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Disability Insurance

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

A. 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 than 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 that 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.

Q: How much disability insurance should I own?

A. 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. The assistance of a professional insurance adviser normally should be sought in making this determination.

Q: What type of disability income insurance is best; insurance covering short-term disabilities only or policies that cover long-term disabilities?

A. Assuming that only one of these types of disability insurance products will be purchased, sound risk management principles would suggest the purchase of long-term disability (LTD) insurance. LTD insurance protects the insured against disabilities that may last many years, or even a lifetime, and thus provides protection against large losses of potentially catastrophic magnitude. Although long-term disabilities occur less frequently than disabilities of a relatively short duration (e.g., several weeks or even a few months), the loss of income for a short duration can be more easily absorbed by the family unit than can an income loss that lasts for several years or longer.

Q: What are the primary differences between short-term disability (STD) and long-term disability (LTD) insurance policies?

A. These two types of insurance coverage 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.

Q: What is an elimination, or waiting period and how does its definition differ between STD and LTD insurance policies?

A. 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.

Q: What is a maximum benefit period and how does its definition differ between STD and LTD insurance policies?

A. 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.

Q: What types of "definitions of disability" are commonly included in STD and LTD insurance policies?

A. 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.

Q: In addition to coverage of partial or total disabilities and temporary or permanent disabilities, what other aspects of a "definition of disability" are important to consider when purchasing disability income insurance?

A. The way in which a disability is defined, especially as it relates to the inability of the insured to perform a particular occupation, 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. Sometimes a "split definition" is used which incorporates an "own occupation" definition for an initial period (e.g., 2 years), followed by an "any occupation" definition thereafter.

Q: Are disability insurance policies available that do not express the eligibility for disability benefits in terms of an "occupational" definition?

A. 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.

Q: Do all disability insurance policies cover losses arising from both accident and sickness?

A. No. Some policies cover only disabilities arising from an accidental injury, providing no coverage for disabilities caused by sickness. A careful reading of the contract is recommended to determine the extent of coverage provided under the disability insurance policy that you are considering purchasing. Sound risk management suggests the purchase of a policy that covers disabilities arising from either an accident or an illness.

Q: What specific causes of disability, if any, are generally excluded from coverage in disability insurance contracts?

A. 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.

Q: The terms "noncancelable" and "guaranteed renewable" are often used when referring to disability income insurance policies. What do these terms imply, and how do they differ?

A. "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. A guaranteed premium is stipulated in the contract and may not be changed by the insurer. During the noncancelable period, the insurer is precluded from canceling the contract or otherwise making any unilateral change in the policy benefits. "Guaranteed renewable" contracts also provide insureds with the right to renew their policies to age 65 (typically) through the timely payment of the premium. However, 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, albeit 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).

Q: What factors affect the premium cost for disability income insurance?

A. 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.

Q: How do the lengths of the waiting (elimination) period and the maximum benefit period affect the premium cost of disability insurance?

A. 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.

Q: Why is it frequently true that group long-term disability (LTD) insurance purchased at work is less expensive than individually purchased LTD insurance?

A. There are a number of reasons why group LTD may be purchased by employees at a lower premium cost than what these same individuals can purchase on their own, away from their place of employment. First, an employer often contributes toward the premium cost of group LTD coverage, thereby reducing the out-of-pocket cost to employees. Secondly, group LTD insurance plans almost always coordinate their benefits (i.e., plan benefits are reduced) with any disability benefits payable under Workers' Compensation or Social Security. In contrast, individual disability income insurance typically pays benefits in addition to any benefits payable under social insurance programs. Third, individual policies often contain a longer maximum benefit period, a "noncancelable" feature, a "cost-of-living" benefit rider, and an option to purchase additional insurance -- expensive features not always found in group LTD policies. Fourth, marketing and sales, administrative, underwriting and other expenses are usually lower for employer-provided group insurance than for insurance purchased individually from an agent.

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

A. 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.

Q: Where can more information on disability insurance be obtained?

A. A free copy of the Consumer's Guide to Disability Insurance can be obtained from the Health Insurance Association of America, 555 13th Street N.W., Suite 600 East, Washington, D.C. 20004-1109.