Written by Tom Salmon, Senior Claims Assessor at Pacific Life Re
Some policyholders mistakenly expect an Income Protection (IP) policy to pay their full salary if they can’t work due to illness or injury. In reality, no policy offers this. Doing so would be far too expensive and would complicate the efforts of reintegrating the insured back to the workplace. Instead, the policy is designed to replace a percentage of their salary, which leaves a financial incentive for them to return to work.
At application it needs to be determined what level of cover is required and this is based on the applicant’s earnings over a 12-month period. These earnings are then applied to a ‘replacement ratio’. This is a percentage of earnings up to which the insurer is prepared to cover.
A common example is a policy offering a replacement ratio of around 65% of annual earnings. So, for someone earning £50,000 per annum, the maximum annual sum assured would be £32,500. Other essential factors to consider include the length of the deferred period, which should correspond with any employer provided sick-pay, and any continuing income that will be received if the insured becomes unable to work.
It’s also crucial to stress that an IP policy won’t automatically pay-out the sum assured at claim stage. Various conditions and assessments will influence the final pay-out – a topic we’ll explore in more detail later.
When comparing policies, it’s certainly worthwhile reviewing who offers the most favourable replacement ratio. While some insurers provide a higher replacement ratio than others, this feature should be weighed against other aspects of the policy – including value-added services such as counselling, physiotherapy, and vocational rehabilitation.
Employed vs Self-Employed
For Employed Individuals
Securing IP cover for employed persons is generally more straightforward. For most employees, earnings don’t fluctuate but will often increase over time. Moreover, most employers provide a set period of sick pay, which can serve as a valuable reference when determining the appropriate level of cover. However, this stability also means that if income grows significantly, there is a risk of being underinsured at the time of a claim. Some insurers may also allow pension contributions and benefits in kind to be included, as long as they cease on the event of the insured becoming unable to work.
For the Self-Employed and Company Directors
In contrast, arranging IP cover for self-employed individuals or company directors can be more complex. Earnings can fluctuate from one period to the next, and there’s no fixed sick pay to rely on – even though many still generate an ongoing income. One common error during the application process is disclosing the business’s turnover as earnings. For instance, if a self-employed individual has a turnover of £100,000, they might be offered a sum assured of £65,000 based on a replacement ratio of 65%. This is wrong and will lead to the policyholder being over-insured.
Instead, it’s the net profit before tax that should be used to determine the maximum sum assured. For example, if the net profit is £40,000, then a more appropriate sum assured will be £26,000 – 65% of the net profit.
For directors of a limited company, directors’ remuneration plus any dividends paid from the annual net profit are normally used to calculate how much IP cover is allowed. Some insurers may allow directors’ remuneration and/or dividends for a spouse to be included too. It’s best to check with each insurer to find out exactly what they will allow to be included. However, it’s important to note that whilst directors of limited companies might consider themselves to be self-employed, they are treated differently for tax purposes and unlike self-employed people, their net profit shouldn’t be used to calculate the amount of IP cover they can have unless the insurer specifically allows this.
Table of earnings used to calculate IP cover
| Employment status | Earnings used to calculate IP cover |
| Employed | Annual PAYE income. Some insurers may also allow pension contributions and benefits in kind if they stop when the insured becomes unable to work. |
| Self-employed | Net profit before the deduction of tax. |
| Company Directors | Usually directors’ remuneration and dividends paid from the annual profit, but check as there are exceptions. Some insurers may also allow a spouse’s directors’ remuneration and/or dividends to be taken into account if certain conditions are met. |
The Benefits of Getting It Right
Adopting an approach that uses the correct earnings figure from the outset can lead to a significant reduction in complaints when a claim is made. The insured will have a truer expectation of what the policy pays out, insurers will face fewer disputes, and IFA’s can avoid subsequent complaints regarding the selling of the policy. Ultimately, aligning the sum assured with the correct income, whether through fixed salaries or net profit, benefits everyone involved.
To bring this story to life, Vicky Churcher, Executive Director at the IPTF, invited Tom Salmon, Senior Claims Assessor at Pacific Life Re, to share his perspective. Watch the full video below:
