Shielding protection cover from inflation

At a glance

• The longer a policy is in place, the greater the risk inflation will erode the real value of a fixed benefit.
• Index linking (linking the policy value to inflation) can help the payouts keep pace with rising costs.
• Financial advice can ensure you take out the right protection cover for you and your family. 

Most of us understand that inflation pushes up the cost of everyday essentials, from food shopping to energy bills. But fewer people realise it can also reduce the future value of their protection cover.

If you have life insurance or critical illness cover, the amount paid out might stay the same while the cost of living continues to rise. Over time, that could mean the policy provides less financial support than you originally intended. That’s why it’s worth considering ways to help your protection cover keep pace with inflation, so it continues to provide a valuable safety net for you and your loved ones.

How inflation erodes your spending power

It can be helpful to keep tabs on your everyday costs and outgoings – the mortgage, energy bills, petrol, and food shopping. It supports your household budgeting and helps you feel in control. It can also help you understand how much protection, such as life insurance, critical illness, and income protection cover, you may need.

Many people will have felt the effects of rising costs in recent years as prices have increased. This is inflation reducing the purchasing power of your money. It means the same amount of money today may buy less in the future.

Niki Patel, tax and trust specialist at St. James's Place, says: “The higher inflationary environment of the last few years is a reminder that the spending power of money changes over time. This is an important factor to consider when taking out or reviewing a long-term insurance policy.

“The benefit or payout from a critical illness, income protection or life assurance policy could have much less spending power in a decade or longer if it doesn’t increase over time.”

How cover can keep pace with rising prices

When you take out a protection policy, there will usually be the option to index link the benefits. This is known as indexation.

Depending on the policy, cover may increase in line with an inflation measure, such as the consumer price index (CPI), an earnings measure, or by a fixed percentage each year.

This can make a substantial difference to your benefits over time. For example, £200,000 of cover increasing by 3% each year would grow to around £269,000 after 10 years, and around £361,000 after 20 years.

However, protecting the value of your cover through indexation is likely to mean that your premiums will also rise over time. It is important to consider this when weighing up the pros and cons of indexation.

The affordability of your premiums is an essential factor to consider when choosing or reviewing your cover. If you are unable to continue making payments then the policy will lapse, which could leave you worse off than before.

Keeping your policy relevant

Here is a brief overview of how inflation could affect different types of protection:

• Whole of life assurance pays out on the death of the policyholder. It could be in place for many years. This means that, over time, inflation could create a gap between its nominal value and its real value.
• Term insurance typically pays a lump sum if you die during the term of the policy. Increasing or index-linked cover can help the benefit keep pace with rising costs.
• Critical illness cover typically pays a lump sum following diagnosis of a specified condition. A fixed lump sum can lose spending power over the years before a claim is made.
• Income protection is designed to replace part of your income if you are unable to work due to illness or injury, subject to the policy terms. Depending on the policy, benefits may be able to increase over time, so it is important to understand how your cover works.

Keeping your policy relevant in the face of inflation goes hand in hand with making sure it continues to reflect your circumstances.

Getting married or divorced, having children, changing jobs, buying a home and approaching retirement are examples of changes that could change your protection needs. These life events can provide a useful prompt to review your cover.

Weighing up the options

When reviewing your existing protection planning and cover, consider the following:

• What was the policy originally intended to cover?
• Is that financial need still the same?
• Has the cover increased, decreased or remained the same?
• What would the benefit buy today?
• Does the policy have indexation or options to increase the cover?
• If the cover increases, how will this affect the premium you pay?
• Have my circumstances changed since I took out the policy?

If you are unsure about what cover is right for you, or if your existing cover is still appropriate, a financial adviser can help by talking through the options and reviewing your current position.

Niki adds: “Protection planning is much more than simply putting cover in place. It’s also about making sure that cover continues to fulfil the purpose it was designed for.”