Number crunching

Income protection (IP) can provide clients with a valuable safety net if they are unable to work. But cover does not come cheap and those who make a commitment to pay the premiums expect to reap the benefits of protection should they need to claim.

But depending on which index different providers use to calculate benefits, and how often clients update their salary details, policyholders could be in danger of having the wrong level of cover. This could dramatically affect the benefits they would be entitled to claim.

It is important therefore that advisers can recognise the possible effects of different benefit indexes to prevent clients being over or under-insured.

The core of any discussion looking at benefit indexes has to be the underlying principle of how income protection works.

In order for any income protection to plan to function, the policyholder must never be better off when claiming the benefit than if they were working. As it says in the Association of British Insurers' Statement of Best Practice, 'Insurers limit the level of benefit paid to claimants to a stated percentage of their pre-incapacity earnings and/or a monetary amount. This is to ensure that the claimant is not better off financially on claim than in work, thereby preserving an incentive to return to former duties.' So if a client is over-insured, they could potentially claim more money than they would usually get through their salary, giving no incentive whatsoever to get back to work. It is for this reason the majority of insurers are forced to take firm action with over-insured cases.

So when are clients in danger of over-insurance? Most providers now offer index-linked benefits for income protection plans so policyholders do not have to worry about increasing their cover as their salary or cost of living rises. These have proved popular as benefits automatically increase in line with inflation. But if these rises do not tally with clients' salary increases, cover may not be valid.

Crossing the line

The risk of over-insurance should therefore remain at the forefront of discussions with clients. Laura Shanks, product development manager at Scottish Equitable, says: 'Caution has to be raised to the fact that clients could be over-insured. It is important to retain real value for IP as it is potentially a 35-year plus contract. Setting up a benefit to automatically increase each year can achieve this, but not if the benefit is increasing faster than the client's income.'

There are several types of benefit structure available within income protection plans. The most straight forward of these is level benefit, where no inflation proofing is provided. This can be the cheapest way to fund protection as the premium is guaranteed not to increase. Although they do not provide much flexibility, there is little risk of over-insurance and the simplicity of the pricing attracts clients.

Claire Williams, product manager at Scottish Provident, says: 'Level plans remain popular with clients as they guarantee a constant premium for a constant level of cover. People struggle to afford insurance as it is, so many feel more comfortable steering away from index-linked benefits.'

Because there is no increase with inflation, level benefit plans are therefore often used to protect mortgage payments rather than lifestyle.

Bulk protection

Index-linked benefits, on the other hand, are designed to protect the bulk of everyday costs should policyholders find themselves unable to work. Two different indices are generally used for calculating income protection benefits. The first of these is the National Average Earnings Index (NAE). This takes into account overtime and bonuses which can, at times, artificially inflate benefit for those clients whose salary increases do not match the national average. It can therefore be more suited to high earners.

It is for this reason that most providers are currently opting to use the Retail Price Index (RPI) to calculate benefit levels. This moves in line with inflation so that policies do not become dated year on year. Rather than concentrating on salaries, this index brings cover levels in line with increasing living expenses. Most providers feel the RPI gives a more precise scale to judge possible income rises.

'We use the RPI index as we feel it is the most accurate index for keeping benefits in line with the increasing cost of living, meaning clients have the same purchasing power whenever they claim their benefits,' says Williams.

But no index is foolproof and some claimants do find they are over-insured when they come to claim. If this is the case, clients will only be able to receive benefits related to their current income. If this is less than the amount insured, then premiums paid up until the claim will ultimately be lost.

Providers will only pay out a percentage of the actual salary, even if premiums have been paid to cover a larger amount. 'If a client's salary drops, or does not tally with the amount covered, the claim will be assessed on the reduced salary and there will be no refund of premiums. This applies to all providers as there needs to be an incentive to return to work. Clients cannot be better off while claiming their benefits, or the principle of income protection would not work,' says Shanks.

Most plans are, however, flexible and allow clients to increase or reduce cover over time. As long as providers are informed as clients' circumstances change, there should be no reason to panic.

'Clients can increase or decrease their cover if they feel they are over or under-insured at their present level. Premiums are then immediately reduced or increased in line with the changes,' says Williams.

Nick Homer, income protection marketing manager at Norwich Union Healthcare, says that before any increases are made, the client's income is checked to make sure they do not over-insure. 'We allow for periodic increase options so that around every three years you can increase cover by up to 20% or 30%. But if clients do want to increase cover, we will make sure they are not at risk of over-insurance before we grant the change,' he says.

Losing out

But if clients do not make use of the flexibility in plans, some providers may take it away, meaning that policyholders will have no choice but to cover whatever amount the index calculates. 'The problem with some plans is that if the client does not use the option to increase or decrease benefits, after a while the option will be lost and they will be unable to make changes in the future. You really need to take note of any small print when choosing a plan because they may not be as flexible as they first seem,' warns Homer.

Over-insurance may also occur if clients do not consider other incomes which would kick in, should they be unable to work. Because policyholders cannot be earning more income when they are not working, providers demand that all incomes ' including benefits from other protection plans such as ASU or mortgage protection ' total a maximum percentage of the client's normal salary.

'The maximum benefit we provide is 50% of a salary,' explains Williams. 'If you have other protection plans in place, you should never be receiving more than 50% of your salary from the combined products.'

Some providers also deduct State benefits when calculating cover levels. But according to Homer, this is inaccurate and unfair as the majority of people may not even qualify for government help.

'Some providers make a bold assumption that all clients will qualify for State support. But bearing in mind the strict criteria that has to be met, we do not take it into account when calculating benefits. If clients are incapacitated to the point that they do qualify for State help, we take the view that they deserve the extra income,' he says.

Taking responsibility

According to Williams, it is the adviser's role to make sure clients do not over-insure due to other incomes. 'When we receive applications, we only check benefits against our own cover levels ' it is the IFA's job to make sure the right level of cover is purchased after other incomes are considered,' she says.

By analysing other incomes, Homer says advisers may be able to prevent clients from over-insuring without losing the income from other protection plans by making efficient use of deferment periods. 'Advisers can make sure that ASU policies dovetail with income protection by using deferment periods so that they do not overlap,' he says.

So when it comes to index-related benefits, whose responsibility is it to make sure that cover levels tally? The general consensus seems to be that it is down to both advisers and providers to make sure that calculations are accurate at each step of the sales process. Some insurers, such as Norwich Union Healthcare, write a regular letter to clients to check cover levels are still appropriate when there are index rises.

But as Shanks says, it is advisers who should be aware of any changes in the client's circumstances that may put cover levels at risk. Indeed, it could help prompt regular review meetings, enhancing the adviser's relationship with the client. 'Advisers should make clients aware of the need to change benefits should their circumstances change through, for example, a salary drop. If the benefit and salary do not tally, it is time for a change. Two yearly reviews by advisers can help prevent potential over-insurance and lost premiums. This can form part of the adviser's role as a whole to manage clients' expectations,' she adds.

Index-linked benefits should not be steered away from with IP plans as over-insurance can be prevented. The key lies in communication. It is up to advisers to keep in close contact with clients so they know when cover levels may need to be reviewed ' saving a lot of disappointment if clients eventually need to claim.