Income protection insurance (also called permanent health insurance or PHI) pays a regular income to the policyholder if they are unable to work due to illness or injury. For employers, a group income protection policy ensures employees continue to receive a proportion of their salary during long-term absence, protecting both the individual and the business.
Unlike statutory sick pay (SSP), which pays the lower of a flat weekly rate and 80% of average weekly earnings for up to 28 weeks, income protection replaces a meaningful percentage of the employee’s actual earnings and can continue paying until the employee recovers, reaches retirement age, or the policy term ends.
How Income Protection Works
- The employer (or individual) takes out a policy with an insurer
- A waiting period (deferred period) must pass before payments begin – typically 4, 13, or 26 weeks
- If the employee cannot work due to illness or injury beyond the waiting period, the policy pays out
- The benefit is a percentage of pre-incapacity earnings, typically 50-70% of salary
- Payments continue until the employee returns to work, reaches retirement age, or the policy term ends
Waiting Period Options
| Waiting Period | Best For | Effect on Premium |
|---|---|---|
| 4 weeks | Maximum protection; suitable when employer sick pay is minimal | Highest premium |
| 8 weeks | Bridges from employer sick pay to long-term support | Moderate premium |
| 13 weeks | Common for businesses with 3 months’ contractual sick pay | Lower premium |
| 26 weeks | Aligns with end of SSP entitlement | Lowest premium |
The waiting period should align with the employer’s contractual sick pay arrangements. If the company pays full salary for 13 weeks, a 13-week deferred period avoids paying for insurance that duplicates existing cover.
Individual vs Group Income Protection
| Feature | Individual Policy | Group Policy |
|---|---|---|
| Who takes it out | The individual (director, sole trader, employee) | The employer |
| Who pays premiums | The individual | The employer |
| Medical underwriting | Required for each applicant | Usually not required below the free cover limit |
| Tax on premiums | Not tax-deductible for employees (deductible for sole traders in some cases) | Allowable business expense |
| Tax on benefit | Tax-free | Taxable as employment income (PAYE) |
| Portability | Continues if the person changes job | Ceases when employment ends |
| Minimum group size | N/A | Typically 3-5 employees |
For Directors and Sole Traders
Company directors who are employees of their own limited company can be covered under a group scheme (even a small one). Sole traders must take out an individual policy, but the premiums are not tax-deductible as a business expense (because the benefit is tax-free when received).
For directors of limited companies, the employer-paid group policy is the more tax-efficient route because the premium is a Corporation Tax deduction while the benefit, though taxable as income when paid, replaces salary that would have been taxable anyway.
What is Covered?
Income protection covers the inability to work due to:
- Physical illness – cancer, heart disease, musculoskeletal conditions, neurological conditions
- Physical injury – accidents, back injuries, fractures
- Mental health conditions – depression, anxiety, stress-related illness (most policies now include mental health, though some limit the duration of mental health claims to 2 years)
Definition of Incapacity
Policies use different definitions, which matter enormously:
| Definition | Meaning | Quality |
|---|---|---|
| Own occupation | Cannot perform your specific job | Best – recommended |
| Suited occupation | Cannot perform any job suited to your education, training and experience | Moderate |
| Any occupation | Cannot perform any job at all | Worst – very difficult to claim |
Own occupation is the gold standard. A surgeon who injures their hand cannot operate but might be able to do administrative work – an “own occupation” policy pays out; an “any occupation” policy might not.
Cost
Group income protection premiums depend on:
| Factor | Impact |
|---|---|
| Workforce demographics | Older and manual workforces cost more |
| Benefit level | 75% of salary costs more than 50% |
| Waiting period | Shorter waiting periods cost more |
| Industry | Higher-risk occupations cost more |
| Claims history | Previous claims increase premiums |
| Policy term | Paying to retirement age costs more than a limited term |
Indicative Premiums
For a typical UK office-based workforce with a 13-week waiting period and 75% of salary benefit:
| Group Size | Approximate Cost (% of salary bill) |
|---|---|
| 5-20 employees | 1.0% - 2.0% |
| 21-50 employees | 0.8% - 1.5% |
| 51-100 employees | 0.6% - 1.2% |
| 100+ employees | 0.5% - 1.0% |
A company with a £400,000 payroll might pay £4,000 to £8,000 per year for group income protection.
Tax Treatment
Group Policies (Employer-Paid)
| Element | Tax Treatment |
|---|---|
| Premiums paid by employer | Allowable Corporation Tax deduction |
| Premiums | Not a taxable benefit in kind for the employee; no P11D reporting |
| Employer NIC on premiums | None |
| Benefit paid to incapacitated employee | Taxable as employment income through PAYE |
| Employer NIC on benefit | Employer pays NIC on the benefit payments |
The net effect is that the employee receives the benefit but pays income tax and NIC on it, just as they would on normal salary. This means the effective replacement rate is lower than the headline percentage. The example below uses illustrative deduction rates of 20% income tax and 8% employee NIC on the whole benefit; the real deductions depend on the employee’s tax code and the rates for the year:
| Gross Benefit (75% of £40,000 salary) | £30,000 |
|---|---|
| Less: income tax (illustrative 20%) | (£6,000) |
| Less: employee NIC (illustrative 8%) | (£2,400) |
| Net benefit | £21,600 |
| Net replacement rate | 54% of gross salary |
Individual Policies
Premiums paid by an individual are not tax-deductible (they come from post-tax income). In return, benefits received are completely tax-free. This makes individual policies attractive for higher-rate taxpayers.
Income Protection vs Other Absence Benefits
| Benefit | Duration | Amount | Paid By |
|---|---|---|---|
| Statutory Sick Pay | Up to 28 weeks | Lower of the flat weekly SSP rate and 80% of average weekly earnings | Employer (no longer reclaimable) |
| Contractual sick pay | Varies (typically 1-6 months) | Full or partial salary | Employer |
| Income protection | Until recovery, retirement, or policy term | 50-75% of salary | Insurer |
| Critical illness | One-off lump sum | Fixed amount | Insurer |
| Personal independence payment (PIP) | Ongoing while eligible | Weekly rates set by DWP, depending on need | Government |
Income protection fills the gap between the end of employer sick pay and the employee’s return to work (or retirement). Without it, an employee who develops a long-term condition faces a dramatic drop in income.
Rehabilitation and Return-to-Work Support
Modern income protection policies do far more than just pay claims. Most group policies include:
- Rehabilitation support – the insurer provides access to physiotherapy, counselling, and occupational health to help the employee return to work faster
- Early intervention – some insurers engage as soon as an employee reports a health issue, before the waiting period even starts
- Phased return – the policy may support a gradual return to work, paying a partial benefit while the employee works reduced hours
- Vocational rehabilitation – retraining or workplace modifications to help the employee return in a different capacity
These services benefit the employer by reducing absence duration and benefit the insurer by reducing claim costs. Employees benefit from professional support they might not otherwise access.
Setting Up Group Income Protection
Key Decisions
| Decision | Options |
|---|---|
| Benefit level | 50%, 60%, 66.7% or 75% of salary |
| Waiting period | 4, 8, 13 or 26 weeks |
| Payment limit | To retirement age (55, 60 or 65) or a fixed term (2 or 5 years) |
| Definition of incapacity | Own occupation, suited occupation or any occupation |
| Eligible employees | All employees, permanent staff only, or selected categories |
| Pensionable salary only or total earnings | Include or exclude bonuses and commission |
Integration with Sick Pay
Design the policy so that income protection payments start when contractual sick pay ends:
| Timeline | Income Source |
|---|---|
| Weeks 1-4 | Full salary (contractual sick pay) |
| Weeks 5-13 | Half salary (contractual sick pay) |
| Weeks 14-28 | SSP only (subject to the statutory weekly limit) |
| Week 14 onwards | Income protection benefit begins (if 13-week waiting period) |
This avoids gaps in income and avoids paying for insurance that duplicates existing arrangements.
Accounting Treatment
Premiums
Record premiums as a staff cost in the profit and loss account:
| Account | Debit (£) | Credit (£) |
|---|---|---|
| Employee benefit costs (income protection) | 6,000 | |
| Bank / Creditors | 6,000 |
Claims
When an employee is on claim, the insurer pays the benefit to the employer, who then passes it through payroll to the employee (deducting PAYE and NIC):
| Step | Entry |
|---|---|
| Insurer pays employer | Debit bank, credit income protection recovery (other income) |
| Employer pays employee via payroll | Debit salary costs, credit bank |
The net cost to the employer during a claim period is the employer NIC on the benefit payments, plus any difference between the benefit level and contractual sick pay during any overlap period.
Related Protection Benefits
Income protection forms part of a broader employee protection strategy:
- Group life insurance – lump sum if an employee dies
- Private medical insurance – access to private healthcare
- Key person insurance – protects the business from the financial impact of losing a critical individual
- Employers’ liability insurance – covers the employer’s legal liability for workplace injury or illness
- Workplace pension – retirement savings
Together, these benefits provide employees with financial security across the main risks: illness, incapacity, death, and retirement.