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12 facts you should know about disability insurance

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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.

See also: Disability insurance: Addressing the facts with clients

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.

Q: Would employees be wise to consider purchasing supplemental disability income policies if their employer’s long-term disability plan does not provide the level and kind of long-term disability benefits they desire?

A: Group long-term disability insurance typically covers around 60 percent of base salary to a monthly maximum benefit of $5,000 or $10,000. The actual policy definitions typically are more restrictive than the definitions in an individual disability insurance plan, and if the employees’ company is making the premium payments for the employees, then the benefits are taxable during a claim. In many cases, after subtracting taxes, the net benefit might be 45 percent to 50 percent (60 percent minus taxes) of the disabled employees’ incomes, with restrictive provisions and definitions. In addition, such insurance plans usually are not portable — the plan does not permit employees to take their disability income coverage to another employer. For many employees this arrangement is not optimal, either in terms of the amount of coverage or in the flexibility of the plan. This is where supplemental disability insurance can help fill the employees’ needs.

A supplemental disability insurance policy can increase the percentage replacement of income up from the actual 45 percent to 50 percent (60 percent minus taxes during the claim), can guarantee the ability to have portable disability insurance, and can likely one more comprehensive disability coverage.

Many group long-term disability insurance plans have very restrictive definitions that define when an employee gets paid for a disability claim. Typically the policy defines disability in terms of one’s own-occupation for only the first two years in a claim, then it changes to a gainful occupation definition of total disability. Usually, group LTD policies also have a limited partial disability benefit and, generally, do not offer any inflation protection as well.

Insurers offer supplemental disability insurance policies that can have a more comprehensive definition of total disability, a significantly better residual disability rider, and can also help protect against inflation with the addition of an optional Cost of Living Adjustment Rider (for extra premiums).

Remember, people sometimes make a huge mistake thinking that they will always be insurable. This type of insurance is not something that is easy for anyone to get. Without even realizing it, many people may be unable to obtain a supplemental disability insurance policy even now. The insurer will review detailed medical records to make sure applicants do not already have a potential disability. Even people who are perfectly healthy now, have no assurance that they will be healthy a year from now. They could develop back problems, diabetes, a heart condition, or some other condition that prevents them from getting a policy or complete coverage. By purchasing a supplemental disability insurance policy people can guarantee themselves they will always have income protection no matter how much money they earn, what company they work for, or what medical condition they develop in the future.

Q: What is short-term disability insurance and how does it work?

A: Short-term disability insurance generally is an employer-sponsored group plan. It pays a specified percentage of disabled employees’ salaries for a specified amount of time if they become ill or injured and cannot perform the duties of their job. Benefit payments usually commence anywhere from one to 14 days after employees suffer a condition that leaves them unable to work. Many times, the plan requires employees to use up sick days before short-term disability kicks in, if they have an illness that keeps them out of work for an extended period of time. This provision is why the plan usually has a different policy for short-term disability caused by sickness versus injury.

Sometimes the employer pays the premiums, sometimes employees pay the premiums, and sometimes the employer and the employees split the cost of premiums for a short-term disability policy. More often, though, short-term disability coverage is employer-paid. Companies do have a choice of having employees pay in whole or in part for coverage, with certain tax implications.

Basically, group coverage for short-term disability can be attained in two ways:

•     Contract agreement through an insurer that covers disability.

•     Through a self-funded plan set aside by the employer directly.

Employers can create a policy dictating that employees must use up sick days before going on short-term disability for an extended illness. They frequently also require documentation from a doctor to prove an illness or injury.

Different short-term disability plans dictate different terms for qualifications. The main terms are listed below:

•     Employees need to work for the employer for a certain amount of time before coverage kicks in.

•     Employees need to work full time or near full time, usually 30 hours or more a week.

The following features are part of what a short-term disability plan benefits package may include:

•     Percentage of weekly salary paid out (typically between 50 percent – 70 percent of weekly salary).

•     Duration of short-term disability benefits (typically between 10 to 26 weeks).

•     Maximum amount of time covered under this disability program.

While most states do not require employers to provide short-term disability benefits, some states, such as Hawaii, New Jersey, New York, and Rhode Island mandate that companies above a certain size (in employment) provide short-term disability benefits for up to 26 weeks.

Q: What is business overhead expense disability insurance?

A: Insurers designed business overhead expense disability insurance with the cash-flow needs of (generally small to medium sized closely-held) business owners in mind. If business owners should become disabled, business overhead expense disability insurance will help them keep their businesses strong by covering the normal, necessary and customary expenses incurred to run their businesses – including such things as mortgage payments or rent, utilities, salaries, taxes, interest on debt, loan payments and more.

The tax advantages of overhead expense disability insurance include that:

•     Premium payments are tax-deductible as ordinary and necessary business expenses.

•     Overhead expense benefits received during a period of disability are taxable upon receipt: however, they are used to pay business-related expenses that are tax-deductible, so the net tax impact is neutral.

Business overhead expense disability insurance is a complicated product, so business owners should take great care to figure out what expenses they need to have covered. Generally, they should not buy overhead expense insurance for their total monthly overhead. For instance, if the business’s monthly overhead is $25,000, the business owner should determine which of these fixed expenses would continue in the event of his disability. Business owners should take time to review their Schedule C’s and/or cash-flow statements to find the expenses that would indeed stop or diminish in the event of the business owner’s disability. To keep the costs within reason, business owners should make sure they only purchase an amount they truly need during a disability. The selling agents and underwriters typically will make recommendations on monthly benefits during the underwriting process.

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