Most working Americans’ greatest assets are not their homes, nor their pensions, nor even their health and fitness, it is their human capital; their ability to work and produce an income over their lifetimes. When family breadwinners die (prematurely), their families are left to fend for themselves without the breadwinners’ financial support, unless of course, the families have life insurance policies on the lives of the breadwinners that will pay death benefits sufficient to replace the lost incomes.
As bad as an early death of a breadwinner may be to a family, it actually can get much worse, at least in financial terms. When breadwinners suffer serious long-term or permanent disabilities, their families not only lose their breadwinners’ income streams, but also, in contrast with when the breadwinners’ die, they continue to incur the direct and indirect costs of feeding, clothing, housing, and caring for (which often involves additional uninsured medical expense) the disabled breadwinner. Although the problem is less severe, even single workers must worry about how they will support themselves in the event they suffer a serious disability. Basically, disability is a double-whammy risk that has led some in the insurance industry to describe such serious long-term or permanent disabilities as a living death.
Disability Income (DI) insurance is living death insurance designed to provide benefit payments (salary replacement) when the insured individual is unable to work due to a disability. Disability may result from either an injury or an illness. DI policies have an elimination period, or waiting period, until benefits commence after the insured becomes disabled. The waiting period is often 90 days, but policyowners usually can elect shorter or longer waiting periods with corresponding changes to premium charges. Insurers usually limit the benefit payments to an amount less than 100 percent of the individual’s salary, typically about 60 percent to 65 percent of income.
Individuals may acquire their disability income benefits through a group insurance plan provided by their employer or they may purchase it as an individual policy. Although disability income policies offered by different insurers have similarities, they also differ in substantial ways from one policy to the next. Disability income policies are contracts and the provisions within may vary. Before purchasing a disability income policy, the potential policyowner should carefully review and understand the policy’s provisions.
Q: What definition of disability does the government use to determine one’s eligibility for disability benefits under Social Security?
A: Disability for Social Security purposes is defined as the inability to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment that can be expected to result in death or can be expected to last for a period of at least 12 months or longer. This is a fairly difficult definition to meet because it requires that disabled individuals be so severely disabled that they not only be unable to work at their previous occupations or professions but be unable to engage in any kind of gainful employment at all.
Q: What is the regular care and attendance of a physician requirement?
A: Generally, an element of meeting the definition of disability under a disability income policy is that the insured person must be under the care of a qualified physician in order to continue to receive disability income benefit payments.
Q: Are disability income benefit payments subject to FICA and FUTA tax?
A: Payments made to disabled employees by either an employer or an insurer are subject to social security tax (FICA) and federal unemployment tax (FUTA) for the first six months after the last month in which the employees worked for their employers. After six months, such payments are exempt from Social Security and federal unemployment tax. However, if the employees contributed to the plans that pay the benefit payments, the portion of such payments attributable to the employees’ contributions is not subject to Social Security tax.
Q: Are disability income benefit payments subject to income tax withholding?
A: While the tax laws generally require employers to withhold income tax from disability income benefit payments, the tax rules do not require withholding on benefit payment amounts that the employees can excluded from their income. Further, if an insurance company or other entity under an accident or health plan makes the disability benefit payments, the tax rules require no withholding of income tax.
Q: How is a disability income benefit received under a life insurance policy treated for income tax purposes?
A: When policyowners receive disability income benefits under a disability rider attached to a life insurance policy, the tax rules treat the amounts as separate accident or health benefits and not as proceeds from the life insurance policy. Thus, such benefit payments are excludable from income as “amounts received through accident or health insurance … for personal injury or sickness.”
Q: What is disability buy-out insurance?
A: Disability buy-out insurance is designed to provide coverage funds to buy out the disabled individual’s interest in a business upon the total and permanent disability of a shareholder or partner.
Because of the many factors involved as well as the increased potential for adverse selection and moral hazard, insurers underwrite these policies very tightly and require the businesses and the key employee-owners to meet stringent business, financial, and personal standards before they will permit a business to purchase this type of coverage. For example, insurers typically require a company to have been in business for a certain amount of time, to have consistent profits and revenues, and stable and strong management before they will issue a disability buy-out insurance policy.
Q: How much does disability insurance cost?
A: Disability insurance is priced according to several factors. The price will depend on the length of the elimination period, the maximum benefit period, age, optional riders, premium structure, occupational class, avocations, gender, state, health, level and type of coverage, and benefit amount. As a rule of thumb, individuals considering the purchase of a quality long-term disability income policy can expect to pay about 1 percent to 3 percent of their annual income, but sometimes more, depending on a whole host of underwriting factors.
Q: What are the underwriting basics for disability income insurance?
A: Very few people can sail through the underwriting process. It is not easy to obtain maximum coverage at competitive rates. Insurance agents specializing in disability insurance will work diligently with the underwriter to provide the best disability coverage available from the insurer. But, having said that, insurance companies will not offer coverage to just anyone because they see some people as being too risky, or as a potential “claim waiting to happen” under the disability insurance contract. Also, even if the insurer is willing to offer a contract, many conditions require the disability insurance company to limit the benefit period, extend the elimination period, add an exclusion rider, or add an additional rated premium onto the policy.
People who are thinking about getting disability insurance need to keep an open mind going into the process. Relatively few people come out of underwriting with a preferred risk discount, even if a life insurer has recently offered them a preferred-risk discount on a life policy. Life insurance and disability insurance underwriting differ in a number of significant ways. The disability insurance company must assesses the probability of insureds becoming unable to perform the material and substantial duties of their regular occupations or professions, which is much more involved and complex than evaluating the comparably simpler and predictable odds of insureds dying in the next few years. Items such as chiropractic visits, arthritis, back problems, neck pain history, mental or nervous counseling, use of anti-depressant medication, and many other conditions play a major role in disability insurance underwriting.
Q: Do any insurance companies offer temporary disability insurance?
A: The authors are not aware of any companies that offer temporary disability insurance. Upon reflection, at least one reason such insurance plans are rare or nonexistent seems pretty obvious. With health insurance coverage, such as when people are between jobs, or even one-year or other shorter-term life insurance policies (which are typically renewable and convertible into long-term permanent policies), the risks to the insurer can be high, but manageable and predictable, with the potential for temporary buyers to become purchasers of long-term continuing coverage policies.
With a temporary disability plan, the policy would remain in force for only a temporary period, say until the prospective insured’s employer establishes a LTD plan in the coming year. So the insured would be planning to keep the policy in force and pay premiums only for a year or so. However, with disability income insurance the risk generally is extremely long term, because a disability occurring during the temporary, premium-paying period while the policy is in force could involve the insurer having to make benefit payments replacing 50 percent, 60 percent or more of the insured’s earnings for many years, until the insured reaches age 65, usually. It would be hard for the insurer to even design a plan with low enough premiums to make a temporary plan feasible.
However, a few insurers (Guardian, for example) offer a slightly different product, called a short-term disability program, in most cases involving group disability insurance sponsored by employers. More insurers also offer what is called supplemental disability insurance which is designed to be an additional tier of coverage on top of a primary disability income policy, which the employer usually provides. Short-term DI and supplemental DI are discussed further in questions below.