What is income protection insurance and how does it work?

Unexpected illnesses or injuries can prevent someone from working, leaving them without a stable source of income. Income protection insurance is a financial alternative designed to mitigate the impacts of such situations. This coverage provides regular payments that replace a portion of lost earnings, which in turn offers financial stability during recovery periods.

This article presents information to help understand how income protection insurance works in Australia, its main components, eligibility criteria, costs, policy options, and the claims process.

What is income protection insurance?

Income protection insurance is a type of life insurance specifically designed to cover a worker in the event of total or partial disability that prevents them from performing their professional duties. This insurance replaces a percentage of your salary during the time you are incapacitated, whether temporarily or permanently.

This coverage is especially relevant for those who are the sole source of income in their family, have debts such as a mortgage or loan, or are self-employed professionals who do not have benefits like paid leave or sick leave.

What does the insurance cover?

Each policy has its own specifics, but in general, income protection insurance covers:

• Up to 90% of pre-tax income during the first six months of leave;
• Up to 70% of income for a specified period after that initial time.

The amount paid is calculated based on the annual earnings from the 12 months prior to the illness or injury. The goal is to provide enough financial support so the person can pay bills and focus on their recovery.

Policies require that certain definitions of partial or total disability are met before a claim can be made. These definitions can be found on the insurer’s website or in the Product Disclosure Statement (PDS), a mandatory document that outlines the terms of the policy.

Who should consider this insurance?

Taking out income protection insurance can be essential for the following profiles:

• Self-employed individuals or small business owners, who do not have paid leave.
• People with dependents, such as children or family members who rely on their income.
• Those with fixed debts, such as mortgages or loans.
• Workers in high-risk occupations, such as construction or physically demanding jobs.

To assess whether this insurance is truly necessary, it is advisable to create and regularly update your personal and family budget. This helps identify the amount of income that would need to be replaced if you were unable to work, while also considering savings, superannuation resources, and other forms of financial support.

Types of policy

There are two main types of income protection insurance policies. However, one of them is no longer available but may apply to your case if you purchased the insurance before the changes:

1. Indemnity value policy

This is the model currently available on the market. It provides coverage based on your salary at the time of the claim. If your income decreases after taking out the policy, the monthly payment amount will be adjusted accordingly.
For people with variable income, coverage is based on the average earnings over a period appropriate to the profession.

2. Agreed value policy (no longer available)

Before March 2020, it was also possible to choose a policy with an agreed value, where the insured amount was set at the time of purchase, regardless of future income changes. This model was withdrawn from the market by determination of APRA (Australian Prudential Regulation Authority), as it could result in disproportionate benefits and discourage returning to work.

Main components of the policy

Waiting period

This is the interval between the occurrence of the disability and the start of payments. It can vary from 14 days to two years, depending on the situation, the type of insured term, and other factors. During this time, no compensation is paid.

However, the longer the waiting period, the lower the premium—that is, the cost of the insurance. Therefore, the best practice is to always assess your savings, accumulated sick leave, and emergency funds to determine the most suitable waiting time.

Benefit period

This refers to the duration of monthly payments in the event of disability. It can range from two to five years or extend until a predefined age, such as 65. Longer benefit periods offer greater security but result in higher premiums.

Stepped or level premiums

When purchasing the insurance, it is possible to choose between two payment models:

• Stepped premiums (age-based variable): recalculated annually based on the policyholder’s age. These tend to increase over time, as the risk of making a claim grows with age.
• Level premiums (fixed variable): have a higher initial cost but increase more slowly over the years. Adjustments are not linked to age.

Choosing between these options affects both your immediate budget and your long-term financial planning.

Common exclusions

It is important to carefully read the terms of your insurance policy when purchasing it to understand what is not covered. Typical exclusions include:

• Injuries resulting from self-harm;
• Pregnancy (unless it leads to a disabling condition);
• Injuries or illnesses caused by war or civil unrest;
• Disabilities resulting from active military service;
• Cases where the condition does not fully prevent the person from working.

Income protection insurance via super

Many retirement funds (super) offer basic income protection coverage. Some of the advantages include:

• Cheaper premiums, generally lower than those from private insurers.
• Automatic deduction of premiums from your super balance.

On the other hand, there are some limitations:

• Lower coverage;
• No tax deduction;
• Fewer customization options and additional features.

Before purchasing a policy outside the super structure, it is important to check whether you already have active coverage through your fund and assess whether that specific option is sufficient for your needs.

How to buy income protection insurance

There are three main ways to purchase a policy:

1. Through a super fund

Many workers already have minimum protection by default. It is possible to increase the level of coverage directly through the fund.

2. From direct insurers

They offer a quick and simplified process, ideal for those who want to handle everything independently. However, they may offer less customization and do not usually conduct full underwriting (a detailed analysis of the insured’s risk).

3. With advisers or brokers

This model includes professional guidance to help select the most suitable product. It can be ideal for those with complex financial or professional situations. However, advisers may request commissions for selling life insurance products, so it is important to make your own critical assessment.

What to inform the insurer

When purchasing or modifying your policy, the insurer will ask a series of questions about:

• Age and occupation.
• Income (pay slips, tax returns, etc.).
• Medical history.
• Lifestyle (smoking, extreme sports, etc.).
• Work hours and location.

If the insurer does not request your medical history, the policy may contain more exclusions or stricter definitions. It is essential to answer truthfully, as misleading information may result in denial of payment or even cancellation of the policy.

Claims process

If you need to make a claim, the first step is to check the insurer’s instructions on how to submit an insurance claim. Payments received must be declared as taxable income in your tax return.

Documents such as medical reports, disability assessments, and proof of income will be required during the process.

Final considerations

Income protection insurance provides an important safety net during vulnerable times. While not every worker may need this type of coverage, taking the time to consider how you would handle the sudden loss of income can make a significant difference in your financial planning.

Ideally, compare policies, check the coverage already available in your super fund, and, if necessary, seek advice from a financial adviser to make a well-informed decision