Self-Employed: What Income Are We Protecting?

When you are self-employed, your income is closely tied to your ability to work. If you become ill or are injured and cannot do your job, the money coming into your household could quickly reduce or stop altogether.

This is where income protection insurance can make a real difference. It is designed to pay a regular income if you are unable to work because of illness or injury, subject to the terms of the policy. It is not unemployment cover, that’s a whole different type of policy!

When you are self-employed, the way you run your business can affect how you should set up your income protection policy and what happens if you need to claim.

A sole trader and a director of a limited company might both describe themselves as self-employed, but their income can work very differently. This means that the right approach to income protection may also be different. There are three ways to arrange income protection in the UK: personal, executive or group cover. If you don’t have a Limited company, then the only option for you is personal income protection.

Let’s look at what you need to consider.

What is income protection?

Income protection is designed to provide a regular monthly payment if you are unable to work because of illness or injury. Depending on the policy you choose, payments can continue for a limited period e.g. 1 or 2 years, or potentially until your chosen retirement age.

It can help you continue paying essential expenses, such as:

• Your mortgage or rent.
• Household bills.
• Food and other everyday living costs.
• Loan and credit commitments.
• Family expenses.
• Other regular financial responsibilities.

The amount you can insure depends on your earnings, the insurer’s rules and the type of policy you take out. You will also need to consider how long you could manage without your usual income, as this will help determine how soon you need the policy to start paying.

For someone who is employed, workplace sick pay may provide some financial support. However, if you are self-employed, you don’t have an employer providing an income while you are unable to work, you also don’t even get statutory sick pay to help you out.

This can mean that sole traders are one of the main groups of people that could really benefit for an income protection policy. It also means that you probably want a policy with as short a deferred period as possible, that suits your budget.

Income protection for sole traders

If you are a sole trader, your business income and personal finances are often closely connected. If you become too ill to work, you could find that your income drops significantly.

A lot of the time, you don’t have a team of people working with you, to make sure that your contracts are still met and the money can keep coming in. The only person you can typically rely on to keep your income coming, is you. If you can’t work you will still likely have business expenses to pay, as well as your personal bills.

Personal income protection can help replace part of your earnings if you meet the policy’s definition of incapacity and the other claim conditions. What you really want to look for is an income protection policy that is set up on an ‘own occupation’ definition, which means that you are covered if you are unable to carry on working in your current role. Other definitions are much broader and really reduce the ability for you to make a claim.

Would you need to wind down your business?

Income protection is intended to support you when illness or injury prevents you from working. It is not business interruption insurance, and it is not designed simply to compensate you because your business is making less money. 

We are seeing more enquiries from people that are social media influencers and they are a good example of how income protection works. If the person is ill and cannot work, a claim can be considered. If contracts drop, algorithms change or the person simply loses their mojo, that isn’t covered by an income protection policy.

Depending on your circumstances, being ill could mean temporarily closing the business, handing work over to someone else or winding it down. The exact position will depend on the policy wording, your occupation, the work you can still do and the circumstances of your claim.

You should not assume that you can continue carrying out your usual work and claim the full benefit simply because your earnings have reduced. Some people think, well I need to carry on working until the claim pays out so I will, but the insurer then says that they can’t pay the claim out because you are still working. But then you think hang on a minute, I can’t possibly not work, I need the money. Ultimately, if you can carry on working, you should do. The income protection insurance is there for when you cannot work.

Let’s take a look at an example of income protection for an electrician. Imagine that you are a self-employed electrician who develops a serious back problem. You can no longer carry out electrical work, but you have several outstanding jobs and customers who still need assistance.

You might be able to arrange for another electrician to complete the work, but you would need to consider whether you are still working in the business, what duties you are performing and how the insurer assesses your incapacity. You would also need to check whether the income you continue to receive affects the claim.

Ongoing income can alter how much the insurer pays to you each month and it’s important that you are very clear with them about any ongoing contracts that you are due to receive income from. A great example here is barristers as they can potentially get income from their cases for a good 12-18 months after the work is done. A claim could be made if they become ill and are unable to work, but the amount the insurer will give them will fluctuate depending upon this ongoing income.

These are questions worth asking before you take out a policy, rather than waiting until you are unwell.

How much of your income can you protect?

Insurers will assess your earnings when determining the amount of income protection available to you. For self-employed applicants, this can involve looking at business profits and evidence of income, such as tax returns or accounts.

The way an insurer calculates eligible earnings varies. Some may use an average of previous years’ earnings, which can be a bit tricky if your income fluctuates.

It is important to make sure that the benefit you apply for reflects the income the insurer would recognise if you needed to claim. The insurer will always have an upper limit, potentially around 65%, of your income that can be insured. This is really important for self-employed people. Let’s say that 65% of your income is equal to a monthly benefit of £2,000. You set up an income protection policy for this and everything is good to go.

But, when you make a claim your average earnings over the last 3 years has dropped so that the 65% is now equal to £1,500 per month. Even though you insured at the higher benefit, the insurer will cap the payment to the 65% of earnings. This is why it’s really important to keep reviewing your income protection over time. It’s also why it’s really important to see if the insurer your policy is with can lock in a minimum benefit guarantee, that means that if your income drops below a certain level, they will still honour the higher amount.

You should also think about how much money you actually need each month. Protecting the income required to meet essential bills may be more affordable than trying to replace your entire usual earnings.

Income protection for directors of limited companies

If you operate through a limited company, the situation can be different.

As a company director, you might receive a combination of salary and dividends. You may also have other company-related financial arrangements that need to be considered when calculating how much income you need to protect.

There are two main approaches worth exploring: personal income protection and executive income protection.

Option 1: Personal income protection

A company director can apply for personal income protection in much the same way as an individual applying for cover in their own name.

You pay the premiums personally, and the policy is designed to pay you a benefit if you meet the claim conditions.

The amount of income you can protect will depend on the insurer’s eligibility rules and how it assesses your earnings. It is important to check whether salary, dividends or a combination of the two can be taken into account.

This option can be straightforward. You know that if you insure yourself for £2,500 per month and you make a successful claim, that is what is coming into your bank account each month.

Option 2: Executive income protection

Executive income protection is arranged through a limited company to protect an eligible employee’s income if they are unable to work because of illness or injury. It can also be available to company directors.

One of the main differences is that the company owns and pays for the policy, rather than you paying the premiums from your personal bank account.

There are several potential benefits to this arrangement.

The company pays the premiums

The premiums are paid by the business and can usually be offset against corporation tax, subject to the relevant tax rules and the company’s circumstances. Your accountant can confirm how the policy should be treated for your business.

A higher level of income may be insured

Some executive income protection policies can insure a higher percentage of eligible earnings than personal policies. Depending on the insurer and policy, this may be up to around 80% to 85% of income.

The insurer will still apply its own rules about what counts as eligible income and how much it will pay if you make a claim.

National Insurance and pension contributions may be included

Some policies allow the company to insure additional costs, such as employer National Insurance contributions and pension contributions. This can be useful if the aim is to help the business maintain elements of your remuneration package during a period of illness.

The availability and limits of these benefits will depend on the policy.

The company receives the claim payment

With executive income protection, a successful claim payment is generally made to the company, rather than directly to your personal bank account. The company can then use the money in accordance with the policy terms and the relevant tax and payroll rules.

The important considerations with executive income protection

Executive income protection can be a useful option, but there are practical issues that company directors need to understand.

Your company needs to remain active

If you make a claim, the company will generally need to remain in existence to receive the benefit and operate the arrangement. 

So whilst a higher monthly benefit can be offered, you need to keep in mind that you will need to continue paying for payroll services and other business expenses, to keep the claim active.

This is particularly important if you are a director of a small company with limited cash reserves.

What happens if you stop receiving PAYE income?

Your employment and payment structure can also affect whether executive income protection remains appropriate.

For example, you might move from receiving a salary through your limited company to working under an IR35 arrangement where your payments are structured differently.

If you stop receiving the PAYE income required by your policy, you may no longer meet the insurer’s eligibility conditions. In most instances the income protection policy will need to end or be replaced with a more suitable arrangement.

Do not assume that an existing policy will automatically continue to protect you if your remuneration structure changes.

If you are considering a move away from PAYE, speak to your adviser and insurer before making the change. You need to understand what it means for your existing cover and whether another type of income protection may be available.

What if you cannot work but the company still needs you?

There is another practical issue that can affect company directors.

If you are the main person responsible for delivering the company’s services, you might feel that you have to keep working, even when you are unwell. You may be concerned that the business will struggle or fail if you stop.

However, an income protection claim depends on the policy’s definition of incapacity and the circumstances of your work. Continuing to perform your normal duties could affect whether you meet the claim conditions. You might be able to work reduced hours and claim a proportional benefit, rather than the full amount.

You also need to choose a suitable deferred period. This is the time you must wait before the policy starts paying a benefit, provided the claim is accepted.

A longer deferred period can reduce the premium, but it may not be appropriate if you have little money set aside and need financial support quickly. The key is to balance affordability with how long you could realistically manage without your usual income.

Which type of income protection is right for you?

There is no single answer for every self-employed person. Your business structure, income, personal commitments and ability to keep the business running will all influence the options available.

As a starting point:

• Sole trader: Personal income protection may be appropriate, but you should understand how the insurer assesses your inability to work and what happens to your business during a claim.
• Limited company director: Personal income protection may be an option if you want cover in your own name and know that if your business folds or is sold, that you still have this insurance in place.
• Limited company director considering executive cover: This may offer advantages through company-funded premiums and the potential to insure additional remuneration-related costs, but you need to consider the company’s ongoing obligations and how the policy fits your payment structure.

It is also worth reviewing your cover whenever your circumstances change. A growing business, a change in earnings, new employees, a different salary arrangement or a move to an IR35 contract could all affect the suitability of your existing policy.

What income are we actually protecting?

When arranging income protection, it is easy to focus on the amount of money you would like to receive each month. This is the key part of the policy, but there are a lot of technical extras that need to be set up in the right way, to make sure that the policy does what you are expecting it to.

At Cura, we understand that income protection for self-employed people can be more complicated than it first appears. We can help you explore the options available, understand the differences between personal and executive income protection, and consider how the policy would work if you needed to claim.

If you are self-employed and want to protect your income, get in touch with Cura. We can help you look at the options that may be suitable for you and your business.