How will inflation affect my critical illness/life insurance/income protection policy?
With inflation at a 40-year high, we are all feeling the pinch. The economic fallout as we recover from the pandemic has been compounded by the conflict in Ukraine, and things don’t look like they will improve for some time.
CPI has hit 9.1% and the older RPI metric has hit 11.7% as of April 2022. But what does this mean for your financial protection? What impact is inflation having on your policies?
Let’s take an example using the last 25 years RPI data and a client who took out a term critical illness policy for £100pm and £100,000 sum assured over the same period.
There are three ways this could have been set up: Decreasing, Level and Increasing.
Firstly, a decreasing policy will reduce over the term to £0 by the end of the products’ lifetime. For critical illness cover this is the worst way to set up a policy in most cases. Why? Well as an individual ages, their morbidity, or risk of suffering a critical illness, increases. So, when you are most likely to need the policy proceeds, its value has reduced.
Secondly, a level policy is one that will remain at the same sum assured for the entirety of the product term. That means if you claim on day one or on the last day the policy is live, you will get the same sum.
The final, and often most appropriate way a term policy can be written is on an increasing basis. This protects the buying power of the policy long term.
Let’s compare the second and third options.
Inflation, as measured by RPI, over the last 25 years to 2021 averages at 2.932% meaning that the basket of goods increases by roughly 3% per annum. If the £100,000 policy is taken out on a level basis, the buying power of that sum 25 years later is approximately £50,400. That is nearly a 50% reduction in what the money can buy you when compared to when it is taken out.
However, to mitigate this risk, the policy might have been taken out on an increasing basis and pegged to RPI. That means year-on-year, the sum assured would increase in line with RPI, i.e., if RPI was 5% in the first year then the value of the sum assured would be £105,000 in year two. Naturally there must be an increase in premiums to cover the cost of the additional cover. This is also done in line with inflation multiplied by some factor. More on that in a moment.
If the policy paid out in year 25, the increasing policy would have increased to approximately £198,600 which would equate to the same buying power as £100,000 25 years ago. Morbidity risk increases steadily from birth to middle age and then more rapidly into old age, which means the chance of a policy paying out is higher with advanced age.
The premiums increase in line with RPI but are also multiplied by a multiplier between 1.2x and 1.6x. This means that the premiums grow at a quicker rate than RPI but at different rates depending on which insurer is used. Most insurers in the market are currently at 1.5x RPI. When comparing 1.2x and 1.5x it is important to consider what the premiums look like long term.
If we start with £100pm in 1997, then increasing this by RPI each year would result in a monthly premium of £191.11. Comparing an insurer who increases this by 1.2x and 1.5x then this figure increases to either £217.01 or £262.21 per month. Over a 25-year term that equates to a total difference of £5,457.31, not an inconsiderable amount of money.
Without considering the impact inflation can have on the real value of a protection policy such as critical illness cover, you can be left with much less than you were anticipating in real terms. This can leave a rather nasty taste when you are expecting your money to go further.
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