In basic terms income protection replaces a percentage of your income when you cannot work in your own occupation for a medical or injury reason.
The aim is to provide 75-80% of your in the hand earnings to you at claim time.
Most policies today have a range of options and different flavours. Fundamentally there are two types, those you pay tax on at claim time and those you do not.
The rules and approach around each one are a bit different.
Before we get carried away with the details, it is important that you understand replacement ratios first.
Insurers will insure a proportion, or replacement ratio, of your income. This is the amount they pay if you are disabled. This ratio is determined by the insurer and is designed to replace your income needs but ensure there is still some financial incentive to return to work.
Agreed Value is just that, Agreed at application time and will give you more certainty at claim time.
Because Agreed Value is not taxed at claim time, you do not have to insure the tax portion. The insurer sets a maximum replacement ratio between 55% and 62.5% to account for the lack of tax and to ensure the financial incentive to return to work is there.
There are tax assessable Agreed Value policies in the market at 75%, but we feel you paying additional premium to claim a tax deduction at the end of the year, while opening up your claim to tax assessment, is not in your best interests.
Indemnity Value is the opposite of Agreed.
We discuss a cover level now and at claim time you have to prove the loss of income. Because that loss is associated with a taxable income, the benefit is also taxable.
With Indemnity Value what you receive in your hand can fluctuate based on your situation at the time of disability. The insurers set the maximum replacement ratio at 75%, which accounts for the additional tax requirement and ensures there is still a financial incentive to return to work.
Loss of Earnings:
Loss of Earnings protection operates in a similar way to Indemnity Value; the fundamental difference is the way your claim is calculated.
Loss of Earnings insures up to 75% of the loss in income you experience; Indemnity Value will replace up to 75% of your pre-disability income. Meaning in some situation a Loss of Earnings approach will deliver more at claim than other styles of policies.
ACC/Offsets What does this mean?
In a disability situation where you have ongoing income or ACC payments, Income Protection policies will take this into account when your claim payment is made.
Meaning the insurance company can offset income replacement benefits from other sources and reduce your claim. With indemnity and loss of earnings, this is based on either a maximum claim of 75% of your gross income or 75% of the loss of income depending on which product you have.
What about Agreed Value Offsets?
Yes, offsets apply to agreed value as well.
Thinking about offsets rather than focusing on them. To be realistic, if you can replace a portion of your income from other sources, where is your loss?
The insurance companies understand this and price it into their premiums. From a premium rate point of view, $ per $1000 of cover, you will find that Indemnity Value will be the cheapest, then Loss of Earnings and Agreed Value will be the most expensive with a particular provider.
Keep in mind with Agreed Value you insure less as you do not have to pay tax on it, so the overall premiums across the three product types for the same structure will be similar. The Agreed Value will give you more certainty at claim time.
Where possible we arrange agreed value income protection for our clients; there are fewer surprises at claim time. Especially for business owners and self-employed people, we see better outcomes with this approach.
Especially for business owners and self-employed people, we see better outcomes with this approach.
For employees the strength of agreed value shines through if you start your own business or become self-employed, your present salary is locked in. This is particularly important for the first few years starting out.
This is not to say financial evidence will not be required at claim time, in almost all cases it will be needed at some point. Establishing the level of claim is significantly more secure with an agreed value approach.
Why is this?
Because of offsets, your standard income protection policy will have inbuilt offsets; this is where the insurance company can deduct other benefits or income you receive from your claim.
In the situation of ACC, which is the most typical client discussion we have, they will be paying 80% up to their limit of your income in an accident disability.
This means the income protection will top up any shortfall if you earn more than ACC limit.
When ACC determines you can do any job, but you cannot do your own, income protection then becomes your primary financial support.
The other situation, for those who own businesses, is where the ongoing income from the business can be offset against the claim.
This is where the indemnity approach becomes challenging, and the agreed value strengthens. Indemnity often does not care who produced the income, if it is coming from the business, it will get offset against the income protection claim.
With most agreed value policies, while they have offsets, they are focused on the disabled person’s direct exertion to produce the ongoing income.
If you have a new manager in your business and they cover their costs and still produce a profit, in an agreed value situation the offsets would not typically apply.
As we mentioned before we recommend Agreed Value Income Protection where it is possible for you to mitigate any surprises at claim time. This also minimises the impact on you to get your claim paid, when you need to be focused on your recovery.
I am still not happy about this offset thing?
We understand this. Offsets are the one thing which clients find a problem at claim time because they impact on your pocket. Accident claims and ACC payments are the most commonly commented on.
What you need to keep in mind is ACC will pay for your accident-related loss of income from disability.
When you get to the point where your disability is caused by an underlying condition, or you are unable to return to your own occupation, ACC will direct you to another job or the sickness benefit.
This results in ACC reducing your payments. It is at this point your income protection will step up and replace your income long term as it is about protecting your income in your own occupation.
How can I manage offsets?
We have a couple of approaches; one is the use of Loss of Earnings but you have to prove the loss at claim time, we are not all that happy with this method because of the risk of not being able to prove a loss.
If you have a mortgage, we have a preferred approach, which is to use a Mortgage Protection Repayment policy in conjunction with an Income Protection Policy.
Mortgage Protection is very similar to Agreed Value Income Protection, with some providers it is the same with one key exception if you have a mortgage, and a claim is paid there are no offsets.
Can I have more of this than my Mortgage Payment?
With most providers yes, up to 100% or your required monthly mortgage payment can be insured.
- If 55% to 62.5% of your income is less than your mortgage payment, you will be already able to get more with this approach than standard income protection.
- If 55% to 62.5% of your income is more than your mortgage payment, we can insure the difference on an Agreed Value income protection policy.
So I could end up with two policies?
Yes, this is possible, though with most insurance companies it is two benefits on the one policy and they work together.
We would counsel against having your income protection with more than one company.
If you have income protection policies with two or more insurers, offset wordings my conflict and result in you receiving less of a claim than you expected, at claim time.
Ok so I’ve had a look around, and I have all of these quotes that don’t make sense to me:
This is something we often come across as different insurers use different language and advisers will give you various options.
The most common thing you will see is different wait periods and payment terms.
A waiting period on an income protection policy is how long you have to be disabled before a claim payment is paid.
Most flavours of wait period are 4 weeks, 8 weeks, 13 weeks as well as 26 weeks, 52 weeks and 104 weeks.
The last three we do not recommend as the reduction in premium does not warrant the extra risk you take on.
We would use the longer three options in some business situations in conjunction with other risk management tools.
The longer you can wait the less your premium will be.
Possibly the simplest part of income protection, how long do you want your claim to be paid?
This can have unintended consequences if you are choosing shorter payment terms.
Typical payment terms are 2 years, 5 years, to age 65 and to age 70. Some insurers have shorter terms of 6 and 12 months available, and some old policies will only go to age 55 or age 60 for claims payments.
The fish hook in the nominated term policies, like 2 and 5 years, is the term relates to the maximum combined duration of the condition claimed.
If you have a back claim, and it becomes a recurring problem, after 2 or 5 years of combined claims, your policy will stop covering you.
With the to age options, we do not have this barrier. This is why we will always recommend the longest term available to you.
Your extended family may help in the short term, a month or two, but they will not necessarily help you financially if you are disabled for 20 years.
Understand budget is also a concern and having something, like a 2 or 5-year term, is better than no cover at all.
With all standard income protection policies, none of them covers job redundancy, only disability caused by an accident or illness.
Redundancy Protection can be added, at an additional cost, and is subject to additional considerations.
Looking for other resources on income protection?
- Check out our blog section on income and mortgage protection
- as well as our blog section on risk management
Where to from here?
If any of this has raised questions about the cover you have or the need for cover, please Contact Us.
We would welcome the opportunity to clarify things for you so you have confidence the cover you have will do what you want it to.