What to Look for in Disability Income Policies

Peter C. Katt

Disability insurance is a must for many individuals. But no two policies are the same. What are the various options and features—and which ones do you really need? A guide to buying disability insurance.

Disability income policy benefits replace occupational income lost as the result of a disabling accident or sickness. The object of each policy is to give the disabled insured an income stream to replace wages lost due to the disability. Generally, the maximum amount of disability income that can be purchased is 60% to 70% of occupational earnings.

The intent of this article is to discuss the risk of income loss due to disability, important disability policy provisions, and disability insurance policy purchase recommendations.

The Risks of Becoming Disabled

An important aspect of any insurance is the likelihood that the event being insured against will occur. What is the risk that the average individual will suffer a disability?

According to one disability insurance brochure: the "probability of at least one long-term disability (90 days or longer) occurring before age 65 is: 50% for age 25; 45% for age 35; 38% for age 45; and 26% for age 55." However, one article on disability insurance (appearing in Financial Planning, May 1989) states that, according to the U.S. Public Health Service, lawyers, accountants, physicians and dentists had a 4% incidence of a disability lasting 60 days or longer during their careers. Unfortunately, research has proven unsuccessful at obtaining any useful morbidity (sicknesses and accidents) statistics from various insurance companies selling disability insurance policies that would clear up this discrepancy.

Most likely, the first claim applies to the general population, not specifically to the professional occupations (such as physician, lawyer and business executive). However, farmers and construction workers—physicians and business executives—would be hard pressed to find any company that has a disability insurance policy they could buy. This speculation is supported by disability insurance policy premium rates relative to potential benefits. If morbidity rates were anywhere near what the brochures claim, companies selling disability insurance policies would be insolvent.

How should disability insurance be viewed? As with other insurance, it depends on the extent of existing savings and the number of people dependent on the worker for support. A young physician with several children, for example, should consider disability insurance a necessity. However an older physician who has sufficient assets to protect himself and family from a loss of income due to a disability is in less need of such a policy.

Policy Options

Disability insurance has important policy options from which the insured can select. The premium cost of the policy will depend on the policy options selected. With proper attention to rational risk management, consumers can customize their coverage to meet their particular needs.

Although the risk of a disability lasting more than five years is very low, I would not recommend that a young professional select such a short benefit period. The greater concern here should be the catastrophic disability situation.

For most individuals, optimal coverage would be (when available) lifetime for an accident-induced disability and to age 65 for a sickness-induced disability. My rationale is that an accident-induced life-long disability may not reduce the insuredís life expectancy, while a life-long disability caused by sickness probably will.

However, there is at least one situation in which a five-year benefit period may make sense: If you are fortunate enough to be a child of wealthy parents and stand to inherit a substantial sum, say, more than $1 million, in the not too distant future. A five-year benefit period may be rational in this situation, because the chances of a disability lasting longer than five years is very remote, but if it did the large inheritance in the future would provide a secure asset base.

For most young professionals, a 90-day period is a good compromise between accessing benefits earlier and lower premiums. For young professionals who may have several young children, a spouse who works only in the home and perhaps are still paying off college loans, a 30-day waiting period may be appropriate. But this short waiting period should be increased as soon as the family is able to financially handle the longer waiting period.

As professionals progress in their careers they should reassess disability income insurance needs. If significant assets have been accumulated allowing for a good deal more disability income self-insurance than was possible when they were young, professionals should probably reconsider their waiting period. Waiting periods of six months or a year could be considered if invested assets could provide income protection for these periods and beyond. It may be discovered, however, that with existing coverage purchased at a much younger age, the difference in premium between a 90-day wait and six months may not be sufficient to warrant the change. But, if new coverage is being purchased, the longer waiting period will provide a significant premium savings.

Residual benefits pay a percentage benefit based on the amount of income loss. For example, if the insured has a disability income policy (with a residual benefit) specifying a total disability benefit of $6,000 per month and he can only work part time because of his disability, thereby suffering a 50% reduction in income, the residual benefits are $3,000 per month, or 50% of his specified monthly benefits of $6,000.

Residual benefits are very important for two reasons. First, the incidence of partial disabilities with a loss of income is significant. How significant this risk is is difficult to judge because insurance companies are reluctant to give much information. One company, however, told me that their claim experience has been that 47% of the benefits they pay out are residual benefits. Second, without residual benefits, insureds who are recovering and able to work part time would be faced with the dilemma of either continuing to claim total disability (and receiving their monthly disability benefits) or going back to work part time (with part-time income) and losing all of their benefits. Residual benefits remove this dilemma.

When evaluating the residual benefits of a disability income policy, two features are very important. The first is the method of calculating pre-disability earnings. Policy provisions that have the effect of increasing pre-disability earnings will later provide for greater partial disability benefits. Some policies, for example, allow pension contributions to count toward pre-disability earnings. The other important feature is indexing pre-disability earnings. The better disability income contracts will index pre-disability earnings, increasing them annually based on the consumer price index or a fixed percentage. Obviously, if pre-disability earnings are indexed, the insured can receive larger part-time income without it affecting his residual benefits.

Good disability income contracts donít require the insured to take an income-paying job in another occupation if he is unable to return to his previous occupation due to his disability. For example, if the insured is a surgeon whose disability affected her hands, a good disability income contract will not require her to take another job she is qualified for or lose benefits. On the other hand, as mentioned above, residual benefits may motivate the surgeon to teach, or to start a family practice and not lose the benefit of the disability income policy. Do not purchase a disability income policy with residual benefits that can require you to take a job in another occupation if you are qualified.

Good disability income contracts have zero days in the qualification period. Do not buy a disability income policy that has a qualification period. There are too many diseases that are progressive and have no total disability at the beginning. Under such circumstances, a qualification period of, say, 30 days would prevent the insured from receiving any residual benefits.

I have always been something of a heretic about this issue. It seems to me that own occupation provisions arenít insurance, but more like a lottery. For example, if a young surgeon earning $300,000 with disability income policy monthly benefits of $15,000 suffered a disabling injury to his hands and after some retraining opened a family practice earning $150,000 annually, he would be entitled to his full disability income monthly benefits. He is able to profit from his disability income benefits.

I prefer the use of good residual benefits on the disability income policy, and generally recommend that individuals forgo the own occupation provision, which results in a premium savings of approximately 10%. Using the example of the surgeon above, the move to become a family practice physician would be entirely his; the insurance company could not force this decision. His loss of income is 50% ($300,000 divided by $150,000), and therefore his residual benefits would be $7,500 per month (half of his total benefit of $15,000 per month). Residual benefits provide protection against a loss of income, which is exactly what disability income insurance is supposed to do.

You may think I am being idealistic when trying to convince everyone to prefer a monthly residual benefit of $7,500 to an own occupational benefit of $15,000. Iím not. The cost/benefit ratio of own occupation disability income provisions doesnít favor the policyholders in the aggregate. Many professionals purchasing disability income insurance with the own occupation provision wonít ever become disabled: some will have a short-term disability, but few will have a long-term disability and even fewer will have the type of disability situation described above. The additional 10% premium cost in the aggregate isnít worth purchasing a benefit that allows a very few to collect extraordinary benefits not related to their loss of income.

This is insurance on your ability to purchase more insurance later. What will they think of next? Some disability income policies have automatic benefit increases (and automatic premium increases, naturally).

Table 1. Disability Income Policy Options
Policy Option Description of Option For the Typical Individual
Benefit Period Period of time the insurance company is obligated to pay the monthly disability benefits. Commonperiods are: five years, to age 65, and lifetime. Lifetime for accident-induced disability, to age 65 for sickness-induced disability
Waiting Period Period of time from the commencement of the dis- ability to payment of monthly benefits. Common waiting periods run from 30 days to one year. 90 days
Residual Benefit Pays a partial benefit when the insured is not totally disabled. Residual benefits are a percentage based on the amount of income loss. Highly recommended, but make sure you are not required to take a job in another occupation if you are qualified
Qualification Period Period of time the insured must be totally disabled before residual benefits can begin. 0 days
Own Occupation Provides for 100% of disability income benefits if the insured is unable to return to the duties of his specific occupation even if insured earns income from another occupation. Unnecessary; residual benefits option is preferred
Cost of Living Total disability and residual benefits each year are increased by a specified percentage or by the CPI; does not increase benefits prior to the commencement of a disability claim. Expensive; can be foregone
Future Purchase Options The right to purchase additional amounts of monthly benefits at regular intervals without the insurance company inquiring about the individualís health. Unnecessary

Tax Considerations

The amount of monthly disability income benefits available are generally 60% to 70% of an insuredís earned income. This is an approximate aftertax replacement of the insuredís income. Disability income benefits are tax-free unless the premiums have been deducted by the purchasing corporation (many professionals operate as a corporation). Deducting the annual premiums is a great temptation. However, I caution that this not be done. Individuals are much better able to weather the financial consequences of not taking a disability income premium deduction when they are actively working than they are to handle the taxation of their disability benefits when they are unable to earn income due to a disability.

The disability income insurance market is very competitive, with companies coming out with new and improved policies. UNUM and Paul Revere Insurance Company have excellent disability income policies that stress the importance of residual benefits. Both are full-commission policies and must be purchased from a salesman. USAA has a low-load, no-commission disability income policy that they refer to as an income replacement policy. You can deal with USAA directly by calling (800) 531-8000.

Peter Katt, CFP, LIC, is sole proprietor of Katt & Co., a fee-only insurance adviser located in West Bloomfield, Michigan. His book, "The Life Insurance Fiasco: How to Avoid It," is now available through the author.

© AAII Journal November 1992, Volume XIV, No. 10