Disability Insurance Basic Concepts
Here we outline the concepts related to disability insurance. The most fundamental idea is that disability insurance replaces lost income in the event of injury or illness that prevents your client from being able to earn a living. If your client’s financial lifestyle would be adversely affected by a disability, he or she probably needs disability insurance. The descriptions here, in alphabetical order, focus primarily, but not solely, on individual policies. An * indicates particularly important concepts.
How much the client will receive on claim is perhaps the most important issue in any policy. For individual policies, up to about $100k of income, 60% is about what most carriers will replace at the time the policy is issued. At higher incomes, the benefit amount goes up, but the replacement ratio drifts down. The current limit in the domestic market for professionals and executives is $20k of monthly benefit (not all carriers will participate to that amount). Higher limits are available through excess carriers. Our general advice is to keep the benefit amount as high as possible. If premium becomes an issue, most often we suggest dropping riders or even reducing the benefit period before lowering the benefit amount. Most people cannot afford a 40% cut in income, having the cut be even greater is a common mistake.
The benefit period is the amount of time that a policy will pay benefits. In general, for individual policies, we recommend a “to age 65” or “to age 67” benefit period to protect clients in the event of a truly catastrophic event, but we are also firm believers in the idea that some protection is better than no protection. The average claim is about 5 years in length, so if a client cannot afford a benefit period to age 65, you will still do them a service by helping them buy a five or even two year benefit period.
Buy-Sell or Buyout
A buy-sell policy can be bought by small business owners in addition to an individual policy (and possibly in addition to an overhead expense policy as well). The idea here is similar to the idea of funding a buy-sell agreement between two or more owners with life insurance. In this case, a disability policy can be purchased to fund the buy-sell agreement in the event of disability. The elimination period is one to two years and the pay-out can range from a lump sum payment to five years of monthly benefits. Buy-sell agreements are a very important part of transition planning for small business owners.
Catastrophic Illness Rider
This rider pays an additional monthly benefit in the event of a catastrophic disability. The language is similar to that of a long term care policy for most carriers, i.e., in the event of needing help with two out of six activities of daily living or in the event of significant cognitive impairment, the client would qualify for addition monthly benefits. This rider may not be the most important part of an individual disability policy, but it is a way of obtaining more coverage for your clients. Combined with the base policy you can replace up to 100% of current income.
Cost of Living Adjustment (Indexed Cost of Living or COLA)
This benefit is added by a rider to individual policies; it helps the benefit amount keep up with inflation, while on claim. It adjusts the benefit amount at the end of the first year of claim and each year thereafter (with most carriers). Typically the amount of increase is tied to the consumer price index in some way (e.g. CPI-U) and has a cap (e.g. 3% or 6%).
The increase can be simple or compound depending upon the carrier, and some carriers have a “catch-up” feature for those years in which inflation exceeds the cap. When trying to keep the premium amount down, this is typically one of the first riders to be dropped, but the younger the client, the more one should consider adding this rider.
*Definitions of Occupation
How the occupation of the client is defined is one of the most important policy differentiations. In general, if we can get it, we want to the client to be able to receive benefits if he or she is unable to perform his or her occupation, but that does not mean that the strongest (and most expensive) necessarily makes sense for everyone.
In the private insurance market there are basically four definitions of disability, described here from strongest to weakest:
- Own Occupation or Regular Occupation(sometimes True Own Occupation): The inability to perform the substantial and material duties of your occupation—this definition would allow the client to work in another occupation and still collect all of his or her benefit, regardless of how much he or she might earn in the new occupation, if disabled from his original occupation. This feature is very popular with physicians, dentists and attorneys. In theory, a surgeon could continue to collect his $20,000 of monthly benefit, for example) and could make a million dollars a year as an insurance agent.
- Transitional Own Occupation: This definition is similar to the own occupation, and differs only if the client chooses to work in a different occupation. In that circumstance, the carrier will compare the new income of the client in combination with their benefit amount with their pre-disability earnings. If the new income and benefit amount are less than the pre-disability earnings, the client will continue to receive the full benefit (same as the true own occupation definition). However, if the new income and the benefit combined exceed the pre-disability earnings, then the carrier will reduce dollar for dollar the benefit amount (one carrier has a floor of 25% of the benefit in this type of scenario). Since this makes the client whole even if working in another occupation, it is popular with physicians and dentists.
- Own Occupation and Not Working (or not engaged): The inability to perform the substantial and material duties of your occupation and not working. The and not working is what differentiates this from the true own occupation definition. For most occupations, this definition is what we recommend, if we can get it. The vast majority of all clients who return to work after being disabled return to their same pre-disability profession—this is particularly true for executives and small business owners. It is rare even for physicians to work in different occupations after being disabled from their own. The key here is that clients are protected in their occupation as long as they do not choose to work in a different occupation—and the carrier cannot force them into a different occupation.
- Any Occupation: Often this definition comes with language that relates the definition of disability to the client’s level of training and experience, but do not be fooled. With some occupations or health conditions, however, it is the best that can be offered.
The elimination period functions as a deductible—it is the period of time that must elapse from the start of the disability until benefits are paid. For individual disability policies, the most common elimination period is 90 days. But this means that the client must self insure for that time period. Shorter and longer elimination periods are available, but shorter periods are significantly more expensive and longer periods offer only limited savings.
Some carriers offer the possibility of buying a policy that starts out very inexpensive, but steadily increases in premium overtime. Such policies can make sense for clients right out of school or just starting a business, but over the course of the policy, these clients will pay much more than with a level premium. Even more importantly, they will be tempted to drop the policy in their 50’s and 60’s when the policy becomes very expensive. The odds of disability go up with age. In the DI world, it is an exception for us to recommend replacing a policy that is more than two or three years old. Policies that have graded premiums are an exception to that rule of thumb.
Guaranteed Renewable (GR)
Guaranteed renewable means that the carrier can never change or cancel a policy as long as the client keeps paying the premiums, but it does not have a rate guarantee.
Unlike what it sounds like, this feature is a rate guarantee—the carrier can never raise rates on these polices. When included, most carriers build the cost into the product—so you usually do not see the cost broken out. For blue/gray collar workers and for older clients we sometimes recommend forgoing this feature to save money. Keeping the premium affordable is key to being a good DI salesperson. In the event of a disability the best policy in the world is the one that your client actually owns.
Overhead Expense (OE, DOE or BOE)
An overhead expense policy can be bought in addition to a DI individual policy by owners of small businesses (i.e. business with up to eight or ten employees). The benefit period is short, one to two years, and is designed to keep the doors open on the business long enough for the owner to recover or to sell the business. While the owner’s salary is not covered, most other deductible expenses usually are, for example rent, utilities, leases, professional licenses, property taxes and employees salaries to name a few.
The occupation class is one of the key ways that insurance carriers assign risk (along with health issues, age and gender). Typically, the more manual labor involved, the lower the occupation class. A few occupations, such as off-shore drilling, are uninsurable.
Determining the occupation class can be a bit of an art. So when we ask you what feels like a hundred questions about what your client does, how long he or she has been in business, how much they make, etc, it is because we are trying to get the best occupation class we can for you client. The occupation class will affect the premium significantly, and sometimes will affect the benefit amount the definition of disability.
Purchase Options (e.g. FIO, GIO, Benefit Update or Guaranteed Insurability) and Automatic Increases (AIO, AIB)
This feature, usually added by rider, allows the client to increase the monthly benefit on specified anniversaries without evidence of medical insurability. Only financial returns and a very brief application are required. This rider is generally inexpensive and is a great deal for your client. We strongly recommend including it when available. It is not available for older clients and typically is not offered when there are health concerns.
Automatic increase riders also increase the monthly benefit, but by a set amount. Usually the increase is something like 5% every year for the first five years of the policy. The premium will increase accordingly. Typically, the client will receive a letter each year stating that unless they actively refuse the increase, it will take place automatically. No income documentation is required.
Usually this feature is added by rider. It allows the insured to collect benefits while partially disabled and working. The amount of benefit paid is proportional to the loss of income. For example, a 40% loss of income would result in receiving 40% of the benefit. Strong versions of this benefit potentially pay in the event of recovery from total disability as well as in the event of a slowly developing disability, for example Parkinson’s or multiple sclerosis.
The definition usually reads something like: “Due to injury or sickness the insured is unable to perform one or more of the substantial or material duties of their occupation, is working and is suffering a loss of income of at least 20%.” If the insured has a loss of income of 75% or 80% depending upon the carrier, the insured is deemed totally disabled and receives full benefit. Residual is one of the most important features of a disability policy, since many claims become residual if it is available.
Retirement Savings Disability
This type of policy is in addition to an individual policy and goes by several names in the industry (e.g. Retirement Security). When disabled the insured typically can no longer afford to fund his or her 401k or qualified plan. This policy replaces savings for retirement in the event of a disability. Higher benefit amounts are offered because on claim the benefits are paid into a trust until the client reaches retirement, comes off of claim, or dies—at which point the trust funds will be distributed to the client or his or her heirs.
Social Security Offset
This rider goes by a wide variety of names in the industry. The basic idea is the risk for a portion of the monthly benefit is shared by the carrier and the Federal and State Governments. The base policy benefit pays regardless of other benefits received, in particular social security disability benefits or workman’s compensation. The benefit amount that is offset, however, is reduced when such benefits are received. The maximum benefit that can be offset varies by carrier, ranging from about $1,200 a month to $2,000.
The advantage of offsetting is that the premium is lower than for the base policy benefit, and for some occupations the carriers require an offset to obtain the maximum coverage. We typically do not recommend offsetting for those who can obtain the maximum benefit without the offset. Again, we generally want to get the client as much benefit as possible.