Individual Disability Income Insurance

Edward E. Graves

There is a wide variation of disability income coverages and related disability policies. Many of these variations involve the definition of disability itself, the duration of benefits available, the elimination period, whether and how partial-disability benefits are provided, the waiver-of-premium protection, how recurring disability is handled, and how, if at all, cost-of-living adjustments are made to disability benefits.

Situations Often Warranting Coverage

Insurance companies that offer disability income policies are very concerned about overinsurance and consequently limit the amount of benefits relative to the income of the individual. As a result, many individuals with in-force coverage through their employer or other sources are ineligible for additional disability income protection.

Anyone who earns at least $20,000 per year from gainful employment and is not already covered by private disability insurance has a significant need for disability income protection. Obviously this includes the self-employed, business owners and partners, individual workers, and anyone who would have an inadequate income if he or she were to become disabled and unable to continue working for compensation.

Unfortunately disability insurance is not available for many occupations. Agents marketing disability income insurance must become familiar with the occupational classifications and direct their prospecting toward individuals engaged in insurable occupations. As with life insurance, insurance companies differ widely in how they classify occupations for disability insurance. Some companies will not insure plumbers for disability income; other insurers will offer a special disability policy for plumbers; still other insurers will offer their regular policy to plumbers at higher than standard premium rates.

Anyone who works for a living has a need for disability income insurance. That need generally ceases upon retirement. Single individuals as well as family breadwinners have a very definite need for such protection. Low-income individuals will probably rely exclusively on the disability protection provided through social security. Although some employers do provide adequate amounts of disability income coverage for their employees, most employees are either not covered at all or inadequately covered. This presents an additional need for individual policy protection.

Further, many corporate events can alter employer-provided disability income protection and therefore increase the need for individual protection. First, corporate mergers or acquisitions may result in a change in management and management philosophy and may result in the termination of previously provided benefits. Second, bankruptcy or severe financial problems may prompt management to cut back on employee benefits such as disability income insurance. Third, the insurance company that provides disability income protection through the employer could terminate the policy. In this case, if the employer is unable to find another insurance company willing to write the coverage, there will be no replacement disability protection. Even if coverage could be obtained from another insurer, management may decide not to seek replacement coverage.

Since most employers do not provide disability income insurance, it is quite possible that an employee who changes jobs may be giving up disability income protection in a prior job that is not provided by the new employer. Such job changes create a definite need for individual disability income protection. One advantage of relying on individual protection rather than employer-provided group protection is that the individual is not subject to termination at the whim of corporate decision makers. Also, individual coverage is portable and can go with the insured to new geographic locations and new career paths. Changes in occupation may require the insured to inform the insurance company of such changes, and the premium payable may be adjusted if there is a significant change in the risk classification for the occupation.

Disability income coverages are also important for partnerships and closely held corporations. Such coverages can provide the financial means for healthy partners or stockholders to purchase the ownership interest of the disabled partner or stockholder. Disability income policies can also be used by the business enterprise to replace lost income or revenue due to the disability of a key person.

Policy Provisions

The primary objective of disability income policies is the replacement of lost income when an individual is no longer able to continue earning that income because of injury or illness. The concept is simple, but the variations of both risk and coverage provisions make disability income insurance very complex. As mentioned earlier, there can be multiple claims, and in most cases separate claims are mutually exclusive. However, it is possible to have multiple disabilities affecting an individual concurrently. One way that insurance companies differentiate between risks is by the definition of disability that they use in their contracts. For social security purposes, disability is defined as "the inability to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or which has lasted or can be expected to last for a continuous period of not less than 12 months." This is one of the most restrictive definitions in use. Essentially, if you are able to do anything for pay, you are not disabled. Only a few private insurance company contracts use similarly restrictive definitions, but these products should not be considered quality disability income products. They are commonly referred to in the insurance industry as "any occupation" definitions, which means that benefits are only payable if the individual is disabled severely enough that he or she cannot engage in any occupation.

Much more common is a definition stating that disability is "the inability to perform the duties of any occupation for which the individual is reasonably suited by reason of education, training, or experience." This type of coverage will not provide benefits if the insured is able to enter a new career that is reasonably comparable to the one in which he or she were engaged prior to the disability.

The most generous benefits are available under disability income policies utilizing an "own occupation" definition of disability. Essentially these policies define disability as "the inability to perform the material and substantial duties of the individual’s regular occupation." For example, these policies will provide benefits to a surgeon who is no longer able to perform surgery but can still practice medicine. Many specialists within the professions will often insist on such definitions when they are seeking disability income coverage.

Many disability policies provide a two-stage definition of disability. They provide protection for the insured’s own occupation for a period such as 2, 3, or 5 years and then will only continue to provide benefits if the individual is unable to perform the duties of any occupation for which he or she is reasonably suited by reason of education, training, or experience. Obviously this is less generous than a policy that would provide benefits for the inability to perform one’s own occupation to age 65 or for lifetime. However, the insurance company anticipates that the individual can use the benefits during the first-stage definition to prepare for an occupation that he or she will be able to perform when the second stage of the definition becomes effective.

To this point the definitions discussed have dealt with total disability. Currently many disability policies also provide benefits for either partial disability or residual disability. Both types of benefits (partial and residual) are intended to encourage insureds to return to the work force prior to total recovery. Some experts argue that the absence of these benefits encourages disabled insureds to malinger so that they can collect total-disability benefits.

Partial disability is usually defined as the inability to perform some stated percentage of the duties of the insured’s occupation or to perform at such a speed that completion of those duties takes a longer-than-normal amount of time. The more severe the limitations, the higher the benefit that will be paid. Theoretically, under such a contract an individual could return to work on a full-time basis at full salary and still be eligible for partial-disability benefits.

Residual-disability benefits, on the other hand, provide for a replacement of lost earnings due to disability. Here the focus is on how much income reduction has been sustained as a result of the disability rather than the physical dimensions of the disability itself. Residual benefits are particularly well-suited for self-employed professionals such as accountants, attorneys, and physicians whose caseload often determines their income. A disability that reduces their capacity for work would automatically lead to a reduction in income.

Policies providing residual-disability benefits usually specify a fraction (representing the proportion of lost income) that will be multiplied by the stated monthly benefit for total disability in deriving the residual benefit payable. The numerator of that fraction is usually income prior to disability minus earned income during disability; the denominator of the fraction is income prior to disability. The contract will specify a definition of each form of income. The definitions will differ from one insurance company to another, and these differences become extremely important for individuals whose income fluctuates widely. Some contracts may specify predisability income as the average monthly income derived during the 6 months immediately preceding the onset of disability; others may specify predisability income as the greater of the average monthly income derived during the 12 months preceding the onset of disability or the highest 12 months of consecutive earnings during the 3 years preceding the onset of disability. There are many variations, but the important concept here is that persons subject to income fluctuation should insist upon a definition allowing the greater of two different base periods so that they will not be unduly penalized as a result of a single base period applied during a slump in income. Most of the definitions either explicitly or implicitly include not only income earned from work activities but also pension or profit-sharing contributions made on behalf of the individual. Thus an individual with a $60,000 nonfluctuating salary and a 10 percent pension plan contribution would be considered to have a predisability income of $66,000.

The income received during residual disability that is used to calculate the income loss in the fraction is usually defined to include all money received during the period being evaluated even if it represents payment for services rendered prior to the disability. A few insurance company definitions exclude payments made on services rendered prior to the disability from residual income.

Let’s consider an example. An individual with a $66,000 annual predisability income has a policy providing $3,500 per month for total disability. This individual has been able to return to work following a total disability and is earning $2,500 per month during the current period of residual disability. The predisability income amounts to $5,500 per month from which the $2,500 residual earnings are subtracted to derive a lost income of $3,000 per month. The lost-income ratio ($3,000 ¸ $5,500) is then multiplied by the stated monthly benefit for total disability ($3,500) to provide a residual-disability benefit of $1,909 (rounded to the nearest dollar). Most residual-disability benefits cease whenever the income loss drops below 20 percent of the predisability income. In this example, residual benefits would cease whenever the monthly income exceeds $4,400.

It is also common to find a clause within residual-disability-benefit provisions that specifies that the minimum benefit payable for residual-disability periods is at least 50 percent of the benefit payable for total disability. At least one insurance company will provide 100 percent of the total-disability benefit during residual disability if the lost income exceeds 75 percent of the predisability income. Under most policies residual-disability benefits are payable to the end of the benefit period. For long-term disability contracts this would be age 65 or later. Some policies impose an 18- or 24-month limitation on residual benefits for partial disabilities beginning after a specified age, such as 54.

Another aspect of residual-disability coverages is whether or not they require a prior period of total disability for residual benefits to be payable. The more generous policies provide that residual-disability benefits are payable for partial disabilities not preceded by a period of total disability. Obviously this generosity increases the premium for the benefits. Those policies that do require a prior period of total disability, often called a qualification period, vary as to its duration with the most common qualification periods being 30, 60, 90, or 120 days.

Ability to Keep the Coverage in Force

Disability income contracts generally include some provision regarding renewability. Top-quality contracts will be at least guaranteed renewable to some specified age such as 65 or even lifetime, or, even better, they may be noncancelable. Guaranteed renewable means that the policyowner has the right to continue the coverage in force by paying the premium due. The premium itself may be increased on a class basis for all guaranteed-renewable policies in a classification, but the premium cannot be increased on an individual basis. The important point is that the insurance company does not have the option to refuse renewal of these contracts prior to the end of the guaranteed-renewal period. Noncancelable disability contracts not only guarantee that the individual can keep the policy in force by paying the premium but also that the premium will not increase.

Some disability insurance contracts have less generous renewability provisions than guaranteed renewable or noncancelable. These policies provide very questionable protection for the insured because the insurance company is allowed to refuse renewal of the contract in some circumstances. Some policies contain a provision, which is commonly called optionally renewable, that gives the insurance company the option to refuse renewal at any anniversary date. Another provision, which is called conditionally renewable, sets forth specific conditions whose occurrence would give the insurance company the right to refuse renewal of the contract on the next policy anniversary. Sometimes the conditions refer only to items controlled by the insured, such as a change in occupation, but more often the conditions refer to factors beyond the control of the insured, such as the performance factors of the insurance company itself. The real problem with any renewability provisions that are less generous than guaranteed renewable is that the policy may in fact be terminated when an insurance company refuses to review the policy of an individual who has become uninsurable and can no longer obtain coverage from other sources.

Policies containing these provisions are often issued by companies that are not committed to the long-term disability market. Many life insurance companies move into and out of the disability income market on a relatively short-term basis. They often enter the disability segment of the business in the years following record profits reported by the disability income specialty companies. A few years later such insurance companies are dissatisfied with the profitability of their disability coverages and decide to exit the market or increase their premium structure to where they are no longer competitive with market leaders. They can handle the in-force coverage issued during their active years in different ways. Some companies reinsure all that coverage with another company that is committed to the disability market while others choose to retain the coverage and work off that particular block of policies until they all expire as a result of nonrenewal, expiration date, or death of the insured. Some companies choose to apply both techniques by setting a relatively low reinsurance threshold and still maintaining the policies and service claims as they come due.

The insured is best protected under disability insurance policies by guaranteed renewable or noncancelable contracts from an insurance company that has a good track record and commitment to the disability income market. Some major life insurance companies have entered into agreements with top- quality disability insurance companies to have their own life insurance field force sell the disability products of the specialty company. This is an explicit recognition of the success of the specialty carrier and the inability of the life insurance company to match its performance with the resources available to the life insurance company. In many cases these agreements allow the field force to earn production credits recognized by their own company for the disability coverages placed with the other insurance company.

When Benefits Start

Disability income policies generally have an elimination period before benefit payments begin. In fact, most insurance companies provide the purchaser with an option to select the duration of this elimination period. The elimination period is that period of time between the onset of the disability and the beginning of the eligibility for disability payments. Since benefits are paid on a monthly basis at the end of the month, the first benefit payment will be 30 days after the end of the elimination period. Common elimination periods are 30, 60, 90, or 120 days. Some policies are available with a zero-day elimination period, but they are not very common and the premium increase to get rid of the elimination period is significant because it includes benefits for many more very short-term disabilities.

Obviously the longer the elimination period, the more severe a disability must be before benefits will be payable. Even a 30-day elimination period will preclude benefit payments for minor injuries and illnesses when full recovery takes place within the 30-day period. Premium levels are affected by the length of the elimination period, and longer elimination periods are associated with lower premium levels. However, selection of a particular elimination period should not be based solely on the premium differential.

Many factors should be considered when selecting the elimination period for a disability income policy. Of utmost importance is the ability of the insured to pay living costs and other expenses during the elimination period. Another pertinent factor is whether or not the insured has other sources of funds available for short-term disabilities. For example, he or she may be employed by a firm that provides salary continuation or sick pay. In this case the elimination period chosen might equal or exceed the maximum salary continuation period from the employer. Individuals purchasing coverage in those states that have nonoccupational disability coverages should choose elimination periods that equal or exceed the maximum benefit period under the state plan. The individual may have an adequate accumulation of emergency funds to sustain a relatively long elimination period without alternative sources of income during that elimination period. The insured should not select an elimination period that is so long that he or she is unable to financially sustain himself or herself given the available sources of funds subsequent to the onset of a disability.

Insurance companies differ as to whether they require the elimination period to be satisfied with consecutive days or whether they allow the accumulation of nonconsecutive disability days to satisfy the elimination period. In some policies it is spelled out explicitly in the contract that the elimination period can be satisfied with nonconsecutive days. In other policies the language of the contract is silent on this point, and the company’s claims-handling philosophy must be ascertained to determine the answer. Those policies requiring consecutive days of disability to satisfy the elimination period provide a less generous benefit than those allowing accumulation of nonconsecutive days to satisfy the elimination period. Residual-disability benefits provided in many policies specify what is commonly known as a qualification period, which specifies the number of days of total disability that must be sustained before residual-disability benefits are payable. The most generous residual-disability policies have a zero-day qualification period and therefore require no total-disability period prior to being eligible for residual or partial benefit payments. Under that type of contract, residual benefits could begin at the end of the elimination period to replace lost income, such as the income lost by a surgeon suffering from severe arthritis. A policy that has residual benefits with a qualifying period equal to the elimination period could also start paying residual benefits at the end of the elimination period if the individual had been totally disabled for the entire elimination period and recovered enough to return to work with a reduced income immediately after the end of the elimination period. It is quite common for the qualification period associated with residual benefits to actually exceed the elimination period, but there is not necessarily a connection between the elimination period and the qualification period. In fact, many insurance companies do not offer a choice relative to the qualification period for residual benefits.

Recurring Disability

Most disability policies have provisions setting forth a specified period of recovery (usually measured by return to work) that automatically separates one disability from another. For example, suppose an individual became disabled as a result of an automobile accident and was totally disabled for 6 months. The individual then returned to work for 8 months before having a relapse and becoming totally disabled again from causes associated with the automobile accident. The new disability will be treated as a separate disability because the recovery and return to work exceeded 6 months, which is the specified period separating recurring disabilities in most disability income policies. If the return to work lasted fewer than 6 months, the second period of disability would be treated as a continuation of the initial disability and no new elimination period would be applicable. However, in the case where the return to work lasted 8 months, the second period of disability will be treated as a new disability and a new elimination period will be applicable before benefits are again payable.

For disability policies with a limited benefit period, it can be advantageous to have each relapse classified as a new disability. The advantage is that any new disability starts with a full benefit period being applicable. Consider a policy with a 2-year maximum benefit period in our above example. Six months of that benefit period would have been used up before returning to work. When the relapse occurs with less than 6 months of recovery, the second period of disability would only be eligible for 18 months of benefit payments. In the case of the 8-month recovery, the insured would have to sustain a new elimination period but would then be entitled to the full 24 months of benefit payments if the disability lasts that long. The issue of qualifying for a new benefit period can be extremely important for short-term disability policies but is not a significant issue for policies providing long-term benefit periods running to age 65.

Duration of Benefit Period

Just as disability income policies differ according to definitions of disability and length of elimination period, they also differ according to the duration of benefits that they will provide once that individual becomes disabled. Benefit periods are one of the most important factors in determining the level of disability income premiums. Most insurance companies offer choices for the benefit duration and charge the appropriate premium for the duration selected. Short-term disability contracts often provide choices such as 2 years, 3 years, or 5 years for the maximum benefit period. In the long-term category the maximum benefit period may often go to age 65 or even for lifetime. Some long-term disability coverages are automatically renewable to age 65 and conditionally renewable to age 70 or 75 if the individual continues to work at his or her occupation. Obviously the longer the potential benefit period, the higher the premium necessary to support such benefits.

Some companies differentiate between disabilities caused by injury and disabilities caused by illness. It is not uncommon for policies that use that type of classification to provide lifetime benefits if the disability results from injury but to limit benefits to age 65 if the disability stems from illness. Other companies offer a total range of options or selections between the maximum duration of benefit periods for both injury and illness. For example, an individual could select injury to age 65 and illness to age 65, injury to lifetime and illness to 65, or the maximum of lifetime for both injury and illness. Those companies that differentiate between injury and illness as a source of disability will not usually allow the maximum benefit period for illness to exceed the maximum benefit period for injury. In other words, you could not get illness for lifetime if you were only purchasing injury to age 65.

The disability definition in concert with the maximum benefit period is the real essence of coverage. Coverage for a surgeon in his or her own occupation to age 65 is quite different from coverage to age 65 that only provides own-occupation coverage for the first 2 years and then provides coverage for any occupation for which the insured is reasonably qualified by reason of education, training, or experience to age 65. Comprehensive protection requires a combination of a generous definition of benefits and a maximum benefit period of age 65 or lifetime.

Short-term Disability. Short-term disability policies do not provide comprehensive protection against disability, but their main appeal is the premium savings associated with the relatively short maximum benefit period. The premium for a 2-year benefit period can be as low as 40 percent of the premium required to extend benefits to age 65. That percentage differential is for individuals aged 18 through 40. The percentage of premium reduction for short-term benefit periods reduces with age. At age 55 an individual is likely to pay nearly 50 percent of the long-term premium to obtain 2-year benefit coverage. As would be expected, 5-year benefit periods require higher premiums than 2-year benefit periods and range from 55 percent of the long-term premium for the ages between 18 and 25 and increase to over 70 percent of the long-term premium by age 55.

Premiums for disability income policies are similar to life insurance policies in that the premiums are based on the policyholder’s age at the time of policy issuance and remain level for the duration of the coverage. Consequently an individual can lock in the greater percentage differential by buying the policy at a younger age and keeping it in force.

Short-term disability policies are sufficient to cover most disabilities since well over one-half of all disabilities by frequency or occurrence have durations of less than 2 years. The real shortcoming of these policies is that they do not provide adequate protection for the severe disability that lasts longer than the 2-year or 5-year benefit period. Consider a policy that provides $3,000 per month. If the individual is disabled, he or she receives $36,000 per year in benefits. For a 2-year benefit period the individual is limited to benefits of $72,000 per disability; for a 5-year benefit period he or she is limited to $180,000 per disability (paid out on a monthly basis for the duration of the benefit period if the disability lasts that long). A long-term disability policy to age 65 providing $3,000 per month in benefits could provide up to $1.7 million in benefits for an individual disabled at age 18. The problem in selecting coverage is that no one knows in advance who is going to sustain a long uninterrupted disability. A short-term disability contract is clearly inadequate for a person who does sustain a catastrophic disability loss. The full benefit period is available for each separate disability the insured sustains, and an insured who sustains many separate disabilities could theoretically collect almost as much under short-term disability contracts as the maximum benefits payable under a long-term disability contract. The problem is that because individuals cannot control when and how they will be disabled, there is always the possibility that an individual could be disabled for longer than the benefit period available under short-term disability contracts.

Long-term Disability. Some companies provide disability income coverages with benefit periods of 10 years, which are invariably classified as long-term disability contracts. The benefit period provides more protection than short-term disability contracts but is still less than lifetime coverage. In recent years the predominate maximum benefit period for long-term disability policies is to age 65. Such coverage ensures that the individual will have a source of replacement income through to the normal retirement age for most individuals. The availability of medicare, social security, pensions, and other benefits beyond the age of 65 makes it less important to rely on disability income benefits beyond age 65.

Even those policies purporting to provide lifetime benefits for disability include limitations on disabilities occurring after specified ages such as 50, 55, or 60. These disabilities with their first onset after the specified age will often be limited to benefit periods of 2 or 5 years or may terminate at a specified age such as 65, 68, or 70. In other words, lifetime benefit payments are only available for those disabilities that initially occurred before the specified age limitation and that remained continuous and uninterrupted for the remainder of the life of the insured.

Long-term disability policies are being issued to high-income individuals for significant amounts of coverage, such as $10,000 to $50,000 in benefits per month. Such policies present a potential liability of millions of dollars to the insurance company. For example, an insurance company could pay out $12 million between the ages of 45 and 65 for an individual insured for $50,000 in benefits per month. Even short-term disabilities under such policies would result in benefit payments of $600,000 per year.

With such amounts at risk it is understandable that insurance companies are more restrictive in writing long-term disability policies than they are in writing short-term policies. Fewer occupations qualify for long-term disability coverage than for short-term disability policies. Long-term disability policies are rarely available to any occupation that involves physical labor or direct involvement in dangerous processes. For example, funeral directors are insurable for long-term disability as long as they do not participate in embalming, and pressmen who work in lithography are often eligible for long-term disability policies whereas pressmen who work in printing plants are generally ineligible.

Long-term disability benefits continue for as long as the insured individual is disabled according to the contract provisions. Insurance companies often require repeated verification that the disability still satisfies those qualifications for benefit eligibility. Benefits for total disability will cease when the individual has recovered enough that the disability no longer satisfies the criteria of total disability. In long-term disability policies providing residual benefits, benefit payments may continue at a reduced amount when the individual has recovered enough to return to work but still sustains more than a 20 percent reduction in income. Total recovery of the insured will terminate any benefit payments under disability income policies. Short-term recovery with relapses often triggers a resumption of disability income benefits. Recovery is generally measured by a return to work. If the intervening work period is less than 6 months, the disability will be considered a continuation of the prior disability and the benefits will resume without having to satisfy a new elimination period. If the recovery and return to work last more than 6 months, most policies require the recurrent disability be treated as a new disability rather than a continuation of the old one and consequently must satisfy a new elimination period.

Obviously no benefits are payable under lapsed or terminated disability income policies. It is relatively unusual for such policies to lapse or to be terminated while an individual is disabled since most policies provide waiver-of-premium protection. Lapses and terminations usually occur before the onset of a disability and preclude the payment of benefits for subsequent disabilities. There is limited protection from lapses in the grace period that allows continuation of coverage by payment of premiums within 31 days after their due date. Most insurance companies will allow lapsed policies to be reinstated automatically if the premium is paid within 15 days of the end of the grace period. Lapsed policies will often be reinstated within 30 or 60 days of the end of the grace period without evidence of insurability if the insured applies for reinstatement. However, the insurance company has the right to impose evidence-of-insurability requirements in any case.

Residual Benefits

The residual-benefit provisions in disability income policies are designed to provide less than full benefits at the time during the recovery period when the insured is no longer totally disabled and is able to return to work but with a reduction in earnings. As mentioned earlier, this type of benefit is more concerned with measuring the loss of income than with ascertaining the degree of physical incapacity. Obviously the loss of income must be due to the limitations of the insured’s disability. Under some policies the total monthly benefit may be payable as a residual benefit if the lost income equals or exceeds 80 percent of the predisability income. In some ways this part of the residual provision is similar to the presumptive disability associated with total-disability benefits.

The basic philosophy behind providing residual-disability benefits or partial-disability benefits is to encourage an insured’s rehabilitative efforts so that he or she can return to work as soon as possible. In the absence of residual benefits or partial benefits, the insured is often encouraged to continue satisfying the total-disability definition and to not risk a reduction in benefits by attempting to return to work.

Residual benefits may be payable for a relatively long period of time if the insured plateaus at some level of partial recovery. However, residual benefits are subject to the maximum benefit period provisions in the contract. For example, in a short-term disability contract providing the maximum of 5-year benefits, the combination of total-disability and residual-disability benefits would not be permitted to exceed 5 years in aggregate for any one disability. Since residual benefits can and sometimes do exceed one year in duration, the residual-benefit provisions must deal with cost-of-living adjustments in those policies that contain such inflation protection. For residual benefits this means that the predisability income amount must be adjusted annually for continuous periods of disability. Without such adjustments the percentage of lost income would be underrepresented in the benefit calculation during periods of inflationary wage and price increases.

Each insurance company tends to have its own variation as to adjustment mechanisms for the predisability income amount during prolonged disability benefit periods. In general, the predisability income amounts are adjusted in much the same manner as the total-disability benefit amount would be adjusted under the cost-of-living adjustment provisions. This provision may be a flat stated percentage on a simple interest calculation basis, a compound interest escalation, or in some way tied to a consumer price index for items in general or for specific health care cost increases. Sometimes the provision is even a hybrid of a stated amount that can be increased more rapidly when consumer index prices exceed a threshold amount during any given one-year period. Another variation will have no increases at all unless there has been an inflationary index exceeding a stated threshold amount, such as 3 percent or 5 percent during the previous 12-month period.

Level of Benefits Payable

Disability income policies specify the level of monthly benefits to be payable during periods of total disability after the elimination period has been satisfied. At the time of policy issuance the stated monthly benefit amount will be in line with the insured’s income and should provide fairly complete protection. However, over time the stated benefit amount is likely to become inadequate as the insured’s income increases due to both inflation and job promotions. Disability income policies are available with provisions to counteract such erosion in benefit levels. It is probably best to discuss these provisions under two different categories. First, there are provisions that provide increases in the benefit payments during periods of disability when benefits are being distributed. Second, there are those provisions that are aimed at increasing the stated benefit level at various time intervals while the coverage is in force but the insured is not disabled.

Provisions dealing with increasing benefits during periods of disability are often referred to as either cost-of-living adjustments (COLAs) or inflation-protection provisions. They tend to provide either a fixed-percentage increase per year or a floating-percentage increase where the floating amount is determined by some external index such as a consumer price index. These benefits are almost always provided as an optional rider for an additional premium over and above the base policy. Many companies that do provide COLA riders offer purchasers a choice with respect to the percentage increase ceilings on the rider. In other words, a COLA with a 3 percent annual increase will have one premium whereas a COLA with a 4 percent annual increase will have an appropriately higher premium. Some companies allow the purchaser to choose any rate between zero and 7 percent for annual increases.

In addition to these annual increase limitations, COLA riders usually contain an aggregate limit on benefit increases such as two times the original monthly benefit amount. For example, an insured may purchase a 5 percent flat benefit increase rider to a policy originally providing $2,000 per month in benefits and may subsequently become disabled for a continuous period of 20 years. After the individual has been disabled for one year, the benefit amount would increase to $2,100 per month reflecting the 5 percent increase. After 2 years the benefit would increase to $2,205 if the increases are based on a compound interest adjustment or to $2,200 if the increases are based on a simple interest adjustment. If the COLA rider contains an aggregate limit of twice the original benefit amount, the policy will reach that upper limit of $4,000 per month after about 14 1/2 years of continuous disability if the adjustments are made on a compound basis or after 20 years of continuous disability if the adjustments are made on a simple basis.

COLA riders are extremely important in protecting the purchasing power of disability income benefits because insurance companies will not allow purchasers to obtain coverage for benefit levels in excess of their current discretionary income. Insurance companies are very concerned (with good reason) about overinsurance with disability coverages. Consequently they will not allow individuals to insure for excess amounts in anticipation of future inflation. The only way for insureds to keep future benefit payments in line with inflationary requirements is to obtain COLA riders with their base policies. However, purchasing COLA riders will not keep the initial benefit level in line with inflation prior to the onset of a disability. Many disability policies are in force for years before a disability occurs. Income and expense levels may have increased three-fold over that interval, but the level of disability benefits payable will not have changed unless additional coverage has been purchased in the interim.

There are basically three approaches to keeping disability income benefits in step with increased income for insured individuals who are not disabled. First, the oldest and least attractive methodology is to purchase new policies to supplement the in-force policies incrementally as income increases justify such increased increments of coverage. The drawback to this approach is that it requires evidence of insurability every time incremental amounts of coverage are obtained. If the individual’s health deteriorates, additional coverage may not be available at any price.

The second approach to adjusting disability-benefit levels is through a rider that guarantees the right to purchase additional coverage at specified future intervals up to some specified maximum age, such as 45, 49, or 55. This approach is similar to the first one in that additional coverage must be purchased every time an adjustment is needed. However, it differs in that additional amounts can be acquired at the specified intervals regardless of the health of the insured. These incremental purchases are subject to underwriting requirements with respect to the current income of the individual. In other words, the insurance company will not issue new coverage if the incremental addition would increase aggregate disability income benefits above the underwriting guidelines for that individual’s current income on the option date. This is another way for insurance companies to prevent overinsurance and to minimize adverse selection.

Third, the most attractive way to adjust benefits upward for inflation while the insured is not disabled is to use riders that automatically increase the base benefit amount on a formula basis, such as some stated flat-percentage amount at each policy anniversary. Even this approach requires purchasing additional coverage so that the premium will be increased appropriately. As with the second approach, the additional increment of coverage will be purchased at premium rates based on the insured’s attained age at the time it is added to the policy. The real advantage to this approach is that the changes are automatic unless they are refused by the policyowner.

Insurance companies are not required to provide any inflation adjustments, and some insurance companies selling disability income policies choose not to make such riders available.

Insurance companies that offer both options for purchasing additional coverage in the future and for automatic percentage increases in benefits will look at both features in limiting future incremental additions and make sure that they are in line with the earnings of the insured. Such companies often refuse to issue the options if the insured has another policy already containing such riders or if the base policy was issued on an extra premium basis because of health problems.

Insurance companies offering both automatic benefit adjustments and future purchase options as separate riders on the same base policy often suggest that the automatic increases tied to inflationary expectations and that future purchase options be used to cover income increases due to career promotions. One problem with the latter suggestion is that many career promotions may come at ages beyond the guaranteed future purchase dates. In those cases the only way to increase coverage will be to purchase a new policy for which the individual must show acceptable evidence of insurability.

Premium Payments

Premiums can be paid on an annual, quarterly, or monthly basis for these policies with premiums paid on a quarterly basis showing the lowest persistency. All the forms of automatic payment available for life insurance policies are also available for disability income policies. They can be set up on a payroll-deduction basis or an automatic bank draft plan. Premiums must be paid on a timely basis to keep the coverage in force, but the policies do contain a 31-day grace period for late premium payments.

Most disability income policies automatically include the waiver-of-premium provision. For long-term disability policies some companies will usually waive premiums after 90 days of disability, while other companies will waive premiums after 60 days of disability. Some short-term disability policies may contain options as to what elimination period is applicable to the waiver-of-premium provision. Obviously the premium will vary according to the length of the elimination period. The shorter the elimination period, the higher the premium for the-waiver-of-premium provision if it is charged for separately. Disability policies differ as to whether or not the elimination period associated with the waiver of premium requires consecutive days or allows aggregate nonconsecutive days from short disability periods to satisfy the elimination period.

Some policies waive only future premiums after the waiver-of-premium elimination period has been satisfied; other policies will retrospectively waive prior premium payments made after the onset of disability but before the waiver-of-premium eligibility requirements had been met. Once the insured individual recovers and no additional disability benefits are payable, $s for specified conditions. The most limiting modification is an outright exclusion for any benefits associated with disabilities stemming from specified causes or conditions. Although this approach may seem drastic, it at least allows individuals to obtain disability coverage for causes other than the major problem that is preventing them from getting full disability protection.

Proper disability underwriting requires a sophisticated knowledge of medical problems and medical treatment. The home office underwriters often require much more information and supporting documents than are necessary to satisfy life insurance underwriters. The home office disability underwriter must get an accurate picture or perception of the individual and the applicable risk without ever meeting or seeing that individual. The entire image or perception must be created by the information supplied from the field agent to the home office staff. Very rarely will the home office underwriter even talk with the applicant by telephone. The documents presented with the application must bring the applicant to life and make him or her real to the home office underwriter.

The disability underwriting process commonly includes one or more requests from the home office for additional information. Although this does delay the issuance of coverage, it does not necessarily indicate that the coverage will not be issued. Disability insurers use significant resources in an attempt to accept and insure all applicants that fall within their acceptable risk classifications. Obviously some risks will not meet the minimum company standards and will be rejected outright. Individual applicants who are rejected by one company may not necessarily be uninsurable; another company may classify risks in a different manner and apply different cutoff standards. Individuals who experience difficulty in obtaining disability insurance should shop for coverage from other insurance companies on a sequential basis and should not apply for coverage with many insurance companies concurrently. There are brokers who specialize in substandard insurance who can be helpful in obtaining disability coverage for individuals with serious health problems.

Business entities are dependent on their personnel to carry out their activities and generate revenues and profits. Very often there are a few key individuals whose unique talents and experiences are crucial to the success of the business entity. The loss of that individual’s contributions by reason of disability or death could deal a devastating blow to the financial well-being of the enterprise. In fact, sometimes the dependence is so critical that losing the individual’s participation could lead to the bankruptcy or termination of the business itself. This is particularly true of professionals operating as solo practitioners.

Many business enterprises have recognized the importance of those key individuals who make the most critical contributions and have obtained disability income insurance covering these key individuals. The justification for such coverage is very similar to that for key person life insurance policies. Proceeds from key person disability policies can be used to replace lost revenue directly attributable to the key person’s disability, to fund the search for individuals to replace the insured person, to fund the extra cost of hiring specialized individuals to replace the multiple talents of the insured, and to fund training costs that may be incurred to prepare replacements to carry out the duties performed by the insured. Some or all of these considerations may prompt enterprises to obtain key person disability policies. The motivation itself may help the business managers determine the appropriate amount of coverage to obtain. The costs of training, hiring, and compensating are usually rather easy to ascertain, while estimating lost revenue is a very difficult and complex task.

Even though a business entity may determine a desired amount of disability income protection for each key individual, it may not be able to obtain that amount of coverage. The underwriting processes of insurance companies limit the maximum amount of coverage available on any one individual. A wide range of guidelines is utilized for setting these limitations, and it is usually difficult to get an insurer to waive any of these limitations. Sometimes a business entity is able to make a strong enough argument on both financial and economic grounds to justify an exception and obtain the desired amount even though it exceeds underwriting guideline limitations.

Key employee disability policies are purchased by the business entity, and the benefits from such policies are payable to the same business entity when the insured key employee is disabled. The policies used for these purposes are usually the same as the group or individual disability income policies available to the general populace. They are subject to the same range of policy provisions already discussed with respect to definitions of disability, benefit periods, elimination periods, waiver of premium, renewal period, and other considerations.

Disability policies owned by the corporation or business entity with benefits payable to that same entity are not deductible business expenses for federal income tax purposes. Payment of those premiums does not create a taxable income to the insured employee. Consequently the receipt of insurance proceeds under the policy by the business entity is not considered taxable income to the business.

Salary Continuation Plans

Disability income policies can be purchased by the business entity to fund formal corporate salary continuation plans. Formal plans can be set up in two different ways. The corporation can own the policy and be the beneficiary under the policy, or the corporation can pay the premiums on a policy owned by the employee to whom benefits would be paid. When the corporation is both the owner of the policy and the beneficiary, premium payments are nondeductible by the corporation and the corporation will receive the insurance proceeds free of any federal income tax liability. Premium payments for such coverage will not be considered taxable income to the employee.

When the corporation merely pays the premiums on a policy owned by the employee, the premiums are deductible expenses of the corporation as long as they meet reasonable expense criteria. The premium payments are not considered taxable income to the employee; however, benefits paid under the policy will be taxable income to the employee.

Sometimes informal salary continuation plans are set up where the corporation pays a large enough bonus to the employee for the employee to buy an individual disability income policy. If the bonus payments are reasonable compensation, they are deductible by the corporation. The bonus is taxable income to the employee. The premium payments made by the employee are not deductible. Any benefit payments received by the employee will have no effect on the corporation and will be received free of any federal income tax liability by the employee.

Disability Buy-Sell Funding

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