Journal of Financial Planning - June 1997

For several years, the disability insurance market has been in turmoil due to policies sold in the 1980s now being underpriced. Peter Katt reviews key disability insurance issues.

Be Wise About Disability Insurance

by Peter Katt, CFP, LIC

During the past several years the disability income insurance (DI) market has been in considerable turmoil because it is now apparent that many forms of (DI) policies sold in the 1980's are underpriced. This underpricing is primarily due to selling (DI) policies with guaranteed premiums at a time of historically high insurance company investments yields which have since returned to more normal levels (which should have been anticipated) and much higher claims experience then anticipated.

Own Occupation Contracts

An "own occupation" provision provides that if the insured is unable to perform the important duties of his or her own occupation, the insured will be considered totally disabled. Own occupation contracts became very popular with physician specialists, dentists and specialized attorneys, and DI companies fell all over themselves providing narrower definitions of such occupations. For example, if an orthopedic specialist with a DI policy that defines his occupation exclusively as an orthopedic surgeon experiences back problems, preventing him from standing throughout a long surgery, he would probably be considered totally disabled. Based on this narrow occupation definition, some insured specialists have the opportunity to make claims that some companies selling own-occupation contracts believe are fraudulent. Indeed, according to a February 2, 1997 National Underwriter article, some companies are using surveillance of DI claimants to uncover unwarranted claims. Clearly, this problem of excessive claims was se lf-inflicted because of some companies' penchant for narrowing occupation definitions to gain an advantage in the market. But narrow own-occupation definitions formulated in the 1980's are fast becoming museum pieces.

Income Replacement

It has long been my position that the importance of disability insurance is to protect the insured's ability to earn a living. If the insured is unable to work because of a disability, he or she will be entitled to full benefits. However, if, due to a disability, the insured is able to earn only a portion of the income earned prior to the disability (either because of working fewer hours in the same occupation or working in a new occupation) a partial disability benefit will be paid. That is if the insured earned $10,000 a month prior to a disability, but is now earning only $4000 a month, the insured to 60 percent of the DI benefit. Treating income replacement as the primary goal eliminates the need to carve out an own-occupation definition for total disability, which, as previously noted, DI companies are moving to anyway because of the problems they are experiencing with own-occupation contracts. An income replacement issue you should be aware of and discuss with your clients is how the policy treats requiring an insured to take a job he or she is suited for outside of his or her occupation or lose total disability benefits. For example, some income replacement policies will provide total disability benefits based on the defined occupation for a specified period, say five years, then will stop benefits if the insured is unwilling to work in an occupation he or she is physically able to perform and is suited for. That is, an orthopedic surgeon unable to perform surgery might receive total benefits for five years if he or she isn't working at all, but then would be required to find work as a non-surgical physician or have benefits cut off entirely. Alternatively, the surgeon could become, say, a sports medicine consultant, earn less that his prior income and receive a portion of the income replacement DI benefits.

Benefit Levels

Another reason for FI company problems is the high level of benefits they were willing to write. Highly compensated professionals could purchase DI benefits that were close to their after tax actual earnings. Fox example, an orthopedic surgeon earning $50,000 a month could purchase own-occupation DI benefits of $30,000. If the premiums had not been deducted, this benefit is income-tax free, making it equivalent to $50,000. An insured unable to perform surgical duties receiving the after-tax equivalent of his or her pre-disability earnings has little incentive to return to any work because financial goals are being resolved by DI benefits. In response to this, maximum DI benefits are being trimmed so that professionals can't purchase all of the benefits they want. Companies are selling DI benefits in amounts they think the professional may need. If orthopedic surgeons of the future can only purchase DI benefits of, say, $10,000 a month, an orthopedic surgeon suffering back problems who could earn $15,000 as a general practitioner has more incentive to work that rely on DI benefits. This creates the kind of incentive that insurance companies need to avoid unnecessary claims.

Reviewing Existing DI Coverage

The changes being made to DI policies make policies purchased in the 1980s and early 1990s generally more valuable because total disability definitions are favorable, the benefit levels are much higher, and unit premium costs are lower. Therefore, it is unlikely that these DI policies should be replaced. However, a review of DI policies should focus on several important issues:

1. Is the waiting period a good match to the clients current financial situation? That is, if a DI policy has a 30 day waiting period because the insured had a few invested assets, a longer waiting period is probably desirable if the insured has since accumulated significant wealth. My experience suggests a 90-day waiting period has the best cost/benefit ratio.

2. Are riders such as future purchase options or cost of living adjustments still needed, now that the insured's net worth may be much higher than when the policy was purchased? Frequently, significant savings can be achieved with the elimination of expensive riders if they serve no real risk management purpose.

3. Is the DI policy needed at all? An insured who has accumulated significant wealth and has no risk management need for the coverage might just cancel it entirely.

4. What is the financial strength of the insuring company? If the company's financial strength has become weak, even though the existing policy has a better total disability definition, higher benefits and lower unit costs, the client might be inclined to replace DI coverage from a weak company and replace it with a lower amount of coverage at higher cost with a stronger company.

New Attitude About Companies Selling DI

Although the effects on companies with possible DI policy underpricing can't be accurately predicted, I have developed some degree of caution about those companies that have a large portion of their overall business tied up in DI policies, especially policies sold during the 1980s, and I no longer recommend them. Rather, I recommend companies that have substantial financial strength ratings whose DI exposure is small compared with their total insurance business so that possible underpricing won't have much effect on their solvency. And because I am most concerned with a company's financial stability and DI exposure as a percentage of their total business, I am less interested in comparing DI on the basis of premium cost.

Priced to the Market

The problems that have contributed to possible DI underpricing could be instantly cured if DI policies were priced to the market, as almost all cash value life insurance is. In contrast to the so-called noncancellable (premiums guaranteed) DI policy, adjustable premium DI policy premiums could be changed to match current investment yields, claim experience and expense ratios that are constantly changing. Indeed, some mutual companies have begun setting DI guaranteed premiums much higher than in the past, allowing the non-guaranteed dividends, based on investment, mortality and expense experience, to adjust the net premium to market conditions. This is a very rational approach and should be followed by all companies selling disability insurance.

Reprinted with permission by the Financial Planning Association, Journal of Financial Planning, Volume 10, No. 3, June 1997.

Peter Katt, CFP, LIC, sole proprietor of Katt & Co., is a fee-only life insurance adviser located in Kalamazoo, Michigan (269.372.3497).