Disability Insurance

If I cannot afford to buy both life insurance and disability insurance, which coverage should I buy?

Both life insurance and disability insurance are important and vital to the financial security of most individuals. In some instances, however, financial resources are inadequate to purchase the needed amounts of both types of insurance. Generally speaking, throughout the typical working lifetime (e.g., ages 20-65), the probability of an individual suffering a major disability (e.g., a disability lasting 3 months or longer) is considerably greater that the likelihood of dying. The probability of a young worker suffering a major disability is as much as 6 (or more) times the probability of dying; the multiple is still 2 or more even at the higher working ages. These relative probabilities would suggest that the purchase of disability income insurance is a more important purchase than is the purchase of life insurance. Another factor supporting this view is that, in the case of disability, total expenses of the family unit will also be higher due to the costs of caring for the disabled worker.

Short Term Disability (STD) & Long Term Disability (LTD) differ most importantly in terms of the length of the elimination (waiting) period, the length of the maximum benefit period, coordination of the benefits payable under the policy with benefits payable under social insurance programs (e.g., Social Security and Workers' Compensation), and the "definition of disability" incorporated into the contract language. 

How much disability insurance should I own?

The recommended amount of disability income insurance generally ranges from 60-70 percent of pretax income. The applicable percentage for higher-income persons is usually somewhat lower than the percentage recommended for lower-income individuals, due primarily to differences in income taxes. Amounts considerably less than full replacement of earnings are recommended due to a reduction in income taxes and decreases in commuting and other work-related costs that are likely to occur in the event of disability. On the other hand, medical, rehabilitation and certain other expenses are often higher for disabled individuals creating a need for larger amounts of replacement income. In determining how much disability income insurance to buy, any benefits payable under Workers' Compensation, Social Security, and employer-provided disability benefits under pension or group insurance plans should also be considered. Whether the disability benefits themselves are subject to income taxation should also be factored into this determination.

What is an elimination, or waiting period?

The elimination, or waiting period in disability insurance refers to the length of time between the onset of a qualifying disability and the point in time when benefits under the disability insurance policy first become payable.  

In STD plans, waiting periods may range from 0 days to 3, 7, 10 or 14 days, depending on the specific insurance policy and the cause of disability. Disabilities resulting from accidents often are subject to shorter elimination periods (e.g., 3 or 7 days) than are disabilities caused by sickness. In LTD plans, elimination periods generally range from 3 to 6 months for disabilities arising from both accidents and illnesses.

What is a maximum benefit period?

The maximum benefit period in disability income insurance refers to the maximum length of time during which benefits will be payable to an insured with an ongoing, qualifying disability.

By definition, STD insurance policies are those policies whose maximum benefit period does not exceed two years (24 months) in length. Typically, however, STD insurance provides coverage for benefit periods lasting a maximum of 13 or 26 weeks. In contrast, LTD insurance policies typically provide benefits (contingent on continued disability, of course) for as long as 5 years, to age 65 or 70, or even lifetime.

What is a definition of a disability?

The way in which a disability is defined is exceedingly important. Several insurers market policies that define total disability in terms of the inability of the insured to perform the usual and customary duties of his or her "own occupation"-- the job the insured was doing at the time of the injury or onset of sickness. Other policies define total disability in terms of the inability to perform the regular duties of "any occupation." "Any occupation" is often defined as a job for which the insured has the necessary skills and training and, possibly, at a salary commensurate with the one in which the insured was employed at the time of the incident. The "own occupation" definition is more liberal to the insured and is frequently recommended over an "any occupation" definition.

Some insurers market disability insurance policies that define disability not in terms of a particular occupation, but rather simply in terms of the amount of income actually lost. Under these contracts, if an insurable event occurs such as an accident or illness, then disability benefits are payable to the extent that the insured suffers a loss of income that exceeds a threshold amount, e.g., a loss of 20 percent or more of the individual's earnings prior to the happening of the insured event. When the threshold amount is exceeded, the policy pays a benefit that is based on the percentage of total "prior earnings" lost due to the disability.

Some disability income insurance contracts provide coverage only for "total and permanent" disabilities.  Others provide coverage for "total and permanent" disabilities, "partial disabilities," and "temporary" disabilities. Some policies providing "partial" disability coverage require that the "partial" disability be proceeded by a period of "total" disability.  Since these terms are often confusing, with their definitions differing somewhat from one policy to the next, it is recommended that insureds discuss this issue at length with their insurance adviser.

What are common disability exclusions?

Generally, injuries that are intentionally self-inflicted or caused by war or an act of war are excluded.  Disability policies may also include a "preexisting conditions" exclusion whose purpose is to exclude from coverage, during an initial period (e.g., the first one or two policy years), a disability arising from an undisclosed health condition that was both present within a prescribed time period prior to policy issuance and required medical treatment or otherwise caused symptoms that normally would require medical care. Through the "military suspense provision," coverage under a disability insurance policy is suspended during any period that the insured is on active duty in the military.

What do the terms "noncancelable" and "guaranteed renewable" mean in a disability policy?

"Noncancelable" policies provide insureds with the right to renew their policies each year, typically to age 65, by the timely payment of the required premium.   During the noncancelable period, the insurer is precluded from canceling the contract or otherwise making any unilateral change in the policy benefits.

A guaranteed premium is stipulated in the contract and may not be changed by the insurer. "Guaranteed renewable" contracts also provide insureds with the right to renew their policies to age 65 (typically) through the timely payment of the premium. Under "guaranteed renewable" policies, the insurer retains the right to change premiums if it does so for all insureds in the same rating class.  The insurer is not permitted to cancel the policy or unilaterally amend the policy benefits during the period that the policy is guaranteed renewable.

Further, under both types of contracts, the insurer is not permitted to increase the premiums, on a selective basis, only for those insureds whose health status has deteriorated. Because of the premium guarantee feature, "noncancelable" policies may be somewhat more expensive than "guaranteed renewable" policies. In general, disability policies containing a "guaranteed renewable" or a "noncancelable" feature provide better protection to an insured, possibly at a higher cost, than do "conditionally renewable" or other similar types of disability insurance policies that give the insurer a right to refuse to renew coverage for reasons stated in the policy (and typically also give the insurer the right to increase premiums and change benefits so long as these changes apply to all insureds in the same class).

What factors affect the premium cost for disability income insurance?

A number of contract features and options affect the premium cost for disability income insurance. Several of the more important factors are (1) the amount of weekly or monthly benefit purchased, (2) the length of the elimination (waiting) period, (3) the length of the maximum benefit period, (4) whether or not the disability insurance benefits are coordinated with social insurance benefits, (5) the occupational class of the insured, (6) the definition of disability, and (7) whether the policy is noncancelable or guaranteed renewable.

The elimination (waiting) period in disability income insurance serves the same purpose as a deductible in medical expense, automobile and other types of insurance. It eliminates initial, or "first-dollar," benefits from coverage under the insurance policy.  As such, longer waiting periods result in lower premiums. There is a similar, but opposite, relationship between varying maximum benefit periods and the premium cost for disability income insurance. As the length of the maximum benefit period increases, total premium cost also increases. When limited dollars are available to purchase disability income insurance, it is generally recommended that longer waiting periods be selected so that longer maximum benefit periods can be afforded. Of course, the amount of cash reserves available to the insured as a "safety net" should also be factored into the determination of the length of the waiting period that is selected.

What is the federal income tax treatment surrounding benefits received from a disability insurance policy?

The answer to this question depends on who paid the insurance premiums. If the insured paid the premiums with after-tax dollars, then the disability benefits should be received income tax-free. In contrast, if an employer paid part or all of the premiums then an equivalent portion of the benefits are generally taxable to the insured (in this instance, however, an income tax credit may be available to the insured).  In any event, your tax adviser should be consulted with respect to the probable income tax treatment of any disability income coverage that you currently have or are contemplating purchasing.