Should You Protect Your Income? The Ultimate How to Guide
There are massive changes coming to income protection.
Despite being the most expensive personal insurance, and premiums increasing recently, insurers are losing money annually.
The Australian Prudential Regulation Authority (APRA) has stepped in to address concerns about insurance provider sustainability. An open letter from APRA to insurers outlines its intentions for the near future.
Changes are planned to commence March 31st 2020, when it will likely become impossible to secure “Agreed value” policies covering more than income in the 12 months preceding the claim.
From July 2021, further changes are expected, with abolition of agreed value policies altogether and insurance policies requiring renewal every 5 years – under new terms and conditions.
My take on this is that income protection is going to become even more expensive, and less generous. If you are considering starting a policy, talk to an adviser as soon as possible to try and get in before the changes.
What is Income Protection? How Does it Work?
Income protection is the personal insurance you are most likely to claim. It provides a regular income in case of inability to work due to illness or injury.
Those over the age of 25 will usually have some automatic income protection through their superannuation, but those under 25 have to request insurance.
We see patients becoming unexpectedly injured or severely unwell at work all the time, but often don’t consider the financial consequences of lost income – which can be severe enough to cause home repossession.
Most people, including doctors, feel somehow immune to these random events, but of course they can happen to anyone.
Do You Need Income Protection?
This really depends on your situation. What would happen if you contracted an illness or catastrophic accident requiring months to years off work?
Unless you are financially independent through investments, or have someone who loves you earning more than enough to support you both, it is likely you should have some income protection.
Even if you don’t need insurance now, it is worth considering whether your needs are likely to change. Do you plan to have children? If you will need income protection within the next 5 years, consider securing the policy now. Premiums escalate surprisingly rapidly as you age (significantly in 2-3 years during my 30s as I discovered!) Delay also risks developing a medical condition in the meantime that could make you un-insurable, far more expensive to insure or have significant exclusions in your policy.
How much Income protection do You need?
This is tricky! It will take a detailed look at your budget, and what your obligatory expenses are (you won’t be holidaying overseas if your ill enough to claim income protection).
Then you need to look into the future and anticipate changes to those expenses. For the reasons outlined above, it’s best to make your policy as future proof as possible.
Consider other sources of income. How much of your obligatory expenses could be covered by your partners income? Do you have any investment income coming in that would continue despite illness or injury? Also take in to account any significant long-term savings that could help financially support you.
Remember to calculate gross income required – your benefits will be taxed as personal income. You may (in the next few months) still be able to secure an “Agreed value” insurance policy. This means you will be paid a prior agreed benefit in the event of a claim (Up to $30,000 per month).
It is likely agreed value insurance policies will not be possible after July 2021 (perhaps sooner).
The other type of policy (the new norm) is “Indemnity Value” – the benefit paid is based on your income immediately prior to the claim.
Indemnity value policies may be better for those going up the payscale over the next few years, but could be disastrous for individuals becoming ill or injured after 12 months of parental leave, other extended time off work, or the 1st year of a private practice before profits kick in. It also could be detrimental for those whose health has been deteriorating for a period of time, and who have reduced hours worked as a result.
If taking out an indemnity value policy, try to find one that will calculate the benefit on your income over the past 3 years to minimise the risk of being short changed.
Can You get Income protection?
Your ability to secure a policy depends on age, medical history and “Risky” activities and occupations. Chronic illnesses, extended periods of time off sick or a history that is perceived as high risk to insurers (especially back pain in men, anxiety in women) will make securing a policy more difficult and more expensive.
Sometimes insurers will offer a policy with specific exclusions that won’t be covered if they recur (such as back pain if you once complained of pain in the back!). It is definitely not worth lying about your history, as the insurance providers will not pay out if they find you have been dishonest (even if it’s completely irrelevant to the eventual claim).
Exclusions can be reviewed and sometimes removed at a later date, provided you have had no further issues, you have a good insurance broker to negotiate on your behalf, and the provider decides to play ball.
When does Income protection kick in?
You can choose different waiting periods before your income protection starts paying benefits, usually 30, 60 or 90 days. This should be based on your amount of sick leave accrued (assuming you are staying with your current employer) and how long your emergency fund would last if the worst happened.
Premiums drop significantly as you increase the waiting period. Do remember, though, that if you have two episodes of illness with a brief return to work between, the waiting period may have to be served for the second illness again.
How long does Income protection last?
Superannuation income protection policies often pay out for only 2 years – not much use if your surgical career is ended by a traumatic limb amputation. Other policies continue to age 60 or 65 years, which will provide long lasting income replacement – at significant cost.
When considering how long you need income protection for, consider your savings, debt, partner income, dependents, your age, superannuation balance, and your Total permanent disability insurance payable if you were never able to return to work.
Own Occupation vs Any Occupation
Many cheaper insurance policies (including those that come with your superannuation) will only pay out if the insured cannot work in any capacity.
Unless you can cover your expenses with a minimum wage job (I’m impressed if you can!) get own occupation insurance. Again, you will pay extra for this.
Should You Buy Income Protection Inside or Outside Superannuation
Premiums are tax deductible whether they are in or out side of super. If you need to claim on the insurance, income is taxed at your marginal rate, regardless of whether premiums were paid inside or outside superannuation.
Paying from within superannuation can help affordability at the time if cash flow is tight. If you are not salary sacrificing the maximum into superannuation, increasing your salary sacrifice to cover the premiums is a tax efficient way to pay.
If no extra is contributed to superannuation to cover into the premium, they will eat into your superannuation balance and cost a lot more in the long-term due to lost investment earnings on the premium amount.
Insurance inside superannuation is often cheaper, and the most hassle-free way to secure insurance. Unfortunately, superannuation income protection is often an inferior product, often paying benefits for only 1-2 years.
Benefits may cease if the insured becomes permanently incapacitated (qualifying for Total permanent disability if they have it).
For protection inside super, the unwell person needs to meet the legal condition of release of superannuation law as well as the insurance policy definition of incapacity.
Insurance inside superannuation cannot be moved to another superannuation provider. If the insured is moving employers, they must either keep the same superannuation or start a new policy.
As well as excess management fees associated with multiple superannuation accounts, automatic insurance could mean individuals with more than one super account are paying multiple insurance premiums.
If the insurance is left with an old superannuation account, and the premiums consume the entire balance, the insurance will obviously be cancelled.
Income protection inside superannuation may be appropriate for you if you have few expenses, or have significant savings and no plans for adding dependents to your household. You also need to have reviewed your superannuation and made sure you’re happy using the fund for the long-term.
If you have insurance through your superannuation, it is worth checking your occupation rating.
Doctors (apart from retrieval) are considered low risk and therefore attract a cheaper premium, as long as the correct occupation rating is applied. If you are automatically enrolled as a blue-collar worker, you are paying more than you should.
Income protection insurance outside super has a larger choice of features and usually more extensive cover available, at a greater cost. It is a hassle to get set up – requiring medical underwriting, lots of paperwork and lots of questions from the insurance company. But once it’s set up, as long as you pay the premiums, could last as long as you need income protection (before July 2021).
Stepped or Level Premiums
You have a choice of two fee structures. Stepped premiums start out much cheaper and are based on age, but escalate significantly as you get older.
Level premiums start out significantly more expensive but do not increase with age, and are generally considered more cost effective if income protection is required for 10 years or more.
Over the past 5 years, even level premiums have increased significantly due to an increase in claims. I had been horrified by my “level” premium increases, but now read that the insurance industry has been making massive losses for the past 5 years – and frankly it benefits no-one if these companies go bust.
Income protection and other payments
It is worth checking whether your income protection policy will continue paying benefits even if you qualify for TPD. This will make a huge difference on how long you should have income protection benefits for (2 years or up to age 65) and how much TPD you require.
Income protection is taxed as normal income (assuming you’ve claimed tax deductions on the premiums), so remember this when planning how much you require. Base your benefit amount on gross income required. The ATO have a simple tax calculator to help you work this out. https://www.ato.gov.au/calculators-and-tools/simple-tax-calculator/
Look at the small print on whether premiums are reduced should you receive compensation payment or social security benefits
Income Protection and Tax
Income protection is a tax-deductible expense. Insurance benefits paid in the event of a claim are therefore taxed as normal income
Does Your Policy Cover Partial Disability?
Check whether partial disability is covered. When Dr Cristina Yang was stabbed in the abdomen with an icicle , she probably wouldn’t have been able to return to work for a while. Her employer may have put her on a “Return to work” program of half shifts two or three times a week. Would her Income protection policy have covered the rest of her income?
If a self-employed anaesthetist has a fracture requiring a dominant hand plaster cast, he will be able to perform some administrative tasks but will not be able to anaesthetise patients – likely leading to a significant reduction in income. Will income protection make up the difference?
Do you get paid super?
I’m reading a lot about inadequate retirement savings lately. Periods of time not contributing to your superannuation (eg parental leave, extended time off work) make a significant dent in retirement savings. It is possible to get a policy that pays superannuation, just as an employer would. You guessed it – at a cost. Decide whether you need it, and check this small print when comparing policies.
Is the income protection benefit index linked? This means the benefit paid increases with time to compensate for inflation. If Dr John Dorian suffered a major head injury from his scooter, aged 25, will his income protection benefit still cover his expenses in 40 years time? Not a major issue if you only need income protection for a few years, but worth getting if needed for a decade or more.
Policies also have general exclusions that they will not pay for – Usually they will not pay if the insured is in a combat zone, injured due to acts of war or terrorism or no longer an Australian resident, illness as a result of pandemic or pre-existing condition, self-harm and attempted suicide. Similar to your house or car insurance, it’s important to read and compare the policies in detail to understand what is covered and what is not.
How much does income protection cost?
This is extremely variable depending on age, waiting period, length of benefit payments, pre-existing conditions etc. Expect to pay anywhere between 2 and 5% of the benefit amount as a premium (Mine comes to 3% currently).
If you are buying several polices, ask for a discount!
Where to buy the best income protection?
You have three options – through your superannuation, through an insurance broker, or direct.
Income protection is extremely complex, and is absolutely no use if you buy a policy that in the event of a reasonable claim, does not pay out.
A broker will have a great understanding of all the pros and cons of different policies and help you weigh up what is most important. They should also manage the claim process in event of illness of injury. As you may know, insurance companies in general like to avoid paying out, so it would be beneficial, in my view, to have someone experienced and knowledgeable negotiating on your behalf.
Insurance brokers are paid a significant amount of commission for signing you up, so they are clearly not independent. It probably makes sense to work with more than one insurance broker, and get quotes from direct insurers and carefully compare the terms of the policies. It’s advisable to get all this right the first time so you only have to do it once!
When to stop income protection?
Insurance companies would like you to stay fit and well (Awww!) and working while paying premiums for the rest of your working career. Premiums will increase as time passes, and stepped premiums will escalate dramatically as you age.
In order to be cost effective as possible, you need income protection for the minimum time you really need it – often with debt, dependents and little in the form of assets. As debt is paid down, dependents become independent and asset base grows, there will come the point you can self-insure. Make sure you assess this carefully, and only cancel your policy when you’re sure you don’t need it. I imagine it will be a great feeling to get rid of those hefty premiums once and for all!
Income protection is a fairly complex topic, thanks for sticking with me through this mammoth guide!
At the end of the day most people will find they have to balance their needs with keeping insurance premiums reasonable. I hope this guide gives you an idea where you can make compromises.
Did you get the TV Medical drama references or am I just showing my age?! Go on…indulge me. Who is your favourite TV Doc?
Now go ahead and work out your insurance needs, and get that policy sorted ASAP.