay for other insurances should be factored into the affordability decision. For example, a reduction in the premium for income protection may allow a person to increase the sum insured for life and TPD.

Waiting period

Typically, waiting periods for income protection are divided into the following brackets: 14 days, 30 days, 60 days, 90 days, 180 days, 365 days or 730 days. The idea is simple: in the event that a person becomes injured or ill and cannot work, they cannot make a claim for the chosen waiting period. The longer waiting periods are therefore associated with longer-term illnesses.  Longer-term illnesses are less common than shorter-term ones – every longer-term illness is also a shorter-term one, but not every shorter-term illness becomes a longer-term illness. So, the likelihood of the insurer having to pay a claim for a longer waiting period is lower. This allows the insurer to charge a lower premium for a longer waiting period.

There is no particular method for selecting the waiting period for an income protection policy. That said, there are some general principles that can be applied. The first of these is to factor in a client’s sick leave entitlements. Most policies date the start of the waiting period from the date of an accident (if the person cannot work due to injury) or the date of diagnosis (if the person cannot work due to illness). Many clients decide that it makes sense to use their sick leave entitlements first before turning to benefits, and so they choose a longer waiting period. In addition, many insurers insist that sick leave entitlements be used before they will pay a benefit, meaning that there is no point in insuring with a waiting period shorter than the sick leave entitlement anyway.

 In many cases, sick leave accumulates. That is, employees are able to ‘carry forward’ unused sick leave from one year to the next. For example, members of the Victoria Police are entitled to 15 days of paid sick leave a year. These days accrue if unused, meaning a member who has not taken a day off sick in five years will have 75 days available to him or her. These are working days, so this equates to 15 weeks, or 105 actual days. A client who has accumulated a large number of sick leave days can obviously afford to extend the waiting period on their income protection. That said, if the client then uses some or all of their sick leave they may need to re-visit the issue of their waiting period.

The next principle is to decide the extent to which a client can self-insure. Many clients can cope with some period off work, relying on things like savings, equity or the assistance of family and friends. Simply put, the greater the potential to self-insure, the longer the waiting period.

Another factor that should be considered is whether the client also wants to make use of trauma insurance. While the criteria for trauma insurance are not exactly the same as those for income protection, meaning that an event might occur that would trigger a payment for one but not for the other, there is considerable overlap. So, clients might choose to combine a trauma policy with a longer waiting period for income protection, hoping that any illness or injury that they experience is of the kind that will trigger a payment on the trauma cover. These clients might also receive the additional benefit of receiving a payment following the trauma insurance event even if they did not lose employment income due to the event.

Another factor to consider is whether the client would benefit from more than one policy, with one policy providing a small amount of cover on a short waiting period and the other providing a larger amount of cover with a longer waiting period. Often, the shorter waiting period can be held within a superannuation fund, which reduces the burden on cash flow and can therefore make the overall premiums more affordable. (The client still pays, and will experience lowered superannuation benefits as a result, but the payment is made out of inaccessible benefits and thus contemporary cash flow is not affected).

The benefits of this arrangement are sometimes marginal, however, especially when the tax benefits of income protection are factored in. A worked example is shown below.

In addition, taking multiple policies requires careful consideration both of the terms of each policy and also the way in which these policies interact. Benefits received under the first policy may impact on the benefits that become payable on the second. Advisers need to ensure that the two policies are appropriate for the client both separately and in combination.

Benefit period

Clients can also adjust the period over which the insurer will pay benefits in the event of a claim. The typical benefit periods are two years, five years, to age 60, to age 65 or to age 70. As the description of these last three types suggests, they will pay a benefit until the recipient reaches the particular age.

Shorter benefit periods lead to smaller premiums. This is for the obvious reason: the amount that the insurer will need to pay out is lessened when the benefit period is shorter.

Again, there is no particular method for selecting the benefit period. A judgement needs to be made. The main factor to include in the judgement is the client’s capacity to self-insure. The greater this capacity, the greater the client’s ability to take a shorter benefit period. Higher assets and the availability of non-employment income increase the ability to self-insure.

Another factor is the potential for the client to access retirement benefits. Superannuation benefits typically become available at the age of 60, meaning that a client with substantial superannuation benefits might choose to not insure their income beyond the age of 60. Alternatively, a client might become eligible for Centrelink’s aged pension at the age of 65. If they could live on this amount, there might be no need to insure their income beyond the age of 65.

A third factor might be the availability of TPD insurance. A client might decide to insure their income for a fixed period of, say, five years in the expectation that any illness or injury that lasts longer than that is likely to be permanent. Once again, the definitions used to define TPD and a qualifying illness or injury are not the same, and so advisers looking to use a blend of insurance types need to ensure that the policies recommended are compatible.

Examples

The following list of examples use the situation of Mithali, a 42 year old woman earning $75,000 a year. The examples are intended to illustrate the way in which changing one or more variables impacts on the insurance premium that applies. They are not intended to be used as templates for how advisers should structure insurances. Each client requires individual structuring.

Each example compares a ‘standard’ income protection policy (30 day wait, 75% of income, stepped premiums, payable to age 65) with various alternatives.

The examples are current as at February 2016. Choice of insurer is random and should not be seen as a recommendation of that insurer.

Longer waiting period

An income protection policy with Asteron will cost Mithali $2,285 a year (for the first year of a stepped premium) for a 30 day waiting period and benefits payable until the age of 65. She pays tax at 30%, and the premium is deductible, such that the after-tax expense is effectively $1,600.

If Mithali instead chooses an income protection policy with a 90 day waiting period, the premium drops to $1,236, or $865 after tax. This is a reduction of $735 after-tax. In the event of a claim, this would cost Mithali $9,375 pre-tax in potential benefits (being the maximum benefits payable between day 31 and day 90 if she had taken a 30 day waiting period). So, Mithali saves a guaranteed $735, and gives up an after-tax benefit of no more than $9,375 (less if the illness lasts less than 90 days).

Mithali could use the money saved to increase her other insurances.

Combination of policies

An income protection policy with Asteron will cost Mithali $2,285 a year (for the first year of a stepped premium) for a 30 day waiting period and benefits payable until the age of 65. She pays tax at 30%, and the premium is deductible, such that the after-tax expense is effectively $1,600.

Mithali decides to investigate using her super fund (REST Super) to provide income protection for a period of up to two years for an insured amount of $2,400 per month. The premium for this is $728 per year, payable out of her superannuation benefits. She then takes out a separate policy with Asteron for the fuller amount of 75% of her income with a waiting period of two years, payable to age 65. The first year premium for this policy is $1,061. After-tax, this is $742. Overall, this strategy improves her after-tax cash flow by $858 per year, while reducing her retirement benefits by $728 per year.

However, in the event that she is ill for more than two years, this combination of policies will have cost her $55,200 before tax, being the difference between the benefits payable under the 30 day waiting period and the benefits payable given the combination.

Mithali decides that the amount saved is insignificant compared to the benefits she passes up and sticks with the 30 day waiting period.

Combined trauma with a longer waiting period

An income protection policy with Asteron will cost Mithali $2,285 a year (for the first year of a stepped premium) for a 30 day waiting period and benefits payable until the age of 65. She pays tax at 30%, and the premium is deductible, such that the after-tax expense is effectively $1,600.

If Mithali instead chooses an income protection policy with a 90 day waiting period, the premium drops to $1,236, or $865 after tax. This is a reduction of $735 after-tax. In the event of a claim, this would cost her $9,375 in potential benefits (being the benefits payable between day 31 and day 90 if she had taken a 30 day waiting period). Mithali could use $307 of this saving to purchase trauma cover of $50,000, and still be more than $400 better off.

Provided Mithali can get by until the payment of $50,000 arrives, and presuming that the event that leads to her losing her income also meets the criteria for a trauma insurance benefit to be paid, this option is a good one to consider.

Income Protection with reduced benefit period and superannuation benefits

An income protection policy with Asteron will cost Mithali $2,285 a year (for the first year of a stepped premium) for a 30 day waiting period and benefits payable until the age of 65. She pays tax at 30%, and the premium is deductible, such that the after-tax expense is effectively $1,600.

Mithali considers that she will have enough to retire at the age of 60. So, she reduces the period over which the benefits are payable to the age of 60. This reduces the premium to $1,520, or $1,064 after tax. This will save her around $600 per year after tax.

Whether Mithali can comfortably retire at age 60 is really a function of the level of her assets at the moment. Simply put, the higher her assets, the greater her ability to retire at age 60.

Income protection with reduced benefit period and TPD

Mithali is a 42 year old woman earning $75,000 a year. An income protection policy with Clearview will cost her $1,714 a year (for the first year of a stepped premium) for a 30 day waiting period and benefits payable until the age of 65. She pays tax at 30%, and the premium is deductible, such that the after-tax expense is effectively $1,200.

If Mithali changes the cover to a benefit period of five years, the premium falls to $1,253 per year. This is a saving of $461, or $322 after tax. If she then chooses to insure for $500,000 of TPD, with the same insurer, the premium rises again to $1,747 in the first year. So, for around the same premium, she insures her income against temporary illness or injury for up to five years, and will receive a benefit of $500,000 in the event she becomes permanently disabled.

Care will need to be taken to ensure that the TPD policy is likely to pay out in the event of a five year illness.

The Dover Group