Why most sickness and unemployment insurance is a waste of your money

There are few real 'must have' insurance products, writes Tim Bennett. Beyond that it’s all optional, and in many cases unnecessary - despite what your financial adviser may say...

This article is taken from Merryn Somerset Webb's free weekly personal finance email, Money Sense. Click here to sign up now: Money Sense

"You can buy yourself insurance against almost any conceivable risk even alien abduction," says Claudia Dyer of consumer group Which?. While most of us are probably not covered against extraterrestrial kidnapping, it is likely that we have more cover than we need in some areas, and less or none at all in more important ones.

Given the pressure that rising food and energy prices are putting on household budgets right now and the need therefore to cut out non-essential expenditure, this is a great time to review what you are spending and cancel any useless and often expensive cover.

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The truth is, the only insurance products that are, "must haves" are car, home and, for anyone with dependents, life cover. Beyond that it's all optional, and in many cases unnecessary, no matter what your financial adviser often hoping to earn a commission - may say to the contrary.

This week, I'll look at three types that all deal with the problem of how to maintain your income during an absence from work; payment protection insurance, critical illness cover and income protection. Most people couldn't survive on state benefits alone - at just £75.40 a week (from this month), statutory sick pay barely covers the weekly food shopping for one, which is why Andrew Merricks of Skerritt Consultants comments that, "you need to build your own little welfare state because no-one else is going to do it for you".

However, before rushing off to buy tons of extra cover, consider what you already get through work your employer may offer up to say three months' salary at full pay should you fall ill. That's not great for long-term illnesses, but if you also have significant savings set aside, sufficient to cover at least six months of your essential net monthly outgoings (the mortgage being the biggest one for most people), extra cover may be a waste of money.

Accident, sickness and unemployment insurance

Confusingly this is also known as "mortgage payment insurance" and "payment protection insurance", the objective being to cover your mortgage and loan repayments (which can include credit card balance cover) should you fall ill, get injured or lose your job. Given the wide range of unfortunate circumstances covered are these policies too good to be true?

I'm afraid so. The fact that the FSA fined HFC, an HSBC subsidiary, over £1m in January for mis-selling this type of product, coupled with a wider two-year investigation of the whole area by the Office of Fair trading, should be sufficient warning typical PPI policies are expensive and riddled with small print and exclusions.

For example, a typical policy will only kick in after anywhere between two and four months after the accident or illness, and then run for a limited term, often no more than twelve months. Most will also only let you claim after a year in the same permanent employment. Most tellingly, an unimpressive 20% of claims are paid out on these policies according to the Telegraph. Avoid.

Critical illness cover (CIC)

Nothing if not popular, last year we bought 583,900 policies according to Swiss Re, largely because they appear, on first sight, to be fairly straightforward. Alas that's often not true but CIC remains a lucrative commission earner for financial advisers.

The premise is deceptively simple you pay a monthly premium so that should you be unlucky enough to contract one of the specified "critical illnesses", the plan pays a predetermined lump sum, say £200,000, to be spent as you see fit, perhaps on paying down a mortgage or buying private treatment.

So, what's the problem? As ever with insurance, it's the small print. To ensure you are covered you need to scour the contract pretty thoroughly. That's because certain common medical conditions may be excluded altogether a classic for men is prostate cancer and many plans also disallow pre-existing conditions, often a grey area when it comes to settling claims.

Also, as you get older premiums can climb steeply for example, according to godirect.co.uk a 45-year-old female non-smoker can expect to pay well over £100 a month for £200,000 of cover. Finally if you already have significant cash savings, CIC is pointless since you could simply spend those instead, should the worst happen. All in all, whilst a better bet than payment protection, CIC is far from perfect for many buyers.

Income protection

The best of the bunch, the product favoured by Which? and, says consultancy Defaqto, "the only one that comprehensively protects against the consequences of incapacity". Yet, oddly, UK sales last year were only around one quarter of CIC products with many consumers still seemingly unaware of its existence, according to Lifesearch.

Income protection is designed to pay out up to 75% of your gross monthly salary tax free (50% is more usual and sufficient in many cases to match after-tax income) should you be unable to work because of sickness or injury but not, it's worth noting, unemployment. The payments usually last until you return to work, or should that not be possible, your retirement date. Usefully, unlike either of the other plans, income protection will often cover problems such as back pain or stress, the two biggest causes of absence from work.

Be aware that there are two rather different types of plan the more flexible, "own occupation" type which pays out until you can return to your specific job, and the "any occupation" type that only pays out in the (less likely) event that you are unable to return to any kind of employment.

Premiums can be high however, whether that's the case depends on several factors. First off, the longer the "deferral period" before the plan starts to pay out after you are forced to leave work, the less you pay each month, so always review how long your cash savings would last before deciding on this and go for the longest period you can.

For example, a three-month deferred start can reduce monthly premiums by 30-40% compared to an immediate start, according to Lifesearch. Then there's the job you do manual workers pay more per month for cover than office workers and your age and lifestyle, with premiums rising for older employees and, somewhat predictably, smokers.

In short then, as times get tight, no one wants to be shelling out money needlessly on expensive insurance. Therefore, say no to, or cancel, any form of payment protection cover and, if it's illness cover you need, don't follow the crowd - take a look at income protection ahead of critical illness plans. Even then, a little time spent understanding the product and shopping around for a competitive premium using a site such as moneysupermarket.com or your financial adviser is time well spent.

Merryn Somerset Webb is away.

This article is taken from Merryn Somerset Webb's free weekly personal finance email, Money Sense. Click here to sign up now: Money Sense

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.