Exam FX Chapter 3. Disability Income Insurance

Function of Disability Income Insurance

One major risk that individuals face in their lifetime is the possibility that they will become totally disabled and be unable to perform work duties for a period of time. Recent statistics show that there is a 30% chance of a 25-year-old being disabled for more than 90 days prior to age 65. it is far less likely that the same 25-year-old will suffer a premature death prior to age 65

For most people who are unable to go to work, employment income would terminate after a brief period of time. Consequently, most people would be forced to turn to personal savings to pay normal living expenses such as food, rent and utilities. A question to ask is how long a person can survive without any income.

Disability income insurance is designed to replace lost income in the event of this contingency, and is a vital component of a comprehensive insurance program. It may be purchased individually or through an employer on a group basis.

Individual Vs. Group Coverage

Group plans differ from individual plans in a variety of ways. Listed below are the most common differences between group and individual disability plans:

• Group plans usually specify the benefits based on a percentage of the worker’s income, while individual policies usually specify a flat amount.

• Short-term group plans usually provide maximum benefit periods of 13 to 52 weeks (with 26 weeks being the most common), with weekly benefits of 50% to 100% of the individual’s income. Individual short-term plans have maximum benefit periods of 6 months to 2 years. Short-term plans are not renewable

• Group long-term plans provide maximum benefit periods of more than 2 years, with monthly benefits usually limited to 60% of the individual’s income

• Group disability plans also have minimum participation requirements. Usually the employee must have worked for 30 to 90 days before becoming eligible for coverage

• Group plans usually make benefits supplemental to any benefits received under workers compensation

• Some group disability plans limit coverage to only nonoccupational disabilities

Group disability plan benefits are based on a percentage of the worker’s income; individual policies specify a flat amount.

Financial Planning Considerations

Most people in our society depend upon their wages or salary to satisfy basic physiological and psychological needs and wants. When that income is cut off, regardless of the cause, the result can be catastrophic to a person. The income of individual can be cut off by premature death, depriving his or her dependents of the income upon which they rely to meet their basic needs. Most individuals protect against this “risk” through the purchase of life insurance. Often, however, people overlook an equally-important threat to their income-earning ability, the “living death” of disability. Just as death terminates the income of the deceased, sickness or an accident can cause a loss of income for those who suffer from a disability. The chances of disability are much greater than that of premature death, and disability may occur more than once in an individuals lifetime.

Some practical considerations in determining disability incomes needs include the following:

• Establish the minimum income required if income stops because of disability (remember that in addition to the stoppage of income, there will be the added expense of caring for a disabled person.)

• Consider the need for retirement plan maintenance if the indivdual has such a plan that would be disrupted in the vent of long-term disability

• After establishing total needs, allow for any benefits that would be provided by Social Security and/or Workers Compensation

• Include enough long-term disability coverage for both occupational and nonoccupational sickness and injury, as well as short-term disability coverage in order to provide income during the Social Security waiting period or in order to supplement Workers Compensation.

Alternatives to disability income insurance

If person suffers from a disability but does not have disability insurance, he or she may consider other alternatives for funding needs rather than purchasing disability income insurance. The following are some of those alternatives and possible problems that could arise from using them:

• Using savings- Using savings that are not specifically designated for that purpose could wipe out a retirement program or children’s education fund. If a person is totally or permanently disabled, this type of alternative plan would probably be lacking. (if an individual saved 5% of his or her income each year, 6 months of total disability could wipe out 10 years of savings.)

• Borrowing- the most immediate problem is finding a lender who will lend money to someone without an income. If a loan is made, how will it be repaid?

• Depending on spouses income - will it be sufficient to support the family? Also consider that the spouse may too become disabled.

• Liquidating assets - funds may be raised by selling the home and perhaps other assets, but it is sometimes difficult to get a fair market price when the liquidation is forced

Only disability insurance can guarantee that in the event of disability, adequate income will be provided for the duration of the disability.

Defining total Disability

Disability income benefits are limited to a percentage of earned income. The insurer wants a claimant to have a financial incentive to return to work. A person becomes eligible for regular disability benefits when they meet the insurance company's definition of disability due to either a sickness or an injury. This definition of disability does vary from company to company. It is important for the applicant and the producer to be fully aware of this important benefit trigger.

To pay benefits, a disability income policy will require for the insured to not be able to perform the duties of his or her occupation. The benefits will also depend on the definition of disability chosen for the policy. 

Total disability is defined differently under some disability income policies. Some policies use a relatively strict definition such as the any occupation definition, similar to Social Security. This definition of total disability requires the insured to be unable to perform any occupation for which the insured is reasonably suited by reason of education, training, or experience. Other insurers have adopted a more liberal definition that defines total disability as the "inability to perform the duties of one's own occupation." As would be expected, the more liberal "own occupation" definition of disability makes it easier to qualify for disability benefits.

Own Occupation

An own occupation policy will provide benefits when the insured is unable to perform any duties of their own occupation because of sickness or accident.

This definition is usually limited to the first 24 months after a loss. It allows insureds (claimants) to receive benefits if, because of disablement, they cannot perform the duties of their normal occupation, even though they might be able to earn income from a different occupation. After 24 months, if the insured is still unable to perform the duties of their own occupation, the definition of disability narrows to mean the inability to perform any occupation for which the insured is reasonably suited by education, training, or experience. This is a dramatic reduction in the insurer's liability because it is very likely that claimants can find something they can do for financial gain. The “own occ” definition is generally used for highly trained, skilled occupations such as surgeons, trial attorneys, etc.

Any occupation

A policy that has an "any occupation" provision will only provide benefits when the insured is unable to perform any of the duties of the occupation for which they are suited by reason of education, training, or experience. "Own occupation" is the more liberal definition and therefore provides a better benefit for the insured.

Although some companies still utilize the two-tier approach by combining both definitions in a single disability income policy, from an underwriting standpoint, it is much easier for an insurance company to justify the "any occupation" definition when agreeing to issue a policy. Considering a disabled insured is able to perform some duties of the occupation, coverage under the "any occupation" policy is more likely to be denied than under the "own occupation" policy.

Presumptive Disability

Presumptive Disability is a provision that is found in most disability income policies which specifies the conditions that will automatically qualify the insured for full disability benefits. Some disability policies provide a benefit when people simply meet certain qualifications, regardless of their ability to work. The presumptive disability benefit provides a benefit for dismemberment (the loss of use of any two limbs), total and permanent blindness, or loss of speech or hearing. Some policies require actual severance of limbs rather than loss of use.

Occupational vs. Nonoccupational

Health insurance, including disability insurance, can be written on an occupational or a nonoccupational basis. Occupational coverage provides benefits for illness, injury or disability resulting from accidents or sicknesses that occur on or off the job. Nonoccupational coverage, on the other hand, only covers claims that result from accidents or sicknesses occurring off the job. While many individual health policies are written on an occupational or nonoccupational basis, most group plans are nonoccupational only. It is assumed that accidents or injuries occurring on the job will be covered by Workers Compensation coverage. Policies written on an occupational basis cover accidents or sicknesses that occur on or off the job. When written on a nonoccupational basis, policies cover claims that result solely from accidents or sicknesses occurring off the job.

Probationary Period

Probationary period is another type of waiting period that is imposed under some disability income policies. It does not replace the elimination period, but is in addition to it. The probationary period is a waiting period, often 10 to 30 days, from the policy issue date during which benefits will not be paid for illness-related disabilities. The probationary period applies to only sickness, not accidents or injury. The purpose for the probationary period is to reduce the chances of adverse selection against the insurer. This helps the insurer guard against those individuals who would purchase a disability income policy shortly after developing a disease or other health condition that warrants immediate attention. Probationary periods apply to sickness, not accidents or injury.

Elimination Period

Elimination period is a waiting period that is imposed on the insured from the onset of disability until benefit payments commence. It is a deductible measured in days, instead of dollars. The purpose of the elimination period is to eliminate coverage for short-term disabilities in which the insured will be able to return to work in a relatively short period of time. The elimination periods found in most policies range from 30 days to 180 days. Just as a higher deductible amount results in lower premiums for medical expense insurance, a longer elimination period translates into a lower premium for disability income insurance. An important consideration in selecting the elimination period is that payments are made in arrears. Therefore, if the insured selects a 90-day elimination period, the insured will be eligible for benefits on the 91st day, but payments will not begin until the 121st day. The insured must determine how long he or she can go without benefit payments following disability in selecting the duration of the elimination period. The elimination period is a "time" deductible, designed to eliminate coverage for short-term disabilities and reduce the filing of excessive claims.

Benefit Periods

Benefit period refers to the length of time over which the monthly disability benefit payments will last for each disability after the elimination period has been satisfied. Most policies offer benefit periods of 1 year, 2 years, 5 years, and to age 65. Some plans offer lifetime benefits. The longer the benefit period, the higher the premium will be.

Benefit Amounts

Benefit Limitations—The amount of monthly benefit that is payable under most disability income policies is based on a percentage of the insured's past earnings. The benefit limits are the maximum benefits the insurer is willing to accept for an individual risk. It is common to find policies that limit benefits to roughly 66% of the insured's average earning for the period of two years immediately preceding disability.

Rarely will an insurer write a disability income policy that will reimburse the individual for 100% of lost income. The reason that insurers don't pay benefits that are equal to the insured's prior earnings is to reduce the chance of malingering on the part of the insured. If an insurer were to pay an insured benefits that were as much or more than the insured earned, the individual would have no incentive to return to work as quickly as possible. Paying the insured an amount that is less than their prior earnings creates an incentive for the insured to return to work after a disability, as opposed to collecting benefits when the insured is capable of returning to work.

Most insurers will adjust benefits in accordance with any amounts that the insured may be receiving from Social Security or Workers Compensation. If the insured is receiving benefits from these programs, the insurer will decrease the amount of benefit that is paid under the policy so that the insured will not be able to profit from the disability.

Confining vs. Nonconfining Disability

While not common, some disability income policies may include a provision that differentiates between disabilities as either confining or nonconfining.

Total, confining disability refers to a condition that requires the individual to stay indoors, perhaps in a hospital or at home, except for visits to the health care provider.

Total, nonconfining disability refers to a condition that disables but does not require the individual to remain confined indoors.

Unless a policy specifically includes this provision, the absence or presence of confinement does not affect the total disability classification.

Partial Disability

Partial disability is often defined as the inability to perform one or more of the regular duties of one’s own occupation or the inability to work on a full-time basis, which results in a decrease in the individual's income. The purpose of the partial disability benefit is to cover a partial loss of income when the insured is disabled to the point of  being able to report to work, but not being able to perform all of the regular duties of the job. The partial disability benefit is typically 50% of the total disability benefit, and is limited to a certain period of time, as noted in the policy.

The benefits paid on a partial disability policy are paid in a flat amount, or a residual amount. Partial disability covers a partial loss of income for disabled insureds who are unable to perform some, but not all, of their regular job duties.

Residual Disability

Residual disability is the type of disability income policy that provides benefits for loss of income when a person returns to work after a total disability, but is still not able to work as long or at the same level he/she worked before becoming disabled. Many companies have replaced partial disability with residual disability. Residual disability will help pay for loss of earnings. If the person can only work part-time or at a lesser paying position, residual disability will make up the difference between their present earnings and what they were earning prior to disability. Residual disability is calculated as a percentage, determined by current earnings and earnings prior to disablement.

Recurrent Disability

Recurrent Disability is generally expressed in a policy provision that specifies the period of time (usually within 3-6 months), during which the recurrence of an injury or illness will be considered as a continuation of a prior period of disability. The significance of this feature is that recurrence of a disabling condition will not be considered to be a new period of disability so that the insured is not subjected to another elimination period.

Delayed Disability

Sometimes an accident or sickness can result in delayed disability. This describes a situation in which the individual is not disabled immediately, but as time passes, the person becomes totally disabled. Most policies will still pay benefits if the disability occurs within a span specified in the policy and is expressed as the number of days following the event, usually 30 to 90 days.

Combined Accident and Sickness Disabilities

A person who is disabled as the result of an accident will sometimes contract a serious illness which would have also caused disability even in the absence of the accident. If this person is insured under a policy with disability income benefits, he or she might assume entitlement to benefits for both of the disabilities (the total accident disability and the total sickness disability). However, the objective of disability income coverage is to partially reimburse the insured for loss of income due to either accident or sickness. When both types of disability are present at the same time, the individual suffers only one loss of time and will therefore collect only one loss of time benefit.

Nondisabling Injuries

Most disability income policies do not provide benefits for nondisabling injuries in which the insured is injured but not disabled. However, some policies do provide such benefits to cover the cost of lost time due to medical consultations or minor surgery. In order to receive a benefit under this provision, the insured must be able to show that the treatment caused a loss of work time. A nondisabling injury benefit is usually limited to a maximum amount of 10% of the regular weekly benefit.

Optional Short-Term Benefits

For an additional premium, the insured may select other short-term benefits to be a part of the disability income coverage. They include the following:

• Supplemental income (aka, additional monthly benefit rider): provides additional income during the first several months of a long-term disability.

• Hospital income: pays a stipulated amount per day when the insured is hospitalized.

• Elective benefits or indemnities: provides lump-sum payments for certain injuries, such as fractures, dislocation, sprains, or amputation of toes or fingers. (The lump sum payment is elected by the insured in lieu of the periodic weekly or monthly benefits as stated in the contract.)

Rehabilitation Benefit

f the insured has been totally disabled, it is possible that rehabilitation will be necessary to help get the insured back to work, either in their old occupation or in another occupation. The rehabilitation benefit will cover a portion of the cost for the insured to enroll in a formal retraining program that will help the insured to return to work. This benefit usually offers a specified sum (several times of the monthly indemnity) to cover costs not paid by other insurance.

Refund Provisions

Some insurance companies offer an incentive for low claim usage by offering a refund under the proper conditions.

Return of Premiums

The return of premium rider provides a refund of a percentage of premiums at certain times. For example, at the end of the tenth year, the insurance company may offer to refund 80% of the excess of premiums paid over claims.

Cash Surrender Values

The cash surrender rider creates a cash value of around 70% of the premiums paid in excess of claims. This cash value is often only available to the owner at the termination of the contract.

Business Uses

Just as an individual purchases disability income insurance to protect his/her ability to earn a living, a business purchases business disability insurance on its key employees to protect it from loss when the employee becomes disabled.

Key Person Disability

Key person disability is purchased by the employer on the life of a key employee. The key person's economic value to the business is determined in terms of the potential loss of business income which could occur as well as the expense of hiring and training a replacement for the key person. The contract is owned by the business, the premium is paid by the business, and the business is the beneficiary. The person is the insured, and the business must have the key person's consent to be insured in writing. In key person disability insurance, the business is the contract owner, premium payor, and the beneficiary.

Business Overhead Expense

Business overhead expense (BOE) insurance is a unique type of policy that is sold to small business owners who must continue to meet overhead expenses, such as rent, utilities, employee salaries, installment purchases, or leased equipment, following a disability. The business overhead expense policy reimburses the business owner for the actual overhead expenses that are incurred while the business owner is totally disabled. This policy does not reimburse the business owner for their salary, compensation, or other form of income that is lost as a result of disability. There is usually an elimination period of 15 to 30 days and benefit payments are usually limited to one or two years. The benefits are usually limited to covered expenses incurred or the maximum monthly benefit stated in the policy. The premiums paid for BOE insurance are tax deductible to the business as a business expense. However, the benefits received are taxable to the business as received.

Reducing Term Disability

Small businesses often incur fixed payment obligations that are paid from business revenues, and as long as the owner can run the business, repayments payments can be made, or if the business owner dies, insurance can guarantee that obligations are satisfied.

Serious financial problems can arise in the event that the business owner is totally disabled and unable to operate the business. Disability reducing term insurance can be the solution to many of these problems for a business.

Some of the risks well suited for coverage under this type of insurance program include

• Salary contract guarantees: to attract the proper type of personnel, an owner may have to offer a multi-year guaranteed employment contract (payable whether the employee dies or is totally disabled). This could represent a large fixed payment obligation, should an employee become totally disabled and a replacement employee had to be hired;

• Contract performance guarantees;

• Funding of medium term loans dependent upon the business talents of a key individual for their repayment; and

• Purchase agreements.

Note that if reducing term insurance covers employment or performance contacts, the benefits would be received by the owner on a tax exempt basis and paid out on a tax deductible basis.

Unlike decreasing term life insurance which reduces the face amount of coverage over the term of the policy, disability reducing term insurance reduces the benefit period, but the amount of coverage remains the same.

Disability reducing term insurance may be purchased of any number of years from 5 to 30, but cannot extend beyond age 60. As with other disability contracts, the coverage contains an elimination period (from one month to one year). The benefit period begins at the end of the elimination period until the end of the period of coverage or prior recovery from total disability. The minimum term period is 12 months during the last year of coverage. If the insured is disabled and recovers, the unused benefit term is still available.

Disability Buy-Sell

A buy-sell agreement is a legal agreement prepared by an attorney. The buy-sell agreement specifies how the business will pass between owners when one of the owners dies or becomes disabled. It is common for the business to purchase insurance to provide the cash to accomplish the buyout when the owner either dies or becomes disabled. The policies that fund buy-sell agreements generally have an extremely long elimination period, possibly one or two years. Generally, these policies funding buy-sell agreements also provide a large lump-sum benefit to buy out the business rather than monthly benefits.