The ins and outs of Disability Insurance
When you’re disabled, your income stops – but your bills don’t.
What is Disability Insurance?
Disability insurance provides you protection against loss of income where an accident or illness causes you to be disabled. Without an income and other financial resources, you may face financial hardship.
Disability insurance policies are not easily comparable from one insurer to the next. That’s because a contract is comprised of a number of provisions any one of which may differ from one policy to the next.
To determine the adequacy of a policy, you’ll need to understand provisions that deal with:
- Benefit eligibility (What’s the definition of total disability? And if you’re only partly disabled, would you still be eligible for some benefits?);
- Period of time from the onset of a disability until benefits begin (otherwise known as the Elimination Period)
- Amount of benefits payable
- Duration of payment of benefits (also called the Benefits Period)
- Whether benefits are indexed for inflation?
- Whether you’ll have to go through a second waiting period if you become disabled a second time (also called Recurrent Disability)
- Contract variation and renewability – Can the contract provisions or premium change from year to year? Or worse still, can the insurer choose not to renew your policy?
In addition, you might also want to know about each insurer’s:
- claims paying experience – do they frequently challenge and delay payment of claims?
- financial stability – will they be around should you become disabled and have to rely on receiving benefits for many years into the future?
Every disability insurance policy from every insurance company is very different – this is not a product to simply shop for the most competitive rate. To buy the cheapest disability insurance policy on the market is to throw money away. The odds of getting paid a monthly benefit under a cheap contract may be significantly lower than receiving benefits from a quality contract.
To help guide you through this complex area, we’ll go through some of the key contract provisions. But before we get underway, we’ll first talk about how we figure out how much disability insurance you might need. And we’ll also discuss other benefits – like government and employer benefits which could reduce the amount of coverage you might need.
How much do you need?
There’s no simple way around it, you have to do a budget to figure out what you reasonably need to survive.
You should begin with your current budget. Normally one begins with your needs while working and then you modify those amounts as if you’re no longer working. And you also exclude items you can live without. We also look at whether you’d trade down your home or sell other assets that could be used to cover needs. Once you’ve mapped out your living needs, we then do a Cashflow Projection that compares your current resources against your needs to determine how much, if any coverage, you might need.
What about government benefits?
Depending on the nature and severity of your disability and your participation in certain government programs, you may be entitled to benefits from Workers’ Compensation , Employment Insurance Sickness Benefits and CPP Disability.
We don’t include these benefits in the projection as they provide very limited benefits for a very limited duration:
- Workers’ Compensation only covers for work-related injury or diseases;
- EI Sickness benefits pays a relatively small amount of money for up to only 15 weeks if you pay into EI; and
- CPP Disability, if you qualify requires your injury or disease to be severe and prolonged.
What about employer benefits?
Many employers provide disability coverage that contain three components:
- i) Sick Leave: If sick or injured, you receive full pay for a short period – usually a few days to two weeks. This is uninsured coverage that’s normally provided by your employer at no cost to you.
- ii) Short Term Disability (also called “Weekly Indemnity”): This begins when your sick days run out. Most plans pay a percentage of your salary, for example 70%, up to a stated dollar amount. Benefits are taxable and usually run 15, 26 or 52 weeks.
iii) Long Term Disability (LTD): This coverage starts when Short-Term Disability runs out (usually one has to be continuously totally disabled for 120-days to qualify – this makes it tough to become eligible). Benefits typically replace 60 to 70 percent of your salary, to a maximum dollar amount and are normally payable up to two years. Thereafter total disability definition changes to exclude all but the most severe disability situations. And even in these extreme situations benefits are normally terminated at age 65.
Benefits are tax-free if you pay for the entire premium; otherwise benefits are taxable as regular income.
- The cost per dollar of benefit is normally low compared to private coverage
- You’re automatically covered up to the non-evidence maximum – there’s no health exclusions or riders. This is a tremendous advantage if you’re in poor health.
Most group plans don’t have the following features:
- cost of living benefits (benefits are not indexed when you’re on disability),
- partial or residual benefits (if you’re only partially disabled and working you don’t get any benefits),
- portability options (if you leave your job or are terminated, you can’t take the policy with you – and if you’re in poor health, you could have problems qualifying for individual disability).
Not only are they missing those desirable features, they will usually contain the following undesirable features:
- 120 days of continuous total disability (a Qualifying Period) – this makes it extremely hard to qualify for benefits. Any break in the continuity means you’re back at day one in the waiting period.
- low dollar level of maximum benefits and income definition of salary (“normal income”) – as a result, high-income earners may end up being under-insured. The base salaries of many executives and high-producing salespeople are often only 20 to 75 percent of their overall compensation with the balance of their income received in the form of bonuses, stock option, etc. Business owners can take out dividends and split their income with family members. Yet this additional income is usually not acknowledged in the structure of the typical group LTD.
- change in the definition of Total Disability to Any-Occ after 24 months – this is the biggest problem since someone has to be very ill to be on claim for 24 consecutive months, yet the insurer can still jettison you at the beginning of the 25th month.
- premiums are subject to change, ie., if the group has claims, the premiums will rise significantly. And even if there are no claims, as the members of the group age, the group rate will rise to reflect the increase in age.
If your employer provides you with group benefits and you have a need for disability coverage, we’ll want to review your disability policy and what options you have to improve the contract. If you need disability coverage, we want to make sure you aren’t throwing away your money for a poor contract. Here we’ll not only examine your policy, but also consider:
- “untainting” your policy (by fully paying premiums) so benefits will be tax-free;
- choosing to pay for better definitions or increase coverage limits (you might have to provide evidence of insurability); and
- explore individual disability insurance policies to find something that makes sense for you. And we’ll do it in a way to complement your existing group coverage.
In the remainder of this article we’ll go through what we consider as key definitions for disability insurance policies (this applies to both group and individual/private policies). This should give you some idea of what your advisor looks for in helping you identify an appropriate policy.
- Total Disability
To qualify for disability benefits, you must meet the definition of total disability. You need to know the exact language of this definition. There are three basic definition types:
- Modified Own-Occupation
- Any Occupation
- Combination Definitions
- A) Own-Occupation (“Own-Occ”) also called Your-Occupation (“Your-Occ”)
This is the most comprehensive and most favorable definition of total disability available. This type of policy will have a definition that says:
“You are considered totally disabled if, due to sickness or injury, you are unable to perform the material and substantial duties of your regular occupation .”
Own-occupation disability insurance is the only plan that does not penalize you for going back to work in a different occupation while on a claim. Under this type of plan, the bottom line is that if because of a sickness or injury you cannot perform in your occupation, you will be considered totally disabled, even if you choose to do something else.
- B) Modified Own-Occupation
The “Modified Own-Occupation” is the most common definition of current DI offerings. This type of policy will have a definition that says:
“You are considered totally disabled, if solely due to sickness or injury, you cannot perform the material and substantial duties of your regular occupation and you are not working in any occupation.”
Basically it says that if you can’t work in your regular occupation because of sickness or injury, you’ll be paid your full disability benefit. However, if after the disability, you choose to work in another occupation, then you are no longer totally disabled. If the policy has a Residual Disability clause, then you might receive benefits based on your percentage loss of earned income.
I’d suggest you don’t get a policy with this definition if you can get the true “own-occupation” contract. If you become totally disabled and then switch to a new career, then you’ll be punished financially. Once you hit the 70% to 80% of your pre-disability income threshold, disability benefits completely terminate. Disability income policies usually provide coverage for between 50-60% of earned income. So, you’ll be hurt financially if you choose to go back to work in another occupation.
- C) Any Occupation (“Any-Occ”)
This is the worst definition available. A typical definition will look like this:
“You are considered totally disabled if, due to sickness or injury, you are unable to perform the duties of any occupation for which you are suited (or deemed reasonably qualified) by education, training and experience.”
In my opinion, a policy with this definition is worthless. The insurance company has the right to determine what “suitable” or “reasonable” occupation you could work in. If you could flip burgers at McDonalds or work as a parking attendant cashier, it is doubtful that you’ll receive any benefits under this policy. They’ll simply deny your claim.
- D) Combinations
Some policies contain a combination of definitions of total disability. Basically, they provide a definition that reads something like this:
“For the first 24 months of a covered claim, you are totally disabled, if due to sickness or injury, you are unable to perform the material and substantial duties of your regular occupation. Thereafter, the definition is the same as above plus you are not working in any gainful occupation.”
This type of combination is commonly found in employer sponsored group long-term disability insurance policies. Basically, you really only have 24 months of “true coverage”. Thereafter you’ve got to be practically a vegetable in order to continue to collect anything under this policy.
The first aspect of any disability insurance policy one needs to understand is the renewability feature. There are three basic types of renewability on the market today.
- A) Non-Cancellable and Guaranteed Renewable
It is important that the disability insurance policy be a non-cancellable (“non-can”) guaranteed renewable policy. Under this type of policy, once the policy is issued (“in-force”) and the premiums are paid, the insurance company cannot: (i) cancel the policy, (ii) increase premiums, (iii) make changes to the contract terms, (iv) reduce benefits, (v) change your occupation class.
In other words, once the policy in-force that there will be no changes to your premium schedule, your monthly benefits, or your policy benefits to age 65 or a certain age. The insurance company legally can’t change a thing unless you want them to.
Many people do not have a guarantee that their income will never go down again. Under a Non-Cancellable policy even if your income goes down later in life, if you are totally disabled the company will pay you the total disability benefit you originally placed in-force. Under a Non-Cancellable policy even if you changed jobs from being a white collar, low-risk occupation to a professional weight lifter the company could not change your benefits for the worse.
- B) Guaranteed Renewable
This type of renewability feature is a big step down from Non-Cancellable and Guaranteed Renewable. The insurance company must renew the policy but can raise the premiums (where it is a group; it must be raised for everyone in that group). Similarly, the insurance company may be able to change the policy wording.
- C) Conditionally Renewable
A conditionally renewable policy offers you no guarantees. Here the insurer can decline to renew the policy, change policy wording or charge more (to reflect previous claims). Stay away from these policies!!!
- Residual Disability Insurance
Residual – You can still perform the material and substantial duties of your occupation, but you have a loss of income of at least 20%.
Many disability insurance claims either start or end in a residual claim. The basis of a residual claim is that a person is still actively engaged in their occupation, but because of a sickness or injury is:
- Suffering a loss of time and duties
- Suffering a loss of income of at least 20%
As you can see there are two major types of a residual claim. One is based on a loss of income only, and one is based upon a loss of time and duties. A residual disability provision which is based on loss of income is better. You want the bottom line to your residual claim to be that the insurance company will continue to pay you until your income is back up to what it was before you were disabled. Under a loss of time and duties claim they generally stop paying you once you’re back to work full time. A residual disability provision based on income is like having an unlimited recovery benefit.
A Residual Disability Benefit is better than a Partial Disability Benefit. Under a Partial Definition of disability, you would have to be totally disabled during the elimination period whereas under the Residual Definition of disability, you don’t have to be totally disabled.
- Elimination Period
Elimination Period – The period of time from the onset of a disability until benefits begin.
The elimination period is a fairly easy choice to make. The elimination period is the period of time between the onset of a disability, and the time you are eligible for benefits. It is best thought of as a deductible period for your policy. For an individual disability insurance policy the industry has made the most attractive offer a 90 day elimination period. They will charge you with an extremely high rate if you choose to go with a shorter elimination period of 30, or 60 days. They will give you a price break if you can go longer than 90 days. While the cost of having a shorter elimination period is much higher, you will find that going with a longer elimination period does not save you much money at all for the risk you take on. It is my opinion that insurance carriers set it up so that the logical choice is a 90 day elimination. Most options past 90 days are 180, 365, and 720 day elimination periods. It is important that you understand once the elimination period has been satisfied, you receive actual benefit checks at the end of the month. In reality, a 90 day elimination period means you are four months away from getting any claims dollars on a disability insurance claim.
There are some policies on the marketplace that require an elimination period be satisfied with a total disability only, or with consecutive days of disability. Never own a contract that does not allow an elimination period to be satisfied with either a residual, or a total disability. Also make sure they have an accumulation period so that you can finish your elimination period in the shortest amount of time. Typically an accumulation period allows 7 months for a three month elimination period (2 times the elimination period + one month).
- Benefit Period – How long benefits will be paid
I think the first thing to go over is to define a benefit period. Try to explain what it is, and even more importantly, what it is not. A benefit period is the period of time you are eligible to collect benefits while on a disability insurance claim. If a sickness or injury occurs that prevents you from performing the material and substantial duties of your occupation, the elimination period begins. Once the elimination period has been satisfied, monthly benefit checks will begin to come in at the end of the month. The maximum amount of months that these checks can possibly come in is your benefit period. Your benefits stop when you return to work in your occupation, or depending on the contract to another occupation making the same income.
The most popular choice for a disability insurance policy is To Age 65. Almost 90% of the policies that I see on a daily basis are put in-force with this benefit period. The bottom line is if you are permanently disabled your last benefit cheque is on your 65th birthday. Obviously the lifetime benefit period will be more expensive, but often it is not much more expensive than the to age 65 policy. For those of you looking to save premium dollars on your disability insurance, a five year benefit period will cover the average length of disability which is about 3.2 years. I never recommend a two-year benefit period unless you already have another policy that has a two year elimination period.
- Optional Riders
Optional Riders – Features you can add to a base policy for additional protection.
- A) Cost of Living Adjustment
Often referred to as a COLA rider, this rider only kicks in if you actually go on a disability insurance claim, and then only if the disability lasts for more than one year. Depending on the percentage option you elected when you took out the policy, it will increase your monthly benefit every year while you are on a claim along with the CPI up to the maximum you elected. It is quite often the most expensive rider available on a disability insurance policy. I normally do not recommend this option to people over the age of 42. It is designed to protect you against inflation, at after age 42 you are not as much at risk for inflation as you were in your younger years. I would recommend saving your money here unless you are younger, and must have this option because a permanent disability would devastate you.
- B) Future Increase Option
The is an optional rider offered by most carriers to protect your future earnings. Without this rider, or an automatic increase rider, there is no way to protect your future earnings without evidence of insurability. A disability insurance policy by itself only protects the amount of income that one makes at the time they take out the policy. It does not grow automatically unless you have this, or an automatic increase rider. This rider locks in/guarantees your insurability for a certain period of time (normally to age 55). So as you increase in age, and increase your income level, you can increase your monthly benefit regardless of any health changes. Usually the only thing you need to provide when increasing your monthly benefit is a copy of the most recent tax return to prove your new income level. But the most important thing this rider protects is all the money you may make in the future. The worst thing that could happen to you is to take out a small disability insurance early on in life, with no future increase option. Then ten years down the road there is a change in your health history that prevents you from getting anymore disability insurance. You’d be real upset that you did not get future increase option then.
- C) Automatic Increase Rider
This is a simple rider that serves a simple purpose. It increases your total monthly benefit each year for about five years. Your premium will go up with this rider each year because you are buying more disability insurance coverage. Generally they give you about a 25% increase in coverage over five years. The idea is to have your coverage increase with inflation over time without you having to pay attention to it. In terms of recommending this rider, it is simply a choice for you to make. If you want your coverage to increase, then get it.
- D) Presumptive Disability
Presumptive – Regarding loss of sight, speech, hearing, or any two limbs
The definition of presumptive disability varies among contracts. Some contracts do not even have a presumptive disability insurance provision. The basic idea of presumptive disability is to protect against drastic disabilities that occur suddenly. They generally protect you against the loss of hearing, sight, speech, or the use of any two limbs. This is not a provision for which you pay an extra premium, it is built into most contracts. The main differences are in the definition language, specifically in the words; Total, Permanent, Irrecoverable. A total loss of sight, speech, hearing, or the use of any two limbs is a lot different from an irrecoverable or permanent loss. Total losses protect you from temporary loss of site, speech, hearing, and broken limbs. An irrecoverable loss is just that, the disability must be permanent. All contracts that have a presumptive disability provision pay first day benefits for these losses.
- E) Recurrent Disability
Recurrent Disability – After You Recover From One Disability, And Another One Happens
A recurrent disability is exactly as it sounds. You are disabled once, re-cover, then have a recurrent disability. You will find that most contracts have a recurrent disability provision built in. The average provision will say something like this:
“For a recurrent disability, within 12 months, from the same or related cause, the insurance company will waive the elimination period.”
The recurrent disability insurance provision is designed to make sure that a person does not have to go through more than one elimination period within a certain period of time.
Once something goes wrong with the human body to cause a disability, this tends to set off a chain reaction of events. Condition Y will cause the human body to develop condition X over the next few years. With a long waiver of elimination period, you wouldn’t have to prove to an insurance company how one disability is related to another to waive the next elimination period. So the longer the elimination period waiver the better.
The next step
If you have a need for disability insurance or have any questions, please call me at (604) 288-2083 or email me at firstname.lastname@example.org.
Written by Steve Nyvik, BBA, MBA ,CIM, CFP, R.F.P.
Financial Planner and Portfolio Manager, Lycos Asset Management Inc.