Income protection vs critical illness cover
Both income protection and critical illness insurance provide financial support if your health deteriorates, but they work in very different ways.
The distinction matters, particularly for company directors, where income protection is often arranged through the business, while critical illness cover is usually held personally.
How income protection works
Income protection pays a regular monthly benefit if you’re unable to work because of illness or injury. Payments continue until you recover, your chosen benefit period ends, or you reach retirement age.
Executive policies, used by limited company directors, can typically insure up to around 80% of combined salary and dividends, subject to insurer limits. Personal policies usually cover a lower proportion of income. Where the policy is paid for by the company, premiums are often treated as a business expense and may reduce your Corporation Tax bill.
The key point is that income protection replaces earnings over time. It is designed to maintain an income stream while you are unable to work, rather than provide a single payment. You can choose short-term or long-term cover depending on how long you want payments to continue.
How critical illness cover works
Critical illness cover pays a single lump sum if you are diagnosed with a condition defined in the policy. Common examples include cancer, heart attack and stroke, although the exact list varies by insurer.
The payment is made once and can be used for any purpose, such as repaying debt or covering major expenses. After a successful claim, the policy normally ends.
Unlike income protection, it does not provide an ongoing income. It is therefore more suited to dealing with one-off financial commitments rather than replacing regular earnings.
The Association of British Insurers (ABI) provides further detail on how critical illness cover is structured.
Key differences
- Type of payout: Income protection provides a monthly benefit while you are unable to work. Critical illness pays a single lump sum.
- Trigger for payment: Income protection pays where a medical condition prevents you from carrying out your role (subject to the policy definition). Critical illness cover only pays if a specified condition is diagnosed.
- Duration: Income protection can pay for an extended period, potentially until retirement. Critical illness cover pays once and then ends.
- Tax treatment: Critical illness payouts are usually tax-free. Income protection benefits are tax-free where policies are personally funded, but are taxable where paid to a company under an executive policy.
- Purpose: Income protection is intended to replace lost earnings. Critical illness cover is typically used for larger, one-off costs.
Many directors hold both types of policy, but for different reasons. A critical illness policy can deal with immediate costs following diagnosis, while income protection provides a continuing income if you are unable to work for a longer period.
If you are unsure how to structure cover, it is worth discussing the options with a regulated financial adviser. They can take into account how you are paid, whether through salary, dividends or both, and how existing sick pay arrangements affect your position. You can also get a quote to compare costs.