Income protection insurance traps

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Income protection insurance is an interesting financial tool, but of all life and health insurance products, it is the most misunderstood by customers and insurance industry people alike. Here are 11 traps for the unwary:

Friday, May 30th 2008, 11:27AM 2 Comments

by Graeme Lindsay

1. Make sure you have a guaranteed right to renew the policy until age 65! Do not accept a policy that the insurer can cancel for any reason – there are a few of these out there. The last thing you need is to have your first heart attack the day after the insurer cancelled your policy.

2. Look out for the benefit period – i.e. how long they will pay you if you have a long-term disablement. We sometimes see policies with two-year and five-year benefit periods. These are unacceptable – we only ever recommend benefit periods to age 65. If you're sick long-term, you don't need the insurer saying 'sayonara' after two or five years!

3. Do not accept a policy that does not have a benefit payable if you are partially disabled! A recent study of income protection claims showed that over 70% of claims go from totally disabled to partially disabled before, in most cases, full recovery. Don't get caught out in the cold with a 'no partial disability claim' policy.

4. Watch for a two-year limitation on partial disability claims. This is almost as bad as no partial disability claim – I have two clients now who have been on partial disability claim for over two years – in one case, almost 10 years.

5. Do not accept a two year limitation on mental health (read stress and depression ) claims. Anecdotal evidence shows the greatest single cause of IP claims is stress and depression. Why would you have income protection that limits benefits for the largest cause of claims?

6. Beware the policy that says that the partial disability claim ceases if you are able to work full time. Many claims for partial disability involve conditions that reduce your productivity, but not the hours you can work. For example, we have one professional client who prior to his breakdown, worked 60 hours per week. On medical advice, he now works 40 hours per week and at a less frenetic pace than previously. He is earning about one half of his pre-disability income. If he had the bad policy, he would be out in the cold. He has a good policy that recognizes reduced productivity as a partial disability.

7. Watch out too, for the policy that allows the insurer to deem that you are earning if you are medically able to work but are unable to earn. For example, you can't hold down the responsibility of partner or business owner, but medically you are able to work as a clerk. But, you can't find a job – after all, who wants to hire someone who had a nervous breakdown 18 months ago and has lost his/her business? The bad policy can deem that you are earning what they say you are capable of earning, and will offset that amount against any benefit you expect.

8. Be careful of "group" policies that are cheaper than "retail" – they often have restrictive clauses. One that we see and don't like provides that a partial disability benefit is only payable if you are working for the original employer! So, if your illness means that you can't work as an accountant, but can as a gardener, you are out in the cold! Discounts usually mean reduced benefits!

9. Watch for restricted cover policies. Some insurers offer policies that only pay benefits if you suffer a major trauma type illness/injury. These do not cover stress and depression, but are cheaper and some salespeople find them easy to sell. We will not use them.

10. Agreed value policies do not automatically pay out the "agreed value" if you are disabled. All income protection policies offset any on-going income you receive or are entitled to receive for the "agreed value". It is logical that they do, but many salespeople are unaware of this, or overlook it.

11. The tax treatment of agreed value policies is still an area of concern. Two insurers believe that any benefit will be taxable as income and accordingly the premium is deductible. These insurers will allow you to cover up to 75% of income. Four other insurers believe that the benefit is not taxable and the premium non-deductible. These insurers will only allow you to cover 55% of income. IRD has a working party considering the issue and we await their decision. The risk is if you have the 55% cover and IRD rule that they are taxable/deductible and you have become uninsurable. You now only have cover of 55% of income and it is taxable! Our preference is for the taxable/deductible route.

In summary, there are excellent polices, offered by quality insurance companies with none of these traps, so you don't need to settle for second best.

Graeme Lindsay runs Strategy Financial which provides research to advisers on insurance products. The comments in "Strategy Thoughts" outlines his view on recent product and policy changes.

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