Companies that sell disability income insurance policies sometimes offer a “settlement” or “buyout” paid as a lump sum when a client enters a claim. While potentially beneficial to the client in the short term, the settlement may ultimately be to the individual’s detriment if the payout undervalues the policy’s future potential benefit (i.e., what the client would otherwise receive in the form of a monthly check to, say, age 65 or life expectancy).
Before agreeing to such a deal, clients and their advisors need to determine a policy’s actual worth. They also need to ascertain the pros and cons of a buyout, taking into account, among other things, the client’s near- and long-term financial needs and goals; and the opportunity costs of forgoing a lump sum payment.
Putting a price tag on the policy
How does one determine a disability income policy’s worth? The number to start with is the disability income policy’s “present value,” which is determined by the insurance company’s reserves and a discount factor that represents “unearned interest” for future years. If the policy includes a cost of living (COLA) benefit, the insurance company may pay it as “simple” or “compound” interest, depending on the contract. (Almost all COLA benefits level out at age 65.)
After reducing the future potential benefit to the “present value” and applying an interest factor, the insurance company makes an additional reduction for mortality (when the insurance company thinks the client will die) and a morbidity factor (if the insurance company thinks the client may go back to work). The insurer will apply a further discount to provide a “profit margin” and, thus, justify the buyout. The lower the offer is the higher will be the profit margin.
An actuary experienced in disability claims should be used to work up numbers for your client. Finding one may be difficult since those currently working for insurance companies are usually not available to claimants. However, they can be found–and the right actuary can make a difference in the numbers.
Why do a buyout?
There are many reasons to consider a buyout and all are unique to your client’s personal situation from both an emotional and financial standpoint. After securing buyout figures, the client should consult with a financial planner since the planner will most likely have a broad overview of the client’s financial picture, including goals and aspirations. Some of the reasons to consider a disability buyout are:
(1)Tuition money is needed for college-age children and the claimant’s long-term goals have to be set aside to take care of short term obligations.
(2)A financial investment may arise that will provide substantial gains in the future and may not be available at a later date.
(3) The claimant desires to enter a business and employ skills and education that do not conflict with his or her medical symptoms.
To weigh against the above advantages are negative aspects of a buyout. Some of the reasons a client should reject a buyout offer include:
(1) The client has a “lifetime payout” in his or her occupation and a family history of longevity.
(2) The client may squander the money foolishly by making bad investments or exercising bad judgment, in spite of your best advice.
(3) Friends or relatives may jump out of the woodwork to ask for money funded from the lump sum payment that should be used for long term investment purposes.
Following are typical figures from an actuary related to a recent disability buyout:
The claimant, born in 1960, is disabled due to carpal tunnel syndrome and cervical problems dating from August 1996. He has a disability income policy with lifetime benefits and cost of living adjustments (COLAs) to age 65. His original monthly benefit, before COLA, was $18,550.
Currently aged 46, he has a life expectancy to age 79.2, according to recent Society of Actuaries standard mortality tables. With the COLA already applied, his current benefit is $25,228. Connected to the consumer price index (CPI), the COLA has a 4% minimum increase and has been assumed to be 4% in the future. The client’s maximum payout, including future 4% COLA increases, would be $14,383,240.
If these benefits were received today, discounting at a 5.50% interest rate, the value would be reduced to $5,940,352, or 41.3% of his maximum anticipated payout. The reduction in value is significant because of his young age and long expected lifetime.
The insurance company will hold reserves based on the 1987 Commissioner’s Group Disability Table and is allowed to include additional morbidity factors. This reduces the value of benefits to $4,058,169 or 28.2% of his full payout. Again, this reduction reflects the client’s young age, which according to the standardized insurance table, projects a chance of recovery from the disability.
That prognosis may or may not apply to this claimant. Finally, the insurer might settle this liability for approximately 80% of the reserve. That equates to $3,246,535, or 22.6% of his maximum payout. (See chart.). Assuming that a buyout makes sense in all other respects, a claimant should consider accepting this offer.
When to partner
A disability buyout can provide your client with additional funds to meet short- and long-term objectives. But a reasoned analysis of an offer and the negotiating skills required to reach a satisfactory settlement requires specialized expertise. If, as the client’s financial advisor, you find the process difficult to manage on your own, then you would be wise to partner with someone who has the requisite expertise.
Knowing when and where to go when outside counsel is needed will enhance your credibility and separate you from those who act less professionally. Clients will show their appreciation by remaining loyal–and keeping the referrals coming.