What an insurer pays when your earnings move year to year

When your income is a salary, an insurer has an easy figure to work from. When it isn't, they need a way to decide what you actually earn, because that figure sets the most you can claim if you're ever unable to work. Getting a sense of how that calculation works before you apply means fewer surprises when a policy is priced or a claim is assessed.

Averaging, not your best year

Insurers typically look at your accounts or tax returns over a run of years, often two or three, and average them. A year where you earned well does not immediately raise what you could claim. A quieter year further back can still be dragging the average down, even if your current trading looks strong.

This cuts both ways. It protects you a little if last year was weak, because older, better years are still counted. It also means a recent improvement in your income takes time to show up in the cover you can get.

What you'll be asked for

To work out that average, an insurer needs documentary evidence. The usual requests are:

• Tax calculations or tax year overviews covering the years being averaged
• Accounts prepared by an accountant, where you trade through a business
• Business bank statements, in some cases, to support what the accounts show
• Evidence of how long you've been trading, since a shorter history gives the insurer less to average

Keeping these organised each year makes the process considerably less tedious when you need them.

A lean year doesn't stay in your accounts. If your policy bases what you could claim on a share of your typical earnings, a drop in income works its way into that calculation too, and it can stay there for longer than you'd expect.

Insurers that calculate your maximum cover from an average of your past earnings don't simply swap in a new figure each year. The lean year sits inside the averaging period alongside the better years, pulling the average down until enough time passes for it to drop out of the calculation.

That has a practical effect. You might be earning normally again, but if the insurer is still averaging across a period that includes the lean year, the maximum benefit you could claim is lower than your current income alone would suggest.

What to check

• Which years your insurer includes when working out your average earnings, and how recent the most recent one needs to be
• Whether a single lean year is weighted the same as any other year in the average, or treated differently
• How long a lean year stays inside the calculation before it stops pulling your maximum cover down

Practice differs between insurers, so the only way to know how a lean year would affect your own cover is to read the earnings rule in your policy document or ask your insurer directly.

You can read the cover sizing guide with your current earnings in front of you, to see how a cap set as a share of earnings works, and compare that against what a lean year still inside your insurer's averaging period might hold your maximum down to.

If you run your own limited company, your income is not a single number pulled from one line on a payslip. You draw a salary, you take dividends, and the company may keep some of what it makes back each year. An insurer has to decide which of these it will count as yours, and that decision sets the most cover you could be sold.

Salary and dividends

Most insurers look at your salary and dividends together, since for many directors the salary is kept deliberately low and the dividends carry most of the income. Dividends move with how the company has done and with the choices you and your accountant make about what to draw, so an insurer will usually ask for more than one year of figures before settling on a number to work from.

Retained profit

Profit the company keeps is treated differently again. Some insurers will count a share of it as yours, on the view that it is profit you generated even if you chose not to draw it. Others count only what actually reached you. Where an individual insurer draws that line matters most if you habitually leave profit in the company.

Why this sets the cover you can hold

Whichever approach an insurer takes, it will not sell you more cover than its own calculation of your earnings supports. Two directors with the same company turnover, but different habits around drawing dividends against retaining profit, can end up with different maximum benefits from the same insurer, and different figures again from another insurer working from the same accounts. Working out what monthly benefit your outgoings actually call for, and seeing it against what an insurer would be prepared to offer, is the next step and one the cover sizing guide walks through. Checking how a particular insurer treats retained profit before you apply tells you whether the cover you want is one it would actually sell you.

Insurers do not all establish self-employed earnings the same way. One may average two years of accounts, another three; one may weight a stronger recent year more heavily, another may not. The rule that applies to a claim is the one written into the policy taken out.

Why the gap between insurers is worth checking

If the averaging method differs, so does the maximum that could be claimed after a year where earnings fell. Two people with identical accounts, insured with different insurers, could find different figures sitting in their policy documents for exactly that reason. Reading the rule before a policy is taken out is the point at which it is still possible to choose.

What to ask before taking out or renewing a policy

• Which years of accounts or tax returns are used to set earnings, and is that period fixed or can it move
• Whether a single poor year is averaged away or whether it lowers what could be claimed
• How dividends and retained profits are treated if cover is being taken out through a limited company
• What happens to the figure used if earnings have risen sharply in the most recent year

The cover sizing guide explains how insurers cap cover as a share of pre-tax earnings, so a figure worked out this way can be checked against the cap in your own policy. The claim definitions guide covers the separate question of whether a claim succeeds at all, which depends on the occupation definition. Neither guide replaces reading the policy document itself, or asking the insurer or a regulated adviser the questions above directly.